Eurosummit: Much Ado About Something?

I’ve agreed to write some posts on European issues for They have a far higher readership than I get from this blog or my Twitter feed, so it’s a good opportunity to get more readers. That said, I’m still going to post content here as before. Everything I write for Forbes will be linked to here and, of course, I will continue to post my usual mix of Irish-related posts and links to presentations and papers, so there will be no reduction in content here.

Anyway, here‘s my first post for Forbes, which is a quick summary of the problems facing the euro area and my reaction to the summit. Yes, my reaction is quite positive. No, I haven’t been captured by aliens and replaced by a clone.

Presentation on Ireland’s Bank Debt

Today, I’m giving a presentation titled “Ireland’s Bank Debt and What Can be Done About It” at the IIEA’s conference Exiting the Crisis. The slides from my talk are available here as a PowerPoint slideshow and here in PDF.

The presentation is based on this earlier blog post, though I think that post failed to emphasise enough that I prefer a restructuring of the promissory notes within the current ELA arrangement to replacing ELA with a loan from the ESM.

The slides were prepared prior to today’s EU banking announcement but are, if anything, more rather than less relevant as the summit did actually make some progress towards EU risk-sharing in relation to bank recapitalisation costs.

Despite this morning’s euphoric claims from Enda Kenny and Eamon Gilmore that this is a “seismic change” and a “deal changer”, I would recommend serious caution. Ireland’s bank debt is a complex sui generis issue and its resolution will not fit easily into the tools the EU is now developing to deal with banks elsewhere. There is lots of negotiating still to be done and premature celebrations can be counter-productive.

Presentation: Target2 and the Euro Crisis

Yesterday, I gave a presentation on “Target2 and the Euro Crisis” at the Bank of England’s Centre for Central Banking Studies. The slides from my talk are available here as a PowerPoint slideshow and here in PDF. Probably needless to say but the content of the presentations reflects only my own views and its presentation at the Bank of England does not imply their endorsement.

Ireland’s Mortgage Crisis is Real

The front page headline story in yesterday’s Irish Independent was “Central Bank figures ‘overstating’ number in mortgage crisis” by Laura Noonan. Inside the paper, there were two further stories by Laura on the same topic, one of which is this story titled “Gloomy, ill-informed ‘experts’ are talking through their hats”.  I couldn’t find the third story on the Independent’s webpage but two’s enough to get the jist.

The front page story says that

OFFICIAL figures on the “mortgage crisis” overstate the number of households in real trouble

An objective definition of “real trouble” would be pretty hard to find, so it’s hardly surprising that the Central Bank figures don’t provide a good measure of the number of people with this status. What they do measure is exactly what they say they measure: Arrears. They show that, as of March, 18,193 mortgages have cumulative arrears of over 90 days and 59,437 mortgages have arrears of over 180 days. Is being over half a year behind on your mortgage payments in “real trouble” or not? I guess it’s in the eye of the beholder but, from my point of view, it’s not a good position to be in.

Other issues with the figures are raised by the Independent as follows:

An investigation by the Irish Independent has revealed the Central Bank’s figures include several types of borrowers who are no longer in trouble … these figures include:

– Those who missed payments long ago and have since resumed paying normally.

– Those who fell behind and agreed ‘restructuring’ deals with their banks to lessen monthly payments.

– Those who have successfully done more informal deals to work through their mortgage problems.

In other words, an investigation has revealed that the figures on arrears measure arrears. If you fell behind on your mortgage and are now making your monthly payment, you may be included in these figures. And, indeed, many of the people included in these figures will recover to pay off all of the arrears. Laura Noonan may believe that “gloomy ill-informed experts” have left the public “with the impression that one in 10 mortgages isn’t being repaid and will never be paid” but I don’t know of a single person, gloomy or otherwise, that ever said that this is what the Central Bank figures measure.

An alternative investigation might also have revealed, however, that the Central Bank arrears exclude

  • People who have restructured their mortgage before they ran into arrears. The Central Bank figures show an additional 38,658 mortgages that not classified as being in arrears have been restructured by moving to interest only, reduced payment or arrears capitalisation. Many of these mortgages may prove unsustainable if people cannot come up with the money to start paying down the principal.
  • People who are paying their mortgages in full but are suffering serious deprivation as a result.
  • People who are in arrears on buy-to-let mortgages. The Central Bank’s Macro-Financial Review (page 35) has reported that the rate of arrears on these mortgages is about twice what it is for owner-occupied property.

So a balanced investigation into the arrears figures could have come up with other factors that contribute to the figures understating the scale of the problem.

The Independent also claims that the figures are misleading because they show a worsening of the arrears problem when the situation is actually improving.

A large number of senior bankers right across the industry who spoke to the Irish Independent now insist the situation is improving ..

The Central Bank figures — which show that more than 10pc of households are in arrears — also fail to capture a “significant” improvement in payments that some senior bankers claim they have seen.

This is because the quarterly reports focus on households that owe more than three months of mortgage payments. This means that a change in arrears cases won’t be reflected in the figures for three months.

Since the last set of figures only goes to the end of March, the “latest” surge in mortgage arrears could be due to an increase in people running into trouble late last year, and not a fresh crisis.

In fact, it hardly takes much investigation to figure out that an improvement in mortgage arrears in the first three months of the year could have showed up in the data. The figures show a slow but steady increase in the number of people that are more than 90 days in arrears.  This must mean there were some people who were less than 90 days in arrears in December but who added on enough arrears to appear in the figures.

More worryingly, the fraction of people who are more than 180 days in arrears is steadily increasing. It is possible that some of these people that have racked up larger amounts of arrears are now moving in the right direction even though still in the 180 days plus category. But I’m more inclined to believe the negative trends in the figures than to trust the banking sector sources cited in these articles.

The inverted commas (“mortgage crisis”) in the opening line of the front page story suggests that the Irish Independent believes there is no such crisis. Personally, I believe there is a very serious problem and trust the evidence that suggests it is getting worse over time. But then I suppose I’m just gloomy, ill-informed and talking though my hat.

A History Lesson for Professor Sinn

Hans-Werner Sinn has an article in today’s New York Times. The main point of the article is to rebut arguments from President Obama that Germany should be doing more to resolve the euro crisis.

Sinn argues that Germany has done enough:

Should the euro fail, Germany would lose over $1.35 trillion, more than 40 percent of its G.D.P. Has the United States ever incurred a similar risk for helping other countries?

Most of this $1.35 trillion potential loss figure comes from the possible loss of the Bundesbank’s Target2 credit, something which I have argued can be dealt without any new taxes on German citizens.

But, forgetting that for a moment, it appears that Sinn views “Has the United States ever incurred a similar risk for helping other countries?” as a rhetorical question to which the answer is “No”.  In fact, I suspect the vast majority of US citizens are perfectly aware that the answer is “Yes”.

One example that the good professor has probably heard of: World War 2. Once the United States entered World War 2, defense spending rose from 1.64% of GDP in 1940 to 37.19% in 1945.  The US debt ratio went from below 40% of GDP in 1941 to over 120% of GDP in 1946. And this doesn’t put a price on the tragedy of over 400,000 deaths of US troops.

The readers of the New York Times are likely to be aware that the freedom and prosperity that modern Europeans enjoy is due in no small part to the massive financial and human costs incurred by earlier generations of Americans. Perhaps Professor Sinn should consider an apology.

A Better Deal for Spain?

Much of the reporting and instant commentary on the announcement of the deal involving EFSF\ESM funding for Spanish bank recapitalisation has focused on the idea that “Spain got a better deal than Ireland”.  The principal points being cited are that the Spanish deal has “no conditionality” and there will be no visits from the troika.

This strikes me as a wrong-headed way to view the Spanish and Irish deals. At least for now, Spain is only borrowing to recapitalise its banks. And Spain must satisfy conditions relating to this programme. The Eurogroup statement on this has only just over a page of text so it’s not hard to find this:

the policy conditionality of the financial assistance should be focused on specific reforms targeting the financial sector, including restructuring plans in line with EU state-aid rules and horizontal structural reforms of the domestic financial sector.

Unlike Ireland, Spain is (for now at least) still borrowing from financial markets to fund its deficit.  And Spain’s projected deficit for the year, at 6.4 percent, is about half the underlying deficit that Ireland was running in 2010. Because the EU and IMF were agreeing in 2010 to provide very large amounts of money to fund Irish budget deficits, it was hardly surprising that they insisted on being able to monitor how this deficit was closed.

Note also that the IMF are not involved in the Spanish deal, so there is no need for troika visits. Furthermore, Spain is already implementing an Excessive Deficit Procedure programme so any fiscal conditionality requested by Europe would just look the same as the current Spanish fiscal adjustment programme, making such conditionality redundant.

On RTE’s This Week today, the FT’s Peter Spiegel argued that Spain got a better deal than Ireland because it was banking debt that locked Ireland out of financial markets and a “banks only” deal (without troika monitoring of fiscal policy) would have been sufficient for Ireland. However, there is nothing about the way the current Spanish deal is being done that would have improved Ireland’s prospects of retaining access to sovereign bond markets in 2010.

The reason banking problems contributed to shutting Ireland out of the sovereign bond market is because bank-related losses were transferred onto the sovereign.  The current Spanish deal is no different. The fact that the money is being loaned to the FROB does not mean the Spanish government doesn’t have direct responsibility for it. Again, it’s not hard to find this in the one-page statement.

The Eurogroup considers that the Fund for Orderly Bank Restructuring (F.R.O.B.), acting as agent of the Spanish government, could receive the funds and channel them to the financial institutions concerned. The Spanish government will retain the full responsibility of the financial assistance and will sign the MoU.

If, as was the case with Ireland, the FROB’s “investments” in Spanish banks turn out badly so it is unable to generate the funds to repay the EFSF\ESM loans, then the Spanish government must pay the money back. As with the Irish case, the burden of recapitalising insolvent banks or loss-making acquisitions of solvent banks will fall on Spanish citizens.

For this reason, this weekend’s announcement may well end up shutting Spain out of the sovereign bond market. And if the EU agrees to provide funding for Spanish budget deficits then more intense monitoring of fiscal developments (and other areas such as structural reforms) is likely to feature in a revised MoU, even if the fiscal targets will probably remain the same as the current EDP targets.

So there really is nothing in this deal that should make Irish people in any way jealous or resentful. In contrast, this “banks only” deal from EFSF or ESM possibly sets a precedent that would make the kind of retro-fitting of Ireland’s banking arrangements that I discussed here (acquisition of bank stakes and refinancing of promissory notes) more likely to happen. And that would be good news.

What Is Ireland’s Bank Debt and What Can Be Done About It?

In both the run up to the referendum and its aftermath, there have been widespread references to something called “Ireland’s bank debt” with widespread agreement among all right-thinking folk that “something should be done about it” particularly in light of ongoing discussions about the use of EU funds to recapitalise Spanish banks.

One problem with this discussion, as two recent pieces by John McHale and Seamus Coffey discuss, is that there is a lot of fuzziness in discussions of the bank debt issue with a lack of clarity about what people mean by bank debt and what they expect to be done about. Here I want to clarify the size of the Irish state’s outlays and commitments to the banking sector and consider some of the steps that could be taken to reduce the burden associated with these outlays.

Total Outlays and Commitments

The figure of €64 billion has been widely circulated as the cost of bailing out Ireland’s banks. I’m happy to be corrected but I believe the most recent estimate of the total outlays in terms of cash and promissory note commitments comes from this written answer from Michael Noonan on 18th April.  The answer contains a handy table that I reproduce below and it shows the total figure at the slightly-lower €62.8 billion.  Of this, €34.7 billion was supplied to the institutions that comprise the IBRC, while the other €28.1 billion was spent recapitalising and acquiring full ownership of AIB/EBS and Irish Life and Permanent and acquiring preference shares and a minority ordinary shareholding in Bank of Ireland.

IBRC was recapitalised with €30.7 billion in promissory notes and €4 billion in exchequer resources. €20.7 billion from the National Pension Reserve Fund was used to acquire preference and ordinary shares in AIB and Bank of Ireland. Additional exchequer resources were used to spend €4.7 billion on AIB and €2.7 billion on ILP.

So the total outlay and commitments to the Irish bank bailout can be broken into three components:

  • €30.7 billion in promissory notes of which two installment payments have been made (or one made and one kinda-sorta-maybe made depending on your point of view) with many more to come.
  • €20.7 billion from the NPRF has been invested in acquiring ownership stakes in AIB and Bank of Ireland.
  • €11.4 billion of additional exchequer resources have been spent on IBRC, AIB and ILP.

It may be stating the obvious but these figures show that the €63 billion figure does not simply refer to a unique “bank debt” waiting to be defaulted on or renegotiated. The €20.7 billion from the NPRF could have been used to finance deficits instead of borrowing money from the sovereign bond markets and the troika. Similarly the €11.4 billion of cash balances used was largely obtained via borrowing.  However, there are no particular sovereign bond issues or slices of the borrowings from the troika that are specifically earmarked “bank debt.”   The part of the debt that is clearly and unequivocally bank debt, however, is the IBRC.

Let’s look separately at these two areas, the IBRC debt and the rest of the outlays.

AIB, Bank of Ireland and Irish Life and Permanent

The government invested a combined €25.4 billion in acquiring the shareholdings in AIB and Bank of Ireland currently held by the NPRF.  The NPRF’s latest set of accounts values these holdings at €9.36 billion. Those accounts don’t break down the valuations between the two banks but these accounts from 2011:Q3 value the holdings at €9.6 billion, of which €7.1 billion is allocated to the ownership of AIB. The book value of equity in AIB at the end of 2011 was €14.6 billion.  Given weak operating profits and ongoing loan loss writedowns, the NPRF valuation looks highly optimistic.

The government also own Irish Life and Permanent, which had equity with a book value of €3.5 billion at the end of 2011. Given the bank’s serious ongoing problems, I’d be surprised if it had a market value much above zero.

So the Irish government has invested €28.1 billion in bank shares that are likely worth less than €9 billion now.  This calculation omits €2.0 billion received from Bank of Ireland in preference share dividends, the repurchase of warrants and the sale of ordinary shares to Wilbur Ross’s consortium. Still, you’re looking at a loss in the region of €17 billion, which is over 10 percent of GDP.

This raises the question of what could happen with these investments if ESM was to be given the power to recapitalise banks (a big if).   Personally, I would be shocked if such a decision did not come with guidelines for ESM to recapitalise banks in a manner consistent with not losing money.   For example, insolvent banks may have to be restored to a “zero capital” point by creditor write-downs or national government funding before ESM gets involved in recapitalizing banks.

Even if ESM was allowed get involved in directly recapitalising banks in this manner, that does not mean it will be allowed to simply acquire shares in banks that are already recapitalised. And even if it was, it is wildly optimistic to believe that the EU would sanction acquiring these shares for the €28.1 billion we spent on them rather than what they are currently worth.

All told, I think we should welcome the prospect of ESM acquiring AIB and ILP as well as our shares in Bank of Ireland.  We could use the funds obtained (perhaps €9 billion if my guess above is correct) to reduce debt and perhaps implement some well-judged capital programmes. We should also welcome ESM playing a role in any future recapitalisation of these institutions as this would eliminate this source the uncertainty from considerations of the Irish public finances. But Irish citizens will almost certainly still be left with the large loss on their “investment” in these institutions.


Despite putting €35 billion in to recapitalise the IBRC, the institution only has equity capital of €3 billion.  The €31 billion in promissory notes thus account for almost all of the loss the taxpayer is incurring due to the IBRC. As is now pretty well known (see details here) the payments on the promissory notes will be used to repay ELA loans from the Central Bank of Ireland and that these loan repayments will retire the money issued when the ELA loans were created.

Many people would like the Central Bank to simply write off these loans but the Eurosystem’s rules do not allow this. An alternative is to delay the repayment of the ELA. However, Eurosystem rules allow the ECB to block any renegotiation of the terms of the ELA loans and, despite months of negotiations, it seems pretty clear that the ECB are not in any way minded to allow a rescheduling of IBRC’s ELA repayments.  If lobbying from Ireland had been likely to produce a rescheduling, then it would have occurred in late March of this year.  Instead, IBRC were required to meet their scheduled ELA repayment in full and on time.

Perhaps the most realistic option for replacing the promissory notes is to use Ireland’s potential access to the European Stabilisation Mechanism (ESM) to refinance the IBRC.  For example, ESM could issue thirty-year notes to financial markets and loan the funds raised to the Irish government over the same term.  In turn, the Irish government could give these funds to IBRC as a replacement for the promissory note.  IBRC could then pay off all of its ELA debts and be quickly wound down.

I read Seamus’s contribution as arguing against an ESM deal and John’s contribution as neutral. I’m happy to say that, in the absence of any deal with the ECB on restructuring the promissory notes, I am willing to endorse an ESM deal as an obtainable second best.

What can be said in favour or against such an approach? Against this approach is the fact that the interest rate on such a loan, likely to be around 3 percent, is higher than the effective current cost of ELA, which is the ECB main refinancing rate (1 percent at the time of writing).  Another complication is that the size of such a loan from ESM would be large: €28.1 billion would be required to pay off the remaining ELA and the IBRC’s one-year loan from Bank of Ireland.  The existing European debt issuance agencies such as EFSF and EFSM have not yet placed a thirty-year bond of anywhere close to this size and this may make it difficult to achieve the desired low interest rate.

Those caveats noted, the benefits to this arrangement seem to far outweigh the costs.  An ESM loan locks in a low interest rate for a long period and may provide lower cost financing than the ELA arrangement once the ECB’s main refinancing rate moves upwards again.  More importantly, a thirty-year ESM loan would require only an annual interest payment for 29 years followed by a payoff of the principal in year 30.

This deferral of principal payments would significantly reduce Ireland’s cash financing requirements over the next decade.  It would also provide a substantial reduction in the net present value of the burden of this debt when calculated using realistic discount rates reflecting Ireland’s likely cost of funding.

For example, in this paper, I calculated that the IBRC’s ELA would be paid off by 2022 if Ireland sticks to its current schedule of paying off €3.1 billion a year in promissory notes. Using a 7 percent discount rate, this stream of planned promissory note payments plus the IBRC’s loan repayment to Bank of Ireland in 2013 have a combined net present value almost twice as large as the stream of payments associated with paying 3 percent interest on a €28.1 billion loan for 29 years and then repaying the principal in year 30. (Calculations in this spreadsheet. Since the promissory note example incorporatse €3.1 billion for repaying the IBRC’s one-year loan from Bank of Ireland next year while the ESM example has that money being borrowed from ESM).

Given the seriousness of the current problems with the public finances, one can hardly say that such a restructuring would guarantee sustainability but it would represent a significant improvement over current arrangements.

As a final thought, I’d note that each of the realistic options for lowering the burden of the bank debt, whether they involve purchases of equity stakes in live banks or refinancing the debts of dead banks, involved access to the ESM.  Those who advocated voting No to facilitate a “deal on bank debt” were advocating cutting off access to ESM.  I’m still in the dark as to how those who adopted this position believed Ireland was going to renegotiate a bank debt deal after voting No.