On Ireland’s bond success

I listed Ireland in two of my surprises for 2013. I wrote that Ireland’s government bonds do not outperform again. Greece outperforms this year.  I also wrote that Ireland goes to OMT. The first prediction is probably more controversial than the second now that Ireland has issued its benchmark bond with success. There are questions about Ireland’s success though.

The Telegraph reports that, “traders said the new debt would yield around 4.15pc, compared to a yield of 3.7pc on Ireland’s current benchmark 2020 bond. At the height of bailout fear less than two years ago, the yield on the 2020 bond had stood at more than 15pc.” I would call this success. Like me, Divyang Singh at IFR believes the next stop for Ireland is OMT. Let’s review the situation to OMT.

First, getting to OMT and making it work really requires Europe move on Ireland’s sovereign bank debt takeover. I have talked about this a bit in the past. See posts tagged “Ireland” and “OMT“. The long and short of it is that Ireland’s debt to GDP has moved up nearly 100% of GDP from about 25% of GDPbefore the crisis to a level approaching 120% now, near Italy’s level. Most all of this has been due to bank bailouts. The rest is due to the collapse in tax revenues and increase in automatic stabilizers as the post-bubble economy went into freefall. That might seem ok for now. However, as we see with Italy, which has had a near primary budget surplus, the instant rates go up, the economy’s deficit and debt to GDP balloons.

The promissory note to the ECB has been ameliorated somewhat by lengthening maturity and reducing the rate. But all the bank debt is still there. The contrast to Iceland, which allowed the banks to default, is striking. Though much of the positive contrast economically is countered by the currency devaluation’s implicit lowering of Icelanders’ standard of living, the fact remains that the sovereign is investment grade, in control of its own currency and not laden with debt.

Now the IMF is fully behind Europe’s moving get rid of this problem. The Germans are against it though. Wolfgang Schaueble, the German Finance Minister, is on record as saying it was Ireland’s lack of regulatory controls which caused the problem and so the Irish should deal with it. This is a curious framing given how much the German banks were complicit in the Irish credit bubble and how their skin was saved by the Irish sovereign takeover of Irish debt. Steven Kinsella pointed this out recently.

Clearly, Schaueble is looking to protect the German banks, which have weak capital structures. For example, Commerzbank, the 2nd largest German bank behind Deutsche Bank, is looking to raise 2.5 billion euros of capital to reduce government ownership from 25 to 20 percent. And its shares promptly fell 15% on that news today. We also know via a whistleblower how Deutsche Bank was able to prevent its derivatives book from being marked to market during the economic crisis. Had Deutsche marked these positions correctly, the firm would have seen its capital levels dip and there could have been a wholesale funding revolt. And Deutsche Bank is too big to fail. All around, German banks are highly levered, exposed to the European periphery in a major way and repeatedly reported to be loaded with toxic paper. Those toxic assets have not just disappeared anymore than they have in the US or the UK.

Having worked in German banking I know why this is so. German banks are heavily laden with commercial loans that suppress return on equity. After a reunification binge, these loans soured and credit conditions worsened. It is precisely because opportunities inside Germany have been limited over the past decade that German banks have taken a risk-seeking-return mentality abroad. And this has got them into trouble time and again: Hypo Real Estate, BayernLB, IKB, HSH Nordbank, Dresdner Bank (now a part of Commerzbank) and WestLB are but a few names that are amongst the bailout casualties that ballooned German government debt to GDP from just above the Maastricht 60% hurdle before the crisis to now well over 80% of GDP. The German banking system is a mess, frankly. And Mr Schaeuble knows it. Mr Schaeuble is being exceedingly disingenuous. And the reason for that is bailout fatigue in the German electorate.

So the Germans are going to be a problem here despite the real need for Europe to use Ireland as a poster boy for the success of austerity – the country has seen what Ambrose Evans-Pritchard describes as a fiscal squeeze of 16% of GDP since the crisis began and has met every one of the 190 requirements of the Troika. And remember, the Germans promised to decouple sovereign and bank risk as the Solution to the Spanish crisis last year. Rajoy fell for this but later learned he had been hoodwinked as the Germans, the Finns and the others have all backtracked on these promises. This is what forced Draghi to do the OMT.

Second, the real economy in Ireland is dicier than some of the numbers might suggest. The large banks are still in a state. The best of the lot, the Bank of Ireland, is facing an avalanche of mortgage arrears. The fear is that this could force it into state hands due to credit writedowns. Bankers are warning that thousands of Irish are defaulting on their mortgages and letting them lapse into arrears. The estimate is that more than 90,000 are at least three months in arrears.

And let’s remember here that while Ireland is growing, it is doing so from a reduced base.  Unemployment is 14.1 percent, which contrasts quite negatively to the US where it is just 7.7% despite a large housing crash. And house prices are still falling, one reason arrears are mounting. If Ireland wrote down mortgages to their real levels, it would fully wipe out the country’s banking capital base. So there is definitely a large measure of regulatory forbearance occurring in Ireland despite the huge writedowns already taken. (This should tell you how much worse it is in Spain which has not taken the same level of writedowns.) 

It is by no means clear that Ireland is over the hump. Things certainly look better. Nevertheless, many, many problems remain. If the economy slumps, the 120% government debt to GDP will become a problem that will demand ECB intervention.

My conclusion then is that Ireland looks to be the best case the EU can put forward. It has been a success relatively speaking. But the banking system is still a disaster, unemployment is still sky high, and the housing market is still falling. Much work remains. Without a decoupling of the bank debt burden from the sovereign risk profile, Ireland may well re-couple to the rest of the periphery at some point down the line. From a relative-value perspective that makes Greece a more compelling play than Ireland.