Who Owns Senior Irish Bank Bonds?

I’d like to pass on a few comments on the question of who owns senior Irish bank bonds, an issue that has been discussed on a number of occasions by Seamus Coffey from UCC.

Here’s a nice chart from Seamus’s blog using data from Table 4.2 of the Central Bank’s Money and Banking statistics. The chart shows that when the September 2008 guarantee was put in place, only €23 billion of the €97 billion in outstanding bonds of the covered banks were classified by the Central Bank as being held by Irish residents while today that share is €50.7 billion out of €77.6 billion.

There are a number of reasons why one should be careful in interpreting these statistics.

First, as I understand it, the Central Bank don’t keep track of secondary market activity in these bonds and so don’t actually know who the current owners of these bonds are. The estimates are largely based on the first holder of the debt when it is issued.

Second, in some cases, the “holder” is a trustee that manages the debt issuance and the subsequent payment streams on behalf of the issuing bank. So, for example, if an Irish bank issues debt that is held by an Irish resident firm Custodian Plc who manage the payment streams, but the ultimate beneficial owner of the debt (who ultimately gets the coupon payments, etc.) is a German pension fund, then the Central Bank statistics will report the debt securities as being held by Irish residents.

Third, much of the €50.7 billion currently deemed to be held by Irish residents is stuff like “own-use” bonds guaranteed by the Irish government. If, however, one is debating the question of failing to pay out on unguaranteed bonds, then you are generally talking about bonds issued prior to September 2008 and these are largely classified in these statistics as “foreign resident” bonds.

Finally, this may be obvious but it’s perhaps worth pointing out that the fact that some of these bonds may be owned by Irish residents is hardly a sufficient justification for using taxpayer funds to redeem them, rather than letting the pension funds or private citizens lose money on a bad investment.

To be honest, the fate of senior Irish bank bonds is probably generating more heat at this point than it should. It seems to me that there is no chance of the government adopting a policy of failing to pay out on AIB or Bank of Ireland’s senior bonds, so what is genuinely at debate is the roughly €4 billion or so in senior bonds outstanding at Anglo and Irish Nationwide. For what it’s worth, I suspect that most of these bonds are currently owned by international hedge funds and distressed debt desks of investment banks. So far, their investment strategy has been working out really well.

In relation to the cost of the banking bailout, an issue that may loom larger in the future than senior bonds is the policy the Irish government should adopt in a potential sovereign default situation to future payments on the Anglo and INBS promissory notes, keeping in mind that their major creditor is a certain Frankfurt-based institution.

U-Turn on Bondholders?

Today’s newspapers contain stories that the government are denying any U-turn in relation to previous commitments on bondholders.

“We have not broken our word,” Mr Noonan said, arguing that all election promises were predicated on agreement being reached at European level.

He said that since the banking crises had emerged Fine Gael had been in favour of burden-sharing and said that it has already happened with subordinated debt.

“We want burden-sharing but we would not do it unilaterally. We would only do it with the agreement of Frankfurt and we did not get it,” he told RTÉ.

“The ECB in Frankfurt has held out solidly that senior bondholders will not be touched. It’s a majority view in Frankfurt. There are governors in Frankfurt who do not hold that view.”

He said the ECB had been “very good to Ireland”, providing almost €200 billion in liquidity. He also added that the Government was reserving its position in relation to Anglo Irish Bank.

He said if Anglo told the Government there was a need for more capital the Government would enter discussions with the ECB on burden-sharing in respect to senior bonds in that institution. But he agreed the Government would not be pushing for renegotiation on senior debt in either AIB or Bank of Ireland.

“The debate is over. Frankfurt would not agree,” he said.

Well let’s take a look at Fine Gael’s banking policy document “Credit Where Credit’s Due”. Pages 5 and 6 list a set of options that Fine Gael wished to pursue for “a more credible, fairer package that is better for Ireland and Europe.”

These options included extending the EFSF “to take equity and long-term debt investments in systemically important European banks, such as AIB and Bank of Ireland”, EU-funded insurance schemes, procedures for restructuring debts of troubled banks, and “a more sustainable funding solution for the Irish banks.”

Page 6 then tells us that

Should some credible, combination of these options prove not be available from Europe, the next Irish Government would – in order to restore its own credit worthiness – be left with little choice but to unilaterally restructure of the private debts of those Irish banks in greatest need of recapitalisation.

Well, none of these options have been made available. And yet rather than unilateral restructuring, we’re told “The debate is over. Frankfurt would not agree.”

Looks like a U-turn to me.

Irish Times Needs Better Sources

Prior to today’s announcements, the Irish Times were flagging the following:

Mr Noonan will make a “watershed” argument for a EU-wide solution around passing bank losses on to bondholders in response to the tests on Bank of Ireland, AIB, Irish Life and Permanent and EBS building society. Government colleagues last night described it as the first radical policy departure from the previous Fianna Fail-led government.

A few months ago, just prior to the announcement of the EU-IMF agreement, the Times had reported:

The source said there was a “common understanding” between delegations from the EU Commission, the European Central Bank and the IMF that senior and junior bondholders should each pay a share of the rescue costs.

Two conclusions to draw from this. First, people shouldn’t pay much attention to the Irish Times reports on these matters. Second, the Times need better sources.

New IIEA Blog\Post on Bank Debt

I’d like to flag an excellent new initiative that our readers are likely to find useful. As many of you know, the Institute for International and European Affairs has played a very important role in recent years in promoting debate on European issues. The Institute has now started a blog focusing on European topics which already has a lot of interesting material. I have agreed to contribute some longer pieces there.  They’ve promised to make me some pretty graphs if I ask nicely which might make a nice change sometimes from the no-frills approach we adopt here at the IE blog!

Which brings me back to an issue related to my proposals for a debt-to-equity swap for central bank loans. Some commenters have rightly pointed out that this proposal seems to give up on burden sharing with bondholders. That it does so is just a reflection of the current EU position on this issue. However, this strengthens the case for the EU becoming involved in owning the Irish bank sector: If they want the bondholders paid back so badly, then one can argue that they should contribute some of their own funds to the effort.

But coming back to the European debate on bank debt, I think the EU officials are adopting the wrong approach to dealing with this issue. I also think that the proposals adopted by the European Commission to allow haircuts on bonds that are issued in the future, say after 2013, is unworkable. For a discussion of this and an alternative approach, see this post at the IIEA site.

FG Banking Policies

Fintan O’Toole has a piece in today’s Irish Times that criticises Fine Gael for various flip-flops and changes of position on banking issues. You can read it yourself and decide if these points are important or whether Fintan is over-egging it a bit.

I’m reluctant to get into political argument on this point. However, I would note that Fintan seems to have missed the biggest change in Fine Gael position. While Fine Gael are currently placing a lot of emphasis on haircutting senior bank bondholders, as recently as October this was not their position at all. Here’s a link to a Bloomberg piece quoting Michael Noonan as follows

Fine Gael, Ireland’s biggest opposition party, said Oct. 8 that it would also repay Anglo Irish senior bondholders in full. In September, the party had demanded that Finance Minister Lenihan negotiate with bondholders.

The party doesn’t want to “risk the reputation of the country” as a re-payer of its debt, said Fine Gael finance spokesman Michael Noonan.

Bloomberg also have a more detailed story on this interview which, unfortunately, is not on the web. However, here are some excerpts:

Anglo Irish Senior Bondholders Should Be Repaid, Opposition Says

2010-10-08 12:06:09.402 GMT

By Joe Brennan

Oct. 8 (Bloomberg) — Anglo Irish Bank Corp. senior bondholders would be repaid in full by an Irish government led by Fine Gael, the countrys biggest opposition party, finance spokesman Michael Noonan said.

Last month, the Dublin-based party demanded Finance Minister Brian Lenihan sought negotiations on all Anglo Irish bonds, including 4 billion euros ($5.5 billion) which lost the government guarantee on Sept. 30. Noonan said yesterday that circumstances had changed.

“The advice I got was you might get half a billion euros out of it on a negotiation”, Noonan, 67, said in an interview in the parliament in Dublin. “Now, I don’t think we should risk the reputation of the country for the sake of a half billion.”

and

Lenihan said yesterday the government wouldnt impose losses on senior bondholders via new laws.

“It was an option two years ago when there was very serious amounts, about 17 billion, of senior bonds there that wasn’t under guarantee”, Noonan said. “ The debate is effectively over now.”

One can, of course, argue that circumstances have changed again since October. But the general point that Fine Gael have been inconsistent on banking policy seems a fair charge.

EU Commission Document on Bank Resolution Framework

The European Commission has released a “working document” that “seeks views on the technical details of a possible EU framework for the management of failing credit institutions and an appropriate class of investment firms.” There’s a press release here and an FAQ here.

The document contains a lot of sensible proposals that would lead to a common future European approach to dealing with failing banks, in contrast to the chaotic and disorganised approach that was seen during 2008-2009.

There’s plenty in the document worth discussing but, given the particular focus of this blog, it is clear that the most interesting aspect of the document is the annex starting on page 86 titled “Debt writedown as an additional resolution tool”.  It’s worth reading in whole but here’s the basic idea:

Thus, to provide additional flexibility and to ensure that any write down power is sufficient to deliver the policy objectives, this consultation outlines two possible models for additional write down powers. Building on the minimum powers above, the first ‘comprehensive’ approach aims to make a broad range of senior creditors face the real risk associated with bank failure. The second ‘targeted’ approach aims to create a more focused tool for resolving in particular, institutions which have been assessed as likely to prove difficult to resolve with traditional resolution tools at a time of fast moving idiosyncratic or systemic crisis.

Resolution authorities could be given a statutory power, exercisable when an institution meets the trigger conditions for entry into resolution, to write off all equity, and either write off subordinated debt or convert it into an equity claim. However, in some cases this will not be sufficient to ensure that an institution in difficulty returns to viability so as to maintain market and creditor confidence when the markets next open. (For example, RBS’ balance sheet at the end of 2007 contained £38bn in subordinated liabilities, while losses before tax in 2008 amd 2009 amounted to around £43bn.

As is de rigeur these days the Commission argues that “Such a power would only apply to new debt issued (or existing debt contracts renewed or rolled over) after entry into force of the power.”  In other words, existing European senior bank debt cannot take a haircut in this way.

However, the problem with this argument, as well its sovereign cousin (the idea that only post-2013 sovereign debt will be open to restructuring) is that it is subject to what economists call time inconsistency. As described by Wikipedia, “time inconsistency describes a situation where a decision-maker’s preferences change over time in such a way that what is preferred at one point in time is inconsistent with what is preferred at another point in time.”

Today, Europe has lots of troubled banks and some troubled sovereigns. Ideally, the powers that  be would like financial markets to not worry about being defaulted on and to keep lending to these banks and sovereigns. No agreed EU resolution regime for banks or sovereigns is in place, so the authorities would like to reassure current lenders that they will be safe when such a regime is put in place and that it is future lenders who will take the hit.

However, when the future arrives, it becomes the present and future senior bank bond investors will consider a regime in which only they are subject to a resolution regime involving selective haircuts as totally unacceptable.

The time-inconsistency of the current sovereign debt proposals are clearly recognised by sovereign bond markets, which are pricing current Irish and Greek government bonds at yields that clearly indicate the likelihood of default. For banks that are already in trouble, it seems unlikely that these proposals will really comfort bond investors that they are genuinely safe from getting haircut by a future resolution regime.