What Investors Should Know About The Irish Bailout

So the bailout is in. BBC News is reporting that the Irish are to receive 85 billion euros. Let me highlight a few points.

My first thought has to do with the European stress tests. If you recall, the two Irish banks tested were Bank of Ireland and Allied Irish Bank.  Both passed the tests. These paragraphs from the BBC capture the essence of the official response at the time:

The banks had already passed more severe stress tests carried out by the Irish Financial Regulator in March.

Irish finance minister Brian Lenihan has welcomed the outcome of the tests for AIB and Bank of Ireland.

He said they vindicated the financial targets set for the banks by the Central Bank and Financial Regulator earlier this year.

He added that he welcomed the increased transparency that the EU-wide test had brought to the banking system.

Clearly, the tests were not very stressful given the Irish bailout – more so, given the Irish government carried out more severe tests in March. In fact, the market reaction since the Irish application for bailout money demonstrates that bond investors have no faith in the stress tests.

The political fallout is already happening. The Green Party is calling for new elections in January of 2011. The opposition party has signalled it wants elections in four weeks' time. And Fianna Fail backbenchers are looking to heap the blame on Irish PM Cowen so as to save the party's credibility in that election.

On the ratings front, Ireland was downgraded multiple notches to A from AA- by S&P with negative watch for further downgrades. It is about to receive a massive downgrade from Moody's. The ratings agencies had been stoically silent during the turmoil, not wanting to insert themselves into a politically charged environment. But now that the bailout is a done deal, you can expect the downgrades to come fast and furious.

Going beyond Ireland for a second, the biggest problem is clearly Spain given the size of its domestic economy, an estimated $1.46 trillion according to the IMF. By comparison, the Irish economy is only $228 billion. Europe's biggest economy in Germany is $3.35 trillion. When I covered the stress tests in July, I noted that 26 of the 91 banks tested were Spanish. The inference is that the banking problems in Spain are large. The difference to Ireland is that the Spanish government has not done a bank debt and deposit guarantee and that Spanish property prices have not yet fallen as much as they have in Ireland. But, the stress tests were clearly precipitated by worries about Spanish banks more than Irish banks. So this remains the country to watch.

Ambrose Evans-Pritchard has a good write-up on Portugal that I suggest you read. Here is one good highlight:

Yes, Portugal's public debt is manageable at 86pc of GDP - although even that figure is in question. Opposition leader Peder Passos Coelho said over the weekend that the real figure is 122pc, accusing the government of "fictitious" accounting. Be that as it, public debt is not the core problem. Private debt is one of the highest in the world at 239pc (Deutsche Bank data), and the events of the last two years have taught us that private excess lands on the taxpayer one way or another in a crisis. A chunk of this is owed to foreigners, and must be rolled over.

Portuguese banks have been well-behaved. There is no property bubble. But as the IMF points out in its Article IV report, the banks have a "heavy reliance" on external funding, equal to 40pc of total assets. It was a funding crisis that killed Northern Rock, not bad loans.

In short, Portugal's problems are quite different to Ireland's and are more structural: labour costs, export competitiveness, current account deficit.

Back to Ireland for one second, I have to point out again that the Swedes also gave bank debt and deposit guarantees when their banks failed in the early 1990s. So, despite everyone's falling all over themselves to pinpoint this as the crucial reckless error by the Irish, there is precedent here. You should understand that the key difference is private sector debt levels in Ireland are some 700% of GDP because of the enormous size of the Irish financial sector. It is the Icelandic problem, not just the deposit guarantees, or even the debt guarantees,  since other euro countries also guaranteed deposits (important that you see here).

P.S. –  And yes, I talked about the bank debt guarantees here as a critical error as far back as November 2008 but only in the context of the large size of Ireland's financial sector. I recommended deposit guarantees and think that partial deposit guarantees were a must in Europe in 2008 to stop bank runs. Moreover, other countries have the too big to rescue problem as well. It's not just Ireland.

So where does that leave us now? Here's what I said two years ago (see here):

The Paulson Plan is not going to solve this problem by a long shot. And, until a few days ago, the Europeans were acting like this was an Anglo-American problem. It is not. Recently, I wrote a piece in the Guardian where I outlined what needs to be done in the U.S. and Europe. It comes down to four things:

1. Guarantee bank deposits. To halt the decline, The U.S. and European governments should follow Ireland, Greece and Germany and make an explicit guarantee of deposits to end potential distrust among depositors. I believe political will for this already exists and Europe will certainly do it, will the US?

2. Guarantee interbank lending. Governments need to bite the bullet and temporarily guarantee interbank loans taken at Libor (the London interbank offered rate). This would unfreeze the inter-bank market, which is creating liquidity problems in the financial sector.

3. Liquidate insolvent financial institutions. But, as guarantees increase moral hazard, governments must require national regulators to quickly determine which banks are insolvent. The government can then decide on whether to liquidate these insolvent banks or sell their assets to other financial institutions.

4. Re-capitalize the banking system. The private sector should be used to re-capitalize the remaining solvent banks. Many investors are ready to contribute capital under the right circumstances. However, if necessary, the government should contribute through preferred shares or warrants.

   Regulators might also look to separate “good” assets from “bad” assets in the solvent banks to further bolster interbank confidence. Instead of buying assets up at inflated prices, as treasury secretary Hank Paulson has suggested the U.S. government do, they should stick bad assets into a separate “bad bank” controlled by the regulators at market prices.

You can see that the European governments got behind measure #1, at least temporarily. Measure #2 is no longer applicable. But it is measures 3 and 4 where the rubber hits the road.  What we have seen in the US and Europe is a extend and pretend kind of mentality that has meant the crisis festers. This is true everywhere including the places not under attack like Austria and Germany.

The result of extending and pretending is the bank run in Ireland. Two years ago, during the panic I wrote about this possibility, saying:

It remains to be seen whether there is a sub-current of panic about the fragile Irish banking system that could lead it to Iceland's fate. In fact, commentators like Wolfgang Munchau have argued that the single currency is a boon to the likes of Ireland because it prevents currency attacks like the one Iceland suffered, leading to its downfall.

However, a run on Irish banks is what would ultimately bring the Irish down. After all, it is the Government bank guarantee which creates the vulnerability. The Irish Government needs to make some contingency planning because an Icelandic fate is not out of the question. It need not worry about a currency run, but a bank run is still possible.

There are two ways to skin a cat.

Well it seems that the panic is back and the bank runs have actually come to pass – a clear result of dithering by European officials. In Ireland, at least they have tried to deal with the situation head on. Unfortunately, their bloated and bankrupt financial sector was too far gone by the time the crisis hit. My view is this:

The Irish are going ahead with the recapitalisation plans. So that is done. But I would strongly suggest that the sovereign let the bank guarantee scheme lapse in June.

There is the tax issue, of course. But I think the Irish might be able to beat this back.  In the end, trying to flog off one of the banks to a foreign competitor might be the way to go once the liquidity crisis dies down.

I think Ireland is solvent once it jettisons its bank debt guarantee.

-Here come the Argentine Style Riots in Ireland

Spain, on the other hand, has not come close to addressing its banking sector's problems – and has only been protected because the ECB has been funding Spanish banks, because the government is not on the hook for guarantees and because property prices have not fallen as far. In my view, this problem will eventually come to a head. So Spain really needs to get on with it because they are not likely to get a bailout; the EFSF cannot fund a Spanish bailout. So, as eyes turn to Portugal and Spain, Spain is really what matters.

Edward Harrison is the founder of Credit Writedowns and a former strategy and finance executive with twenty years of business experience. He started his career as a diplomat and speaks six languages, a skill he uses to provide a more global perspective. Edward writes a weekly column for Benzinga every Wednesday.