Bondholder ‘Immunity’ to Losses Challenged in Ireland

Bondholder ‘Immunity’ to Losses Challenged
A customer uses an ATM machine at a branch of the Allied Irish Bank. Photographer: Crispin Rodwell/Bloomberg

Two years after assuring senior bondholders that they wouldn’t lose their money if banks failed, the Irish government is making the same promise again.

This time, some bondholders are skeptical the government will bail them out with taxpayer funds, sending down the price of senior guaranteed debt for Anglo Irish Bank Corp. to 90 cents on the euro, according to pricing data compiled by Bloomberg, to account for the risk it might not be repaid in full.

Some equity investors, including Neil Dwane, who helps oversee about $80 billion of equities as chief investment officer at Allianz Global Investors’ RCM unit in Frankfurt, are angry the pledge is being made at all.

“It’s as if bondholders have diplomatic immunity from losses,” Dwane said. “Two years into this crisis we’ve learned nothing and done nothing. Bondholders have got to understand that they can lose money when they invest in banks.”

The bailout habit is hard to break. Governments have poured hundreds of billions of taxpayer dollars into European and U.S. financial institutions since 2008 to give investors confidence to keep buying bonds at cheap enough rates so that banks can continue lending to support companies and households. The 201 members of Morgan Stanley Capital International’s World Banks Index need investors to help refinance $3 trillion of bonds coming due by the end of next year, Bloomberg data show.

Flawed System

“It’s very hard to wipe out the bondholders because they are the source of funding to keep the banks going,” said Philip Hampton, chairman of Royal Bank of Scotland Group Plc, whose Edinburgh-based bank received 45.5 billion pounds ($71.5 billion) in the biggest bank bailout in the world during the financial crisis. “That’s the critical element: How do you get pools of private capital -- not government capital -- which can help banks deal with a very severe crisis?”

The bailouts created a flawed financial system in which holders of the safest, or senior bonds, don’t have enough risk of losses, according to William White, a former chief economist at the Bank for International Settlements in Basel, Switzerland.

“It would have been better if they’d stuck it to the bondholders in the first place,” said White, 67, who’s now chairman of the economic development and review committee at the Paris-based Organization for Economic Cooperation and Development, explaining that the government had created a moral hazard at the expense of taxpayers. “The fundamental problem is that there was so much concern at the time about the fragility of the system that nobody really knew what would happen if a big bank defaulted.”

White said he was speaking for himself, not for the OECD.

‘Monitor the Downside’

Bond investors who have more of a risk of losing their money will act as better assessors of banks, according to Paul Tucker, deputy governor of the Bank of England. Regulators are working to create such a bond market, he said.

“It will mean that debt-holders as well as equity-holders are at risk, and debt-holders will monitor the downside when they lend money to banks and dealers and others, rather than taking it for granted that they will always get their money back, because they won’t,” Tucker said at a conference in London on Oct. 4.

Governments have been wrestling with the dilemma of whether to use public money to bail out banks since at least the year 33, when Emperor Tiberius provided funding for failing Roman lenders, Morgan Stanley analysts including Carlos Egea wrote in an Oct. 15 note on the future of bank senior debt.


“It seems almost inevitable that the political climate will force a greater debate on risk-sharing,” Egea wrote. “As policymakers go on the record in support of burden-sharing for bank bondholders, the prospect of a ‘bail-in’ world -- where senior debt gets swapped for equity in banks under stress -- becomes ever more real.”

Investors in subordinated debt of Anglo Irish, the recipient of Ireland’s biggest bailout, were yesterday asked to exchange existing bonds for new ones with a par value 80 percent lower. Subordinated or junior debt is repaid after senior debt in the event of a default, making it more risky.

The Irish government may seek to extend a guarantee on bank deposits and senior bonds after it expires on Dec. 31, two people with knowledge of the situation said today.

“The government will continue to support the banks through a guarantee scheme as appropriate,” Ireland’s Finance Ministry said in an e-mailed statement.

Except in Iceland, investors in European senior bank bonds have been paid the par value of their investments in troubled banks, according to Morgan Stanley. Bond investors in New York- based Lehman Brothers Holdings Inc. weren’t bailed out, sending shock waves through the global financial system after the firm filed for bankruptcy in September 2008.

‘Financial Collapse’

Creditors of Iceland’s Kaupthing Bank hf, Glitnir Bank hf and Landsbanki Islands hf are owed as much as $86 billion --more than seven times the country’s 2009 gross domestic product -- after the lenders’ collapse brought down the economy.

The nation lost its Aaa rating from Moody’s Investors Service in May 2008 and is now Baa3, the lowest investment grade. Consumer prices, excluding housing, rose 41 percent from January 2007 through September of this year, as Iceland’s krona fell as much as 80 percent against the euro in the offshore market. Disposable incomes slumped 20.3 percent last year, while house prices have plunged 34 percent in Reykjavik, the capital, since an October 2007 peak, according to the central bank.

Risk of ‘Collapse’

Irish Finance Minister Brian Lenihan said Oct. 20 that any suggestion of defaulting on senior bank bonds would lead to “financial collapse.” In September, Lenihan said Ireland “is not prepared to be some kind of social experiment for bank default” because it would affect the willingness of international investors to buy government and bank bonds.

Two years ago, Lenihan’s decision to guarantee bond investors and depositors in Irish banks triggered similar assurances by governments from the U.K. to Germany, as money flowed to Ireland.

Irish banks owed international lenders $284 billion as of the end of March, according to the BIS, more than the country’s 2009 GDP of $227 billion.

The government has already spent 33 billion euros ($69 billion) bailing out lenders, including Anglo Irish, Allied Irish Banks Plc and Irish Nationwide Building Society, after a property boom and bust, pushing the country’s fiscal deficit to 32 percent of GDP this year. The final tally may be as much as 50 billion euros, the government said on Sept. 30.

‘Negotiated Settlement’

“For domestic taxpayers, it’s been a disaster,” said Joan Burton, finance spokeswoman for Ireland’s Labour Party, the second-biggest opposition group. “What we need is a banking resolution regime in place, where you could have a negotiated settlement with all bondholders, including senior bondholders, if a bank goes bust.”

The government said it wants to cut the budget deficit to 3 percent of GDP in 2014.

Dan Fuss, a bond investor who helps manage $150 billion as vice chairman of Loomis Sayles & Co. in Boston, isn’t convinced by the Irish guarantee that senior bondholders in Dublin-based Anglo Irish and other lenders will be repaid. Anglo Irish was nationalized in January 2009 after borrowing from international investors and lending to property developers who couldn’t repay loans when the real estate market crashed.

“The fear of the government not paying everything is why we’re not there frankly,” Fuss said in an interview. “We looked really hard at the Irish banks, including Anglo Irish, a couple of weeks ago as an alternative to Irish state debt,” he said. “The government has room to renegotiate the terms.”

Anglo Irish Notes

Anglo Irish’s 1.25 billion euros of unguaranteed senior unsecured floating-rate notes maturing in 2012 are quoted at about 86 cents, equivalent to a yield of 12.5 percent, according to pricing data compiled by Bloomberg. That compares with a yield of 6.9 percent on its government-guaranteed senior bonds, signaling investors assign a greater probability to the bank restructuring its debt than the government doing so.

Fine Gael, Ireland’s biggest opposition party, said Oct. 8 that it would also repay Anglo Irish senior bondholders in full. In September, the party had demanded that Finance Minister Lenihan negotiate with bondholders.

The party doesn’t want to “risk the reputation of the country” as a re-payer of its debt, said Fine Gael finance spokesman Michael Noonan.

The politicians’ view that a default would be bad for the nation’s reputation has support in Dublin’s finance industry.

‘Lessons’ of Lehman

“What is being bailed out is a domestic banking system,” Donal O’Mahony of Dublin-based broker Davy wrote in an e-mail. “If you fail to see that, then the lessons of the Lehman bankruptcy have been lost on you.”

Sony Kapoor, a former Lehman banker who’s critical of how the global banking system operates, disputes that another Irish bailout is in the national interest.

“The battle between financial-sector investors and taxpayers is intensifying,” said Kapoor, who advises governments and nonprofits on regulatory policy as managing director of Brussels-based research group Re-Define. “Those with the weakest voices will be left carrying the can. Unborn future taxpayers have the weakest voices of all.”

Nations pay for bailouts through inflation or increasing debt, said RCM’s Dwane. Ireland is restricted from causing inflation, which erodes the value of loans, because it is part of the euro zone and can’t print its own money, he said.

‘One Hand Behind Their Back’

“They are genuinely stuck with one hand behind their back,” said Dwane.

The power of the bond market isn’t new. James Carville, a former adviser to U.S. President Bill Clinton, said he wanted to be reincarnated as the bond market, so he could come back and scare everyone, after he saw how bond investors could determine the success or failure of economic policy.

Ireland needs to change its approach to holders of bank bonds and set a new precedent for other nations, Dwane said.

“What’s at stake is the need to finally find a solution to the global banking crisis,” he said. “It would save taxpayers a lot of money if bondholders are forced to convert into equity.”

RBS’s Hampton expects the market for bank credit to change.

“There are lots of conversations going on about the structure of future bond issues,” he said in an Oct. 4 interview. “New instruments will be created.”

Contingent Convertible Bonds

Senior bondholders’ reluctance to take losses is helping fuel interest in contingent convertible bonds, debt that converts to equity when there is a triggering event, such as a decline in an issuer’s capital ratio or its stock falling to a pre-set price.

The Basel Committee on Banking Supervision, which last month announced new capital rules for banks worldwide, said on Oct. 19 that it’s developing “a well-integrated approach to systemically important financial institutions,” which could include “combinations of capital surcharges, contingent capital and bail-in debt.”

Swiss regulators seeking to ensure the nation isn’t dragged down by the collapse of its biggest banks have proposed requiring its two biggest lenders, UBS AG and Credit Suisse Group AG, both based in Zurich, to issue contingent convertible bonds, or CoCos, that can be used to write off losses “at the point of non-viability,” according to an Oct. 4 report.

The bonds, which would offer higher yields, would require the creation of a new market. Bond investors want more information on the events that would trigger conversion into equity, said Roger Doig, an analyst at Schroders Plc in London.

‘Trigger Points’

“Investors accept that we can’t expect banks to be bailed out by taxpayers,” Doig said. “What we want are clear trigger points from regulators.”

The power of bond investors vexes John McFall, a British Labour Party lawmaker who led a Parliamentary investigation of banks during the financial crisis.

“That issue of moral hazard is one that won’t be sorted out in the next year or two years,” McFall said in an interview. “It’s going to take a long time.”

It may take 25 years, according to the Bank of England’s Tucker. Regulators worldwide want big banks to be able to fail without taxpayer support, he said Oct. 4.

“That is an enormous goal, which over the next quarter of a century will bring about some kind of a revolution in our financial-services industry,” he said.

Brady Dougan

A restructured bond market also may hold the key for reining in executives, Tucker told bankers, including RBS’s Hampton, at the London conference. Paying bankers partly with debt may make them more responsible, since bondholders have a vested interest in preserving the stability of the institution. Credit Suisse Chief Executive Officer Brady Dougan said yesterday bankers may receive part of their future pay in contingent convertible bonds.

“It is important that they have the downside as well as the upside,” Tucker said.

RCM’s Dwane said aligning executives’ pay with investors is crucial to reorganizing bank funding. “The whole system has massively disadvantaged shareholders,” he said.

Economies are too fragile now to allow for bondholders to go under, said Loomis Sayles’s Fuss.

“As a longer-term goal, you have to bring some element of risk back,” he said.