27/10/2012: UBS on Irish banking debt restructuring

UBS' European Weekly Economic Focus is dealing in detail with the prospects of Ireland getting a deal out of the EU Summits promises to break the links between the banks liabilities and sovereign liabilities. Comments are mine.

"Taking the June 29th statement at face value, there is a strong case for supporting Ireland by breaking the link between the government and the financial system." 

[I wholeheartedly agree - the case can be made across a number of points: (1) Ireland de facto underwritten the euro system in the early stage of the crisis; (2) the cost of (1) to Irish taxpayers is unprecedented in modern history; (3) Irish banking fallout is partially based on absolutely mis-shaped monetary policy pursued by the ECB; (4) Ireland is the only country in the euro periphery, in my view, that has potential to organically grow out of the current Great Recession, assuming the country gets a significant (€40-45 billion) writedown on the banks debts; and more]

"There are two potential routes for euro zone support to the Irish state. The direct route involves the ESM acquiring all or a part of the government’s stake in the banks, thereby assuming responsibility of the Irish lenders and absolving that liability of the Irish state. The alternative, less generous, approach is a relief on the promissory note/ELA commitments by the ECB."

[I disagree - the impact from both of these measures taken individually will be minor. What is needed is a combination of the two measures, with ELA commitments writedown of at least €30 billion. The reason for this is simple: the ESM will not be able to take on IBRC liabilities even in theory as IBRC is not a functional bank. Hence, route 1 outlined by UBS can amount to ca €5-6 billion in maximum potential recovery to the Irish state. Route 2 take by itself alone will simply see marginal relief on the net present value of promo notes liabilities, something close to €3 billion yield. Hence, even combined, such measures are unlikely to generate more than €10 billion, or roughly 1/8th of the assumed current and future liabilities.]

"In our view, there is very little chance that the ESM will acquire a stake in Irish lenders any time soon, for the simple reason that a direct ESM intervention requires the establishment of a euro area bank regulator and that would take a long time, in our view." [I agree. And worse, not only ESM has to be fully established, it also has to be fully operational and, potentially, have a track record of sorts before it can be used to underwrite banking sector directly.]

"What’s more, Ireland will need to remain a programme country for longer. Depending on the potential scale of the intervention, the first argument is likely more important that the second, but either way this route is not likely to be available for a long time." [I fully agree and this is the reason why I argued earlier this week that the Irish Government push to 'exit' the programme is rushed and unwise.]

"How about a recapitalisation via the sovereign? To start with, this approach does not help sever the link between the sovereign and the banks, one key driver for euro area intervention. More importantly though, it is not clear to us that Ireland will qualify for that sort of intervention even if it tried, for the simple reason that ESM funds can only be provided to limit ‘the contagion of financial stress’. The financial sector in Ireland is no longer a threat to the rest of the euro area and, as such, it would not qualify for ESM intervention. 

[I spoke about this factor for a number of years now. As long as Ireland continued replacing private liabilities to bondholders and inter-bank funding sources with sovereign obligations, it continued to dilute its own power in the bargaining game. I warned years ago that once we complete this process, we will be left alone. No tramp cards in our hands. Fully exposed to carrying the weight of banking debts on taxpayers shoulders. This Government and the previous one have failed to listen. Now, its a payback time.]

"The only way around this is if the ESM facility is made available retrospectively, but that is unlikely if the statement from the Dutch, Finnish and the German finance ministers where they rejected ESM assistance for ‘legacy assets’ is true." 

[At the time of June 29th summit I wrote about the cumulative potential exposures that such retrospectively can yield. It was clear then, as it is clear now, that ESM will not be able to absorb all potential calls on such a measure. Hence, Fin Mins statement breaking retrospectively clause is fully rational and expected.]

The rest of the note is based on a superb and must-read analysis by Karl Whelan of the promo notes.

In summary - and this is my view - Irish policymakers have carelessly forced the country into a corner: we worked hard to assure some stabilization in fiscal space, which in turn undermined our ability to get meaningful relief. Congratulations to our policy makers who seemingly traded the interests of the longer term debt crisis resolution for friendly pats on the back from Europe.