At its core, the cause of the Irish financial crisis is the same as the 2007/2008 global credit crisis. The root cause of the crisis is the inability of investors and other market participants to independently analyze and value commercial and residential real-estate loans.
Unlike most European governments and the US government, the Irish government responded to the global credit crisis by both guaranteeing the solvency of its banks and by deciding to remove all of the 'bad' assets from its banking system. To do this, the Irish government set up a 'bad bank' to acquire the 'bad' assets.
The intent was to leave behind 'good' banks that were free of 'bad' assets and that could access the capital markets based on their own creditworthiness. In theory, these 'good' banks could then resume lending and help pull the Irish economy out of its recession.
Unfortunately, the good bank/bad bank idea requires that all of the 'bad' assets are moved to the 'bad' bank when assets are first transferred. As soon as there is a subsequent round of assets purchased by the 'bad' bank from the 'good' bank, investors are forced to ask the question: have all the 'bad' assets been transferred now.
The Irish experience has been not one, not two, but three rounds of asset purchases. After each subsequent round, investors have become increasingly reluctant to conclude that all the 'bad' assets have been transferred. This limits the 'good' banks access to capital markets and defeats the purpose of removing the 'bad' assets in the first place.
Success of the good bank/bad bank idea also relies on the assumption that the price the 'bad' assets are transferred at reflects a realistic valuation for these assets. This is particularly an issue when the Irish government is in the position of injecting capital into the good banks to make up for any losses taken on the 'bad' assets. If the assets are not transferred at a realistic valuation then investors are forced to guess whether the good banks or bad bank benefited.
Compounding the problem of the multiple rounds of asset purchases for the Irish government is the fact that each subsequent round of asset purchases was done at an increasing discount. Each of these percentage discounts was set by the same independent third party.
Like the Rating Agencies, investors are reliant on the independent third party valuations. Investors do not have access to the data on the individual 'bad' assets that they need to conduct their own independent analysis and valuation.
Just like the Rating Agencies lost credibility from being wrong in their rating of sub-prime mortgage backed securities, so too has the independent third party in its valuation of the 'bad' assets.
Like the sub-prime mortgaged backed securities, the devaluation cycle on the Irish 'bad' assets appears to have no logical stopping point other than zero. As a result, investors are questioning the solvency of Ireland.
With the investors' questioning comes an increased reluctance to invest in securities issued by the Irish government or its banks. This reluctance is reflected in the higher yield of 10-year Irish government bonds over German government bonds.
Seeing the difference in interest rates between these bonds increase, EU officials are encouraging the Irish government to accept a bailout to restore confidence in Ireland's solvency. The officials hope that this will also stop the spread of financial market turbulence to other euro members.
Naturally, if Ireland accepts a bailout from the EU and the IMF to close the difference in interest rates, it faces both the stigma associated with applying for aid and restrictions on the government and its fiscal policies. This is a very high price to pay for treating the symptoms of the problem like high interest rate differentials.
There is an inexpensive alternative available to the Irish government which treats and cures the cause of the devaluation cycle of the Irish 'bad' assets.
This success of this alternative is based on the Irish government having identified all the 'bad' assets and properly discounted them. If so, the Irish government is in a position where it can tell the bond market that the bond market can see for itself the validity of what the Irish government is saying about both the assets and that there is no need for a bailout. The alternative is to provide all market participants observable event based performance data for all the assets in the 'good' and 'bad' banks.
Investors could use this performance data to independently analyze and value the assets. Investors could use their choice of analytic tools and valuation models to see for themselves:
- Whether or not the 'bad' assets were properly valued;
- That the exposure of the 'good' banks to bad assets is de minimus; and most importantly,
- That there is a logical stopping point other than zero for the 'bad' assets and that Ireland is solvent without any need for a bailout.
The importance of the solution of observable event based reporting was demonstrated in the Brown Paper Bag Challenge.
Existing disclosure practices do not provide the investor with the information on the performance of the loans, whether backing a security or in the good or bad bank, the investors needs 'when' the investor needs it to make a fully informed buy, hold and sell decision.
Current disclosure practices are the equivalent of putting the loans into a brown paper bag. Then asking the investor when the contents have changed, but have not been reported, to guess the value of the contents of the brown paper bag.
The proposed solution of providing observable event based reporting puts the loans into the equivalent of a clear plastic bag. With observable event based reporting, all the changes, like payments or defaults, to the loans are reported on the day that the changes occur. Investors can see what they are buying and can value the securities or the good or bad banks the loans support. If investors can value the loans, they can also determine that Ireland is solvent without a bailout.
At the start of the global credit crisis, the US government faced a choice in how to handle its financial crisis: the inexpensive cure of observable event based reporting or the expensive bailout treatment of the symptoms. The US government chose expensive bailouts to treat the symptoms.
The expensive bailouts did not prevent the problem of investors not being able to value commercial and residential real estate from recurring in Ireland 2 years later. It is now the Irish government's time to chose between the inexpensive cure of observable event based reporting or bowing to pressure from the EU and accepting expensive bailouts to treat the symptoms.
Hopefully, the Irish government will set the global standard and select the inexpensive cure of observable event based reporting.