Repay Bond holders in full (with mortgages)

You can’t hope for isolated solutions in world where everything is bound together, which is the foundation for taking a more pragmatic look at a solution for Irish Banks and households, because one inherently is reliant upon the other.

That our banks were underwritten by all of our citizens (minus any consent in that debt bondage process) is a given, however, it would be a mistake to think that there can only be a one way flow of funds or solutions between the two parties.

The conundrum thus far is that the ECB don’t want to see any bond holders ‘burned’, while at the same time this nation should not be guaranteeing any facet of the securities markets any more than we should have protected bank share holders; and then we have the third and fourth legs on this table of madness, the IMF who (counter to the ECB) want burden sharing and an overly indebted society incapable of paying back the money they borrowed.

Somehow within this morass we also need to de-leverage our banks while making credit available to businesses and home buyers, literally every rung of this ladder is a contradiction to the preceding step.

Up to now, core nation support for the periphery is not entirely altruistic, many of the largest creditors of the PIIGS are French and German banks, and a debt should ideally be honoured where possible or you create genuine moral hazard so how can we find a solution that keeps a smile on every face?

A practical solution is to tick every box in the most broadly acceptable manner while bypassing narrow self interest within the groups that constitute every stakeholder party.

Unfortunately this will involve a credit event, but one that has a sensible work out attached, naturally bondholders will scream about it – just remember, nobody gets there legs hacked off and dances a jig at the results of same. However, it is possible to deliver some painkiller with the pain…

We repay the bondholders in full, but not with cash, instead with another bond which is made up of mortgages, the largest asset remaining on bank balance sheets, an idea that is similar to what Arthur Doohan from was proposing. A swap of sorts which is hived out into a non-bank debt collection company – not entirely dissimilar to what Bank of Scotland have done with Certus.

Neither the existing bonds or mortgages can be reasonably valued at 100% but in this process bondholders are actually likely to do better than they would currently if we applied a market price ‘burn’ to their holdings. The recent Liability Management Exercise (LME) by Bank of Ireland is testament to that, bondholders may well have preferred a book of highly distressed loans.

In this process the bondholders take some losses and at the same time we reduce the liabilities of our banks (bond holders) while bringing down the level of assets (home loans). In this new ‘work out company’ there is considerable incentives for both parties to work with each other for a mutually acceptable end, this will result in creative debt solutions.

If a bondholder is expecting 25c on the Euro (or could only obtain that on the secondary market) then a mortgage backed bond with a potential value of 90c on the Euro is an attractive proposition, albeit the interest earned and maturity date may change versus their current position (I take 90c as being loan value minus 10% impairment which is the general proxy in our stress tests)

So €20bn of bonds are removed from the banks debts and the bondholders are given €20bn worth of mortgages to manage. They might only reasonably expect to obtain 70c on the Euro with some loans (a better option than the bond work outs to date), but in return they may offer mortgage holders a debt writedown of a certain percentage if they successfully make payments – a process already working in the USA via the ‘Loan Value Group’ who orchestrate such schemes. They might give the person a 20% reduction in their loan if they make timely payments which still puts them far ahead of the 25c/€1 position they were in prior to this.

Households get a better deal, bond holders get a better deal, the immediate writedown is containable if the Europe wide stress tests are to be believed and most importantly we get some of the heavy lifting of de-leverage out of the way and move on with a more robust economy to boot in which debt and banks are less of a drag on output.

Between July and August €660m in bonds will mature and be paid to bank creditors, €660m is about 40% more than the annual Jobs Initiative costs (€470m) it is almost one tenth of the €7bn due to mature this year, and yet there is still time, because the real battleground will be from 2012 to 2014 during which  €66bn of bank bonds will mature and be paid out by the Irish taxpayer.

It is literally insane to continue on the path we have chosen to date, and yet the mantra has become one of ‘if at first you don’t succeed then get a bigger hammer’. Banks are edging up margins where possible forcing bad bank lending costs onto the shoulders of the few.

At the same time we are not going to see legislation passed in a time-frame that will likely aid the 100,000 and more mortgage holders who are either in total default, arrears or renegotiating to paying only the interest.

Our salvation was, and is perhaps, the IMF. They have set a fair course looking for realistic demands which may not sit well with an entitlement oriented populace but which do seek to address some of the hard structural imbalances we have such as the difference between the taxes we raise and the money we spend.

It surely is a curious world when the IMF are the only good guys left…

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