Time for a Debt Haircut

There is no end in sight to Ireland's debt crisis, but here's one thing we know: The Irish will not get kicked out of their own country. No matter how many multiples of the nation's gross domestic product are owed to German and U.K. banks, sovereign foreclosure is not an option.

In most other respects, though, the state of Ireland is similar to the predicament that 1 in 5 American homeowners with mortgages find themselves in—owing more than their property is worth, so burdened with debt that the economy is stalled by their inability to borrow and spend as they used to. With homeowners, at least, there's foreclosure, which is devastating but creates hope that debtors might regain something close to a normal life, albeit as renters. Those determined to stay in their own homes need something lenders have thus far been reluctant to offer: a reduction in principal, a lessening of the debt. Another word for it is a haircut. The entire taxpaying public of Ireland, it turns out, needs the same thing done to the debts it acquired in saving the nation's reckless banks. A growing chorus of economists, including Carmen Reinhart of the University of Maryland, is making this argument. But policymakers have shown few signs of even considering it. Why?

The situation in Ireland certainly calls for dramatic action. In Dublin, a protester driving a cement truck emblazoned with the words "TOXIC BANK" rammed the ornate iron gate of the Irish Parliament early on Sept. 29. Later that day, inside the purple-carpeted chamber of the lower house, representatives from opposition parties grilled Prime Minister Brian Cowen over the enormous cost of bailing out Anglo Irish Bank, the shaky real estate lender Ireland was forced to nationalize in January 2009 after Irish land prices fell as much as 70 percent from their peak. "What you have done with this government has crushed the spirit of the people," said Enda Kenny, leader of the opposition Fine Gael party.

Ireland illustrates why governments need to make private creditors share the pain. The bursting of its real estate bubble left the country overwhelmed with bad debts and forced the government to impose painful budget cuts. Embracing austerity has won Ireland the praise of the European Union—and little else. The Irish economy shrank at an annual rate of 5 percent in the second quarter because the sharp reduction in government spending hasn't been offset by a jump in private spending. And its borrowing costs have surged. Investors now have to pay 4.7 percent of the face value of Irish government bonds annually to protect against the risk of default for five years, 12 times the cost for insurance on German bonds.

What's forcing up borrowing costs is the Irish government's fateful September 2008 decision to throw a blanket taxpayer guarantee over all the liabilities of Ireland's six big banks. Three have since been nationalized. Standard & Poor's (MHP) projects that the bailout of Anglo Irish alone might ultimately cost €35 billion or more. Measured against the size of the economy, that's comparable to a $3 trillion bailout for a single U.S. bank. On Sept. 30, after this magazine's deadline, the Irish government was set to present its plan for winding down Anglo Irish. Advance word was that the government still aimed to repay the bank's senior bondholders in full. "Burning" bondholders "would be an absolute, utter disaster," Dick Roche, a junior minister, told Dublin-based broadcaster RTE on Sept. 26.

Like Ireland, the U.S. has been slow to impose big losses on creditors. That pattern goes back to 2008, when the government took over American International Group (AIG), then the world's biggest insurer, and fully insulated AIG's bondholders from losses. Today, protected creditors include banks that made unwise loans, bondholders and other lenders to those banks, and holders of securities backed by mortgages, auto loans, credit-card receivables, and other debts. Mike Larson, a real estate analyst for Weiss Research in Jupiter, Fla., says that by modifying loans without reducing what people owe, "You're not fixing the problem. You've got to start thinking about principal reductions."

The foot-dragging on writedowns is most obvious in the failure of mortgage-modification efforts by both George W. Bush and Barack Obama. To save mortgage lenders from having to post big losses, the efforts steered away from principal writedowns, focusing instead on reducing interest rates or stretching out loan terms to lower payments. According to the State Foreclosure Prevention Working Group, an organization of state attorneys general, "the vast majority" of mortgage modifications raised rather than reduced the amount of money homeowners owed.

Creditors object that debt forgiveness will encourage bad behavior. People, they say, will borrow recklessly knowing that if things go bad they won't be required to pay it all back. This argument has merit. However, it's equally misguided for the government to guarantee penny-for-penny repayment of private debts. That encourages even more foolish lending because creditors know they'll be fully protected from the consequences of their dumb lending decisions. Says Reinhart: "Before private debt becomes public, it's important that it do so at a very realistic price so it doesn't inflate the government balance sheet unnecessarily. And that means big haircuts."

One way or another, the world's savers and investors are going to have to pay the bill for unrecoverable debts. The question is whether that happens in a rip-the-Band-Aid-off round of debt reduction or is dribbled out over years in the form of government-induced inflation (which will ease the burden of debt while eating away at the value of savings). Policymakers are clearly concerned about the potential consequences of principal reduction. If my neighbor gets his mortgage reduced, why not mine? The stigma will be gone, and then who knows what happens? It's scary, all right. Yet the situation in Ireland shows there may be no alternative.

With Dara Doyle and Joe Brennan

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