I used to be in a Chess Club, and one thing it taught me (apart from how to lose using the Kings Gambit) is that you can often see a general result long before you see it exactly, when you are a piece down and can’t control the centre of the board you know you are in trouble, but how and where the checkmate occurs is unknown, game theory can’t tell you precisely and reverse integration from the end game may not bring you to where you started from, but the player knows instinctively that they are up against the wall.
Sometimes appearances can be deceiving, you might think you are fine and you are not (2003-2009), other times you can get caught up about losing a pawn but you are in fact gaining ground (2010), albeit painfully and slowly.
I believe the same can often apply to markets. Today we will look at the reasons for why we believe the banks are going to survive and furthermore, what the results will be of their survival.
The core belief in this firm is that market rules should apply, the banks should have to stand on their own or or shut down or find a buyer, its just that simple, however, we have not allowed that to occur so we now have to find our way through having avoided that option. In chess this is the equivalent of trying to save the Queen instead of Castling – the Queen is just too important, or is she? Depends on who you ask. We think not, but the decision makers made the play.
Our primary belief is that the banks will survive. Sometimes the noise is hard to ignore, but this time last year there were many commentators saying that our banks would be nationalised within a month or two, then the we should leave the Euro, last month the Euro was going to collapse and now we are once again on the road to hell minus the Chris Rea soundtrack, the truth is we’ll muddle through and come out the other side one way or another.
So why will the banks make it? For no other reason than because we have pinned the hopes of this country upon their survival, to the point of no return. In the absence of a ‘Plan B’ the success of ‘Plan A’ becomes highly incentivised. The current big issue that some people are pointing to is that of the bond credit that has to roll over by the end of 2010, the figure was c. €74bn (previous calc’s said €71bn) which is made up of Interbank Lending €16,405m, Senior Debt €57,791m and Subordinated Debt €866m.
We’ll focus on the bond holders as they represent a foundational risk to the system, so… Will the bond holders stay the course and support Ireland? I would imagine the answer to be ‘yes’, but I’ll qualify it.
2. What failure would mean
3. ECB support & approach thus far
4. Shareholder support
5. Euro implications
6. Effect on cost
1. Guarantee: We have made a guarantee to world markets, world markets like that kind of thing, the state will ensure that no institution will not be able to come good on their liabilities and it is underwritten by the state guarantee (taxpayers), this kind of ‘can’t lose’ situation is preferable to fixed income markets, it is the reason the USD is a safe haven when you can’t trust much else (bar gold or perhaps Yen). No bondholders have been burned and they are generally satisfied that their capital values are safe, over and above coupon payments, bond buyers want to know that they are going to get their capital back (in full and on time). No bank has yet defaulted nor will they, as a default on a state guaranteed bank is essentially a sovereign default – it ain’t gonna happen.
Some people think a sovereign default might be just the answer, it is hard to disagree in many cases, it sounds like a nice plan to go and shaft those big faceless bond-holders, and many countries do, Greece (for instance) has made a career of it – which is why everybody there is so angry at the concept of actually having to get their house in order. Would it be a good idea for Ireland?
I doubt it – there is not only the implications of default to consider, firstly, the ECB would likely force non-default, taking up the slack and forcing us to pay eventually anyway, secondly, we export a lot of financial services and nobody wants to deal in serious finance services with a country that defaults (except of course those that make a profit from restructuring etc.).
Uruguay is a country that people point to as being evidence of the ‘correct’ way to default, having been to that country six times and studied it extensively I can safely say that we don’t want to go down that path (yet). The guarantee will stand and thus the Irish banks will stand. The one outlier in this is if there is some substantial credit event (either large institution or sovereign).
2. What failure would mean: An inability to refinance would be read internationally as a country being broke, believe it or not Ireland doesn’t matter to the international marketplace as much as we’d like it to. I speak to traders in the US regularly enough and they don’t know the difference between Anglo, BOI or AIB – nor do they really care, something bad happens in Ireland and the whole place is tarnished. Oddly we actually have earned great respect internationally for how we are handling our issues (I’m not talking about the OECD/IMF/WorldBank etc. – I’m talking about the opinion of the people who actually buy our bonds as opposed to those who make economic forecasts/comment), a credit event now would spell disaster, we wouldn’t be even be able to finance our public services.
Strangely, the Public Sector Unions are quite vociferous on how ‘angry’ the are about the ‘bank bailout’, failing to see that if the banks fail that their paymaster won’t be able to borrow to pay them, they didn’t cause the crisis but they are one of the primary beneficiaries and if one domino falls the next will follow, it isn’t different this time. Uruguay is testament to that.
3. ECB Support & approach thus far: Name a bank in Europe that was allowed to go to the wall? … Still thinking? After Lehman the banking bluff was seen for what it is, namely a ‘fairly real threat’, banks are not joking when they say ‘if we fail we can bring down the system’, that type of event may not bring the four horsemen charging out of the sky earth-bound and ready for destruction, but it can cause systematic distress which is far beyond the price of avoiding it.
This may not have been the case if we went for this option originally, but certainly now – as it would involve breaking our sovereign promise -it would ensure a far larger bank run than necessary and likely collapse. Bailouts sicken me, especially when I see competitors bailed out who are then able to unfairly chase the same clients we chase, trust me, nobody is angrier than intermediaries when it comes to life support to banger businesses that should have shut down but are instead artificially supported.
4. Shareholder Support: Bond holders are at the very end of the risk queue – the most senior ranking on par with depositors, shareholders on the other hand are the ones playing with dynamite, and despite this, the BOI rights issue was 93% subscribed with buyers for the remaining 7%. That means that people are more than happy to take the most risky asset available, that is the market speaking loud and clear that they trust in BOI’s ability not only to survive but to prosper, if people and institutions are willing to back the equity you can be damn sure they’ll back the bond debt. While the buyers are often of different mind sets (shares v.s. bonds), the fact is that it means there is a bigger buffer of safety for the bond holders, and a pre-auction phone call from the desk will likely help to assuage any fears ensuring that the debt rolls. Saying otherwise is like thinking a person wouldn’t drive a car when there are people trying to get to the same destination on uni0-cycles, the bonds are safe and will remain as such.
CDS’s are often news makers, hard to think that only a decade ago almost nobody even knew what they were, and a decade and a half ago they didn’t exist. CDS’s are like a secondary thermometer: let me ask you – is 30 degrees hot? Yes if you are in Ireland, yes if you are in the North Pole, but no if you are in Brazil and definitely no if you are trying to cook a turkey, but we often see CDS’ prices reported as if they are the one cooking the goose, it isn’t the case, often issuers realise that higher yields players will happily sacrifice some coupon for a hedge, and almost all the CDS’s are settled materially or manually (the actual asset passes to the issuer) rather than via a direct insurance payment.
The likelihood of a qualifying credit even for the reference entity doesn’t have to occur, it just has to be perceived as ‘a risk’, prices can be a reflection of yield sacrifice for a hedge, CDS’s are a secondary measurement, they are not the reference entity and cannot be seen as such, capital values are a better tool in our opinion than looking at the derivative values or bids where that capital value is the reference entity. If an LT2 bond is paying c. 11% then a CDS of 5% isn’t the end of the world, having said that, you would always wonder what might prompt an 11% payment to begin with! However, the main thrust remains – Shareholders have stepped up and that is like a wave of infantry charging over the top, which makes the bondholders who are still in the trenches feel much safer.
5. Euro Implications: Despite the hullabaloo being caused, the EU and even Germany all want a devalued euro, granted, German savers will be angry, but everybody else wins, low rates, quantitative easing and monetary policy that encourages exports will be of benefit to everybody, Germany gets their exports and output back up, Greece gets their bailout, everybody else gets some inflation which will hopefully feed into new employment faster than wage increases for existing employees and we all muddle on through.
This latest test isn’t testament to the failure of the Euro, it is rather testament to the success that it represents in converging largely disparate nations and economies- the USD does the same thing. While the current issues represent a test, it doesn’t represent a ‘failed test’, if a member leaves it won’t be the end of the world, but don’t bet on it, if you could just kick people out of monetary unions then Louisiana would have been kicked out and California would have seceded long ago, don’t doubt the staying power of EU members.
6. Effect on Costs: Far from seeing the present storm as a sign of imminent collapse, I see it as a signal that we are in for a period of much higher financial costs on any credit or financial transactions, banks are going to have to retrench, build deposits, build assets carefully and find operational gains (fire lots of people). The most likely outcome isn’t that a bank will fall, it is that they will find a way through via operational profits and price increases. Much of the past losses are paid for, NAMA has taken away a huge amount and they are jacking up mortgage rates to cover the lagging residential issues. It’s easy to cry ‘Uncle!’ now, or to believe it is upon us, but the fact is that we made it this far and both Ireland, and its banks are probably going to find a way to stagger through, punch-drunk and beaten, to the other side of this mess, I’m not saying it won’t hurt in the mean time, or that there won’t be further slaps to the head, but we’ll muddle through in spite of it, the markets have already spoken, it’s time to listen.