Monday, December 3, 2012

The Promissory Notes and the Deficit

The impact of the €30.6 billion of Promissory Notes provided to Anglo and INBS, now merged as the IBRC, on the public finances is massive, but is often misstated.  Over the weekend Stephen Donnelly wrote:

Over the course of 2010, the Fianna Fail Government invented a loan from the people of Ireland to Anglo and INBS. They essentially wrote a €31bn IOU, promising to pay it to the bank and building society over the following 20 years. In 2013, we are due to make our third payment on this, of €3.1bn.

But it gets worse. Now that we 'owe' them this €31bn, we must also pay them interest. This amounts to an additional €17bn over the 20 years. In 2013, the interest payment is €1.9bn. So contained in the 2013 forecasts is a payment of €5bn to Anglo and Irish Nationwide – two dead casinos, both under investigation on numerous fronts.

It is expected that Ireland will have a general government deficit of €12.6 billion, a €0.8 billion reduction on 2012.  In an earlier paragraph it is claimed that the 2013 deficit should actually be €15.7 billion.

It is true that the headline figure looked at by the troika will fall by about €800m. But due to some accounting wizardry, a full €3.1bn of the €5bn to be paid to IBRC isn't included. When you add that in, the deficit will in fact grow, by a whopping €2.3bn.

As discussed below this is a mis-interpretation of the impact of the Promissory Notes on the deficit.

The recapitalisation of Anglo/INBS in 2010 could only be achieved with the transfer of an asset to the banks to support their balance sheet.  The government didn’t have €30 billion of cash lying around, had little potential to borrow it, so an asset was created for the banks.

The Promissory Notes are recorded as a loan asset on their balance sheets.  The repayment of the Promissory Notes is the repayment of this loan from Anglo/INBS to the state. However, unlike typical loans the in this instance the borrower (the state) is repaying a loan without receiving any of the money in the first place.

By viewing the Notes as a loan from Anglo/INBS to the state it is easier to see that the repayment of the Notes do not increase public debt.  If the repayments are made from current resources the level of debt will fall; if the repayment is made with borrowed money the level of debt is unchanged.  The latter is definitely the case.

For 2012, Ireland will have a general government deficit of around €13.4 billion.  The impact of the Promissory Notes on this is nil.  The annual €3.1 billion payment was made at the end of March (a government bond was issued to BOI to get the cash from them).  This simply swapped one form a debt (the loan liability to IBRC) for another form of debt (the bond liability to BOI).

The capital amount of the Promissory Notes was recorded in full in the 2010 general government deficit when Ireland ‘borrowed’ the money from Anglo/INBS.

As the Promissory Notes are a loan the value of the asset on the balance sheet must reflect the value of the loan.  A €31 billion loan to be repaid over 20 years would not be worth €31 billion if there was no interest on the loan.  The book value of a €31 billion zero-interest loan would not have been sufficient to recapitalise these bust banks.  They needed an asset worth €31 billion so an appropriate interest rate had to be applied to the loan.

As the money was being ‘lent’ to the government over a long period the interest rate chosen was the equivalent-term government bond yield from the secondary market on the day the Promissory Notes were issued.  Here are the rates on the four tranches.

As can be seen the interest charged on the loan in 2011 and 2012 was zero.  There was an ‘interest holiday’ built into the loan for those years for some reason (probably to improve the aesthetics of the annual deficits).  There is a higher coupon from 2013 on to make up the shortfall generated by this interest holiday.

Interest will resume being charged on the loan from the first of January.  In 2013 the interest bill on the Promissory Notes will be around €1.9 billion.  However, it is important to note that this is accrued interest and is added to the capital amount of the loan rather than being paid.

The annual €3.1 billion payment does not change because of the end of interest holiday.  This is still made and the current structure is that this will be paid each year up to 2023.  What changes is the reduction in the capital amount effected by the payment as some of this is consumed by the interest.  This is shown in the following table.

Promissory Notes Payments

The “Interest Due” is the amount of accrued interest charged on the loan over the 12 months to the end of March each year.  The interest charged against the 2011 payment relates to the amount issued during 2010 prior to the start of the interest holiday.  The interest charged against the 2013 payment will reflect the interest accrued from the first of January to the end of March next year.

Whereas the 2012 payment reduced the Promissory Note debt by virtually the entire €3.1 billion payment, the 2013 payment will reduce the debt by €2.6 billion.  The March 2014 payment will be preceded by a full year of accrued interest and will reduce the debt by €1.2 billion.

This distinction between capital and interest doesn’t matter.  Each year the IBRC will get €3.1 billion from the government.  Just like all loan repayments the money doesn’t come under different headings.  It is just a loan repayment. 

Also, as the IBRC is 100% state-owned the transfer to the IBRC doesn’t make a difference to the overall position of the state.  What really matter is when the IBRC uses the money to meet its own liabilities.  The structure of the Promissory Notes makes absolutely no difference to value of these and these are the ultimate liabilities that have to be covered.  The Promissory Notes are just a conduit to provide the money to cover these.

The main liability of the IBRC is now the Exceptional Liquidity Assistance (ELA) it has drawn down from the Central Bank of Ireland which it obtains at an interest rate of around 2.5%.  Prof. Karl Whelan has shown that the IBRC will be able to repay its ELA liabilities using its own assets (proceeds/repayments from remaining customer loans) and the annual payments on the Promissory Notes by 2022.  There will be no need for the subsequent payments.

Based on current interest rates the IBRC needs €31 billion at around 2% to repay its ELA obligations.  The fact that it received €31 billion at around 6% means that the IBRC will be able to repay the ELA faster than the government has to repay the capital on the Promissory Notes.  Once the ELA is paid off the remaining Promissory Notes can be cancelled.

When the IBRC repays the ELA it has drawn down from the Central Bank the money repaid goes out of existence and is “burned”.  Most of the interest paid by the IBRC to the Central Bank is a profit for the Central Bank (they just created the money) and this is circulated back to the government via the payment of Central Bank Surplus to the Exchequer Account.

There will be around €0.5 billion of interest added to the Promissory Notes by the time the €3.1 billion annual payment is made next March.  For the full year to December the amount of interest accruing on the Promissory Notes will be around €1.9 billion and this will be added to the General Government Deficit. 

This is summarised in this table from the last page of the recent Medium Term Fiscal Statement. Click to enlarge.

Promissory Notes Interest Amounts

As explained above the interest costs after 2022 are unlikely to happen.  The problem is the interest cost now.  The €1.9 billion interest cost for 2013 is added to the deficit but we are not really paying it.  We are paying for the cost of the Anglo/INBS disasters and whether the money given them is labelled interest or capital does not change the size of the hole to be filled.

Some of the interest will circulate back to the government via the IBRC and the Central Bank.  Another portion will be used to repay the IBRC’s ELA liabilities which means the Promissory Notes can be cancelled some time around 2022.  Very little of the interest is lost. 

The net external interest cost of the Promissory Notes/ELA construction is the ECB’s main refinancing rate (currently 0.75%) which the Central Bank pays to the Eurosystem as a payment for creating the money used for the ELA.

The figure to focus on is the final cost of the Anglo and INBS disasters.  This is going to be more than €30 billion and is an unbelievable waste of money.  It is money that went to depositors.

As Patrick Honohan said recently:

“It would have been better had Anglo and INBS been put into resolution as soon as it became clear that their capital was going to be wiped-out by unavoidable losses on developer loans.  This should have been evident before September 2008, but was not, leading the Government of the day to include these two failed entities in its blanket guarantee.”

Repaying those deposits is costing us dearly.  A change to the Promissory Note arrangement by March is possible but getting one that results in substantial savings is improbable.

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