Debt Crisis 2.0: The solvency crisis re-emerges with a vengeance

As a column in the Guardian observed,

The conventional wisdom is that August is a sleepy month for markets, with politicians, policymakers and investors all at the beach rather than at their desks. The conventional wisdom is wrong.  

The credit crunch really kicked off on 9 August 2007, when the French bank BNP Paribas suspended three of its investment funds that had been dabbling in US sub-prime mortgages. 

Within a week, the Bank of England's Mervyn King was getting warnings that Northern Rock was in grave danger if the squeeze in money markets dragged on (not that it had any effect on Threadneedle Street's policies). Over the course of that month, the interest rate that banks charged each other for loans – the London inter-bank offered rate (Libor) – surged. 

Investors and commentators began talking about a credit crunch.... These were the first steps that led to the collapse of Northern Rock in September, and ultimately to a near-death experience for the world financial system. And yesterday you could have been forgiven for thinking that it was happening all over again.... 

What investors are demanding right now is not urgent American spending cuts, but a port in a storm – which means IOUs from DC, Swiss francs and gold. What they don't want is assets associated with the eurozone periphery: whether that be government bonds from Italy and Spain, or British banks (which took a pounding yesterday). 

This is a reflection of the return of the question:  who is solvent and who is insolvent.

The alarming thing, as the European commission president, José Manuel Barroso, pointed out yesterday, is that the eurozone periphery keeps expanding. Italy and Spain are now in the firing line. But Belgium is in the distance, too: the gap between the interest on Belgian government loans and their German equivalents has now widened out to over 2.2 percentage points.... Incredibly, a gap has even opened up between French government bonds and those issued by Germany. 

As this blog has repeatedly pointed out, without current asset and liability-level disclosure, market participants have no way of evaluating the solvency of any financial institution or its host country.  This sets up the necessary conditions for contagion.  This is reflected in the expansion of the eurozone periphery.

... At the height of the banking crisis of 2008, policymakers had two priorities: first, prop up the banks; second, protect the real economies as far as possible from the impact of the crash. This time, the task is again twofold, only much bigger: first, prop up the European banks, and ensure emergency low-cost loans for Spain and Italy; second, another round of reflation. Yet this requires money and moreover statecraft of a kind that has gone awol from European politics.

A column by Andrew Lilico in the Telegraph independently addresses the idea of propping up the European banks.

I’ll sketch this in five parts. First, the banks. Then the euro. Then monetary policy. Then fiscal policy. Then growth. 

But before we begin, accept this: the denial, delay-and-hope, no-creditor-shall-lose bailout strategy pursued since early 2008, as well as being immoral and destructive, has failed. Until policy-makers really embrace that point, at least to themselves, no progress can be made. 

The banks- Introduce Special Administration Regimes for banks. Now. Not tomorrow.
- Make depositors preferred creditors, overturning current bond contracts.
- If banks are insolvent but essentially going concerns, impose debt-equity swaps in special administration and provide unlimited liquidity to see off bank runs.
- If banks are insolvent, restructure or liquidate.
- Withdraw all government guarantees.
- Do not provide any further government recapitalisation funds. Especially resist the temptation to throw yet more good money after bad in the banks previously bailed out.
- Enact longer-term structural reforms– quickly. 

Regular readers know that the first step in re-establishing a solvent banking system and confidence in this fact is disclosure of all the current asset and liability-level data.  Without taking this step, market participants will not trust that the financial system is solvent no matter how it is reconfigured.

Market Confidence

Under the FDR Framework, the only source of market confidence is disclosure.  With disclosure, investors can be confident in their investment decisions because they know they had access to all the useful, relevant information in an appropriate, timely manner prior to making the buy, hold or sell decision.

Recently, market confidence has been linked to the push for austerity.  This linkage has been phrased as "if we cut the deficit, it will restore market confidence."

Cutting the deficit has nothing to do with market confidence.

Cutting the deficit simply cuts one source of demand in the economy.  Unless government spending was crowding out the private sector, investors see the drop in demand as reducing the growth rate of the economy and the ability of both the private and public sector to service its debt.

Finalist for ECB ABS data warehouse could have problems

According to a NY Times article, the New York Attorney General contents that Bank of New York Mellon breached its duties as trustee for several Countrywide residential mortgage backed securities.

Whether the attorney general is right or not, his actions once again highlight why everyone involved in controlling and operating a financial information vendor like the ABS data warehouse must be free of conflicts of interest.  If there are conflicts of interest present, market participants will not trust the data.

Mr. Schneiderman’s contention that Bank of New York breached its duties to investors is significant because a trustee that agrees to oversee loan pools like those issued by Countrywide must abide by the rules governing the securities. Such rules require that lenders deliver to the trust complete and original mortgage documents for each loan in a pool, for example, and require that the trustee notify investors when such loan documents are missing. 

Bank of New York led investors in the Countrywide pools to believe that the lender had in fact delivered complete and adequate mortgage files for each loan as was required, the lawsuit said. The bank also misled investors by confirming that loan files relating to hundreds of thousands of mortgages were complete. 

But the bank failed in these duties, the attorney general’s complaint said. After conducting a review of court records in the Bronx and Westchester County, Mr. Schneiderman’s investigators have determined that Bank of New York did not ensure that notes underlying properties were delivered properly to some trusts, according to the lawsuit. If loan documents were not delivered as required to the trustee, investors could recover the money they invested in the mortgages. 

“Investors in the trusts were misled by Bank of New York Mellon into believing that Bank of New York Mellon would review the loan files for the mortgages securing their investment, and that any deficiencies would be cured,” the lawsuit said.

UK's Financial Services Authority turns to disclosure

An article by David Enrich in the Wall Street Journal showed how British regulators are turning to disclosure as the solution for retaining investor confidence in the UK banks.

Even more important than regulators adopting disclosure is that bank's perceive there is an advantage to being at the forefront of disclosure.

British regulators are pushing U.K. banks to publicly reveal more information about their exposures to troubled European countries such as Belgium, a sign of how concerns about the euro zone are spreading beyond southern Europe. 

Lloyds Banking Group PLC on Thursday disclosed its holdings of debt tied to the Belgian government and local financial institutions as part of the bank's second-quarter results. 

Executives said they made the disclosure at the behest of the Financial Services Authority. 

"It was the FSA's suggestion that Belgium be added to the list," said Tim Tookey, Lloyds's chief financial officer. "That is the sole reason" the bank started making the disclosures. 

Sarah Bailey, an FSA spokeswoman, said the regulatory agency has been talking with Lloyds and other British banks about ways for them to improve their disclosures about their holdings of debt tied to cash-strapped countries—a major source of angst among many investors and regulators. The FSA "is looking for greater consistency so the market has clearer information" about banks' holdings, she said. 

One possibility, Ms. Bailey said, is for banks to start reporting detailed information about their exposures to countries whose government bond yields have climbed a certain amount above the yields on U.K. government bonds. 

"This is just a suggestion," Ms. Bailey said. "It's not an instruction." She said the talks with banks are continuing and that details haven't been ironed out yet. 

Those discussions prompted Lloyds to reveal its Belgium exposures. Belgium is coming under investor pressure because of its high debt levels and concerns about political dysfunction. In one indication of investors' growing anxiety, the cost of buying insurance against the Belgian government defaulting on its debts has soared 61% since the beginning of July, according to data provider Markit. 

... Mr. Tookey said Lloyds moved faster than other U.K. banks to report its Belgian holdings in order "to make sure we were right at the forefront of disclosures."

Irish Times Poll: Have the Irish Banks been fixed?

Poll results as of 5:45 pm on August 4, 2011:

Have Irish banks finally been fixed?

29% YES   71% NO

Does the EU have the time to solve its debt crisis?

Judging by the markets reaction over the last two weeks to the proposed changes in the European Financial Stability Fund, the EU is running out of time to solve its debt crisis.  Yields on Spanish and Italian bonds are fast approaching the level at which the EU has previously had to bail out the periphery countries.

Judging by the markets reaction to the ECB restarting both its sovereign bond buying program and its six month liquidity program for banks, the EU is running out of time to solve its debt crisis.  EU capital markets sold off, Spain had to postpone a debt offering, and Swiss Francs and UK Gilts are trading at or close to record highs as EU investors look for alternative investments.

The fact that the EU is running out of time, does not mean that the solution has to be implemented overnight.  This is a critical distinction.

What is important is that the market believes that the solution will solve or lead to solving the problem.

Beginning in early 2008, your humble blogger engaged in numerous conversations with senior US Treasury officials.  They understood that disclosure was the long-run solution to the problem.  However, they were under political pressure to come up with a short term fix.  The result was TARP and a host of other government programs designed to bailout the banks.

The EU has returned to the same place it was at the start of the credit crisis.  Everyone is asking the question of who is solvent and who is not solvent.  This time though, the question applies to both countries and their banking systems.

Another key and critical difference is that the members of the EU have already dramatically increased their debt loads as a result of the earlier short term fix and central banks have lowered interest rates and flooded the market with liquidity.  As a result, they have a limited amount of capacity for engaging in additional bailouts.

Fortunately, the same long-run solution that should have been adopted at the start of the credit crisis in 2007 is still available.  Disclosure answers the question of who is solvent and who is not.  It also answers the question of how much capital is needed.

Please note, and this is very important, the market does not require that all of the capital be raised at once!

Let me use Security Pacific as an example to show you that the market is perfectly willing to let a bank that is currently insolvent work its way back to solvency.  In the mid-80s, Security Pacific was heavily exposed to loans to less developed countries.

It carried these loans at book value even though they were trading for 50% of book.  When John Reed and Citi lead the write-downs on loans to less developed countries, market participants could see exactly the size of the hole in Security Pacific's balance sheet.

Did everyone run and pull their deposits or investments from Security Pacific?  No.  Did its stock price collapse?  No.  In fact it increased significantly.

It was well understood by market participants that its earnings would be retained and not paid out in bonuses and equity would be raised to fill the hole.  And now market participants could even estimate how long this process would take.

What market participants fear is the unknown.  Disclosure eliminates this fear!


The quick and easy solution to the EU crisis is to adopt current asset and liability level disclosure for the banks in the EU system. 


Unlike bailouts, disclosure will end the debt crisis in a timely manner.  Without disclosure, the crisis will continue unabated.  I look forward to assisting the EU in the implementation of disclosure.

Does the EU have the capacity to solve its debt crisis? Update

Since the EU announced its latest strategy for addressing its debt crisis through the European Financial Stability Fund, the capital markets have been questioning does the EU have the capacity to solve its debt crisis.

The debt crisis has two components.  The first component is the banks.  The question here is which banks are solvent and which are not.  The second component is the sovereign.  The question here is can the host country pay its debts.

The two components become intertwined when the sovereign is no longer a potential source of capital for the banks it hosts, but is instead a contributor to their insolvency.

The EFSF is acquiring the authority that it needs to address this interconnection.  Once approved by the EU members, the EFSF will be able to a) help insolvent sovereigns and b) lend money through the sovereign to recapitalized insolvent banks.

The question the market is asking is how much money will the EFSF require to fulfill this mission.

Regular readers know that the only way to answer this question is by providing the market participants with the current asset and liability-level data from the banks.  With this data market participants can determine who is solvent and who is insolvent.  This also allows the market participants to figure out how much capital is required to restore solvency to the EU financial system.

More importantly, once this analysis has been done and the financial system recapitalized, the debt crisis is ended.

As predicted under the FDR Framework, without disclosure, the EU will not be able to put the debt crisis behind it.

Update


A Telegraph article on EC president Barroso in which he describes the problems the EU faces and highlights the fact that the only way to "convince" the markets is to provide the data and let the markets confirm the facts for themselves.

The head of the European Commission urged the 27 European Union leaders to begin a "rapid reassessment" of the bloc's rescue mechanisms. 

He said governments should rapidly review "all elements" including the size of the €440bn European Financial Stability Fund (EFSF) and the €500bn European Stability Mechanism to "address the current contagion" in the eurozone. 

"It is clear that we are no longer managing a crisis just in the euro-area periphery," he said, adding that markets remain to be convinced that the EU is taking the appropriate steps to resolve the crisis. 

He said the July 21 agreements - which has yet to be ratified the individual member states - giving the EFSF the possibility of "precautionary use, recapitalisation of banks and intervention in secondary bond markets, are not having their intended effect on the markets." 

Investors have pushed yields on benchmark Italian and Spanish government bond to 14-year highs, reflecting "a growing scepticism among investors about the systemic capacity of the euro area to respond to the evolving crisis", he said. 

Mr Barroso attributed market pressure on euro states to slow global growth and US debt problems as well as to "first and foremost, the undisciplined communication and the complexity and incompleteness of the July 21 package".

Greece, Portugal and the Irish Republic - known as the eurozone's periphery countries - have needed bailouts. The fear is that the current rescue fund is not big enough to cover bailouts of Italy and Spain.

In short, by not providing the data, market participants could not use the facts to convince themselves that the EFSF would work and had adequate access to capital

Is a decline in demand an unintended consequence of US debt ceiling debacle? Update

In an earlier post, it was suggested that zero interest rate policies create their own economic headwind because they provide an incentive for savers to restrict current consumption to make up for the loss in earnings on their savings.

In this post, I would like to add another policy that is likely to cause its own economic headwind.  That policy is reducing or eliminating the entitlements programs in the name of protecting the solvency of the US government.

Entitlement programs can be thought of as a source of "savings" for retirement.  If these savings are going to be reduced, then individuals who are saving for their retirement are going to have to save more today to offset this reduction.  The impact of this additional savings is to further reduce current demand.

How big an impact on demand could we see now that Washington is officially looking at reducing the entitlement programs?  While I do not have a PhD in Economics, common sense suggests that the impact on demand could be very large.

In China, the government does not offer entitlement programs like Social Security or Medicare.  The reported savings rate there is approximately 50%.

In the US, our reported savings rate last month was approximately 5.4%.  In 1975, it reached 14.6%.

Given that Washington would like to scale back the entitlement programs, is there any reason to believe that the US cannot return to a 1975 level of savings?

If the US did return to these higher levels of savings, demand would be reduced.  Consumers account for roughly 60% of GNP.  If they scale back their consumption to increase savings to 1975 type levels, this implies a drop of approximately 5% of GNP.

Update


In a Bloomberg column, Laurence Kotlikoff reframes the discussion on deficits and social programs in a very useful way.  He puts forth the idea that the budget that should be balance is the generational budget.  At the end of the day, what each generation should pay for the social programs it receives.

Debt crises make great drama...The tough thing is sorting out what’s really going on. In the U.S. case, the answer is: not much...

Whatever you think of the House Republicans, they understand that our country is broke. But they have no idea how broke. They are pushing hard for a balanced-budget amendment. What we need is not budget balance, but generational balance. 

If we are going to amend the Constitution, let’s prohibit today’s adults from leaving tomorrow’s generations with higher lifetime net tax rates. 

A Generational Balance Amendment would specify that, absent prolonged states of emergency, each generation would pay the same share of its lifetime labor earnings in taxes, net of benefits received. 

Stabilizing lifetime net tax rates isn’t just a matter of fairness. It’s critical to our country’s long-term economic survival. 

If we keep raising successive generations’ lifetime net tax rates, we will eventually be hitting up our progeny for every penny they earn, leaving them unable to consume or save. If they can’t save, they can’t invest, which means they won’t be able to maintain -- let alone increase -- the economy’s stock of capital needed to produce goods and services. 

The U.S., incidentally, has a national savings rate of zero and a domestic net investment rate of only 4 percent of national income. Both are postwar lows. 

Memo to House Republicans: Budget balance doesn’t imply generational balance. 

Consider Taxdonia, a country with zero debt. Taxdonia has never borrowed a dime and never will. Its constitution forbids borrowing. But Taxdonia deserves its name, actually, its new name. Its old name was Lovelandia. 

In Taxdonia, every young generation is hit with a higher and higher tax rate, historically called the Love Tax. The proceeds of the Love Tax are immediately handed to the contemporaneous old generation as transfer payments -- much as our Social Security taxes are transferred directly to current retirees. So taxes always equal spending, and the deficit is always zero....

Generational verbal warfare has broken out. Worse yet, the country’s single political party has split into two. One party, the Oldsters, wants to raise spending and taxes. The other, the Youngsters, wants to cut spending and taxes. Each side calls the other extremists and claims it is being cheated. 

Economists in Taxdonia think both are nuts. “What’s wrong? We’ve got budget balance. No debt, no deficit, relax. And stop calling our country Taxdonia. This is Lovelandia! And if you must disagree, disagree agreeably.” 

The Oldsters and Youngsters agree, disagreeably, on one thing: They both want to string up economists. They realize that their country, with the complicity of these fiscal experts, has incurred a huge, off-the-books liability to the oldsters -- a terrible debt, foisted on the young in a country where debt is verboten. 

The Youngsters have hired some young economists to use generational accounting to examine the lifetime net tax treatment of different cohorts. Their report isn’t pretty. It shows that past cohorts received, on a lifetime basis, far more than they put in and that the current young are being asked to participate in a Ponzi scheme. 

They also learn that measuring debt is a meaningless labeling game since the government can take from the young with the words “taxes,” rather than “borrowing,” and incur debts via promises of future repayment that are tied to the “taxes.” 

The latest news: Taxdonia’s central bank, Love Bank, has assured the current young that if their kids can’t pay them their desired old-age benefits, the central bank will keep them whole. It will print money, which will be used to pay their claims. 

The young are scratching their heads. “Won’t this lead to inflation and water down the real value of the money we already hold? Isn’t this just another way of taxing us?” 

Love Bank’s reply: “You’re young and financially inexperienced. Go back to work, pay your taxes, and all will be fine.”

Complexity, concentration and contagion solved by the FDR Framework

Since before the credit crisis, your humble blogger has said and demonstrated that the issues of complexity, concentration and contagion in the financial system are most effectively and efficiently addressed and solved with the simple mechanism of disclosure.

Regular readers are familiar with how disclosure works in the context of the FDR Framework.  Under this framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  Market participants, since they are responsible for absorbing losses on investments under the principle of caveat emptor, have an incentive to use this data to analyze the risk of any investment and adjust both the price and amount of their exposure based on the results of this analysis.

Recently, the Bank of England's Andrew Haldane delivered a speech on haircuts in the repurchase agreement markets.  This speech was a prelude to the forthcoming publication of an article he co-authored titled "Complexity, Concentration and Contagion".

Like Gary Gorton and Andrew Metrick before them, Haldane and his co-authors develop a theory of how secured funding markets work and a model.  As with Gorton and Metrick, Haldane and his co-authors' theory and model are inferior in every respect to the parsimonious FDR Framework.

Gorton and Metrick observed what they called a run on the repo.  Haldane and his co-authors observe that the amount of collateral required for a repurchase agreement jumped significantly from before the credit crisis to the peak of the credit crisis.

Table 1 demonstrates this pattern [for prime counter-parties]. It compares haircuts on a range of financial instruments used to back borrowing – so-called securities financing. They are shown on two dates, before (June 2007) and after (June 2009) the financial crisis. Haircuts rose by up to 90 percentage points in the space of these two years, as the scorching pre-crisis summer gave way to a frozen crisis winter. In other words, haircuts exhibited a rather dramatic pro-cyclicality over the course of the crisis.

Table 1: Typical haircut on term securities financing transactions (per cent)
                                                                             June 2007      June 2009
Medium-term G7 government bonds                         0                     1
Medium-term US agencies                                        1                     2
AAA-rated prime MBS                                            4                    10
Asset-backed securities                                           10                    25
AAA-rated structured products                               10                  100
AAA- and AA-rated investment grade bonds           1                     8
High-yield bonds                                                      8                    15
G7 countries equity                                                10                    15
Source: Committee on the Global Financial System (2010).

This haircut cycle played an important causal role in the crisis. Secured financing became an increasingly important source of credit in both bank and non-bank markets over the past decade. In the US, the repo market financed roughly half of the growth in investment banks’ balance sheets between 2002 and 2007. In the UK, the securitisation market trebled in size over the same period. Those were the heady days of summer. Since then the US repo market has shrunk by 40%, while the UK securitisation market remains frozen.

Why did this increase occur?  Was it predictable? (hint:  the increase was predictable and it is a matter of record that using the FDR Framework your humble blogger predicted it along with the credit crisis)

As discussed in a previous post, Gorton and Metrick acknowledge that they and their theory of how secured funding markets work using informationally insensitive debt are unable to answer these basic questions.  They wrote [link in previous post]

The reason that this shock occurred in August 2007 – as opposed to any other month of 2007 – is perhaps unknowable. We hypothesize that the market slowly became aware of the risks associated with the subprime market, which then led to doubts about repo collateral and bank solvency. At some point – August 2007 in this telling – a critical mass of such fears led to the first run on repo, with lenders no longer willing to provide short-term finance at historical spreads and haircuts.

According to an article by Larry Elliott, the Economics Editor for The Guardian,

On the face of it, there was nothing especially memorable about August 9 2007.  

... It was, however, the day the world changed. As far as the financial markets are concerned, August 9 2007 has all the resonance of August 4 1914. It marks the cut-off point between "an Edwardian summer" of prosperity and tranquillity and the trench warfare of the credit crunch - the failed banks, the petrified markets, the property markets blown to pieces by a shortage of credit. 

On that day, the European Central Bank and the US Federal Reserve injected $90bn (£45bn) into jittery financial markets.

What happened on August 9, 2007?

According to a report by BBC News,

Investment bank BNP Paribas tells investors they will not be able to take money out of two of its funds because it cannot value the assets in them.

Specifically, it could not value the subprime mortgage backed securities in these funds.

Why could it not value these securities?

As was disclosed by the rating agencies in their testimony before the US Congress a month later, these securities could not be valued because there was no access to the data needed to monitor them and to make timely rating changes.

As all market participants know, ratings are just a form of valuing a security.

Under the FDR Framework, what happened in August 2007 is not the unknowable event Gorton and Metrick claim, but rather an easily predicted one.  It was the month in which BNP Paribas announced that all the useful, relevant information about the subprime mortgage backed securities was not available in an appropriate, timely manner and therefore the securities could not be valued.

Please refer back to table 1.  In particular, look at what happened to the haircut on structured finance products (highlighted).  Under the FDR Framework, it is not surprising that the haircut on structured finance products increased significantly.  If you cannot value them, it is irresponsible to lend aggressively against them even to prime counter-parties.


But this only tells part of the reason why haircuts would increase.  The other issue is the notion of a prime counter-party.  At the beginning of the credit crisis, market participants did not have all the useful, relevant information they needed in an appropriate, timely manner to tell if any prime counter-party was solvent or not.  This dramatically increased the probability of ending up with the collateral. 


This too is predicted and easily explained under the FDR Framework.


In his speech, Mr. Haldane does not attempt to address the questions of what caused the increase in the haircuts and was it predictable, but instead introduces a model and how the model can be used to test different policies options.

The model's predictions do not measure up to the accuracy and predictive value of those predictions generated under the FDR Framework [and stated in this blog].

Take for example the prediction that if there was a 20% haircut on secured financings there would be a very low probability of a liquidity crisis.  Had the model been used prior to the credit crisis in 2007, with a 100% probability there would still have been a liquidity crisis in the secured funding market.

What needs to be better appreciated is that market participants could not value the collateral (structured finance securities) or evaluate the solvency of the borrower and therefore elected not to make a "secured" loan.  This froze the market.

As regular readers know, I have been using the FDR Framework since the beginning of the credit crisis to make predictions about the success or failure of different policy options (see the posts on Ireland for example).  As regular readers know, the accuracy of these predictions has been extraordinarily high.

Once again, I am offering my services to Mr. Haldane and the Financial Policy Committee when it comes to evaluating different policy options.

The Looting of the Irish reaches new heights

As predicted on this blog, the Irish government is maximizing the taxpayer losses by not disclosing the current asset and liability-level data for its banking system.

Without this disclosure, the markets cannot value the assets in the banking system and the individual banks.  Without this independent valuation, no one, including the Irish government, knows that it received remotely close to market value for the assets or the equity in the banks that it has sold.

For investment bankers, opacity is their friend as it prevents an independent assessment of value.

This blog described in detail how investment bankers would use opacity to screw the Irish taxpayers.  Incredibly, it has come to pass almost exactly as predicted.

The mechanism your humble blogger described Wall Street as using was an auction.  Information on the bank's assets and liabilities would be shared with a small group of investors.  These investors, all of whom have approximately the same rate of return hurdle, would then "bid" against each other.  Note that this auction guarantees no independent valuation by the market.  It also guarantees a hefty discount on the assets and equity.

What is critically important is that information that was not available to all market participants was shared.

Fast forward to last week.  The Irish government announced the investment by a group of these investors in one of the two banks the Irish government has publicly announced it would keep open.  This came after the government discovered that it was difficult to sell shares in a public offering for these banks where there was no transparency into their current asset level data.

Naturally, the investors, who had the extra information from their prior involvement, were in a position where they could assess an investment.  After that, it was just a question of the degree of looting.

As described in an Irish Times column,

THE LOGIC of the Government’s decision to let private equity into the Bank of Ireland party at this late stage in the game is not entirely obvious. 

Depending on how you calculate these things the taxpayer has put between €2.2 billion and €3.5 billion into Bank of Ireland, most of it when nobody else would have contemplated investing in the bank. 

The State’s investment came after it had taken the bank – along with its four peers – under the protective wing of the the exchequer and bankrupted the Republic in the process. 

Bank of Ireland to this day still continues to rely on State support for its survival. Any emergency borrowing it may have from the Irish Central Bank in order to meet liquidity demands are explicitly guaranteed by the Irish exchequer. Its vital borrowings from the European Central Bank are on the back of the Government guarantee bonds issued to it by the National Asset Management Agency in exchange for its toxic property and development loans. Nama has yet to turn a profit. 

The notion that the Bank of Ireland is not an ongoing burden on taxpayers is thus misleading. Until the bank can stand on its own two feet and attract sufficient deposits in its own right to repay its borrowings from the Central Bank and the ECB, the taxpayer remains firmly on the hook. 

For this reason alone the decision to sell 34.9 per cent of it to a group of private equity investors is questionable. 

The decision to sell it to them for €1.1 billion with no strings attached seems to verge on the foolish. 

The Government is keen to point out that the new investors are long-term value holders. That may well be the case, but what they are not is banks and arguably what Bank of Ireland needs right now is another bank.  

The best and simplest route back to viability for Bank of Ireland is to merge its badly damaged balance sheet with the balance sheet of a stronger bank. This has the potential to solve the liquidity problem overnight. 

Fairfax and its fellow north American investors do not have the facility or the inclination to lend balance sheet support to the bank. 

The best that Bank of Ireland can hope for in this regard is that the vote of confidence implied in the private equity investment will help it attract deposits. 

However, it is still likely that the bank will have to be sold to a larger one sooner rather than later and the big winners will be Fairfax and its co-investors. 

So, if the decision to sell down its stake in Bank of Ireland does not solve the underlying problem and represents bad value for the taxpayer, why did the Government do it? 

Could the advice from investment bankers who stood to make a substantial fee have played any role in the decision?

Well, it saves the Government €1.1 billion. Or to be precise, the Government will have to borrow €1.1 billion less this year. It’s a significant sum but will not in itself turn around the national finances. 

The Bank of Ireland deal is best understood in the context of a wider strategy for the sector. 

This in turn stands or falls on international acceptance that following the stress tests carried out earlier this year Irish banks are adequately capitalised. 

The Government believes a significant investment by an overseas institution in Bank of Ireland is the strongest possible endorsement of those stress tests. 

This blog has already documented how and why the stress test and subsequent banking industry reorganization carried out by the Irish government did not restore investor confidence.

Selling equity to distressed investors does not restore investor confidence.  Distressed investors are masters at maximizing their upside while minimizing their downside.  For example, it turns out that the distressed investors are getting approximately a 4% discount on their stock purchase.  This was not announced at the time the deal with the government was announced.

Who knows what else these investors have negotiated or what other investment positions they have that minimize their risk.

It has put particular emphasis on the fact that there is no risk sharing element to the deal and it was reported over the weekend that the Government rejected an approach from Texas Pacific to buy 15 per cent of Bank of Ireland because they wanted the Government to share any future losses at the bank.

The Irish government is going to absorb any future losses above the Bank of Ireland's capitalization.  The investors are not required to put in money to cover additional losses.

The only question is if there are future losses in excess of the Bank of Ireland's capitalization, will the investors' investment be wiped out first or will the investors be bailed out.

The price of the non-risk sharing approach appears to have been the attractive terms given to Fairfax and its partners who have ended up with 35 per cent. 

Would the Irish taxpayer have been better off with risk sharing had the same investment dollars been used to cover the next losses realized by Bank of Ireland and retaining 20 percent of the equity?

Hard to imagine that the Irish taxpayer would not have been better off as they essentially accepted the same deal only without retaining 20 percent of the equity.

You can argue of course that from this point of view the generous terms of the Fairfax deal are as damaging for the credibility of the stress tests as risk sharing. 

But the Government believes it’s a price worth paying because it eases the task of sorting out AIB and Irish Life Permanent in several ways. 

If Bank of Ireland needs to be taken over, the other two really need to be taken over. In theory the way is now cleared to find trade buyers for those two institutions and, realistically, there is only a limited number of them interested in Ireland. Although this assumes that any international bank looking at Ireland will no longer have a preference for Bank of Ireland, which seems naive. 

There are other “wins” from the State’s perspective in deciding to bring in private equity on generous terms at this stage. Not least that it could be 12 months, or never, before a trade buyer could be found for Bank of Ireland and one thing the Republic does not have is time when it comes to sorting out the banking system. 

Actually, the irish government had and still has plenty of time to provide current asset level disclosure.  Had it done so, it would have been easier and much less costly to the Irish taxpayer to sort out the banking system.

Moreover, there is also the argument that when you are selling your entire banking system, it makes sense to try and have a least one of the pillar institutions in diversified ownership. 

The arguments are quite finely balanced. But the good news is that while the State may once again have made a mistake – and will really only know if it has in a few years – it does appear to have its eyes open this time.