2010
http://voxeu.org/index.php?q=node/5040
Whatever happened to Ireland?
17 May 2010
Morgan Kelly
The Celtic Tiger faces severe challenges. This column argues that the Irish government’s commitment to absorb the losses of its banking system may well lead to a Greek-style debt ratio by 2012. It is a test-in-waiting for the EU, but one that could be solved by a debt for equity swap to cover the losses of Irish banks.
From basket case to superstar and back again – or almost. One has to wonder: How did all this happen? How did an economy where employment doubled and real GNP quadrupled during the “Celtic Tiger” era from 1990 to 2007, come to have GNP contract by 17% by late-2009 (with further falls forecast for 2010), the deepest and swiftest contraction suffered by a western economy since the Great Depression? The adjustments faced by the nation are monumental (see Cotter 2009 and Honohan and Lane 2009).
Two booms
The key to understanding what happened to Ireland is to realise that while GNP grew from 5% to 15% every year from 1991 to 2006, this Celtic Tiger growth stemmed from two very different booms. First, the 1990s saw rising employment associated with increased competitiveness and a quadrupling of real exports. As Ireland converged to average levels of western European income around 2000 it might have been expected that growth would fall to normal European levels. Instead growth continued at high rates until 2007 despite falling competitiveness, driven by a second boom in construction. I analyse this second boom, the Irish bubble, in a recent CEPR Discussion Paper (Kelly 2010).
Credit bubble
Ireland went from getting about 5% of its national income from house building in the 1990s – the usual level for a developed economy – to 15% at the peak of the boom in 2006–2007, with another 6% coming from other construction. In effect, the Irish decided that competitiveness no longer mattered, and that the road to riches lay in selling houses to each other.
However, driving the construction boom was another boom, in bank lending. As Figure 1 shows, back in 1997 when Ireland’s economy really was among the world’s best performing, Irish banks lent sparingly by international standards. Lending to the non-financial private sector was only 60% of GNP, compared with 80% in Britain and most Eurozone economies. The international credit boom saw these economies experience a rapid rise in bank lending, with loans increasing to 100% of GDP on average by 2008.
These rises were dwarfed, however, by Ireland, where bank lending grew to 200% of national income by 2008. Irish banks were lending 40% more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and 75% more to house buyers.
Figure 1. Bank lending to households and non-financial firms as a percentage of GDP (GNP for Ireland), 1997 and 2008.
This
tripling of credit relative to GNP distorted the Irish economy
profoundly. Its most visible impact was on house prices. In 1995 the
average first-time buyer took out a mortgage equal to three years’
average industrial earnings, and the average house cost 4 years’
earnings. By the bubble peak in late 2006, the average first-time buyer
mortgage had risen to 8 times average earnings, and the average new
house now cost 10 times average earnings, with the average Dublin
second-hand house costing 17 times average earnings (see Figures 2 and
3).
As the price of new houses rose faster than the cost of building them, investment in housing rose. By 2007, Ireland was building half as many houses as Britain, which has 14 times its population.
The flow of new mortgages peaked in the third quarter of 2006, and then fell rapidly. By the middle of 2007 the Irish construction industry was in clear trouble, with unsold units beginning to accumulate. More than one-sixth of housing units are now estimated to be vacant.
Figure 2. Irish house prices relative to average industrial earnings, 1980 – 2009
Figure 3. Irish new house prices and first time buyer mortgages relative to average industrial earnings, 1990 – 2009
Banking collapse
This property slowdown was bad news for an Irish banking system which had lent, usually without collateral, an amount equal to two-thirds of GNP to property developers to finance building projects and make speculative land purchases. Share prices of Irish banks fell steadily from March 2007, with the crisis coming to a head in late September 2008 with a run in wholesale markets on the joint-second largest Irish bank, Anglo Irish. After aggressive denials that the banking system faced any difficulties, the Irish government has been forced to improvise a series of increasingly desperate and expensive responses.
As well as guaranteeing the deposits and most bonds of Irish banks, the Irish government has currently spent, or committed itself to spend, around €40 billion on a National Asset Management Agency to buy non-performing development loans from banks, and to invest around €30 billion in Irish banks. Despite this large injection (equivalent to half of GNP), Irish banks remain moribund.
While the Irish government bailout deals with bank losses on loans to property developers, it does nothing about their two other problems: a heavy reliance on wholesale funding; and the prospect of further large losses on mortgages and business loans.
Half of Irish bank funding comes from international wholesale markets. Without continued government guarantees of their borrowing and, more problematically, continued access to ECB emergency funding, the operations of the Irish banks do not appear viable. Borrowing in bond markets at 6% to fund mortgages yielding 3% is not a sustainable activity, and Irish banks face no choice but to shrink their balance sheets. Should Irish bank lending return to normal international levels, our results indicate that property prices will return to an equilibrium two thirds below peak levels, with larger falls possible in the medium term as the flow of new lending is curtailed sharply.
The third problem facing Irish banks is their mortgages. With house prices down by around 40%, renewed emigration, and unemployment tripled to above 13%, Irish banks face substantial mortgage defaults. For comparison, in Florida and Arizona, whose investor fuelled housing bubbles closely resembled the Irish one, 25% of mortgages are non-performing.
On top of the continued disintegration of its banking system, Ireland faces two other problems: unemployment and government deficits. Private sector employment has fallen by 16%, while the number of males aged 20-24 in work has halved. The collapse in Irish competitiveness (wages have risen over 40% relative to its main trading partners since 2000) which cannot be solved by a devaluation, will frustrate efforts to reverse this decline.
Debt crisis
Fifteen fat years allowed the Irish government to cut income taxes, increase spending and still run a budget surplus. Between 2007 and 2009 however, tax revenue fell by 20%, while expenditure rose by 9%, moving the state from a balanced budget to a deficit of 12% of GDP. In contrast to its inept handling of the banking crisis, the Irish government has moved decisively to reduce expenditure and increase tax rates, and appears on target to reduce its deficit to 3% of GDP by 2012.
Ireland’s government debt is still moderate. At the end of 2009 gross debt was 65% of GDP and, after subtracting the state pension reserve and pre-funded borrowing, net debt was 40% of GDP. Assuming that deficit targets are not missed too badly, gross debt should still be under 85% of GDP by the end of 2012.
Conclusions
This debt would probably be manageable, had the Irish government not casually committed itself to absorb all the gambling losses of its banking system. If we assume – optimistically, I believe – that Irish banks eventually lose one third of what they lent to property developers, and one tenth of business loans and mortgages, the net cost to the Irish taxpayer will be nearly one third of GDP.
Adding these bank losses to its national debt will leave Ireland in 2012 with a debt-GDP ratio of 115%. But if we look at the ratio in terms of GNP, which gives a more realistic picture of the Ireland’s discretionary tax base, this is a debt-GNP ratio of 140% – above the ratio that is currently sinking Greece. Even if bank losses are only half as large as we expect, Ireland is still facing a debt-GNP ratio of 125%.
Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.
Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115 billion of bonds through a partial debt for equity swap.
17 May 2010
Morgan Kelly
The Celtic Tiger faces severe challenges. This column argues that the Irish government’s commitment to absorb the losses of its banking system may well lead to a Greek-style debt ratio by 2012. It is a test-in-waiting for the EU, but one that could be solved by a debt for equity swap to cover the losses of Irish banks.
From basket case to superstar and back again – or almost. One has to wonder: How did all this happen? How did an economy where employment doubled and real GNP quadrupled during the “Celtic Tiger” era from 1990 to 2007, come to have GNP contract by 17% by late-2009 (with further falls forecast for 2010), the deepest and swiftest contraction suffered by a western economy since the Great Depression? The adjustments faced by the nation are monumental (see Cotter 2009 and Honohan and Lane 2009).
Two booms
The key to understanding what happened to Ireland is to realise that while GNP grew from 5% to 15% every year from 1991 to 2006, this Celtic Tiger growth stemmed from two very different booms. First, the 1990s saw rising employment associated with increased competitiveness and a quadrupling of real exports. As Ireland converged to average levels of western European income around 2000 it might have been expected that growth would fall to normal European levels. Instead growth continued at high rates until 2007 despite falling competitiveness, driven by a second boom in construction. I analyse this second boom, the Irish bubble, in a recent CEPR Discussion Paper (Kelly 2010).
Credit bubble
Ireland went from getting about 5% of its national income from house building in the 1990s – the usual level for a developed economy – to 15% at the peak of the boom in 2006–2007, with another 6% coming from other construction. In effect, the Irish decided that competitiveness no longer mattered, and that the road to riches lay in selling houses to each other.
However, driving the construction boom was another boom, in bank lending. As Figure 1 shows, back in 1997 when Ireland’s economy really was among the world’s best performing, Irish banks lent sparingly by international standards. Lending to the non-financial private sector was only 60% of GNP, compared with 80% in Britain and most Eurozone economies. The international credit boom saw these economies experience a rapid rise in bank lending, with loans increasing to 100% of GDP on average by 2008.
These rises were dwarfed, however, by Ireland, where bank lending grew to 200% of national income by 2008. Irish banks were lending 40% more in real terms to property developers alone in 2008 than they had been lending to everyone in Ireland in 2000, and 75% more to house buyers.
Figure 1. Bank lending to households and non-financial firms as a percentage of GDP (GNP for Ireland), 1997 and 2008.
As the price of new houses rose faster than the cost of building them, investment in housing rose. By 2007, Ireland was building half as many houses as Britain, which has 14 times its population.
The flow of new mortgages peaked in the third quarter of 2006, and then fell rapidly. By the middle of 2007 the Irish construction industry was in clear trouble, with unsold units beginning to accumulate. More than one-sixth of housing units are now estimated to be vacant.
Figure 2. Irish house prices relative to average industrial earnings, 1980 – 2009
Banking collapse
This property slowdown was bad news for an Irish banking system which had lent, usually without collateral, an amount equal to two-thirds of GNP to property developers to finance building projects and make speculative land purchases. Share prices of Irish banks fell steadily from March 2007, with the crisis coming to a head in late September 2008 with a run in wholesale markets on the joint-second largest Irish bank, Anglo Irish. After aggressive denials that the banking system faced any difficulties, the Irish government has been forced to improvise a series of increasingly desperate and expensive responses.
As well as guaranteeing the deposits and most bonds of Irish banks, the Irish government has currently spent, or committed itself to spend, around €40 billion on a National Asset Management Agency to buy non-performing development loans from banks, and to invest around €30 billion in Irish banks. Despite this large injection (equivalent to half of GNP), Irish banks remain moribund.
While the Irish government bailout deals with bank losses on loans to property developers, it does nothing about their two other problems: a heavy reliance on wholesale funding; and the prospect of further large losses on mortgages and business loans.
Half of Irish bank funding comes from international wholesale markets. Without continued government guarantees of their borrowing and, more problematically, continued access to ECB emergency funding, the operations of the Irish banks do not appear viable. Borrowing in bond markets at 6% to fund mortgages yielding 3% is not a sustainable activity, and Irish banks face no choice but to shrink their balance sheets. Should Irish bank lending return to normal international levels, our results indicate that property prices will return to an equilibrium two thirds below peak levels, with larger falls possible in the medium term as the flow of new lending is curtailed sharply.
The third problem facing Irish banks is their mortgages. With house prices down by around 40%, renewed emigration, and unemployment tripled to above 13%, Irish banks face substantial mortgage defaults. For comparison, in Florida and Arizona, whose investor fuelled housing bubbles closely resembled the Irish one, 25% of mortgages are non-performing.
On top of the continued disintegration of its banking system, Ireland faces two other problems: unemployment and government deficits. Private sector employment has fallen by 16%, while the number of males aged 20-24 in work has halved. The collapse in Irish competitiveness (wages have risen over 40% relative to its main trading partners since 2000) which cannot be solved by a devaluation, will frustrate efforts to reverse this decline.
Debt crisis
Fifteen fat years allowed the Irish government to cut income taxes, increase spending and still run a budget surplus. Between 2007 and 2009 however, tax revenue fell by 20%, while expenditure rose by 9%, moving the state from a balanced budget to a deficit of 12% of GDP. In contrast to its inept handling of the banking crisis, the Irish government has moved decisively to reduce expenditure and increase tax rates, and appears on target to reduce its deficit to 3% of GDP by 2012.
Ireland’s government debt is still moderate. At the end of 2009 gross debt was 65% of GDP and, after subtracting the state pension reserve and pre-funded borrowing, net debt was 40% of GDP. Assuming that deficit targets are not missed too badly, gross debt should still be under 85% of GDP by the end of 2012.
Conclusions
This debt would probably be manageable, had the Irish government not casually committed itself to absorb all the gambling losses of its banking system. If we assume – optimistically, I believe – that Irish banks eventually lose one third of what they lent to property developers, and one tenth of business loans and mortgages, the net cost to the Irish taxpayer will be nearly one third of GDP.
Adding these bank losses to its national debt will leave Ireland in 2012 with a debt-GDP ratio of 115%. But if we look at the ratio in terms of GNP, which gives a more realistic picture of the Ireland’s discretionary tax base, this is a debt-GNP ratio of 140% – above the ratio that is currently sinking Greece. Even if bank losses are only half as large as we expect, Ireland is still facing a debt-GNP ratio of 125%.
Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.
Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115 billion of bonds through a partial debt for equity swap.
http://www.irishtimes.com/newspaper/opi ... 88132.html
Burden of Irish debt could yet eclipse that of Greece
May 22, 2010
OPINION: What will sink us, unfortunately but inevitably, are the huge costs of the September 2008 bank bailout, writes MORGAN KELLY
IT IS no longer a question of whether Ireland will go bust, but when. Unlike Greece, our woes do not stem from government debt, but instead from the government’s open-ended guarantee to cover the losses of the banking system out of its citizens’ wallets.
Even under the most optimistic assumptions about government spending cuts and bank losses, by 2012 Ireland will have a worse ratio of debt to national income than the one that is sinking Greece.
On the face of it, Ireland’s debt position does not appear catastrophic. At the start of the year, Ireland’s government debt was two- thirds of GDP: only half the Greek level. (The State also has financial assets equal to a quarter of GDP, but so do most governments, so we will focus on the total debt.)
Because of the economic collapse here, the Government is adding to this debt quite quickly. However, in contrast to its inept handling of the banking crisis, the Government has taken reasonable steps to bring the deficit under control. If all goes to plan we should be looking at a debt of 85 to 90 per cent of GDP by the end of 2012.
This is quite large for a small economy, but it is manageable. Just about. What will sink us, unfortunately but inevitably, are the huge costs of the bank bailout.
We can gain a sobering perspective on the impossible disproportion between the bailout and our economic resources by looking at the US. The government there set aside $700 billion (€557 billion) to buy troubled bank assets, and the final cost to the American taxpayer is about $150 billion. These sound like, and are, astronomical numbers.
But when you translate from the leviathan that is America to the minnow that is Ireland, it would be equivalent to the Irish Government spending €7 billion on Nama, and eventually losing €1.5 billion in the process. Pocket change by our standards.
Instead, our Government has already committed itself to spend €70 billion (€40 billion on the National Asset Management Agency – Nama – and €30 billion on recapitalising banks), or half of the national income. That is 10 times per head of population the amount the US spent to rescue itself from its worst banking crisis since the Great Depression.
Having received such a staggering transfusion of taxpayer funds, you might expect that the Irish banks would now be as fit as fleas. Instead, they are still in intensive care, and will require even larger transfusions before they can fend for themselves again.
It is hard to think of any institution since the League of Nations that has become so irrelevant so fast as Nama. Instead of the resurrection of the Irish banking system we were promised, we now have one semi-State body (Nama) buying assets from other semi-states (Anglo) and soon-to-be semi-States (AIB and Bank of Ireland), while funnelling €60 million a year in fees to lawyers, valuers and associated parasites.
What ultimately matters for national solvency, however, is not how much the State invests in its banks, but how much it is likely to lose. It is alright to invest €70 billion, or even €100 billion, to rescue your banking system if you can reasonably expect to get back most of what you spent. So how much are the banks and, thanks to the bank guarantee, you the taxpayer, likely to lose?
Let’s start with the €100 billion of property development loans. We’ll be optimistic and say the loss here will be one-third. Remember, Anglo has already owned up to losing about €25 billion of its €75 billion portfolio, so we have almost reached that third without looking at AIB and Bank of Ireland. I think the final loss will be more than half, but we’ll keep with the third to err on the side of optimism.
Next there are €35 billion of business loans. Over €10 billion of these loans are to hotels and pubs and will likely not be seen again this side of Judgment Day. Meanwhile, one-third of loans to small and medium enterprises are reported already to be in arrears. So, a figure of a 20 per cent loss again seems optimistic.
Finally, we have mortgages of €140 billion, and other personal lending of €20 billion. Current mortgage default figures here are meaningless because, once you agree a reduction of mortgage payments to a level you can afford, Irish banks can still pretend that your loan is performing.
Banks in the US typically get back half of what they loaned when they foreclose, but losses here could be greater because banks, fortunately, find it hard to take away your family home. So Irish banks could easily be looking at mortgage losses of 10 per cent but, to be conservative, we will say five.
So between developers, businesses, and personal loans, Irish banks are on track to lose nearly €50 billion if we are optimistic (and more likely closer to €70 billion), which translates into a bill for the taxpayer of over 30 per cent of GDP. The bank guarantee may have looked like “the cheapest bailout in the world, so far” in September 2008, but it is not looking that way now.
Adding these bank losses on to the national debt means we are facing a debt by late 2012 of 115 per cent of GDP. If we are lucky.
There is more. The ability of a government to service its debts depends on its tax base. In Ireland the proper measure of tax base, at least when it comes to increasing taxes, is not GDP (including profits of multinational firms, who will walk if we raise their taxes) but GNP (which is limited to Irish people, who are mostly stuck here). While for most countries the two measures are the same, in Ireland GDP is a quarter larger than GNP. This means our optimistic debt to GDP forecast of 115 per cent translates into a debt to GNP ratio of 140 per cent, worse than where Greece is now.
And even this catastrophic number assumes that our economy does not contract further. For the last two years the Irish economy has not been shrinking, so much as vaporising. Real GNP and private sector employment have already fallen by one-sixth – the deepest and swiftest falls in a western economy since the Great Depression.
The contraction is far from over, to judge from the two economic indicators I pay most attention to. Redundancies have been steady at 6,000 per month for the last nine months. Insolvencies are 25 per cent higher than this time last year, and are rippling outwards from construction into the rest of the economy.
The Irish economy is like a patient bleeding from two gunshot wounds. The Government has moved competently to stanch the smaller, budgetary hole, while continuing to insist that the litres of blood pouring unchecked from the banking hole are “manageable”.
Capital markets are unlikely to agree for much longer, triggering a borrowing crisis for Ireland. The first torpedo, most probably, will be a run on Irish banks in inter-bank markets, of the sort that sank Anglo in 2008. Already, Irish banks are struggling to find lenders to leave money on deposit for more than a week.
Ireland is setting itself up to present an early test of the shaky EU commitment to bail out its more spendthrift members. Probably we will end up with a deal where the European Central Bank buys Irish debt and provides continued emergency funding to Irish banks, in return for our agreeing a schedule of reparations of 5-6 per cent of national income over the next few decades.
To repay these reparations will take swingeing cuts in spending and social welfare, and unprecedented tax rises. A central part of our “rescue” package is certain to be the requirement that we raise our corporate taxes to European levels, sabotaging any prospect of recovery as multinationals are driven out.
The issue of national sovereignty has for so long been the monopoly of republican headbangers that it is hard to know whether ordinary, sane Irish people still care about it. Either way, we will not be having it around much longer.
We have long since left the realm of easy alternatives, and will soon face a choice between national bankruptcy and admitting the bank guarantee was a mistake. Either we cut the banks loose, or we sink ourselves.
While most countries facing bankruptcy sit passively in denial until they sink – just as we are doing – there is one shining exception: Uruguay. When markets panicked after Argentina defaulted in 2002, Uruguay knew it could no longer service its large external debt. Instead of waiting for a borrowing crisis, the Uruguayans approached their creditors and pointed out they faced a choice.
Either they could play tough and force Uruguay into bankruptcy, in which case they would get almost nothing back, or they could agree to reduce Uruguay’s debt to a manageable level, and get back most of what they lent. Realising Uruguay’s problems were largely not of its own making, and that it had never stiffed its creditors in the past, the lenders agreed to a debt restructuring, and Uruguay was able to return to debt markets within a few months.
In one way, our position is a lot easier than Uruguay’s, because our problem is bank debt rather than government debt. Our crisis stems entirely from the Government’s gratuitous decision on September 29th, 2008, to transform the IOUs of Seán FitzPatrick, Dermot Gleeson and their peers into quasi-sovereign instruments of the Irish state.
Our borrowing crisis could be solved before it even happens by passing the same sort of Special Resolution legislation that the Bank of England enacted after the Northern Rock crisis. The more than €65 billion in bonds that will be outstanding by the end of September when the guarantee expires could then be turned into shares in the banks: a debt for equity swap.
We need to explain that the Irish State has always honoured its debts in the past, and will continue to do so. However, the State is a distinct entity from its banks and, having learned the extent of the banks’ recklessness, we now have no choice but to allow the bank guarantee to lapse and to share the banks’ losses with their bondholders. It must be remembered that when these bonds were issued they had no government guarantee, and the institutions that bought them did so in full knowledge that they could default, and charged an appropriate rate of interest to compensate themselves for this risk.
Freed of the impossible bank debt, the Irish State could concentrate on the other daunting problems left by its decade-long credit binge: unemployment, lack of competitiveness and indebted households. The banks would be soundly capitalised and able to manage themselves free of political interference.
There are two common objections to sharing the banks’ losses with their bondholders, both of them specious. The first is that nobody would lend to Irish banks afterwards. However, given that soon nobody will be lending to Irish banks anyway, this is not an issue. Either way, the Irish State and banks are facing a period of relying on emergency funding. After a debt-for-equity swap, Irish banks, which were highly profitable before they fell into the clutches of their current “management”, will be carrying little debt, making them attractive credit risks.
The second objection is that Ireland would be sued in every court in Europe. Again wrong. Under the EU’s winding-up directive, the government that issues a bank’s licence has full power to resolve the bank under its own laws.
Of course, expecting politicians to sort out the Irish banks is pure fantasy. Like their British and American counterparts, Irish politicians have spent too long believing that banks were the root of national prosperity to understand that their interests are frequently inimical to those of the rest of the economy.
The architect of Uruguay’s salvation was not one of its politicians, but a technocrat called Carlos Steneri. The one positive development in Ireland in recent months is that control of the banking system has passed from the Government to similar technocrats.
This transfer did not take place without a struggle – one that was entirely missed by the media. When Anglo announced they wanted to take over Quinn Insurance despite the objections of the Financial Regulator, journalists seemed to view this as just another case of Anglo being Anglo. They should have remembered that Anglo cannot now turn on a radiator unless the Department of Finance says so, and what was going on instead was a direct power struggle between the Financial Regulator and the Minister for Finance.
Having been forced to appoint a credible Financial Regulator and Central Bank governor – first-rate ones, in fact – the Government must do what they say. Were either Elderfield or Honohan to resign, Irish bonds would straight away turn to junk.
Now you understand the extraordinary shift in power that lay behind the seeming non-headline in this newspaper last month: “Lenihan expresses confidence in regulator”.
The great macroeconomist Rudiger Dornbusch observed that crises always take a lot longer to happen than you expect but, once started, they move with frightening rapidity. Or, as Hemingway put it, bankruptcy happens “Slowly. Then all at once.” We can only hope that the Central Bank is using whatever time remains to us as an independent State to devise an intelligent Plan B – or is it Plan C?
May 22, 2010
OPINION: What will sink us, unfortunately but inevitably, are the huge costs of the September 2008 bank bailout, writes MORGAN KELLY
IT IS no longer a question of whether Ireland will go bust, but when. Unlike Greece, our woes do not stem from government debt, but instead from the government’s open-ended guarantee to cover the losses of the banking system out of its citizens’ wallets.
Even under the most optimistic assumptions about government spending cuts and bank losses, by 2012 Ireland will have a worse ratio of debt to national income than the one that is sinking Greece.
On the face of it, Ireland’s debt position does not appear catastrophic. At the start of the year, Ireland’s government debt was two- thirds of GDP: only half the Greek level. (The State also has financial assets equal to a quarter of GDP, but so do most governments, so we will focus on the total debt.)
Because of the economic collapse here, the Government is adding to this debt quite quickly. However, in contrast to its inept handling of the banking crisis, the Government has taken reasonable steps to bring the deficit under control. If all goes to plan we should be looking at a debt of 85 to 90 per cent of GDP by the end of 2012.
This is quite large for a small economy, but it is manageable. Just about. What will sink us, unfortunately but inevitably, are the huge costs of the bank bailout.
We can gain a sobering perspective on the impossible disproportion between the bailout and our economic resources by looking at the US. The government there set aside $700 billion (€557 billion) to buy troubled bank assets, and the final cost to the American taxpayer is about $150 billion. These sound like, and are, astronomical numbers.
But when you translate from the leviathan that is America to the minnow that is Ireland, it would be equivalent to the Irish Government spending €7 billion on Nama, and eventually losing €1.5 billion in the process. Pocket change by our standards.
Instead, our Government has already committed itself to spend €70 billion (€40 billion on the National Asset Management Agency – Nama – and €30 billion on recapitalising banks), or half of the national income. That is 10 times per head of population the amount the US spent to rescue itself from its worst banking crisis since the Great Depression.
Having received such a staggering transfusion of taxpayer funds, you might expect that the Irish banks would now be as fit as fleas. Instead, they are still in intensive care, and will require even larger transfusions before they can fend for themselves again.
It is hard to think of any institution since the League of Nations that has become so irrelevant so fast as Nama. Instead of the resurrection of the Irish banking system we were promised, we now have one semi-State body (Nama) buying assets from other semi-states (Anglo) and soon-to-be semi-States (AIB and Bank of Ireland), while funnelling €60 million a year in fees to lawyers, valuers and associated parasites.
What ultimately matters for national solvency, however, is not how much the State invests in its banks, but how much it is likely to lose. It is alright to invest €70 billion, or even €100 billion, to rescue your banking system if you can reasonably expect to get back most of what you spent. So how much are the banks and, thanks to the bank guarantee, you the taxpayer, likely to lose?
Let’s start with the €100 billion of property development loans. We’ll be optimistic and say the loss here will be one-third. Remember, Anglo has already owned up to losing about €25 billion of its €75 billion portfolio, so we have almost reached that third without looking at AIB and Bank of Ireland. I think the final loss will be more than half, but we’ll keep with the third to err on the side of optimism.
Next there are €35 billion of business loans. Over €10 billion of these loans are to hotels and pubs and will likely not be seen again this side of Judgment Day. Meanwhile, one-third of loans to small and medium enterprises are reported already to be in arrears. So, a figure of a 20 per cent loss again seems optimistic.
Finally, we have mortgages of €140 billion, and other personal lending of €20 billion. Current mortgage default figures here are meaningless because, once you agree a reduction of mortgage payments to a level you can afford, Irish banks can still pretend that your loan is performing.
Banks in the US typically get back half of what they loaned when they foreclose, but losses here could be greater because banks, fortunately, find it hard to take away your family home. So Irish banks could easily be looking at mortgage losses of 10 per cent but, to be conservative, we will say five.
So between developers, businesses, and personal loans, Irish banks are on track to lose nearly €50 billion if we are optimistic (and more likely closer to €70 billion), which translates into a bill for the taxpayer of over 30 per cent of GDP. The bank guarantee may have looked like “the cheapest bailout in the world, so far” in September 2008, but it is not looking that way now.
Adding these bank losses on to the national debt means we are facing a debt by late 2012 of 115 per cent of GDP. If we are lucky.
There is more. The ability of a government to service its debts depends on its tax base. In Ireland the proper measure of tax base, at least when it comes to increasing taxes, is not GDP (including profits of multinational firms, who will walk if we raise their taxes) but GNP (which is limited to Irish people, who are mostly stuck here). While for most countries the two measures are the same, in Ireland GDP is a quarter larger than GNP. This means our optimistic debt to GDP forecast of 115 per cent translates into a debt to GNP ratio of 140 per cent, worse than where Greece is now.
And even this catastrophic number assumes that our economy does not contract further. For the last two years the Irish economy has not been shrinking, so much as vaporising. Real GNP and private sector employment have already fallen by one-sixth – the deepest and swiftest falls in a western economy since the Great Depression.
The contraction is far from over, to judge from the two economic indicators I pay most attention to. Redundancies have been steady at 6,000 per month for the last nine months. Insolvencies are 25 per cent higher than this time last year, and are rippling outwards from construction into the rest of the economy.
The Irish economy is like a patient bleeding from two gunshot wounds. The Government has moved competently to stanch the smaller, budgetary hole, while continuing to insist that the litres of blood pouring unchecked from the banking hole are “manageable”.
Capital markets are unlikely to agree for much longer, triggering a borrowing crisis for Ireland. The first torpedo, most probably, will be a run on Irish banks in inter-bank markets, of the sort that sank Anglo in 2008. Already, Irish banks are struggling to find lenders to leave money on deposit for more than a week.
Ireland is setting itself up to present an early test of the shaky EU commitment to bail out its more spendthrift members. Probably we will end up with a deal where the European Central Bank buys Irish debt and provides continued emergency funding to Irish banks, in return for our agreeing a schedule of reparations of 5-6 per cent of national income over the next few decades.
To repay these reparations will take swingeing cuts in spending and social welfare, and unprecedented tax rises. A central part of our “rescue” package is certain to be the requirement that we raise our corporate taxes to European levels, sabotaging any prospect of recovery as multinationals are driven out.
The issue of national sovereignty has for so long been the monopoly of republican headbangers that it is hard to know whether ordinary, sane Irish people still care about it. Either way, we will not be having it around much longer.
We have long since left the realm of easy alternatives, and will soon face a choice between national bankruptcy and admitting the bank guarantee was a mistake. Either we cut the banks loose, or we sink ourselves.
While most countries facing bankruptcy sit passively in denial until they sink – just as we are doing – there is one shining exception: Uruguay. When markets panicked after Argentina defaulted in 2002, Uruguay knew it could no longer service its large external debt. Instead of waiting for a borrowing crisis, the Uruguayans approached their creditors and pointed out they faced a choice.
Either they could play tough and force Uruguay into bankruptcy, in which case they would get almost nothing back, or they could agree to reduce Uruguay’s debt to a manageable level, and get back most of what they lent. Realising Uruguay’s problems were largely not of its own making, and that it had never stiffed its creditors in the past, the lenders agreed to a debt restructuring, and Uruguay was able to return to debt markets within a few months.
In one way, our position is a lot easier than Uruguay’s, because our problem is bank debt rather than government debt. Our crisis stems entirely from the Government’s gratuitous decision on September 29th, 2008, to transform the IOUs of Seán FitzPatrick, Dermot Gleeson and their peers into quasi-sovereign instruments of the Irish state.
Our borrowing crisis could be solved before it even happens by passing the same sort of Special Resolution legislation that the Bank of England enacted after the Northern Rock crisis. The more than €65 billion in bonds that will be outstanding by the end of September when the guarantee expires could then be turned into shares in the banks: a debt for equity swap.
We need to explain that the Irish State has always honoured its debts in the past, and will continue to do so. However, the State is a distinct entity from its banks and, having learned the extent of the banks’ recklessness, we now have no choice but to allow the bank guarantee to lapse and to share the banks’ losses with their bondholders. It must be remembered that when these bonds were issued they had no government guarantee, and the institutions that bought them did so in full knowledge that they could default, and charged an appropriate rate of interest to compensate themselves for this risk.
Freed of the impossible bank debt, the Irish State could concentrate on the other daunting problems left by its decade-long credit binge: unemployment, lack of competitiveness and indebted households. The banks would be soundly capitalised and able to manage themselves free of political interference.
There are two common objections to sharing the banks’ losses with their bondholders, both of them specious. The first is that nobody would lend to Irish banks afterwards. However, given that soon nobody will be lending to Irish banks anyway, this is not an issue. Either way, the Irish State and banks are facing a period of relying on emergency funding. After a debt-for-equity swap, Irish banks, which were highly profitable before they fell into the clutches of their current “management”, will be carrying little debt, making them attractive credit risks.
The second objection is that Ireland would be sued in every court in Europe. Again wrong. Under the EU’s winding-up directive, the government that issues a bank’s licence has full power to resolve the bank under its own laws.
Of course, expecting politicians to sort out the Irish banks is pure fantasy. Like their British and American counterparts, Irish politicians have spent too long believing that banks were the root of national prosperity to understand that their interests are frequently inimical to those of the rest of the economy.
The architect of Uruguay’s salvation was not one of its politicians, but a technocrat called Carlos Steneri. The one positive development in Ireland in recent months is that control of the banking system has passed from the Government to similar technocrats.
This transfer did not take place without a struggle – one that was entirely missed by the media. When Anglo announced they wanted to take over Quinn Insurance despite the objections of the Financial Regulator, journalists seemed to view this as just another case of Anglo being Anglo. They should have remembered that Anglo cannot now turn on a radiator unless the Department of Finance says so, and what was going on instead was a direct power struggle between the Financial Regulator and the Minister for Finance.
Having been forced to appoint a credible Financial Regulator and Central Bank governor – first-rate ones, in fact – the Government must do what they say. Were either Elderfield or Honohan to resign, Irish bonds would straight away turn to junk.
Now you understand the extraordinary shift in power that lay behind the seeming non-headline in this newspaper last month: “Lenihan expresses confidence in regulator”.
The great macroeconomist Rudiger Dornbusch observed that crises always take a lot longer to happen than you expect but, once started, they move with frightening rapidity. Or, as Hemingway put it, bankruptcy happens “Slowly. Then all at once.” We can only hope that the Central Bank is using whatever time remains to us as an independent State to devise an intelligent Plan B – or is it Plan C?
http://www.irishtimes.com/newspaper/opi ... 65400.html
If you thought the bank bailout was bad, wait until the mortgage defaults hit home
November 8, 2010
THE BIG PICTURE: Ireland is effectively insolvent – the next crisis will be mass home mortgage default, writes MORGAN KELLY
SAD NEWS just in from Our Lady of the Eurozone Hospital: After a sudden worsening in her condition, the Irish Patient, formerly known as the Irish Republic, has been moved into intensive care and put on artificial ventilation. While a hospital spokesman, Jean-Claude Trichet, tried to sound upbeat, there is no prospect that the Patient will recover.
It will be remembered that, after a lengthy period of poverty following her acrimonious divorce from her English partner, in the 1990s Ireland succeeded in turning her life around, educating herself, and holding down a steady job. Although her increasingly riotous lifestyle over the last decade had raised some concerns, the Irish Patient’s fate was sealed by a botched emergency intervention on September 29th, 2008 followed by repeated misdiagnoses of the ensuing complications.
With the Irish Patient now clinically dead, her grieving European relatives face the melancholy task of deciding when to remove her from life support, and how to deal with the extraordinary debts she ran up in the last months of her life . . .
WHEN I wrote in The Irish Times last May showing how the bank guarantee would lead to national insolvency, I did not expect the financial collapse to be anywhere near as swift or as deep as has now occurred. During September, the Irish Republic quietly ceased to exist as an autonomous fiscal entity, and became a ward of the European Central Bank.
It is a testament to the cool and resolute handling of the crisis over the last six months by the Government and Central Bank that markets now put Irish sovereign debt in the same risk group as Ukraine and Pakistan, two notches above the junk level of Argentina, Greece and Venezuela.
September marked Ireland’s point of no return in the banking crisis. During that month, €55 billion of bank bonds (held mainly by UK, German, and French banks) matured and were repaid, mostly by borrowing from the European Central Bank.
Until September, Ireland had the legal option of terminating the bank guarantee on the grounds that three of the guaranteed banks had withheld material information about their solvency, in direct breach of the 1971 Central Bank Act. The way would then have been open to pass legislation along the lines of the UK’s Bank Resolution Regime, to turn the roughly €75 billion of outstanding bank debt into shares in those banks, and so end the banking crisis at a stroke.
With the €55 billion repaid, the possibility of resolving the bank crisis by sharing costs with the bondholders is now water under the bridge. Instead of the unpleasant showdown with the European Central Bank that a bank resolution would have entailed, everyone is a winner. Or everyone who matters, at least.
The German and French banks whose solvency is the overriding concern of the ECB get their money back. Senior Irish policymakers get to roll over and have their tummies tickled by their European overlords and be told what good sports they have been. And best of all, apart from some token departures of executives too old and rich to care less, the senior management of the banks that caused this crisis continue to enjoy their richly earned rewards. The only difficulty is that the Government’s open-ended commitment to cover the bank losses far exceeds the fiscal capacity of the Irish State.
The Government has admitted that Anglo is going to cost the taxpayer €29 to €34 billion. It has also invested €16 billion in the other banks, but expects to get some or all of that investment back eventually.
So, the taxpayer cost of the bailout is about €30 billion for Anglo and some fraction of €16 billion for the rest. Unfortunately, these numbers are not consistent with each other, and it only takes a second to see why.
Between them, AIB and Bank of Ireland had the same exposure to developers as Anglo and, to the extent that they were scrambling to catch up with Anglo, probably lent to even worse turkeys than it did. AIB and Bank of Ireland did start with more capital to absorb losses than Anglo, but also face substantial mortgage losses, which it does not. It follows that AIB and Bank of Ireland together will cost the taxpayer at least as much as Anglo.
Once we accept, as the Government does, that Anglo will cost the taxpayer about €30 billion, we must accept that AIB and Bank of Ireland will cost at least €30 billion extra.
In my article of last May, when I published my optimistic estimate of a €50 billion bailout bill, I posted a spreadsheet on the irisheconomy.ie website, giving my realistic estimates of taxpayer losses. My realistic estimate for Anglo was €34 billion, the same as the Government’s current estimate.
When you apply the same assumptions about lending losses to the other banks, you end up with a likely taxpayer bill of €16 billion for Bank of Ireland (deducting the €3 billion they have since received from investors) and €26 billion for AIB: nearly as bad as Anglo.
Indeed, the true scandal in Irish banking is not what happened at Anglo and Nationwide (which, as specialised development lenders, would have suffered horrific losses even had they not been run by crooks or morons) but the breakdown of governance at AIB that allowed it to pursue the same suicidal path.
Once again we are having to sit through the same dreary and mendacious charade with AIB that we endured with Anglo: “AIB only needs €3.5 billion, sorry we meant to say €6.5 billion, sorry . . .” and so on until it is fully nationalised next year, and the true extent of its folly revealed.
This €70 billion bill for the banks dwarfs the €15 billion in spending cuts now agonised over, and reduces the necessary cuts in Government spending to an exercise in futility. What is the point of rearranging the spending deckchairs, when the iceberg of bank losses is going to sink us anyway?
What is driving our bond yields to record levels is not the Government deficit, but the bank bailout. Without the banks, our national debt could be stabilised in four years at a level not much worse than where France, with its triple A rating in the bond markets, is now.
As a taxpayer, what does a bailout bill of €70 billion mean? It means that every cent of income tax that you pay for the next two to three years will go to repay Anglo’s losses, every cent for the following two years will go on AIB, and every cent for the next year and a half on the others. In other words, the Irish State is insolvent: its liabilities far exceed any realistic means of repaying them.
For a country or company, insolvency is the equivalent of death for a person, and is usually swiftly followed by the legal process of bankruptcy, the equivalent of a funeral.
Two things have delayed Ireland’s funeral. First, in anticipation of being booted out of bond markets, the Government built up a large pile of cash a few months ago, so that it can keep going until the New Year before it runs out of money. Although insolvent, Ireland is still liquid, for now.
Secondly, not wanting another Greek-style mess, the ECB has intervened to fund the Irish banks. Not only have Irish banks had to repay their maturing bonds, but they have been haemorrhaging funds in the inter-bank market, and the ECB has quietly stepped in with emergency funding to keep them going until it can make up its mind what to do.
Since September, a permanent team of ECB “observers” has taken up residence in the Department of Finance. Although of many nationalities, they are known there, dismayingly but inevitably, as “The Germans”.
So, thanks to the discreet intervention of the ECB, the first stage of the crisis has closed with a whimper rather than a bang. Developer loans sank the banks which, thanks to the bank guarantee, sank the Irish State, leaving it as a ward of the ECB.
The next act of the crisis will rehearse the same themes of bad loans and foreign debt, only this time as tragedy rather than farce. This time the bad loans will be mortgages, and the foreign creditor who cannot be repaid is the ECB. In consequence, the second act promises to be a good deal more traumatic than the first.
Where the first round of the banking crisis centred on a few dozen large developers, the next round will involve hundreds of thousands of families with mortgages. Between negotiated repayment reductions and defaults, at least 100,000 mortgages (one in eight) are already under water, and things have barely started.
Banks have been relying on two dams to block the torrent of defaults – house prices and social stigma – but both have started to crumble alarmingly.
People are going to extraordinary lengths – not paying other bills and borrowing heavily from their parents – to meet mortgage repayments, both out of fear of losing their homes and to avoid the stigma of admitting that they are broke. In a society like ours, where a person’s moral worth is judged – by themselves as much as by others – by the car they drive and the house they own, the idea of admitting that you cannot afford your mortgage is unspeakably shameful.
That will change. The perception growing among borrowers is that while they played by the rules, the banks certainly did not, cynically persuading them into mortgages that they had no hope of affording. Facing a choice between obligations to the banks and to their families – mortgage or food – growing numbers are choosing the latter.
In the last year, America has seen a rising number of “strategic defaults”. People choose to stop repaying their mortgages, realising they can live rent-free in their house for several years before eviction, and then rent a better house for less than the interest on their current mortgage. The prospect of being sued by banks is not credible – the State of Florida allows banks full recourse to the assets of delinquent borrowers just like here, but it has the highest default rate in the US – because there is no point pursuing someone who has no assets.
If one family defaults on its mortgage, they are pariahs: if 200,000 default they are a powerful political constituency. There is no shame in admitting that you too were mauled by the Celtic Tiger after being conned into taking out an unaffordable mortgage, when everyone around you is admitting the same.
The gathering mortgage crisis puts Ireland on the cusp of a social conflict on the scale of the Land War, but with one crucial difference. Whereas the Land War faced tenant farmers against a relative handful of mostly foreign landlords, the looming Mortgage War will pit recent house buyers against the majority of families who feel they worked hard and made sacrifices to pay off their mortgages, or else decided not to buy during the bubble, and who think those with mortgages should be made to pay them off. Any relief to struggling mortgage-holders will come not out of bank profits – there is no longer any such thing – but from the pockets of other taxpayers.
The other crumbling dam against mass mortgage default is house prices. House prices are driven by the size of mortgages that banks give out. That is why, even though Irish banks face long-run funding costs of at least 8 per cent (if they could find anyone to lend to them), they are still giving out mortgages at 5 per cent, to maintain an artificial floor on house prices. Without this trickle of new mortgages, prices would collapse and mass defaults ensue.
However, once Irish banks pass under direct ECB control next year, they will be forced to stop lending in order to shrink their balance sheets back to a level that can be funded from customer deposits. With no new mortgage lending, the housing market will be driven by cash transactions, and prices will collapse accordingly.
While the current priority of Irish banks is to conceal their mortgage losses, which requires them to go easy on borrowers, their new priority will be to get the ECB’s money back by whatever means necessary. The resulting wave of foreclosures will cause prices to collapse further.
Along with mass mortgage defaults, sorting out our bill with the ECB will define the second stage of the banking crisis. For now it is easier for the ECB to drip feed funding to the Irish State and banks rather than admit publicly that we are bankrupt, and trigger a crisis that could engulf other euro-zone states. Our economy is tiny, and it is easiest, for now, to kick the can up the road and see how things work out.
By next year Ireland will have run out of cash, and the terms of a formal bailout will have to be agreed. Our bill will be totted up and presented to us, along with terms for repayment. On these terms hangs our future as a nation. We can only hope that, in return for being such good sports about the whole bondholder business and repaying European banks whose idea of a sound investment was lending billions to Gleeson, Fitzpatrick and Fingleton, the Government can negotiate a low rate of interest.
With a sufficiently low interest rate on what we owe to Europe, a combination of economic growth and inflation will eventually erode away the debt, just as it did in the 1980s: we get to survive.
How low is sufficiently low? Economists have a simple rule to calculate this. If the interest rate on a country’s debt is lower than the sum of its growth rate and inflation rate, the ratio of debt to national income will shrink through time. After a massive credit bubble and with a shaky international economy, our growth prospects for the next decade are poor, and prices are likely to be static or falling. An interest rate beyond 2 per cent is likely to sink us.
This means that if we are forced to repay the ECB at the 5 per cent interest rate imposed on Greece, our debt will rise faster than our means of servicing it, and we will inevitably face a State bankruptcy that will destroy what few shreds of our international reputation still remain.
Why would the ECB impose such a punitive interest rate on us? The answer is that we are too small to matter: the ECB’s real concerns lie with Spain and Italy. Making an example of Ireland is an easy way to show that bailouts are not a soft option, and so frighten them into keeping their deficits under control.
Given the risk of national bankruptcy it entailed, what led the Government into this abject and unconditional surrender to the bank bondholders? I have been told that the Government’s reasoning runs as follows: “Europe will bail us out, just like they bailed out the Greeks. And does anyone expect the Greeks to repay?”
The fallacy of this reasoning is obvious. Despite a decade of Anglo-Fáil rule, with its mantra that there are no such things as duties, only entitlements, few Irish institutions have collapsed to the third-world levels of their Greek counterparts, least of all our tax system.
And unlike the Greeks, we lacked the tact and common sense to keep our grubby dealing to ourselves. Europeans had to endure a decade of Irish politicians strutting around and telling them how they needed to emulate our crony capitalism if they wanted to be as rich as we are. As far as other Europeans are concerned, the Irish Government is aiming to add injury to insult by getting their taxpayers to help the “Richest Nation in Europe” continue to enjoy its lavish lifestyle.
My stating the simple fact that the Government has driven Ireland over the brink of insolvency should not be taken as a tacit endorsement of the Opposition. The stark lesson of the last 30 years is that, while Fianna Fáil’s record of economic management has been decidedly mixed, that of the various Fine Gael coalitions has been uniformly dismal.
As ordinary people start to realise that this thing is not only happening, it is happening to them, we can see anxiety giving way to the first upwellings of an inchoate rage and despair that will transform Irish politics along the lines of the Tea Party in America. Within five years, both Civil War parties are likely to have been brushed aside by a hard right, anti-Europe, anti-Traveller party that, inconceivable as it now seems, will leave us nostalgic for the, usually, harmless buffoonery of Biffo, Inda, and their chums.
You have read enough articles by economists by now to know that it is customary at this stage for me to propose, in 30 words or fewer, a simple policy that will solve all our problems. Unfortunately, this is where I have to hold up my hands and confess that I have no solutions, simple or otherwise.
Ireland faced a painful choice between imposing a resolution on banks that were too big to save or becoming insolvent, and, for whatever reason, chose the latter. Sovereign nations get to make policy choices, and we are no longer a sovereign nation in any meaningful sense of that term.
From here on, for better or worse, we can only rely on the kindness of strangers.
November 8, 2010
THE BIG PICTURE: Ireland is effectively insolvent – the next crisis will be mass home mortgage default, writes MORGAN KELLY
SAD NEWS just in from Our Lady of the Eurozone Hospital: After a sudden worsening in her condition, the Irish Patient, formerly known as the Irish Republic, has been moved into intensive care and put on artificial ventilation. While a hospital spokesman, Jean-Claude Trichet, tried to sound upbeat, there is no prospect that the Patient will recover.
It will be remembered that, after a lengthy period of poverty following her acrimonious divorce from her English partner, in the 1990s Ireland succeeded in turning her life around, educating herself, and holding down a steady job. Although her increasingly riotous lifestyle over the last decade had raised some concerns, the Irish Patient’s fate was sealed by a botched emergency intervention on September 29th, 2008 followed by repeated misdiagnoses of the ensuing complications.
With the Irish Patient now clinically dead, her grieving European relatives face the melancholy task of deciding when to remove her from life support, and how to deal with the extraordinary debts she ran up in the last months of her life . . .
WHEN I wrote in The Irish Times last May showing how the bank guarantee would lead to national insolvency, I did not expect the financial collapse to be anywhere near as swift or as deep as has now occurred. During September, the Irish Republic quietly ceased to exist as an autonomous fiscal entity, and became a ward of the European Central Bank.
It is a testament to the cool and resolute handling of the crisis over the last six months by the Government and Central Bank that markets now put Irish sovereign debt in the same risk group as Ukraine and Pakistan, two notches above the junk level of Argentina, Greece and Venezuela.
September marked Ireland’s point of no return in the banking crisis. During that month, €55 billion of bank bonds (held mainly by UK, German, and French banks) matured and were repaid, mostly by borrowing from the European Central Bank.
Until September, Ireland had the legal option of terminating the bank guarantee on the grounds that three of the guaranteed banks had withheld material information about their solvency, in direct breach of the 1971 Central Bank Act. The way would then have been open to pass legislation along the lines of the UK’s Bank Resolution Regime, to turn the roughly €75 billion of outstanding bank debt into shares in those banks, and so end the banking crisis at a stroke.
With the €55 billion repaid, the possibility of resolving the bank crisis by sharing costs with the bondholders is now water under the bridge. Instead of the unpleasant showdown with the European Central Bank that a bank resolution would have entailed, everyone is a winner. Or everyone who matters, at least.
The German and French banks whose solvency is the overriding concern of the ECB get their money back. Senior Irish policymakers get to roll over and have their tummies tickled by their European overlords and be told what good sports they have been. And best of all, apart from some token departures of executives too old and rich to care less, the senior management of the banks that caused this crisis continue to enjoy their richly earned rewards. The only difficulty is that the Government’s open-ended commitment to cover the bank losses far exceeds the fiscal capacity of the Irish State.
The Government has admitted that Anglo is going to cost the taxpayer €29 to €34 billion. It has also invested €16 billion in the other banks, but expects to get some or all of that investment back eventually.
So, the taxpayer cost of the bailout is about €30 billion for Anglo and some fraction of €16 billion for the rest. Unfortunately, these numbers are not consistent with each other, and it only takes a second to see why.
Between them, AIB and Bank of Ireland had the same exposure to developers as Anglo and, to the extent that they were scrambling to catch up with Anglo, probably lent to even worse turkeys than it did. AIB and Bank of Ireland did start with more capital to absorb losses than Anglo, but also face substantial mortgage losses, which it does not. It follows that AIB and Bank of Ireland together will cost the taxpayer at least as much as Anglo.
Once we accept, as the Government does, that Anglo will cost the taxpayer about €30 billion, we must accept that AIB and Bank of Ireland will cost at least €30 billion extra.
In my article of last May, when I published my optimistic estimate of a €50 billion bailout bill, I posted a spreadsheet on the irisheconomy.ie website, giving my realistic estimates of taxpayer losses. My realistic estimate for Anglo was €34 billion, the same as the Government’s current estimate.
When you apply the same assumptions about lending losses to the other banks, you end up with a likely taxpayer bill of €16 billion for Bank of Ireland (deducting the €3 billion they have since received from investors) and €26 billion for AIB: nearly as bad as Anglo.
Indeed, the true scandal in Irish banking is not what happened at Anglo and Nationwide (which, as specialised development lenders, would have suffered horrific losses even had they not been run by crooks or morons) but the breakdown of governance at AIB that allowed it to pursue the same suicidal path.
Once again we are having to sit through the same dreary and mendacious charade with AIB that we endured with Anglo: “AIB only needs €3.5 billion, sorry we meant to say €6.5 billion, sorry . . .” and so on until it is fully nationalised next year, and the true extent of its folly revealed.
This €70 billion bill for the banks dwarfs the €15 billion in spending cuts now agonised over, and reduces the necessary cuts in Government spending to an exercise in futility. What is the point of rearranging the spending deckchairs, when the iceberg of bank losses is going to sink us anyway?
What is driving our bond yields to record levels is not the Government deficit, but the bank bailout. Without the banks, our national debt could be stabilised in four years at a level not much worse than where France, with its triple A rating in the bond markets, is now.
As a taxpayer, what does a bailout bill of €70 billion mean? It means that every cent of income tax that you pay for the next two to three years will go to repay Anglo’s losses, every cent for the following two years will go on AIB, and every cent for the next year and a half on the others. In other words, the Irish State is insolvent: its liabilities far exceed any realistic means of repaying them.
For a country or company, insolvency is the equivalent of death for a person, and is usually swiftly followed by the legal process of bankruptcy, the equivalent of a funeral.
Two things have delayed Ireland’s funeral. First, in anticipation of being booted out of bond markets, the Government built up a large pile of cash a few months ago, so that it can keep going until the New Year before it runs out of money. Although insolvent, Ireland is still liquid, for now.
Secondly, not wanting another Greek-style mess, the ECB has intervened to fund the Irish banks. Not only have Irish banks had to repay their maturing bonds, but they have been haemorrhaging funds in the inter-bank market, and the ECB has quietly stepped in with emergency funding to keep them going until it can make up its mind what to do.
Since September, a permanent team of ECB “observers” has taken up residence in the Department of Finance. Although of many nationalities, they are known there, dismayingly but inevitably, as “The Germans”.
So, thanks to the discreet intervention of the ECB, the first stage of the crisis has closed with a whimper rather than a bang. Developer loans sank the banks which, thanks to the bank guarantee, sank the Irish State, leaving it as a ward of the ECB.
The next act of the crisis will rehearse the same themes of bad loans and foreign debt, only this time as tragedy rather than farce. This time the bad loans will be mortgages, and the foreign creditor who cannot be repaid is the ECB. In consequence, the second act promises to be a good deal more traumatic than the first.
Where the first round of the banking crisis centred on a few dozen large developers, the next round will involve hundreds of thousands of families with mortgages. Between negotiated repayment reductions and defaults, at least 100,000 mortgages (one in eight) are already under water, and things have barely started.
Banks have been relying on two dams to block the torrent of defaults – house prices and social stigma – but both have started to crumble alarmingly.
People are going to extraordinary lengths – not paying other bills and borrowing heavily from their parents – to meet mortgage repayments, both out of fear of losing their homes and to avoid the stigma of admitting that they are broke. In a society like ours, where a person’s moral worth is judged – by themselves as much as by others – by the car they drive and the house they own, the idea of admitting that you cannot afford your mortgage is unspeakably shameful.
That will change. The perception growing among borrowers is that while they played by the rules, the banks certainly did not, cynically persuading them into mortgages that they had no hope of affording. Facing a choice between obligations to the banks and to their families – mortgage or food – growing numbers are choosing the latter.
In the last year, America has seen a rising number of “strategic defaults”. People choose to stop repaying their mortgages, realising they can live rent-free in their house for several years before eviction, and then rent a better house for less than the interest on their current mortgage. The prospect of being sued by banks is not credible – the State of Florida allows banks full recourse to the assets of delinquent borrowers just like here, but it has the highest default rate in the US – because there is no point pursuing someone who has no assets.
If one family defaults on its mortgage, they are pariahs: if 200,000 default they are a powerful political constituency. There is no shame in admitting that you too were mauled by the Celtic Tiger after being conned into taking out an unaffordable mortgage, when everyone around you is admitting the same.
The gathering mortgage crisis puts Ireland on the cusp of a social conflict on the scale of the Land War, but with one crucial difference. Whereas the Land War faced tenant farmers against a relative handful of mostly foreign landlords, the looming Mortgage War will pit recent house buyers against the majority of families who feel they worked hard and made sacrifices to pay off their mortgages, or else decided not to buy during the bubble, and who think those with mortgages should be made to pay them off. Any relief to struggling mortgage-holders will come not out of bank profits – there is no longer any such thing – but from the pockets of other taxpayers.
The other crumbling dam against mass mortgage default is house prices. House prices are driven by the size of mortgages that banks give out. That is why, even though Irish banks face long-run funding costs of at least 8 per cent (if they could find anyone to lend to them), they are still giving out mortgages at 5 per cent, to maintain an artificial floor on house prices. Without this trickle of new mortgages, prices would collapse and mass defaults ensue.
However, once Irish banks pass under direct ECB control next year, they will be forced to stop lending in order to shrink their balance sheets back to a level that can be funded from customer deposits. With no new mortgage lending, the housing market will be driven by cash transactions, and prices will collapse accordingly.
While the current priority of Irish banks is to conceal their mortgage losses, which requires them to go easy on borrowers, their new priority will be to get the ECB’s money back by whatever means necessary. The resulting wave of foreclosures will cause prices to collapse further.
Along with mass mortgage defaults, sorting out our bill with the ECB will define the second stage of the banking crisis. For now it is easier for the ECB to drip feed funding to the Irish State and banks rather than admit publicly that we are bankrupt, and trigger a crisis that could engulf other euro-zone states. Our economy is tiny, and it is easiest, for now, to kick the can up the road and see how things work out.
By next year Ireland will have run out of cash, and the terms of a formal bailout will have to be agreed. Our bill will be totted up and presented to us, along with terms for repayment. On these terms hangs our future as a nation. We can only hope that, in return for being such good sports about the whole bondholder business and repaying European banks whose idea of a sound investment was lending billions to Gleeson, Fitzpatrick and Fingleton, the Government can negotiate a low rate of interest.
With a sufficiently low interest rate on what we owe to Europe, a combination of economic growth and inflation will eventually erode away the debt, just as it did in the 1980s: we get to survive.
How low is sufficiently low? Economists have a simple rule to calculate this. If the interest rate on a country’s debt is lower than the sum of its growth rate and inflation rate, the ratio of debt to national income will shrink through time. After a massive credit bubble and with a shaky international economy, our growth prospects for the next decade are poor, and prices are likely to be static or falling. An interest rate beyond 2 per cent is likely to sink us.
This means that if we are forced to repay the ECB at the 5 per cent interest rate imposed on Greece, our debt will rise faster than our means of servicing it, and we will inevitably face a State bankruptcy that will destroy what few shreds of our international reputation still remain.
Why would the ECB impose such a punitive interest rate on us? The answer is that we are too small to matter: the ECB’s real concerns lie with Spain and Italy. Making an example of Ireland is an easy way to show that bailouts are not a soft option, and so frighten them into keeping their deficits under control.
Given the risk of national bankruptcy it entailed, what led the Government into this abject and unconditional surrender to the bank bondholders? I have been told that the Government’s reasoning runs as follows: “Europe will bail us out, just like they bailed out the Greeks. And does anyone expect the Greeks to repay?”
The fallacy of this reasoning is obvious. Despite a decade of Anglo-Fáil rule, with its mantra that there are no such things as duties, only entitlements, few Irish institutions have collapsed to the third-world levels of their Greek counterparts, least of all our tax system.
And unlike the Greeks, we lacked the tact and common sense to keep our grubby dealing to ourselves. Europeans had to endure a decade of Irish politicians strutting around and telling them how they needed to emulate our crony capitalism if they wanted to be as rich as we are. As far as other Europeans are concerned, the Irish Government is aiming to add injury to insult by getting their taxpayers to help the “Richest Nation in Europe” continue to enjoy its lavish lifestyle.
My stating the simple fact that the Government has driven Ireland over the brink of insolvency should not be taken as a tacit endorsement of the Opposition. The stark lesson of the last 30 years is that, while Fianna Fáil’s record of economic management has been decidedly mixed, that of the various Fine Gael coalitions has been uniformly dismal.
As ordinary people start to realise that this thing is not only happening, it is happening to them, we can see anxiety giving way to the first upwellings of an inchoate rage and despair that will transform Irish politics along the lines of the Tea Party in America. Within five years, both Civil War parties are likely to have been brushed aside by a hard right, anti-Europe, anti-Traveller party that, inconceivable as it now seems, will leave us nostalgic for the, usually, harmless buffoonery of Biffo, Inda, and their chums.
You have read enough articles by economists by now to know that it is customary at this stage for me to propose, in 30 words or fewer, a simple policy that will solve all our problems. Unfortunately, this is where I have to hold up my hands and confess that I have no solutions, simple or otherwise.
Ireland faced a painful choice between imposing a resolution on banks that were too big to save or becoming insolvent, and, for whatever reason, chose the latter. Sovereign nations get to make policy choices, and we are no longer a sovereign nation in any meaningful sense of that term.
From here on, for better or worse, we can only rely on the kindness of strangers.
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