ANALYSIS:The Government and troika are trying to find a cheaper way of paying for Anglo and INBS
SITTING IN an office on Burlington Road in Dublin 4 are nondescript documents that are the focus of the Government’s efforts to reduce debts running to €47 billion on the State.
The office is the home of Irish Bank Resolution Corporation, the undertaker bank that is burying the remains of Anglo Irish Bank and Irish Nationwide Building Society (INBS), and the documents are promissory notes.
The last government chose to provide the promissory notes or State IOUs to the lenders because it didn’t have the cash to bail them.
Since the notes were issued in March 2010, they have risen in value to cover €30.6 billion of the €34.7 billion cost of the failed banks (€25.3 billion of the €29.3 billion cost of Anglo and €5.3 billion of INBS’s €5.4 billion cost).
The Government is in talks with the European Central Bank, European Commission and International Monetary Fund to find a cheaper way to pay for these zombie banks and how the notes could be changed to achieve this.
Minister for Finance Michael Noonan has said that “technical discussions” were ongoing towards a paper being produced next month and the objective is to show the markets that Ireland’s ability to pay its debts has improved.
BACKGROUND
To understand how the notes could be restructured, it is important to understand how they work. By issuing the notes, the Government agreed to inject a sum of money every year on March 31st to cover the €31 billion in capital contributions to IBRC (Anglo/INBS).
The original plan involved paying €3.1 billion a year over a 10-year period.
However, because the notes had to be valued at €31 billion in IBRC, they had to be defined by Eurostat, the EU’s statistics office, as a security and had to pay annual interest or a coupon to benefit the holder of the notes.
The interest had to accrue on the sums due until the €31 billion was paid. The rate was based on the long-term cost at which the State raises money at the time of the instalments.
This was set at 5.8 per cent. In other words, the State had to pay IBRC, as the holder, this rate of annual interest on top of the €31 billion.
The Government decided to take an interest holiday for 2011 and 2012 so the budget deficits would not be as bad for those years. This raised the rate due to IBRC to 8.2 per cent a year for the remainder of the term on the notes.
So, within the annual payment to IBRC, there is an interest payment. Much like a long-term mortgage, the payments in the early years of repayments comprise mostly interest.
As it stands, the annual payments to IBRC, including interest, will be €3.1 billion until 2023, €2.1 billion in 2024, €900 million a year until 2030 and €100 million in 2031.
All told, under the current structure of the notes, the Government is injecting €47.4 billion into IBRC over 21 years, comprising €30.6 billion in capital and €16.8 billion in interest.
The first €3.1 billion payment was made in March 2011 so the lenders got hard cash instead of promises. This leaves €28 billion of capital to be repaid (not including interest).
Eurostat considered the notes and forced the Government to book the €31 billion cost as an upfront charge – the reason why the State deficit hit a jaw-dropping 32 per cent in 2010.
The interest kicks in again this year and this must be added to the Government’s deficit.
That means for every interest payment to cover the State’s 21-year mortgage on Anglo/INBS, the Government must raise taxes or cut spending by the same amount if it is to return the deficit to 3 per cent by 2015 as planned under the EU-IMF programme.
Any restructuring of the notes that reduces the annual interest payment will help the Government reach the deficit target more easily.
So, if the €1.8 billion interest due in the €3.1 billion 2014 payment was reduced, the Government would not have to raise a similar amount of tax and cut as much spending that year.
The quicker the Government can get the deficit down the better. Restructuring the notes is the most efficient way to do this and certainly the most politically beneficial, given the public anger at having to pay for these two lenders.
FUNDING ISSUE
To complicate matters further, IBRC uses the notes as collateral to borrow emergency loans from the Central Bank through its exceptional liquidity assistance (ELA) facility.
So, aside from the benefits of pushing out the capital payments to cover the huge cost of bad loans at Anglo/INBS, State-owned IBRC is using the notes to help fund its rundown at a much cheaper rate than if it were to source market funding (were that even possible).
UCD economics professor Karl Whelan estimated at a conference last week that IBRC had about €42 billion of ELA loans last year.
ELA is a liability of the Irish Central Bank but it requires prior approval from Central Bank governor Patrick Honohan and the 16 other national central bank governors who sit on the ECB’s governing council in Frankfurt.
It is the subject of a letter of comfort from the Government, which commits to repaying the debt to the Central Bank if it is not repaid.
One complication of ELA is that it is rolled over every fortnight so there is always a risk that the ECB could reject a proposal from the Central Bank to extend ELA loans to IBRC.
IBRC might be getting 8.2 per cent interest on the notes from the State but it is paying the Central Bank about 3 per cent for ELA, which it repays as the bank’s own loans are repaid. IBRC books the 5 per cent margin as income.
This arrangement is regarded as a red herring as the State is paying 8 per cent on an IOU to IBRC, which is in turn paying the State’s Central Bank 3 per cent on a loan that the Government says it will repay if IBRC can’t.
This means that the real cost of the structure of the notes is the €3.1 billion the State must borrow every year to pump into IBRC. Reducing this figure is the key to a solution.
POSSIBLE SOLUTIONS
Clearly, it would be a big win for the Government to get the promissory notes off the State’s balance sheet and on to the European balance sheet to reduce the State’s debts.
Equally, it would be in the ECB’s interest to get IBRC off central bank funding as running a dead bank – whether the cash comes through loans from Frankfurt or an emergency credit line through its Dublin branch – is anathema to the ECB’s rules of engagement with banking.
The ECB doesn’t like national central banks extending ELA, as it is fearful of the effect on inflation and that it could promote moral hazard, where risky behaviour is rewarded.
Also, given that ELA funds are provided on lower-quality collateral than the ECB will accept for providing loans, Frankfurt doesn’t like the increased risks on this kind of loan.
The best outcome for the State would be a long-term loan at a low rate directly to IBRC from the EU bailout fund, the European Financial Stability Facility (EFSF), and its permanent successor, the European Stability Mechanism. The EU agreed last July to change the EFSF’s rules to allow it to recapitalise banks but only through loans to governments.
One newspaper reported yesterday that the Government would seek a long-term EFSF loan at 1 per cent which could reduce the interest bill from €17 billion to €5 billion, but the fund is unlikely to lend this cheaply.
“The best outcome for Ireland is that the EFSF or ESM subsequently would provide us with a €30 billion loan at a low interest, say 3 per cent over 50 years – that would be a massive outcome,” said Dermot O’Leary, chief economist at Goodbody Stockbrokers.
A lower rate of 3 per cent on a long-term loan would allow the Government to reduce interest and capital payments to IBRC, pushing them out over an even longer period. This eases the year-to-year drag on the deficit and avoids adding to the already tough budgetary measures to cover the higher yearly payments.
The cheaper the loan and the longer its term, the more it would reduce the net present value of the debt to the Government.
An added benefit is that the Government would reduce the size of IBRC’s balance sheet by about €30 billion in one fell swoop and make a statement to the markets that it has weaned its worst bank off central bank loans – one of the catalysts for Ireland’s 2010 bailout.
It would remove the uncertainty hanging over the Government of the ECB approving fortnightly extensions on ELA loans.
The downside is this will deprive IBRC of an income stream – the 8.2 per cent interest from the State less the 3 per cent it pays for ELA – and this could mean a further capital injection.
Whelan suggested last week that the Government could ask that IBRC not to pay back the loans from the ELA or at least not begin repaying them until the economy recovered.
“The liability is essentially a fiction. Central banks can create money and they can just as easily destroy money; they don’t go bust.”
This would require the approval of 11 members of the 17-strong ECB governing council.
The Irish Central Bank could, in practice, only insist on repayment from IBRC if the State could afford it (so this option is unlikely now or for a long time into the future).
If it were possible, this would in effect be a debt write-off but would only be recognised when the last IBRC loan is repaid. This could be 30 years from now, given that IBRC has long-term INBS residential mortgages on its books.
The Central Bank and State could agree then that the gap between IBRC’s remaining loans and the outstanding ELA be written off.
But the idea of the ECB writing off ELA in the short term is unlikely to wash given that the ECB has refused haircuts on unguaranteed senior bondholders at IBRC, never mind on one of its own branches in the euro system.
If IBRC defaulted on ELA loans and the State couldn’t pay the debt, Frankfurt would in theory have to recapitalise the Central Bank.
Media reports yesterday said the Government wanted to delay further payments on the notes until 2022 (though this was discounted by one source). Such a plan would help, but again IBRC would require the cash from somewhere else.
Other options being considered include swapping the outstanding sum due on the notes (€28 billion), in full or part, for another debt instrument that could be sold to raise funds – from the EFSF or even privately.
The notes could also be substituted with an “in kind” asset of similar value – in full or part.
The possible solutions are complex. Noonan wasn’t wrong to use the word “technical” to describe the nature of the discussions on how to find a way of easing this heavy debt burden.
