By Business & Finance 
Even the most legalistic and litigous bondholder can see the only way out is through some sort of restructuring. John Walsh reports.
The national debt is fast approaching 100% of GDP and is forecast to rise to 120% of GDP. These sobering figures ensure that the next government will not have a honeymoon period. The sclerotic growth rate of the economy, combined with the debt overhang could push the country into a debt deflationary spiral. There is an emerging consensus that something needs to be done. What Ireland does next has huge implications not only for this country but also the euro zone. A debt restructuring of some sort looks inevitable. The shape of this restructuring is the multibillion euro question. Not surprisingly there are an increasing number of views on the best way to proceed.
On the one extreme Sinn Féin is advocating a unilateral withdrawal from the €85bn IMF/EU bailout programme and burning the bondholders. On the other hand Fianna Fáil is adamant that there can be no material change to the terms of the bailout agreement and that any talk of burning bondholders is dangerous.
This article was being written just as the electorate was going to the polls, but it seems certain that Fine Gael will lead the next government either through a single-party majority or through a coalition with the Labour Party. Fine Gael’s finance spokesperson Michael Noonan has spoken on a number of occasions about burden sharing with senior and subordinated bondholders among Irish banks.
In the past, what could be considered pre-election rhetoric would not have registered beyond Ireland’s borders. This time, it really is different. International investors are looking on with keen interest. Any time the words haircut and bondholders are put in the same sentence, volatility on European financial markets increases.
Moreover, if there is one thing that financial markets do not like, it is uncertainty. The run-up to the election created a political leadership vacuum. But the biggest uncertainty of all is the size of the losses in the Irish banking system. Because of the State bank guarantee, that has huge implications for the solvency of the country.
John Sheehan, a Singapore-based distressed debt specialist, says the outlook for Irish financial institutions is bleak. “I have followed distressed debt around the world for 13 years. I have never come across such a bad situation as Ireland in terms of bank balance sheets. They are toxic. NAMA paid 100% over price for bank assets. No one has marked their loan book anywhere near reality. My view is real estate has another 30% to fall from its current price. This is going to take years to play out,” says Sheehan.
One Dublin-based bond market specialist, who didn’t want to be named, says losses in the Irish banking system could be up to €30bn more than what has been officially estimated. The outgoing government has forecast losses across the banking sector to come in at €50bn. The EU Commissioner Oli Rehn has ordered that Irish banks conduct stress tests by the end of March. But it will take much longer for the true complexion of the losses in the banking system to become more apparent because that depends on how the economy performs. Sources close to one of the banks operating in this country say that the average value of collateral is now only worth 25% against the loan values.
The Dublin-based debt market specialist argues that if the government tries to trade its way out of this debt problem, then it will keep the economy in or close to recession for the foreseeable future. He is in no doubt that a restructuring has to take place in the near term. “March would be the best time to do it. The Dáil resumes on March 8. The ECB meets at the end of March. There is an opportunity to restructure the senior debt and present it as a fait accompli at the ECB meeting.
“There is roughly €25bn in senior debt held by Irish banks. If haircuts of between one-third and a half are applied, that would save roughly €10bn. The sale of State assets could deliver another €7bn. That is €17bn, which will give the economy some breathing space. Then it will come down to losses in the banking system. If they are bigger than expected, then something will have to be done about sovereign debt.”
He argues that it would be impossible to apply haircuts to sovereign debt as Ireland would become a pariah among investors. But there is an option of a debt liability management exercise, which would extend the maturities on Irish Government bonds to much longer periods.
But there is far from widespread agreement on whether it is possible to apply haircuts to senior bondholders without triggering a financial panic in this country as well as through euro zone countries.
And that puts Ireland’s relationship with Europe in the spotlight. Sinn Féin is the only political party that advocates a move on a unilateral basis. Fine Gael and Labour are both predisposed to Europe. It is highly unlikely that either party would ignore the instructions of either the European Commission or the European Central Bank.
“There is a tendency to see bondholders as men in balaclavas. But most of them are pension funds and institutional investors like that. The issue for the EU is the legal documentation around those bonds. Whatever about the justice of it, the reality of it is that the legality of it is a very big thing. That the terms of a bond issue could be changed retrospectively could have funding implications for EU banks from the most secure downwards,” says London-based John Mennis, head of equity sales at Evolution Securities. “If because of cutting bondholders in AIB or Anglo could lead to a higher cost of borrowing for French, German and Italian banks, then that would be a very big decision for the ECB to allow to happen.”
A senior Dublin-based academic who didn’t want to be named because of the sensitivity of the issue, argues that there is an implicit agreement with the ECB that in return for emergency funding, the Irish Government does not impose haircuts on bondholders.
Irish banks are still largely locked out of the wholesale money markets. Moreover, there has been a steady outflow of deposits from Irish banks over the past couple of years. The ECB has supplied over €100bn in emergency funding to Irish banks. The Irish Central Bank has provided a further €50bn.
The Government might be able to save up to €10bn by imposing a haircut on senior bondholders, but if that was against the wishes of the ECB, then it could cut off a critical source of funding for the banks, says the academic.
Last month the failure of the eight largest bank, Amagerbanken, in Denmark saw senior bondholders and depositors over €100,000 take haircuts of up to 41% on their holdings. Those who advocate Irish banks pursue a similar strategy, cite Amagerbanken for how it can be done with relatively minimal disruption to the markets.
But there is a difference. Ireland is part of a monetary union. Moreover, the sums involved are considerably larger than what was involved in the Danish example. “What happened in Denmark might make it seem that you can default on senior debt. I am sure that there will be a discussion with the [European] Commission and the ECB about what to do next,” says Nicolas Veron of Brussels-based think tank Breugel. “But the ECB will have serious concerns about a possible restructuring and these concerns cannot be dismissed.
Veron says that there is an argument to be made for looking at the senior bondholders in Anglo Irish Bank and Irish Nationwide. “But the margin for manoeuvre is not unlimited. You do not want to damage your creditors too much. Financial markets will look differently on Ireland in the event of a restructuring. There is a trade-off to be made by the next government on this. But the restructuring of senior debt beyond Anglo and Nationwide is not something to be taken lightly.”
The official view from Europe is that there is no need for restructuring (see box). The view is that both Greece and Ireland need to sell more state assets. The disposal of state assets will go much further to solving Greece’s debt problem than in Ireland as this country has previously embarked on privatisation programmes. The Irish export sector has performed robustly over the past year.
Notwithstanding the improved competitiveness in the economy and the increase in exports, all those interviewed for this article say that some sort of a debt restructuring is inevitable.
Peter De Keyzer, an economist with the Belgian bank Petercam, says there are other ways of restructuring debt rather than imposing haircuts on senior bondholders. He argues that there could be an interest rate subsidy provided to Ireland over the next 10 years or some sort of a debt forgiveness programme – or possibly even a direct transfer from the EU to Ireland.
Mennis agrees that there has to be some sort of restructuring that doesn’t involve hosing down senior bondholders. The ECB could be allowed buy up Irish bonds directly or euro bonds could replace Irish bonds, he says.
“At the end of the day, even the most legalistic of bondholders can see that the problem is catastrophically worse than the Irish Government imagined in its wildest nightmares when they underwrote the banks.
“Even the most legalistic and litigious bondholder can see that the only way out is through some sort of restructuring. A good and conciliatory finance minister must strike some sort of accord. It must be an accord that offers a better solution for everybody, including the bondholders.”
Pushing our luck: Ireland and the EU
When Ireland unilaterally introduced the State guarantee of the banking system on September 28th, it marked a departure in relations between Dublin and Brussels. The electorate had rejected the Lisbon Treaty in June of that year, but the Government had thrown its full weight behind the campaign. The bank guarantee was one of the first times that the Government had acted unilaterally in a European context. It provoked an angry backlash from fellow EU member states. If Ireland were to move unilaterally on the country’s debt and in particular the senior bondholders at Irish banks, then the reaction would likely be much more hostile.
Moreover, there is a massive debt overhang across the euro zone. If there is to be a comprehensive solution, then it will have to be orchestrated by the commission. But as it stands, the Franco-German axis at the core of the euro zone is focused on a different set of priorities. “The euro zone is facing a huge debt crisis. The German Chancellor Angela Merkel is focused on budget restraint and increasing competitiveness. It is a bit like going straight to stage two without having solved stage one,” says Petercam’s De Keyzer.
There is a European summit at the end of March that is supposed to come up with a new approach to tackling the debt crisis. Bruegel’s Veron is not hopeful that any effective proposals will emerge. “[German Chancellor Angela] Merkel has to worry about the German Constitutional Court and anything that resembles a direct transfer from one member state to another. And that is a legitimate concern,” says Veron.
Veron says that there is much further to go in the European crisis. “Look at Europe compared to the US. They have solved their banking crisis, although they now have a fiscal crisis. The banking problem in Europe remains largely unsolved and there is no policy framework to tackle the fiscal crisis.”
