Monday, November 29, 2010

Questions Remain After Irish Bailout

As reported by the WSJ, "Prime Minister Brian Cowen at a Dublin news conference Sunday evening said the package 'provides Ireland with vital time and space to address the problems we've been dealing with since this global economic crisis began.'...Under the deal reached Sunday, Ireland will try again what it has tried unsuccessfully for two years: adding more capital to banks to give investors and depositors more confidence in their solidity."

This leaves three major unanswered questions.  First, why should the effort to convince investors and depositors succeed now?  

As discussed herehere and here, in the absence of current loan-level performance information, how does the market know that the Eur35 billion set aside for recapitalizing the Irish banking sector is enough.

The bailout does confirm that the loan-level performance required more resources than Ireland could provide by itself and that the Irish government's previous efforts to remove Eur50 billion in bad loans and inject capital were insufficient to offset the deterioration in the loans in the banking system.

The bailout itself contains no new information as to the actual performance of the loans in the banking system.  

The Irish banking system still holds over Eur300 billion in loans. Under the worse case assumptions being used by analysts (half the loans could be worth nothing), the Eur35 billion set aside under the bailout would appear insufficient to restore solvency to the Irish banking system. 

The second question is how will the Irish regulators use the time that was purchase at such a high cost through the bailout?  
  • Will the regulators follow policies similar to what Japan has implemented for the two decades after its real estate crash and hope that the real estate market and financial system will recover?  Injecting capital into the banks and proclaiming that they are solvent without providing the supporting current loan-level performance data would be an example of following similar policies and could be expected to be as effective; or 
  • Will the regulators follow the advice of central bank Governor Patrick Honohan and enlist the expertise of the market credit analysts to restore confidence to the market?  Enlisting the expertise of the market credit analysts requires disclosure of current loan-level performance information for all loans on the balance sheets of the Irish banks so that the analysts can independently analyze and value the loans.  Subsequently  Injecting capital into the banks based on where the market perceives a capital shortfall could be expected to be effective in ending the credit crisis.
Third and finally, who would buy Irish or any EU sovereign or bank debt after June 2013 when the debt carries the risk of credit loss?  

In the absence of an ability to evaluate the solvency of banks or countries, why would an investor sign up for the risk of loss?  Under the worse case, analysts would assume that the banking system and/or country is still not solvent.  Their conclusion would be that any buyer of the post June 2013 debt is effectively buying the credit losses that should have been imposed on the investors who held the bank debt and equity at the start of the credit crisis.

If Ireland and/or the EU countries want to sell debt after June 2013 where investors take on the risk of capital losses, they are going to have to make current loan-level performance data available so that credit analysts can determine who is solvent and who is not.  It is only with this independent analysis that investors will feel comfortable taking on the risk of loss from investing in solvent banks and countries.

No comments: