Monday, April 11, 2011

A 50% haircut on unguaranteed bondholders

A previous post asked about the possible savings to be made through burden-sharing with senior bondholders in the banks.  Here we try to answer some of those questions.   The starting point is again this table published by the Central Bank a few weeks ago.

Bonds in Covered Banks (Updated)

The following table works through the figures when imposing a 50% haircut on all unguaranteed senior debt.  Click table to enlarge.

Senior Debt Haircuts

The first column gives a breakdown of the €46.3 billion given to the banks so far.  The next column gives the capital requirements from the recent stress tests.  It excludes €2 billion for IL&P as it is assumed that this can be raised by the sale of Irish Life and the use of other assets in the group.  It also excludes the additional capital “buffer” of €5.3 billion that the banks may receive.  The banks, particularly, but maybe only, BOI, might be able to raise some of this €16.7 billion themselves but we will assume that all of it comes from the State.

The third column shows that losses that will be applied to subordinated bonds if a 70% haircut was applied to them.  The next column gives the total losses that are currently being covered by the State.  Adding the capital “buffer” of €5.3 billion brings the State’s contribution to €63.5 billion.

How much of this can be offset if losses are imposed on unguaranteed senior debt?  The next column gives the losses that would be applied to all unguaranteed senior debt (secured and unsecured) if a 50% haircut is applied. (It is not clear if this can be done for secured debt but we will assume it can).  This shows that more than €18 billion of savings are possible.

However, in the case of BOI and EBS the losses imposed on bondholders are greater than the maximum losses to be covered by the State.  We will assume that the State’s contribution gives the upper limit on losses to be forced on senior bondholders in each bank.   This is the figure given in the second last column.  The only changes are for BOI and IL&P as a 50% haircut on senior debt would result in savings greater than the amount of losses covered by the State in the first place.

This means that savings of €13.2 billion are possible if a 50% haircut is applied to all unguaranteed senior debt (this is in addition to the €5 billion from the 70% haircut on subordinated debt already announced).  Although this is only 20% of the total State contribution to the banking disaster, €13.2 billion is a colossal amount of money.  It must be assumed that somebody somewhere has done the sums of a cost-benefit analysis that shows the benefits to the State of taking these losses exceeds the costs.  Alas, no such analysis has been published.

A revised table assuming a 50% haircut for unguaranteed unsecured debt but a 25% haircut for unguaranteed secured debt is provided here.  Again click the image to enlarge.  The same logic as above is used.  This doesn’t change the arithmetic a huge amount and just under €12.0 billion of savings are possible.

Senior Debt Haircuts 2

€13.2 billion (or €12.0 billion) is a huge amount amount of money and it would be interesting to know what benefits from carrying these losses are believed to offset this amount.  This analysis assumes that guaranteed senior debt is paid off in full, but as 52% of this is in BOI and IL&P the scope for savings here with say a 20% haircut would be small (though this is if we start to consider €1 billion ‘small’!).  The above table also shows the savings that are possible if burden sharing is limited to a 50% haircut to the unguaranteed, unsecured senior debt.

In all analysis the greatest potential for savings is in BOI.  If done on a bank-by-bank basis it may be decided that burden sharing should not be applied in the case of BOI.  This is the only bank that has “non-zombie” status and is the bank that has the potential to return to some form of normality the quickest.  It’s ability to raise capital independently may be unduly harmed if burden-sharing is applied here.  That would reduce the potential savings to below €8 billion and down to around €6 billion for the four “viable” banks.  With the 25% haircut on unguaranteed secured debt the figures are €6.6 billion and €4.8 billion.

It is pretty clear that the biggest sinkholes in this mess are Anglo, INBS and AIB.  The former two are being wound down.  AIB (once merged with EBS) has been designated a “pillar” bank.  This looks like an expensive way to establish a pillar bank.

As we said elsewhere it is probable that the State can service the debt from this banking fiasco.  But the question remains, if we are putting up €64 billion for this disaster, why can’t those who had the money in the first place stump up €8 billion?  Burden sharing with senior debt in Anglo and INBS cannot be avoided.  This will raise less than €2 billion. 

The question is whether it is worth avoiding this scenario for AIB, EBS and IL&P.  A 50% haircut across all unguaranteed senior debt would generate savings of €6 billion.  Even with a the reduced haircut for secured senior debt the savings would be €4.8 billion.  These savings are not as large as those who are shouting loudest might have us believe, but they are significant nonetheless.

It would be nice to think that there is €6 billion (plus interest) of benefits to be gained from taking on this debt, but it would be even nicer to know it.  This question was asked to Patrick Honohan in a recent interview but the answer was less than convincing.  A transcript of the relevant portion is included below the fold.

Vincent Browne: Ok who’s going to pay for this?

Patrick Honohan: I’m afraid that the costs are going to be borne by the beneficiaries of Irish public services and the taxpayer.  I don’t just say the taxpayer because this is a squeeze on the government. The government finances are going to absorb this.  Of course, in the early stages the shareholders lost money, the subordinated debt holders lost money. Ah…

VB: €65 billion of the bank losses that you have calculated here. €65 billion are not covered by the State guarantee.  The guarantee.  Why should we be paying them?

PH:  Well, the figures are laid out.  You’re including some things that although not covered by the State guarantee, that’s fine, but they are also collateralised so they’re not going to be paid by the taxpayer, they’re going to be paid out of the collateral in that case.

The unguaranteed element here is as you know considerably smaller, a number in the, in the, hmmm, oh what is it? About 20-something billion. Anyway that’s a well-known number, of which the subordinated debt, I think, will inevitably take very significant losses.

VB: But there’s €35 billion that now covered by the State guarantee. Now why should the State be paying back those people not covered by the State guarantee?

PH: Ah, in the case of the subordinated debt, which is part of this, I would be very surprised if they won’t be subject to…

VB: No, but the senior debt is €35 billion.

PH: OK, moving into the senior debt. It is an argument of expediency and calculation. OK. There, first of all it’s not legally unproblematic to do this. Maybe you can find a legal way. You certainly need legislation.  Let’s just think through it.

VB: Yes, because the problem of forging of preference, but that would be about the case of liquidation.

PH: You could, you could.. lawyers have proposed ways of doing this, but it’s not unproblematic. 

Secondly, however, you have to evaluate the consequences for the State’s finances, and indeed for the banks’ finances, of a government taking aggressive action of that type. Aggressive, legislated action of that type.

There will be consequences. One has to calculate them. The calculation of expediency that one would make is “is the amount recovered, is that going to be offset by higher funding costs and the smaller the amount to be recovered relative to the total amount of debt, the more adverse that calculation becomes”.

VB: But we going to give €35 billion…

PH: So the amounts of debt that are involved here, that are in play here, are small relative to the potential losses.  That is the calculation that has to be made.

Now, there is a third factor, which is very very important, which is at the spill-over, the potential spill-over on other banking markets in Europe and therefore the effect on the rest of Europe and the consequences for our relationships with the rest of Europe.

Those are the three reasons.

VB: There’s a fourth reason.  There’s a fourth factor which you haven’t mentioned and it is the effect of a further €35 billion going out of this country to these senior bondholders not covered by the State guarantee.  The effect in terms of education.  The effect in terms of poverty.  And misery, unemployment and everything else.

PH: No.No. No. What I am doing is a calculation that says the net advantage to the fiscal accounts, to the ability of Ireland to fund all the services you are talking about.  That is the calculation that has to be made and it is not at all clear that without the support of our European partners, this would be positive.  In fact I think it would be negative.

VB: In other words, our European partners are saying that this deal, this bailout deal that we have given you is conditional on you paying back people not covered by the State guarantee. Is that what you are saying?

PH: The... am. No, they didn’t say that. But there would be consequences for our relationship.

VB: And we have to defer then.  Irrespective of the consequences for this society and our citizens we have to pay €35 billion to people not covered by the State guarantee.   On top of all the other disasters.

PH: We have to take account of the consequences.

VB: On top of these other disasters.

PH: We have to take account of the consequences. It is not on top of it. It is part of it.

VB: On top of the other disasters. The €75 billion, or the €65 billion disaster.

PH: It is all included.

VB: Hmmm. Yeah. You were one of the people who negotiated this EU/IMF deal.  Did you take account of the social costs of the deal we entered into?

PH: Absolutely. This is an arrangement which is attempting to recover the finances of the State, and of the banks, of course you’re talking about the banks today, but of the State. The State was in a position where it had lost access to the markets, lost confidence.

We have very little alternative here, than to seek support from official partners. And they want to see a plan that restores the finances.

VB: As far as I’m know there’s nothing in the EU/IMF deal that requires us to pay this €35 billion.

PH: Absolutely not. That’s right, that’s right.

VB: So, we wouldn’t be breaking the deal if we said we’re not paying.  But you’re saying in addition to that…

PH: No, I’m saying that a calculation has to be made as to whether it would be advantageous.

VB: But the deal would stand in any event.  We would still be paying whatever we’re paying, 5.8% or whatever.

PH: Certainly. But, but I think I’ve pointed out, it’s not legally unproblematic. That there would be consequences in terms of the cost of funds and there would be consequences in terms of the impact on our partners and therefore that would feed back to us.  So it is an argument of expediency.

In this exchange, Prof. Honohan used the words ‘calculate’ or ‘calculation’ ten times.  It is clear that he has done this calculation but not once did he offer the figures involved in this analysis.  He never offered the benefits and costs of this calculation. 

How much does he think can be saved through burden sharing with unguaranteed senior bondholders (and he limits it to unsecured bonds)?  Then, on the other hand what cost does he put on the consequences of this decision?  He clearly believes that the costs exceed the benefits but seems unwilling to provide the numbers behind this view.

As we have seen the savings are not as substantial as might be believed, but still run to several billion.  A 50% haircut on all the unguaranteed unsecured senior debt would generate a savings of €6.3 billion in the four ‘viable’ banks (€3.8 billion excluding BOI). 

From the outside we can only guess what the costs of such a decision would be.  From my limited perspective, I would tend to go with Prof. Honohan’s view, but I would like to be able “to put my finger into the holes”, so to speak, to see and believe for myself.

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