When even Goldman's summary update on Ireland, which conveniently ignores today's news that the country may be preparing for a senior bondholder haircut and most certainly ignores last week's dump of Irish paper by LCH Clearnet from the repo market), is unable to find much if anything good to say about Irish bonds it is really time to get out of dodge (not like anyone was still left in it). The kicker in Francesco Garzarelli's just released analysis: "With around EUR 30bn worth of senior bonds maturing in 2011-12 (40% of which is not already government guaranteed) and under continued reduction of funding efficiency of the covered bond program, rolling over maturing debt remains indeed one of the biggest challenges faced by the Irish banks." Everything else is noise. Add to this the Portuguese government crisis, its own funding crunch, and the rapidly deteriorating German political crisis and Europe will be a very fun place over the next few months. In fact for once we agree with Goldman: "In light of this, Irish bonds [ZH: aka Paddy Paper] will continue to exhibit high volatility, in our view."
From Goldman Sachs: Ireland in the Spotlight, Sunday 27 March 2011
Key announcements this coming Thursday on the restructuring of the Irish banks could also involve enhanced external policy support. If confirmed, this may lead to a reduction in the credit risk premium embedded in Irish government bonds, which is now hovering at the highest level since the crisis started (2-yr Irish bonds closed around 800bp over their German counterparts on Friday). Nonetheless, we are also of the view that the EMU ‘non-core’ sovereign market is heading towards an even greater segmentation between the small ‘outer peripherals’ countries (Ireland, Greece, and Portugal) and the higher rated and more liquid issuers, like Italy, Spain and Belgium. In light of this, Irish bonds will continue to exhibit high volatility, in our view.
The EU Summit came and went, as most market moving information (e.g., the upsizing of the EFSF, and the term sheet of the ESM) had been released previously. There, nonetheless, was some disappointment on Ireland, as a much anticipated reduction to the lending terms provided by the EFSF was not agreed upon. Instead, the decision was loosely linked to an ‘evaluation of the consequences for the financial support program’ of the planned restructuring of the Irish banks.
Adhering to a timetable agreed last November (see the Memorandum of Economic and Financial Policies, available at http://ec.europa.eu/economy_finance/articles/eu_economic_situation/pdf/2010-12-07-mefp_en.pdf), the Central Bank of Ireland, in consultation with private international advisors, has assessed individual institutions’ restructuring plans (involving severe deleveraging) and their capital and liquidity needs under economic ‘stress scenarios’. The findings are expected to be ‘transparently communicated’ this coming Thursday.
According to a poll run by Reuters, bank analysts’ estimates of the potential aggregate capital shortfall are in the region of EUR 25bn. This figure would fall short of the EUR 35bn provisioned for by the EC/IMF support package, but it would be much higher than the EUR 10bn initially earmarked for bank recapitalization. Since the extent of the losses is highly ‘endogenous’, the assumptions under which these numbers are calculated is crucial. A key input in any real estate valuation model is interest rates. Ireland is a ‘price taker’ (monetary policy is set by the ECB) and the domestic cost of funds correlates closely with sovereign risk. The latter, in turn, is heavily influenced by the health of the banks, making the problem circular.
A recapitalization of financial institutions through a further injection of public funds, calibrated under a conservative macroeconomic scenario and endorsed by the ECB, the IMF and private sector consultants of international standing, should work towards allaying concerns over bank solvency. But until the Irish economy stabilizes (the baseline case, let alone the stress scenario, will likely envisage further house price declines), banks’ funding will likely remain strained.
With around EUR 30bn worth of senior bonds maturing in 2011-12 (40% of which is not already government guaranteed) and under continued reduction of funding efficiency of the covered bond program, rolling over maturing debt remains indeed one of the biggest challenges faced by the Irish banks. So far, these have resorted extensively to the ECB and, when collateral did not conform with the ECB standards, directly to the Central Bank of Ireland through an emergency facility (ELA). Since these loans are short-term, however, refinancing risk has escalated.
According to the Irish press over the weekend, the ECB is soon set to unveil a ‘scheme’ to provide Irish banks access to ‘medium term’ funding. Although no official confirmation has come from Frankfurt yet, the fact that the authorities could have been working in this direction seems credible. To the extent that this enhanced facility provides more breathing room for banks to conduct their restructuring plans, it should reduce the risk of credit risk being passed over to the sovereign.
Nevertheless, as we suggested in the January issue of our Fixed Income Monthly, bank funding is likely to be slow to normalize post recapitalization, and public guarantees on senior bank debt could prove necessary for another 2-3 years (as is the case for those UK banks under the government’s guarantee scheme). Ideally, the latter could be supported directly by the EMU peers, via the EFSF for example, rather than via the State or the ECB. All this would allow time for orderly asset sales.
Other outstanding items include: (i) the treatment of the assets originally earmarked for NAMA 2, which the new government has declared it does not intend to pursue; and (ii) the treatment of ‘non core’ assets that are unlikely to find a buyer until the market has stabilized.
If tensions persist regardless of the initiatives outlined above, more radical solutions may be required. One could involve transferring troubled assets into a ‘run-off’ vehicle, where the banks would take a first loss. EMU partners, rather than the national Treasury, could provide credit enhancements to facilitate access to private capital over time. Granted, the transfer price of the troubled assets to the vehicle is a crucial element, as is the pricing of the insurance provided. But banks will have taken further write-downs and provisions, and undergone stress-tests.
Further policy shifts (lower EFSF borrowing rates for the Irish sovereign, lengthier funding by the ECB for the domestic banks) could alleviate some of the pressures that have lately built up depressing the value of Irish government bonds. A credit impairment of these securities remains in our view highly unlikely at least as long as the EC/IMF program is running. Nevertheless, we also think that the ‘non core’ EMU sovereign market is heading towards a greater segmentation between the small ‘outer peripherals’ (Ireland, Greece, and Portugal), and the higher rated and much more liquid issuers like Italy, Spain and Belgium. In light of this, Irish bonds will continue to exhibit high volatility, in our view.