Friday, March 13, 2009

New Credit Markets Acrobats: Brian, Brian & Mary

The media is now ‘seriously’ talking about the Government setting up a ‘shamrock’ SFEF-styled bond (named after Societe de Financement de l'Economie Francaise guaranteed bonds issued by the French) for Ireland (see here).

The bonds peddlers – primary and secondary alike – have been enthused. The idea is that an already nearly-insolvent state will issue strong-guarantee senior, cash-redeemable only bonds covered by Ireland’s AAA rating for a large volume issuance, blah-blah-blah…

In reality there are serious and insurmountable problems with the idea of Ireland Inc issuing a SFEF to be disbursed across Irish banks in order to aid their capitalization and re-start lending.

First problem is that this state can hardly convince the markets to buy its own bonds, let alone a stand-alone, ring-fenced ‘aid’ bonds. The General Government Guarantee for such bond will either have to take priority over the Government guarantees on its own direct debt in order to fly, or it will have to take a second seat to these in order to flop.

In the former case, you can throw away any hope of top tier ratings for Government bonds out of the window, and assign risk weightings to public debt on par or even in excess of those currently allocated to our banks. Hmmm… an appetizing prospect.

In the latter case, the SFEF will be subordinate to the Government Banks Guarantee Scheme (GBGS) – a measure that had spectacularly failed to deliver for the banks and for the Exchequer. Even more to the point here, Ireland’s €440bn bank guarantee scheme has in effect converted Irish banks debts and deposits into a SFEF-styled vehicle already. According to both the European Commission and the ECB – this was a bad deal for the country credit position.

In February 2009, the Commission said the GBGS could have a “potential negative impact on the long-term sustainability of public finances”. The ECB’s assessment of such schemes across the EU also reads like a wholesale condemnation of the overly-optimistic packages, with Irish GBGS being a front-runner for the title of the most reckless of all. “…Together with weakening fiscal positions in the wake of the economic crisis, the bank rescue packages seem to have contributed to a sharp widening of intra-euro area government bond spreads, in particular for member countries with weaker fiscal positions. Looking ahead, it is important that governments return to sound fiscal positions as soon as possible in order to maintain the public’s trust in the sustainability of public finances”.

Expanding the scope of GBGS to cover not only the existent debt and deposits, but also the future lending (under the SFEF), while pushing the Guarantees quality even below the already low stuff that the original Scheme delivered is not an appetizing prospect, either.

Now, another problem with SFEF is that it is restricted by the EU rules to a 2-3 year maturity window (with only a small portion allowed to be issued with a 4-5 year horizon). This means that any SFEF written in 2009 will mature in 2011-2012. The Government latest bond placement shows that from now on, we are likely to see most of the standard new Government debt hitting the 2012 maturity date (for 2009 issues) and 2013 date (for 2010 issues). There is absolutely not a snowball’s chance in Hell that we can frontload so much debt (once our own Exchequer borrowing requirements are factored in) into the economy for 2011-2013 horizon.

In my view, the Government is completely missing the point by pursuing this idiotically frantic search for new cash to throw at the problem of banks balance sheets. As I have proposed in this blog before (here) and in numerous articles in the press, the solution to the problem of stalled lending must begin at the coal face of the credit demand and supply imbalances. These are driven as much by a lack of funding as by a lack of demand for funding. The problem is therefore a twin collapse in fundamentals and it requires address both sides of equation simultaneously.

Side 1: collapsed supply of funding is driven by deterioration in banks balance sheets. Solution: help banks to unload bad loans off the books by doing equity-for-loans swaps under the capitalization scheme.

Side 2: collapsed demand for funding is driven by the excessive leverage of the households and corporates. Solution: take their bad loans and restructure them via a combination of a partial write-down (to the amount equal to the recapitalization funding given to the banks) and restructuring.

This is, really, the only way we can get out of this mess!

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