Interest costs under the “debt deal”

As explained in the previous post it is not the size of the government debt that has a direct impact on the public finances; it is the interest cost it generates (though the size is obviously a big factor in that) 

What was in play with yesterday’s restructuring was a €25 billion Promissory Note debt.  It was a €25 billion debt on Wednesday, it is a €25 billion debt today and it will be a €25 billion debt in 2053.  But because of inflation not all €25 billions are created equally.

Anyway, the debt in question generates two interest costs for the State:

1. The interest on the central bank funding which carries an interest rate equals to the ECB’s main refinancing rate.
2. The interest on the borrowings used to pay down the central bank liquidity.

Here are two tables that showing some hypothetical the interest costs of the old Promissory Note and new Long-Term Government Bond arrangements until 2033. 

These are only hypothetical scenarios designed to gauge the relative difference in the cost of each approach rather than a definitive estimate of the cost of each.  There are a number of simplifying assumptions made.

• The ECB interest rate is expected to rise from 0.75% to 3.00% over the next six years and stay at 3.00% thereafter.
• The ‘margin’ of Irish government borrowing over the ECB rate is assumed to be constant 3.25%.
• All interest is paid from current revenue.
• Borrowings are only made to fund capital payments.  This only impacts the Promissory Note arrangement and from each €3.1 billion annual payment the Central Bank profit is subtracted as it is returned to the Exchequer and also the external interest cost of the ELA as it is assumed that is paid from current revenue.  This keeps the borrowing at €25 billion in both cases so we can assess the interest cost.
• The discount rate used is 6%.

As we are looking for relative differences the assumptions are not hugely significant as both scenarios are played out under the same set of assumptions.

First the Promissory Notes:

And the new Long-Term Bond arrangement:

The interest mix of both changes.  In the first case it is because the Promissory Notes/ELA costing the ECB rate is paid off with new government borrowings at the “market rate”, while in the second case the Central Bank funding at the ECB rate is reduced through the Central Bank selling the bonds it holds thereby making the interest payable to a third party. By 2034 both arrangements are identical in this setting - a debt of €25 billion with an annual interest cost of €1.56 billion (assumed interest rate by then is 6.25%) - as all the Central Bank funding is repaid

So what do we find in? In nominal terms the interest costs are

• Promissory Notes: €27.0 billion
• Long-Term Bonds: €20.6 billion

Getting the present value of the interest payments gives:

• Promissory Notes: €14.3 billion
• Long-Term Bonds: €10.3 billion

The interest cost under the new arrangement is around 30% lower.  This is a gain to the State of the new change which arises from having access to borrowings at the lower ECB rate for longer.  It increases from c.7 years to c.15 years.

The are other gains from the new arrangement.  The above just reflects the interest cost of each arrangement.  The accounting treatment of the Promissory Notes meant they had a very large impact on the deficits over the coming years.  That has now been reduced.  Also the new arrangement means that the debt doesn’t have to be rolled-over until the first of the new bonds matures in 2038 significantly reducing the medium term funding needs of the State. 

The is little doubt that the new arrangement is anything other than a gain for the State.  And unless your expectations were incredibly unrealistic (or more accurately based on fantasy), yesterday’s announcements were pretty much as good as could have been hoped for given the institutional constraints faced.

“Legacy of Debt”

Lots of talk about a “legacy of debt” in response to yesterday’s re-arranging of the Promissory Notes/ELA framework.  First up, governments don’t repay debt, they roll it over.  And, as well as the size of the debt, there are two things that matter for debt rollovers:

• average maturity
• average rate of interest

Today’s announcement does not change the size of the debt but the maturity and interest rate changes are very significant (and beneficial in case there is any confusion).

Yesterday, Ireland was faced with the prospect of carrying a debt of €25 billion on the Promissory Notes and needed to roll that over with payments of €3 billion every year at whatever the best available rate at the time was.

At the end of the Promissory Notes (which would probably have been around 2022) the debt would still exist and what would need to be rolled over would have been the borrowings undertaken in the interim to meet the €3 billion annual repayments.  This legacy of debt was always going to exist and would have needed to rolled over in 2025, 2035, 2045 or whenever.  Government debt is not extinguished, the burden of carrying it (the interest) is eroded through growth and inflation.

Yesterday’s announcement offers some significant benefits for Ireland on both fronts.  Firstly, the average maturity has been extended to an average of 34 years.  This means the debt has to be rolled over far less frequently and through that reduces risk.  Under the current arrangement there would be €25 billion of debt being paid off in chunks of €3 billion and these would quickly accumulate into a total of tens of billions that would need to be frequently rolled over depending on the nature of the borrowings used to fund the annual payments.

The new arrangement postpones this roll over to an average duration of 34 years.  Rolling over €25 billion of debt in 2020 could present significant difficulties.  Rolling over €25 billion of debt on a staggered basis between 2038 and 2053 will be far less onerous.

The new arrangement also offers the significant interest rate benefits.  Under the Promissory Note arrangement debt with a very low net external cost of 0.75% (the ECB MRO rate) was transformed into much more expensive debt (EU/IMF loans at 3.3%) at a rate of €3 billion per annum. 

The net external cost remains at 0.75% but the rate at which the debt is transformed into more expensive debt has been significantly reduced.  As a result of the Central Bank of Ireland selling the bonds it receives as part of the swap this will happen at a rate of €0.5 billion per year up to 2018, €1 billion a year from then until 2023 and €2 billion a year thereafter.

The €25 billion of Promissory Notes would have been turned into full interest-costing sovereign debt by around 2022.  Today’s announcement means that the full €25 billion will not become fully interest-costing until around 2032.  We have gained because the debt with a net external cost of the ECB MRO rate is now available for longer.

Future generations were always going to have a “legacy of debt” of €25 billion.  What yesterday’s announcements have ensured is that they will have access to lower interest rates for longer and will be faced with rolling over the debt less often.  In the arena of public debt both of these are a win.

Here are some figures since 2008:

• 2008: €10.9 billion
• 2009: €15.4 billion
• 2010: €11.8 billion
• 2011: €10.2 billion
• 2012*: €7.0 billion
• 2013*: €3.4 billion

This figures will give a “legacy of debt” of €58.7 billion.  This is more than €30 billion greater than the total in question in yesterday’s restructuring.  What are these figures?  They are the underlying primary deficits (the deficit net of interest costs and banking measures) that the state ran from 2008 to 2011 and the projections of what the primary deficit will be for 2012 and 2013.

This is the excess of government expenditure on public sector pay, intermediate consumption, social transfers, capital formation and subsidies for the current generation over the tax revenue the government is raising from the current generation.  Over a six- year period the government is spending nearly €60 billion more on us in services and transfers than it is collecting from us in taxes and charges.  Why is no one concerned about this “legacy of debt” for future generations?

If we could borrow this money with a zero-interest perpetual bond there would be no need to worry about future generations.  They would have to pay nothing for our borrowings.  This highlights that for governments it is not the amount of debt that matters.  With governments debt doesn’t matter, deficit spending does.

The debt only matters insofar as it generates an interest cost.  If this money has to be borrowed at 4% it will cost future generations over €2 billion a year in interest for the privilege of us spending more on ourselves than we are willing to pay in taxes.  Is this a legacy we are willing to impose on future generations?

“Lots of Debt” in the IBRC?

On last night’s Primetime, Professor Hans-Werner Sinn seemed to support a default on the upcoming €3.1 billion payment on the Anglo Promissory Notes.  From the interview:

PK: If, for example, we decide we are not going to pay the 3.1 billion on the Promissory Note which is due at the end of March.  That means that the former Anglo bank will not have the cash to do what it needs to do – to wind down.  The ECB will say “that’s a default”.

HWS: Why don’t you let it default? Default is the best way to solve such a problem. It doesn’t mean the bank comes to an end; it just means that the creditors have to forgive some of the debt and this is quite natural.  They made the investment decision.

And

HWS: Well there is still lots of debt in the banking sector, including the Anglo Irish Bank, the follow-up bank, the bad bank.  It has bondholders; it has creditors.

PK: So burn them?

HWS: Well, ask them to forgive some of the debt.

“Why not let it default?”  That could be done but it is clear that Professor Sinn does not know what is left in Anglo/INBS, now known as the Irish Bank Resolution Corporation (IBRC).  Here is an abridged version of the IBRC balance for the end of June 2012 taken from its latest interim report (page 24)

IBRC does have a lot of liabilities but 85% of it is the Exceptional Liquidity Assistance (ELA) it drew down from the Central Bank of Ireland in 2010 to repay the huge amount of deposits that left at that time.  The €3 billion of “Deposits from Other Banks” is the repurchase agreement entered into with Bank of Ireland last year with an Irish government bond that was used to meet last year’s Promissory Note/ELA repayment.  The IBRC must repay this in June.

There is not “lots of debt” to renege on unless Professor Sinn means a default on the ELA that is ultimately owed to the ECB and that we should ask them “to forgive some of the debt”.  However, when pressed further he doesn’t seem to advocate this.

PK: The ECB will allow us to do this?

HWS: I don’t know what the ECB will say.

Where was the Xmas “surge” in Retail Sales?

The CSO have released the December 2012 Retail Sales Index.  There is something missing from the data – the much heralded “surge” in retail sales that apparently took place around the Christmas period.  Here is the core retail sales index which excludes the Motor Trades.

There was an increase in December but only marginally.  The trend in retail sales is up but this data do not reflect what was feted as “the best Christmas for retailers since 2007”.  Here it might be a little instructive to use the unadjusted series that just looks at the amount of retail sales without taking seasonal factors into account.  This chart has the unadjusted series for core retail sales (with December 2008 equal to 100).

Unsurprisingly there is a spike in retail sales each December.  At 94.2, this year’s December peak was higher than each of the last two years (92.5 in 2010 and 93.3 in 2011 using the base in the chart) but was below both 2008 (100) and 2009 (94.7).

Maybe we are not looking in the right place.  It would be great if the CSO provided a resource that allowed us to create selected sub-indices from the categories provided.  The retail sales shown in the above charts include fuel, furniture, hardware, medicines and other categories which were likely excluded when Retail Excellence Ireland were making their seasonal claims.  These items only make up about one-fifth of the indices shown above so their effect is unlikely to be significant.

Although limited we can use one of the indices to check for the retail surge.  Non-food sales in Department Stores are only about 1/12th of the above indices but might be expected to reflect the broader pattern in Christmas shopping.  Here are the unadjusted series.

That seems more like it.  The volume of non-food sales in Department Stores in December 2012 was indeed the highest since 2007.  In fact, volume was nearly 20% higher than 2008.  However, the value index was identical.  See here.  The adjusted series also shows a jump last month.

And this also shows that the trend in sales in Department Stores has been positive since about April of last year.  However, apart from Department Stores it is hard to find evidence of the Christmas surge.  Sales in bars did jump 5% in December but the underlying trend in this sector is unmistakeable.

The retails sales of electrical goods (computers and peripherals, televisions, radios and DVD players, games consoles and software and telecommunications equipment) has been positive in recent months (in volume terms at least). 

The recent jump was due to the digital switchover in October rather than any pre-Xmas exuberance.  Even still, the volume in this category in December was up 4% on last year, though the value of sales was down by around 1%.

It looks like the warning at the end of this post that “the plural of anecdote is not data” is borne out by the above data.

Patrick Honohan on ELA

The exchanges in this week’s Joint Oireachtas Committee on Finance at which Governor of the Central Bank, Prof. Patrick Honohan attended as a witness provided some useful insights into to Promissory Note/Exceptional Liquidity Assistance arrangement used to prop up Anglo Irish Bank and the Irish Nationwide Building Society.  

Most of the details of the arrangement were generally known but some confirmation of them was provided by Prof. Honohan.  These are from the transcript.

1. The money is owed to the ECB.

Patrick Honohan: “Two years ago on 30 March 2011, some €3 billion was handed back to the Central Bank. The Government paid some €3.1 billion in cash to the IBRC. The IBRC is already borrowing and I cannot remember how much it had borrowed at that stage. It would then repay the Central Bank of Ireland, which has drawn on facilities in the ECB. Our drawing on the ECB facilities, in other words the money we owe to the European Central Bank as a whole, will decline by that amount.”

1b. Patrick Honohan owes it to the ECB!

Patrick Honohan: “I am the chief executive officer of the Central Bank and I owe that money. I am personally responsible for making sure that debt is repaid.”

2. Default on the ELA would be “uncomfortable” in some undefined way.

Patrick Honohan: “A unilateral action of the type Deputy Humphreys is talking about would be taken very poorly indeed by the ECB, which – without over-egging the case – has provided a lot of finance to this country at a low interest rate. There are a number of ways the European Central Bank, if it chose, could find to make things uncomfortable in a graduated way. It is not in that space but I have to think what it might do. It could do things that would make us uncomfortable. I will not give a list because it might give people ideas.”

“Large sums of money are being lent by the ECB to various Irish institutions and very low interest rates are being applied. All of that could change if the ECB wanted, but I do not say it would. The reaction of the international markets would also be of concern. I am too much of an academic and I take up the question when I should probably have said it is unthinkable and that I could not possibly imagine such a case. If the Deputy wants to go through it blow by blow, the blows would be unpleasant.”

2b. But the ATMs will stay open!

Patrick Honohan: “I will not describe on television some dramatic situation and give a one-liner such as that ATMs would be closed. ATMs would not be closed, but it is not as if one can decide not to give the money and use it oneself. There are consequences. There is a network of international contracts and lenders who will take action against the Government and we have seen it.”

3. The interest rate charged on the ELA is 2.50% (ECB + 1.75 percentage points)

Patrick Honohan: “I am afraid of getting this wrong but as far as I recall, the IBRC currently pays 2.25%.” [Subsequently amended to 2.50%]

4. The interest rate payable by the Central Bank for the facility is 0.75% (ECB MRO rate)

Patrick Honohan: It is at 75 basis points.

Nobody in the session mentioned the interest rate being paid by the Exchequer to the 100% state-owned IBRC so maybe it has sunk in that it doesn’t really matter.  Of the interest rates in the PN/ELA arrangement the one that counts is the 0.75% paid by the Central Bank to the ECB.

There was also some useful information (or at least the non-rebuttal of some information) on the ECB’s holdings of Irish government bonds through the now-defunct Securities Market Programme (SMP) which is below the fold.

Deputy Kevin Humphreys:  “The ECB purchased significant amounts of distressed euro sovereign debt in the secondary bond market in 2010 and 2011 through the security market programme. I understand that approximately €200 billion worth of bonds are being held to maturity. It is estimated that between €15 billion and €20 billion of Irish bonds were bought, mostly at distressed prices well below par.

The Barclays Capital report of January 2012 stated that about €19 billion of Irish Government bonds were being held by the ECB. Is that the correct sum?

We heard a lot about how Franklin Templeton made huge returns by buying Irish bonds at low prices. It is difficult to estimate the profits the ECB will make on the capital proportion of these bonds bought through the SMP but it could be in the range of €3 billion to €5 billion. The problem is, and I asked about this in private session before and was given short shrift, we do not know what the ECB profits may be because the ECB will not tell us. The Governor sits on the board, however, so does he know and will he tell us?”

Patrick Honohan:  “I know how much Irish paper is held by the ECB in the security market programme. I could try to calculate the profits.”

Kevin Humphreys:  “Am I far off in my calculations?”

Patrick Honohan: “I would steer the Deputy away if I thought he was. I think that more information about the SMP holdings will be provided. The SMP has terminated as a programme and the reasons of market sensitivity that caused it not to be disclosed would fade away. At present, however, I am not at liberty to give out those numbers.”

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.

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.

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.

How much are the Promissory Notes worth?

This is a hollow exercise but the 2010 Annual Report for Anglo says:

The fair value of the promissory note is determined by the use of a valuation technique, based on a discounted cash flow methodology, which references observable market data. The fair value is calculated by discounting expected cash flows by reference to current observable market yields for comparable Irish government bonds.

Here are the four tranches of the Promissory Notes:

The 2010 column gives the annual coupon on the notes.   The interest rate was set using an equivalent Irish government bond at the time the tranche was issued.  The first three tranches were issued in the first half of 2010.  Tranche 4 was issued on the 31st December 2010, by which time Ireland had seen bond yields soar and entered an EU/IMF programme.  The annual coupon of the €9.1 billion in Tranche 4 is 8.6%. 

The promissory notes are like an amortising bond in which the interest and some of the capital is repaid each year.  With one-tenth of the capital amount repaid each year the average maturity of the notes is around five years.  The five-year yield as calculated by Bloomberg is currently around 3.9%.  This is nearly five percentage points lower than the coupon on Tranche 4.  What impact does this have on the fair value of the Promissory Notes?

As a simplified comparison, a €100 five-year bond with a coupon of 8.6% that yields 3.9% would have a current value of around €120.  The drop in Irish government bond yields over the past few weeks will do wonders for the aesthetics (rather than the realities) of the IBRC balance sheet.

This is indeed a hollow exercise but things like this probably account for part of the “technical discussions about technical things” we have been hearing about for nearly a year now in relation to rescheduling of the Promissory Notes.  Here is a reference from October 2011 and today in Nicosia at the informal Eurogroup meeting Michael Noonan once again referred to “technical talks”.

Maybe when these are finally concluded we will be a little like Joan Burton was in an early Dail debate on the Promissory Notes when she declared “we need a Powerpoint presentation on this.”

The ‘New’ Bond

The  €3.5 billion increase in Ireland’s government bonds as a result of the Promissory Note transactions announced last Thursday can be seen here.

The change is in the March 2025 bond which now has €11.7 billion in issue rather than €8.3 billion on the last occasion we looked at the Daily Outstanding Bonds Report.

The total amount of bonds in issue has increased to €83.1 billion and when/if the Bank of Ireland component of the announced transactions is put into place, the covered banks will be holding around €16 billion (one-fifth) of these.

Much ado about nothing

With a lot of hope and more than a little expectation, at 4pm yesterday the Minister for Finance made a statement to the Dail on the €3.1 billion payment to be made this weekend on the Promissory Notes to the Irish Bank Resolution Corporation (IBRC).  It turned out to be a bit of a damp squib.

The key issue in this whole sorry saga is the rate at which the Exceptional Liquidity Assistance provided by the Central Bank of Ireland to the IBRC is repaid.  The 2011 Annual Report from the IBRC shows that this stood at €42.2 billion at the end of December.  This money was ‘printed’ by the Central Bank of Ireland and given to the IBRC, and it now needs to be returned by the IBRC so the Central Bank can ‘burn’ it.  Nearly three-quarters of the money to meet this requirement will come via the Promissory Notes.

It is hard to see any change at all.  The IBRC needed to get €3.1 billion of cash this weekend;  the IBRC is getting it.  The IBRC needed this money to give to the Central Bank; the Central Bank is getting it; the Central Bank will burn it.  A statement from an ECB spokesperson makes clear that they don’t see any change either.

“It is very important that the Irish state will honour the 3.06 billion euro amortisation of the promissory notes. This will reduce the emergency liquidity assistance which IBRC receives from the central bank of Ireland and thus the Eurosystem.

We certainly expect that also in the future the promissory notes will be served according to the schedule to which the government has committed itself.

As Ireland strives to regain market confidence, it is of utmost importance that the commitments of the Irish state are met in line with standing contracts and agreements.”

The Governor of the Central Bank, Patrick Honohan appeared before the Oireachtas Joint Committee on Finance last Tuesday.  The transcript is here.  In response to a question from T.D. Stephen Donnelly he said

Professor Patrick Honohan: “The question I noted in particular related to how much cash IBRC needs. In fact, the objective of the plan is to eliminate the cash need by postponing it.”

This would seem to suggest the plan was to defer the cash payment.  That could be the cash payment into the IBRC or the cash payment from the government.  The first is significant and the suggestion it that this was the “objective of the plan”.  Reducing the cash needs of the IBRC can only come about through a reduction in the cash it needs to repay its ELA obligations.  This is not how things have panned out.

The €3.1 billion cash payment to the IBRC will be made but there has been a slight change in how this payment is being funded. Instead of coming from the current funding arrangements of the State (the EU/IMF loans) it will come from a 'new' government bond.  

As a result of this there has been an increase in funding of €3.1 billion. This appears to be only for 12 months which is of little benefit given that we have funding in place for the next 21 months.   In the Minister’s statement it says:

Ultimately, it is intended that this long term Government bond will be financed for one year, on commercial terms, with Bank of Ireland who may in turn refinance the bond with the ECB.

Ultimately means “in the end; at last; finally”.  There is nothing after “ultimately”.  One year is not long term.  There has been mention of a bond maturing in 2025 but this was not included in the Minister’s statement yesterday, in his statement last Wednesday, nor by Governor Honohan this Tuesday.  I cannot find a primary source for the claim that a 2025 bond would be used but it did enter the public domain somehow. 

If the arrangement ends after one year as the Minister’s statement indicates the impact on the January 2014 funding cliff is negligible (possibly even slightly negative).   As it stands, this time next year we will need to make the next €3.1 billion payment on the Promissory Notes and also a repayment on the bond issued to Bank of Ireland.  This is clear in the statement from Bank of Ireland.

Under the terms of the Repo, IBRC will have an obligation to repurchase the Bonds from the Bank for approximately €3.06bn in cash not later than 364 days after the effective date.

Where is the IBRC going to get €3.1 billion in 12 months time?  There may be some attempt  to further extend the actual repayment of this bond but no solid information on this has been provided. There is no indication who might replace the Bank of Ireland if the arrangement was to be extended.  As it stands in 12 months time the Bank of Ireland will give this bond back to the IBRC and the IBRC must find €3.1 billion to pay for it.

If the actual cash payment can be further delayed there would be a funding gain into 2014 and, according to Governor Honohan, a minor improvement in debt sustainability.

Professor Patrick Honohan:  “In the discussion, the use of a long-term bond has already been mentioned. This is a major step forward from a sustainability perspective. The idea of a long-term bond being used in lieu of a cash payment is a very considerable step forward, considering it puts off for a long number of years the actual need to refinance those payments. In addition, the net cost of this - we can speak about complications later - will be quite low relative to alternative sources of finance. There is a very definite gain in debt sustainability. We are only talking about a fraction of the total promissory notes so we cannot say it is a decisive change, but relative to this amount, it is a considerable improvement.”

I don’t think yesterday’s move sits well with this analysis.  To sum: instead of making with the Promissory Note payment with money borrowed from the EU/IMF at 3.5% to be rolled-over over the next three to ten years, we made the Promissory Note payment with money borrowed from the Bank of Ireland at 5.4% to be rolled over next year.