November 17, 2010
The news this morning is of Irish banks edging closer to a bailout from the EU / IMF. But it seems as though the money is about to be wasted as history repeats itself.
The phrase most often used is a ‘haircut’. Essentially, that means that bondholders (investors in debt) will receive less in return than they were expecting when they purchased. In more formal terms, this is debt restructuring.
The rub, however, is that investors in bonds do so knowing that bonds are graded (broadly investment grade or junk) with a set of letters. These are things like AAA or AA or BBB etc. This grading represents the likelyhood of that company, organisation or entity defaulting on their repayment obligations.
Bondholders know in advance of purchase that some debts will be defaulted on or need to be restructured. That is the nature of the beast. Even sovereign debts are defaulted on fairly frequently.
By ‘bailing out’ debts, the risks of investing are being passed on to the taxpayer, while the returns are retained by the funds, corporations and governments that made the investments. This is almost exactly the phenomenon that everyone is complaining about in the banking regulations – by paying big bonuses, banks are keeping the profits in private hands whilst palming losses off to the taxpayer.
If it isn’t right for banking bonuses, why is it right for bondholders?
In addition, this seems remarkably similar to the strategy that was used so unsuccessfully in the US in 2008. A strategy that has come in for a deserved amount of criticism. Most commentators seem to believe that the TARP money was mostly wasted.
As we know, the US was suffering from losses on residential mortgages on a massive scale. These losses are still being racked up, as NINJA’s – as they were known – failed to keep up repayments.
Ireland, it would seem, is suffering from a smaller, but similar problem. Property prices seem to be down by 50%+ in many places, leaving lots of borrowers with negative equity.
So why use the same rescue measures – or at least similar – in Ireland?
If banks are unwilling to lend to each other, this is a crisis of confidence. The lenders are rightly worried that their loans will not be repaid. Quite rightly it would seem.
The lending banks, one would presume, have cunningly copied every other major debt default model by lending out long-term money that they have borrowed short-term. While their borrowers may be able to maintain repayments with interest rates so low, their own lenders do not like what they see. Should their loan books be valued at either mark-to-market or mark-to-model, they are in deep trouble.
Northern Rock anyone?
It sounds like a business model failure to me. In which case, all investors (in both debt and equity) need to take their fair share of pain.financialguy