Friday, December 3, 2010
Fear of a broad economic meltdown prompted officials in Europe and at the International Monetary Fund to protect key investors in Ireland’s troubled banks from losses, despite intense debate about the use of public funds to bail out private companies.
As officials scrambled last week to rescue Ireland from a banking crisis that threatened to make the government itself insolvent, officials drew a firm line when it came to investors who had purchased the most secure form of bank bonds, known as “senior” debt. Senior bonds are a staple source of funding for European banks and are considered such a safe investment that they are widely held by other banks, pension funds and similar institutions. In Ireland’s case, many of those investors are in Germany and the United Kingdom.
Forcing losses on senior bondholders, it was feared, would hit Europe with the same force as the collapse of Lehman Brothers in the United States – casting doubt on an entire system and with potentially global ramifications if it threw Europe back into recession or undermined an important economy, such as Germany’s. Even with taxpayers’ money involved from around the globe, in the form of $30 billion lent to Ireland from the IMF and $60 billion from European countries, the holders of an estimated $50 billion to $60 billion in Irish senior bank bonds were assured their money would be repaid.
“The driving force behind the decision to not involve the senior unsecured debtholders was the fear of contagion to other European banks – Spanish banks, Portuguese banks, maybe even Italian. You just wanted to avoid another sort of freeze on the capital markets,” said Frank Engels, senior European economist at Barclays Capital.
The structure of the Irish rescue deal shows the uncertainties that still surround efforts to shore up the finances of the 16-nation euro zone, a currency region that includes economic giants such as Germany and weak links such as Portugal. Although vast public resources have been pledged to the effort, investors remain doubtful that countries can do what’s needed to right public finances and restore growth.
The European Central Bank moved to calm the situation Thursday, saying it would continue buying bonds of troubled European countries and lending money to banks as needed.
But the Irish bailout has focused attention on some of the central issues yet to be resolved from the financial crisis: how to protect taxpayers from shouldering future bailouts, and how to prevent a crisis in one corner of the world from inflicting damage on the global economy because of the financial links between companies and countries.
The bank and corporate bailouts in the United States also protected many investors – by some reckoning, even a broader group than in Europe. Both senior and “subordinate” creditors were largely made whole in the U.S. rescues of companies such as Citibank and AIG. Although many stockholders lost out, others gained as the bailouts helped some companies recover and the value of their shares rose.
In Europe, by contrast, the drive to punish bank owners and investors has been more forceful as governments there stepped in with trillions of dollars in state support. Stockholders in some companies were fully wiped out when the businesses were nationalized, and owners of less secure debt have, in some cases, suffered losses. Holders of less- secure debt at the Anglo Irish bank, for example, were paid 20 cents on the dollar, and many analysts expect similar writedowns at other Irish banks as the country restructures its financial industry.
But the secure senior debt represents part of a more intense entanglement that Europe needs to resolve if its financial system is to be put back on sound enough footing to support stronger economic growth. Over the years, European banks and financial institutions have invested widely in the bonds of other European countries, and in the bonds of banks in other nations – often with little regard to the underlying risks and on the assumption that each country would ultimately repay its own debts and stand behind its financial institutions.
In a booming economy, no one second-guessed whether Greece was as sound a credit risk as Germany or raised questions when Irish banks fed a local property boom with aggressive lending. As the downturn began to expose the flaws, it remained uncertain how a default in one country or company might affect others.
“You don’t necessarily know where the next domino will fall, but you know there will be a chain effect set in motion,” said Jacob Kirkegaard, a Europe specialist at the Peterson Institute for International Economics.
It has made for complex politics – German officials struggling to balance an underlying distaste for public bailouts with the fact that their banks are deeply entangled in weaker European countries; and the IMF undertaking one of its most direct-ever rescues of a specific industry – but little clarity.
Ultimately, European officials say they want to make clear to investors that those who buy European government or bank bonds may well suffer losses. That is likely to lead to higher interest rates for weaker countries or companies but also a more careful assessment of how banks and nations are run. At Germany’s urging, such a provision may become part of Europe’s debt markets in 2013.