The Definitive Unwrapping Of The "Irish Package"

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Everything you desired to know about the "Irish Package" and then
some, dissected with clinical post-mortem precision by Goldman's
Francesco U. Garzarelli. We can only hope the Spanish, Italian and French packages are deemed more satisfactory by the market.

On the Irish Package and EMU Sovereign Debt

In an emergency meeting this afternoon, EU Finance Ministers and the IMF have agreed to extend financial support to Ireland. According to EU Commissioner Rehn, no ‘haircuts’ will be applied to holders of senior bonds issued by the Irish banks. However, we would caution that additional liability management transactions are still likely at the major Irish banks. The agreement will be formalized in coming weeks in a Memorandum of Understanding.

We think the Irish deal will lead to a moderate compression in Irish government bond spreads. The encouraging elements are the relatively speedy negotiations under the emergency framework agreed this Summer, the emphasis given to the recapitalization of domestic banks, and the long maturity of the loans. We provide details below.

Separately, the Eurogroup (comprising the finance ministers of EMU member states) issued a statement summarizing a political agreement on a new sovereign debt crisis resolution mechanism applicable from 2013, forming part of a broader overhaul of the Euro-area fiscal governance framework. The plan envisages a permanent conditional funding facility (ESM), shaped along the lines of the EFSF but of yet unknown size.

In order to gain access to external conditional funding, an EMU sovereign will in the future need to pass a debt sustainability test conducted by the EC and the IMF, in liason with the ECB. A failure to pass would result in debt restructuring involving private sector participation. To facilitate the process, from June 2013, all bonds issued by the EMU member states will include collective action clauses, as is currently the case in the US and the UK. ESM funds will be junior to IMF loans, but senior to existing bondholders.

The ministers’ announcement clearly states that no private sector participation in restructuring procedures will apply ahead of mid-2013. This will validate the upward sloping term structure of peripheral EMU sovereign bond spreads, particularly up to 5-yr maturities. For currently outstanding bond redeeming after June 2013, the impact should be broadly neutral, as the probability of a credit event does not change in light of this announcement, while the benefits from a reduction of liquidity risk (through the permanent ESM) are offset by the uncertainty created by an ex-ante delegation of resolution authority to the EC/IMF.

It is worth bearing in mind that more than three quarters of Eurozone government liabilities (and a bigger share if bonds issued by Germany and France are excluded) are held by Eurozone members, primarily financial institutions. Moreover, the ECB has already purchased around 17% of the combined debt stock of Greece, Ireland and Portugal. The share of public debt of the former two in public sector hands will likely exceed 50% by mid-2013.

In our opinion, the plan is a necessary addition to the Eurozone’s institutional architecture, enhancing its credibility and going in the direction of reducing public resentment towards conditional aid to other member states. But it leaves several open questions, including what happens to existing bond-holders relative to and potential ‘tiering’ of the bond market. A possibility is that issuers may voluntarily include forward starting collective clauses already before 2013.

Overall, the policy announcements made today testify the Eurozone’s authorities’ ongoing resolve to address the repercussions of the credit crisis. As we wrote last week, however, investors are likely to continue to focus on the Iberian peninsula, namely Portugal’s chronic twin deficits, and the potential unrecorded losses in the non-listed Spanish banks. Both the eventual provision of external support to Portugal through arrangements such as those in place for Ireland and a more decisive recapitalization of the Spanish cajas re in our view within the means of the Eurozone financial capabilities and policy domain. But the speed at which the authorities decide to tackle them will dictate how long market volatility will remain in place.

The ECB faces a serious dilemma on Thursday because they have indicated that they'll spell out their exit strategy on this occasion. Our baseline case has been that the Board would rather see the fiscal authorities take responsibility for what are ultimately fiscal problems However, given the recent events, we think they'll be vague with respect to the precise timing of the removal of full allotment. They will also likely say that they stand ready to do what it takes to secure stability, which would mean both further asset purchases and a shift to variables rates for a while for the full-allotment policy.

We remain of the opinion that the risk premium on Italian and Spanish bonds – the larger EMU non-core countries – already largely discount these tensions. Positioning indicators on the EUR (including risk reversals), and our principal component analysis on the percentage of EMU bond spread variance explained by a common factor, suggests that we are far from the level of systemic risk seen in the wake of the Greek rescue, and we do not see this changing.

The Irish Package (jokes to start in 5...4...3...)

The size of the program is €85bn (a little over 50% if Irish GDP), is broadly in line with prior expectations.
Funding of the €85bn package:

The external assistance amounts to € 67.5bn and will be split as follows:

* €22.5bn from the IMF under the Extended Fund Facility, which has longer disbursement (10-yr) and repayment period (after 4.5-yr) than a regular Stand-by Arrangement. The current cost of this IMF loan is 3.12% in the first 3 years and 4% thereafter.

* €22.5bn EFSM (which has a borrowing capacity of € 60bn). This institution will issue bonds broadly matching the maturity of the loans under a joint and several guarantee by EU-27. This is de facto the EU Commission issuing against the EU Budget, as is presently the case for the Eastern Europe balance of payments support program. Bonds issued by the EFSM will compete against those offered by other supranationals, such as the EIB.

* The European Financial Stability Fund is contributing around €17.5bn, which will issue bonds under a pro-rata guarantee by EMU-16 ex Ireland and Greece. The EFSF is AAA-rated, and over-collateralized. It should fund above Libor.

* The UK, Sweden and Denmark are providing around €5bn in bilateral loans, of which €3.5bn is from the UK.

The remaining €17.5bn of the program will come from Ireland (€12.5bn from the National Pension Reserve Fund –currently EUR 24.5bn -and €5 billion from the state’s cash reserves).

The cost and sequencing of the funding:

The statement indicates that, if drawn down in its entirety today, the funding would attract an average interest rate of 5.8%. However, interest is only charged on the amount that is drawn down. The actual blended cost of funds for the first few years will be lower, in the region of 3.5-4.0%. By comparison, Ireland 1-2-yr rates traded at 4.75% last Friday, and 5-10-yr maturities in around 8%. The sequencing of funding has not been announced, but it is likely that the first to tap the market will be the EFSM.

Allocation of the €85bn package:

The program envisages that €35bn will be earmarked for Ireland’s local banks and €50bn for the budgetary requirements of the sovereign.

Bank restructuring:

Of the €35bn for the banks, € 10bn will constitute an immediate injection in banks capital above and beyond what the government has already committed. The remaining €25bn will be provided on a contingent basis in 2011 after new stress tests and liquidity assessment conducted by the Central Bank of Ireland.

The aim of the program is the ‘a recapitalisation, fundamental downsizing, restructuring and re-organisation of the banking sector. To this aim, banks will be required to run down non-core assets, securitize and or sell portfolios or divisions with credit enhancement provided by the State, if needed. The NAMA scheme, currently tasked to purchase €81bn from banks, will be extended to remove remaining vulnerable land and development loans from Bank of Ireland and Allied Irish Bank by end-Q1 2011 (although this is <EUR20mn according to today’s release).

While there is no final word on bondholder participation in the bank recapitalization plans, we believe that forced loss absorption for senior lenders is unlikely given the statements released today (see for ex. those made by Commissioner Rehn). However, we would caution that additional liability management transactions are still likely at the major Irish banks.  In this respect, we acknowledge that the Irish government’s intention to implement a “special legislative regime to resolve distressed credit institutions early in 2011” is likely to create a framework for future burden-sharing by bondholder levels of the capital structure.

In general, we remain of the view that new resolution regimes for banking sectors in Europe are appropriate and that loss absorbing securities should be an integral part of a bank’s capital structure. However, we caution that this should be for future crises and that bondholder write-downs and/or losses should not be forced ahead of equity.

Turning to equities, the Central Bank of Ireland has set a new ongoing minimum capital requirement for AIB, Bank of Ireland, ILP and EBS of 10.5% Core Tier 1, and is requiring these banks to raise sufficient capital to achieve a capital ratio of at least 12% core Tier 1 by the end of February 2011 (May for ILP). Therefore the total capital injection will be EUR 8 bn, taking account of the capital impact of further NAMA transfers. In total, along with early measures to support deleveraging, there will be an additional EUR10bn of capital injected into the banking system.

This means that AIB requires an additional EUR 5.3bn of core Tier 1 capital (bringing its total still to be raised to EUR9.77bn); Bank of Ireland needs an additional EUR2.2bn of core Tier 1 capital; EBS an additional EUR438mn of core Tier 1 capital (for a total to be raised of EUR 963mn) and ILP an additional EUR98mn (for a total of EUR243mn still to be raised).

If the banks are assessed to be at risk of falling below the 10.5% core Tier 1 target after a stress test in March 2011, further capital injections will occur. Importantly, there will also be an independent third party review of asset quality in the banking sector. There will also be a Liquidity Assessment Review (PLAR), to set specific funding targets consistent with Basel 3 for each bank, including the need for each institution to submit asset disposal plans by the end of April 2011.

Conditionality and prospects for the budget:

The remaining € 50bn will cover the financing of state until market access has been restored. We estimate that this amount should be sufficient to cover the new deficit and debt amortizations over the next two years.

The conditions laid out in the program are broadly similar to those contained in the National Recovery Plan released last week. A series of structural reforms has been recommended, but the flexibility of the Irish economy suggests they are not binding. Crucially, the conditionality is understood not to touch the 12.5% corporate tax rate. The target bringing the deficit from an estimated 11.7% at end 2010 to 3% by end 2014 has been extended to 2015 to compensate for weaker growth over the next two years.

The budget vote on December 7 is still in the balance but, in our view, is likely to be passed. The government’s majority has been cut to two with the outcome of the Donegal South West by-election but two independent MPs have also indicated that they will support the budget.