FT Alphaville continue to be unimpressed with the Irish government’s over-turning of the capital structure of the Irish banks: haircutting subdebt holders while protecting preference shares.
One item that hasn’t been discussed on this blog in recent weeks is the Subordinated Liabilities Order issued by Minister Noonan in relation to AIB’s debt instruments. I guess everyone knew this was coming so the order in itself was no big deal. However, the order is now getting some attention (here and here) due to the fact that it appears to mess with existing capital hierarchies. In particular, it appears to have left the preference shares owned by the Irish government untouched while adjusting the terms of subordinated debt.
This seems to me like a bad idea. I’m all in favour of seeing subordinated bondholders in AIB get wiped out given the enormous extent of state support that has been required to keep the bank going. But if you are going to do this, then you should respect the hierarchy of claims that exists.
Many of us have questioned the wisdom of the protection of senior bondholders in Irish banks at the expense of a potential sovereign default. However, those who have argued in favour of protection of senior bondholders have generally made points about the need to maintain the reputation of the domestic banking sector in light of its huge ongoing funding gap. If this is our approach, then is it wise to get a reputation as a country which randomly up-ends existing claims hierarchies at the whim of a Minister?
The idea of subordinated bond holders in AIB and\or Bank of Ireland potentially taking haircuts has been discussed on various occasions since the IMF-EU deal was announced on Sunday. This post examines this issue and tries to figure out what the government’s strategy is.
The Minister for Finance’s statement on this matter was as follows:
As I said in my statement on the 30th of September last, there will be significant burden sharing by junior debt holders in Irish Nationwide and Anglo Irish Bank. These two institutions had received very substantial amounts of State assistance and it was only right that this should be done.
My Department has been working with the Office of the Attorney General to draft appropriate legislation to achieve this and this is near finalisation. Parallel to this Anglo Irish Bank has run a buyback operation which will offer these bondholders an exchange of new debt for old but at a discount of at least 80%. This process is still underway and will be concluded shortly.
Obviously this approach will also have to be considered in other situations where an institution receives substantial and significant State assistance in terms of capital provided to maintain their solvency ratios. I hope to be in a position soon to announce this legislation.
The policy conditionality document goes into more detail:
Consistent with EU State Aid rules, burden sharing will be achieved with holders of subordinated debt in relevant credit institutions over the period of the programme. This will be based on the quantum of capital and other financial assistance the State commits to support specific credit institutions and the financial viability of those institutions in the absence of such support. Resolution and restructuring legislation will address the issue of burden sharing by subordinated bondholders will be submitted to the Oireachtas by end-2010. Where it is appropriate, the process of implementing liability management exercises similar to that which is currently being undertaken in relation to holders of subordinated debt in Anglo Irish Bank will be commenced by end-Q1 2011.
Now let’s bring into the mix the Central Bank’s statement from Sunday:
The Central Bank has set a new minimum capital requirement for Allied Irish Bank, Bank of Ireland, ILP and EBS of 10.5% Core Tier 1. In addition, the Central Bank is requiring these banks to raise sufficient capital to achieve a capital ratio of at least 12% core tier 1 by 28 February, 2011 in the case of AIB, BOI and EBS and by 31 May 2011 in the case of ILP.
And after this, we get
Bank of Ireland, Allied Irish Banks, ILP and EBS will be subject, as previously announced, to a stress test in March 2011 under the Central Bank’s PCAR methodology. If, as a result of the PCAR, banks are assessed to be at risk of falling below the 10.5% core tier 1 target then further capital injections will occur.
So, the following appears to be the sequence of events:
December: Resolution legislation is introduced outlining a mechanism whereby subdebt holders lose out if the State has to provide a large amount of capital to maintain solvency.
February: AIB and BoI are recapitalised, presumably mainly or totally with state money, to 12 percent core tier one ratios.
March: PCAR is completed. This will involve writing down of asset values and this will trigger the need for more capital injections if the core tier one ratio fall below 10.5%.
So how exactly might burden sharing with subordinated bondholders happen? Frankly, it’s as clear as mud.
One interpretation is the following: AIB and Bank of Ireland are capitalised to 14% and 12.5% core equity ratios by the end of February. After this occurs, there are stress tests and only if these stress tests uncover losses that wipe out the end-February levels of capital will the subdebt holders be start to lose out.
If that’s the scenario, then it would seem pretty unlikely that subdebt holders will lose out. Stress tests rarely uncover that a bank has lost 14% of its risk weighted assets.
So perhaps all the talk of subdebt holders losing is just waffle. However, the tone of the public comments on this has been to suggest burden sharing is likely.
If that’s the case, the process might have to be something like as follows: AIB and Bank of Ireland are capitalised to 14% and 12.5% core equity ratios by the end of February. Then more money is put in after the PCAR. At this point, if the combined amount of state funding that has been put in during these two stages (the “quantum of capital”) is the difference between solvency and insolvency, then the legislation triggers a mechanism through which subdebt holders lose out.
I’m no lawyer but this latter mechanism seems legally dubious. It seems to propose that the state can put €9.8 billion in equity into AIB in February and then turn around in March after some additional losses have been diagnosed and somehow ask bondholders, who are senior to equity in the liability pecking order, to take a hit even though the bank is not insolvent at that point.
There seems to be a cake-and-eating-it problem here. On the one hand, the government wants to reassure everyone owed money by the Irish banks that their money is safe. Thus, it wants to keep the banks adequately capitalised and avoid ever having to declare a bank temporarily insolvent. On the other hand, since there are strong suspicions that the banks really are insolvent, it wants a mechanism to allow it to apply ex post haircuts to subordinated bondholders after a stress test shows that the banks have been insolvent.
Or maybe I’ve got it all wrong. I’m happy to hear from others who perhaps have a better idea than me as to what’s going on.
My earlier post on Standard and Poor’s neglected to mention their comments on Anglo Irish Bank. The key passage is as follows:
Anglo has submitted a restructuring plan to the EC as a consequence of the state aid it has received from the Irish government. It has been reported that the management is proposing that Anglo is split up into a good bank and a bad bank. We anticipate that, if such a plan is approved by the EC, capital instruments such as lower Tier 2 may be left in the bad bank. Other options reportedly considered in the plan are liquidation and an orderly wind-down. Anglo’s plan is yet to be approved by the EC; we understand approval may occur in the first half of 2010.
I’d guess that these lower Tier 2 instruments (i.e. subordinated bonds) left in the Anglo “bad bank” (not to be confused with NAMA …) would end up being pretty worthless.
The S&P downgrades make for depressing reading. I really don’t want to beat the drum again about the government over-promising in relation to what the establishment of a NAMA could deliver. Still, it’s interesting to note that the basic problems afflicting the Irish banks—loan losses, weak operating income and concerns that the banks will be undercapitalised—are pretty much the same as they were this time last year.
This isn’t to say that a NAMA vehicle shouldn’t have been part of the solution: I advocated prior to Peter Bacon’s report that an asset management agency should be part of a comprehensive solution. At this point, it will be interesting to see in the end how different an outcome we get from the one I proposed last Spring and if it’s not so different, whether the government’s policy in the interim period will be seen as the dithering of officials in denial or an inspired period of delay to allow some breathing space to deal with the problem.
One shift in my thinking since last Spring is that the size of loan losses is now clearly large enough to warrant putting the banks through a resolution process and negotiating with bondholders prior to using state funds to recapitalise. In particular, it is worth noting that the covered banks have about €10 billion in outstanding subordinated bonds (€8 billion of which is accounted for by AIB and BoI).
Without doubt, our usual Bond friendly commenters will tell us that any subordinated bondholders losing money would lead to financial ruination for every Irish man, woman and child. However, given that the European Commission has been taking a hardline stance on the idea of state funds being used to compensate subordinated bondholders (see here and here) it is hard to see how this position can really be justified on practical or moral grounds.