BUSINESS OPINION:YOU PROBABLY did not notice but Ireland defaulted last week, and arguably not for the first time. On Tuesday, an organisation called the International Swaps and Derivatives Association concluded that the decision by the Government to force AIB to buy back some if its junior bonds constituted a "credit event" or default.
As a result, a raft of insurance policies – known as credit default swaps (CDSs) – were triggered with the net effect that the insurers – mostly banks and hedge funds – had to pay out something in the region of $500 million to holders of the bonds.
Something similar happened in November when Anglo Irish bought back its bonds at a discount. That was deemed a “restructuring credit event” which is not quite so bad.
But last week’s default was significantly different in that AIB is a functioning bank owned by the Government rather than a failed bank which is being run down by the Government as was the case with Anglo.
The interesting thing about the AIB default is that it caused so little consternation in the market. Any movement in Ireland’s already-elevated bond yields was attributed to what is going on with respect to Greece.
Equally significantly, the whole CDS market did not collapse once the AIB claims were triggered. This is important because it is generally accepted that when people talk about the systemic risk associated with a bank default in Europe they are really referring to the possibility that the CDS market will turn out to be as much of a Ponzi scheme as the subprime mortgage market.
The fear is that if this turns out to be the case then some big bank somewhere in Europe or the US will go down because of its exposure to the CDS market in much the same way Lehman’s was brought down by its exposure to the subprime mortgage market.
This possibility was apparently behind US treasury secretary Tim Geithner’s blocking of the International Monetary Fund initiative to burn senior bondholders as part of the Irish bailout last December. It has also been suggested fears about the CDS position of a large German bank was part of the reason the European Central Bank was so emphatic about not letting any European bank fail in September 2008. It is one of the many paradoxes of modern financial markets that a product that is in theory intended to allow markets absorb defaults has become one of the biggest impediments to allowing them take place.
It is tantamount to being asked to keep on living in your burned-out house because everyone is scared what will happen if you make a claim against your insurance company and it turns out they are insolvent. It is an dysfunctional state of affairs but, given what happened when Lehman’s collapsed, perfectly understandable.
It would be a mistake to extrapolate from the AIB default that the global financial system is good for the €108 billion net CDS exposure it has to the euro area banks. That would require some pretty heroic assumptions about the extent to which banks have learned to manage complex risk since 2008. But it seems that the “success” of the AIB default has emboldened the Government to up the ante and go after the senior bondholders in Anglo.
It remains to be seen whether the ECB will agree to any such move or, more pertinently, whether or not it can block it.
Its main weapon, the withdrawal of €150 billion odd of liquidity support for the Irish banking sector would be far more likely to cause the sort of European banking catastrophe that it fears than the burning of speculative investors in Anglo and Irish Nationwide senior bonds.
At a minimum, the threat of burning the Anglo bondholders gives the Government a useful bargaining chip in its ongoing “engagement” with the EU over our bailout in the wake of the Greek crisis.
The lack of any apocalyptic consequences for the sovereign or the CDS market as a result of the AIB default allows the Government to claim it is not acting recklessly. But lingering uncertainty over the CDS market should focus minds. With this as a backdrop, it is very hard for the ECB to argue against what Ireland is proposing with regard to Anglo. The fundamental issue hanging over Ireland is the size and nature of our debt.
The markets have very serious doubts about our ability to repay it and thus will not lend. The only solution is to reduce the debt load, and a controlled default on the senior debt of broken banks that have been taken over by the State is an eminently sensible way of doing so. But if the ECB has its heart set against even such minor defaults, then the onus is on it to facilitate other ways of reducing the direct burden on the Irish taxpayer of rescuing the banks.
There are plenty of alternatives – direct recapitalisation of the Irish banks by the ECB is an obvious one – but they all come at a price.
