Thursday, March 15, 2012

15/3/2012: What's up with 'collateral'?

An interesting point made today by Michael Noonan that carries some serious implications with it (potentially).

"You could take it that the ECB were never particularly happy with the level of collateral provided by the promissory notes and would like stronger collateral," Mr Noonan said in an interview with RTÉ." (as reported on the Irish Times website).

What can this mean? Collateral for the Notes themselves is Government guarantee plus letters of comfort to the CB of I. In other words, the Notes collateral can only be enhanced by making them fully-committed formalized Government debt - aka bonds. Now, Noonan in the recent past had implicitly linked Promo Notes to ESM.

And herein rest the main problem. Right now, Promo Notes are quasi-governmental obligations and as such are ranked below ordinary Government bonds (hence collateral quality concern of the ECB). Although the Notes are counted into our total debt, they are still not quite as senior as other forms of debt. This, in turn, has marginal implications in the valuation of our bonds. Although at this point this is academic, should we return to the markets, potential buyers of Irish Government bonds will consider them as secondary, since the Notes are not traded in the market and represent a tertiary (quasi- bit) claim on the state after ordinary bonds (secondary) and EFSF-IMF-EFSM (soon to become ESM) debt (so-called super-senior obligations of the state).

By converting these notes into ESM funding, the Government will in effect risk making these Notes super-senior, exceeding in seniority those of ordinary Government bonds. Now, the total amount of debt under the Notes - principal plus interest - is €47-48 billion or roughly-speaking 30% of our GDP and ca 27% of our Government debt. This is hardly a joking matter.

It can have material implications for our ability to access bond markets in the future (both in terms of amounts we can raise and rates we will be charged). But more ominously, it can fully convert quasi-public debt into super-senior public debt.

This will satisfy ECB's concerns about the quality of collateral, but it will also mean that these notes will be put beyond any hope of future further restructuring.


Anonymous said...

Listening to Noonan, Kenny et al, I cannot help but feel that they are not on our side. Is it wrong that I feel they should be putting the interests of the Irish people first or am I naïve?

Brian O' Hanlon said...

Mr. Gurdgiev,

I often wonder about Geanakoplos's theory and the 'Leverage Cycle', which he developed as a way to explain markets and how collateral as held (or not, to varying extents) by borrowers, and buyers in a marketplace, has a huge effect of the dynamic of that given market.

I often wonder, if in today's context, we are seeing sovereign nations and policy for the same as driven by mere 'individuals', otherwise known as 'politicians', or 'elected representatives', is coming to look more and more similar to the model as described by Geanakoplos. That is, where the government itself is becoming more and more leveraged, it means that it is the only 'player' in the market is the government. The normal everyday providers of finance, the normal everyday borrowers who are responsible for countries running under normal circumstances, are shoved out of the market. Because government is in there, and is able to carry a much large amount of leverage with less collateral than other borrowers can.

The price of everything of value is being driven up through competition between leveraged buyers, namely governments at this scale. Lets face it, the German government is leveraged in a certain way, as much as the Irish government is, or the Greek government. Because the Franco-German banks/guaranteed by governments etc, are holders of so much peripheral debt. The leveraged players really at this stage, trying to perform all kinds of weird tricks using 'collateral' are the governments themselves. They have simply picked up, where the leveraged individuals, left off.


Brian O' Hanlon

TrueEconomics said...

Brian, I thought it is an interesting post. Policies are always driven by individual politicians' objectives. IMO, problem arises when these objectives are no longer aligned with those of the governed. When elites become isolated from the rest of the society. This happens when there is no merit in transition across various socio-economic classes, where social mobility is replaced with stasis. Europe is a perfect example of this, where elite is ossified, detached, patrician. No fresh air enters the rooms and if it does, it is forced out into margins.

As per your assertion of leveraged sovereigns replacing leveraged corporates:
1) It is true and the effect is to shut out everyone not in the elites from access to credit and to business contracts, revenue generation capacity etc
2) One should not be surprised this has happened - the entire model of 'managed capitalism' has resulted in manipulation of the market to the extent where business elites are now merged with political elites and professional elites.

Like Irish Social Partnership, the clique of interconnected elites became larger across Europe, but it remain exclusivist, restrictive.

Brian O' Hanlon said...

Mr. Gurdgiev,

I suppose, the point I would wish to add, if I may, is that from a professional economists point of view, it would at least be worth while looking at some study, to track the events over time, in Ireland (and maybe other economists in other EU states could try this also), that as we entered the Euro and we lost our ability to manipulate traditional tools such as exchange rates, and interest rates in our local economy - there was always going to be a 'beauty contest' of sorts - as to what, would replace those tools, in the hands of the government classes, so that they could be seen to be doing something to 'control' the situation and manipulate it.

What we witnessed in the era of the creation of the National Asset Management Agency in Ireland, was not a panic in regards to the Irish economy, or credit supply to citizens within the Irish economy. What we witnessed at that point was a realisation on the part of the government classes, that OMG! Where are our levers? How can be be seen to be driving the bus now, and avoiding the cliff edge, without the barrier, where we will all plummet to or depths, unless the government takes the lever and steers everyone away from the edge.

What I am saying is that, the kinds of levers that would enable us to monitor and adjust degrees of leverage on the part of fewer and fewer borrowers in the Irish economy (who effectively become the market), is the exact sort of lever that our professional economists should learn about and study right now. If only to create an interesting counterpoint in the discussion. Because the government classes at the moment in Ireland, have hosted the beauty contest, and it has already been won. The beauty queen has been created. The 'lever' the government classes most prefer, is this one which enables them to be seen to be regulating credit (in the absence of a maestro with their foot on the interest rate peddle, or the control over our own currency). At best, professional economists may be able to counter balance that beauty contest winner, with an alternative winner of their own. Maybe not as seductive to the government class tastes, but nonetheless.

bokonon said...


This scenario is becoming more likely. Tim Worstall over on Forbes makes the following point about the Spanish bailout that might equally apply to the case you outline above --

What happens to debt when it goes from being pari passu to being junior? Yes, you’ve guessed it, the price falls. Which is another way of saying that the yield rises. Which means that the bonds which the banks currently own fall in value further diminishing their capital and thus needing more bailing out. Also, it makes Spain’s future borrowing more expensive: because any future general bond issuance will still be junior to that ESM issue.
For if as a result of the subordination Spanish bond prices fall enough, then the banks become bust once again and also the Spanish state is facing interest rates too high for them to be able to roll over debt as it becomes due. The difficulty is in knowing what is the definition of “enough”.

-- so extending your what-if, could promoting the PNs to ESM status damage our banks? Again?!