Ireland’s lessons for Spain

By Felix Salmon
February 4, 2011
Michael Lewis's tour de force on Ireland in Vanity Fair. It's long -- over 13,000 words -- and it's beautifully written, giving both a big-picture perspective on the Irish economic boom and bust, and a credible account of the fateful meeting at which the Irish government decided that it should go ahead and guarantee the debts of all Irish banks.

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It almost goes without saying, but you have to read Michael Lewis’s tour de force on Ireland in Vanity Fair. It’s long — over 13,000 words — and it’s beautifully written, giving both a big-picture perspective on the Irish economic boom and bust, and a credible account of the fateful meeting at which the Irish government decided that it should go ahead and guarantee the debts of all Irish banks. That move was the single worst decision among all the policymaker actions over the course of the global financial crisis, and Lewis is right to be astonished at how meekly the Irish population has accepted its devastating consequences.

Ireland was unfortunately yet predictably being run, at the time of the crisis, by the business-friendly Fianna Fáil party, full of lawyers and other pillars of the establishment with a tendency to make decisions on a narrow, legalistic basis. The government paid Merrill Lynch €7 million, at the height of the crisis, for a seven-page report saying that “all of the Irish banks are profitable and well capitalised” and that the government guarantee would therefore cost nothing. The result was an immediate overnight windfall for anybody invested in Irish bank debt:

The bondholders didn’t even expect to be made whole by the Irish government. Not long ago I spoke with a former senior Merrill Lynch bond trader who, on September 29, 2008, owned a pile of bonds in one of the Irish banks. He’d already tried to sell them back to the bank for 50 cents on the dollar—that is, he’d offered to take a huge loss, just to get out of them. On the morning of September 30 he awakened to find his bonds worth 100 cents on the dollar. The Irish government had guaranteed them! He couldn’t believe his luck.

Lewis does a great job of presenting the back-story to the way in which the Irish government chose Merrill to be its CYA mechanism: Merrill was the bank which had recently bowdlerized a prescient report from its own analyst, Philip Ingram, which had cast doubt on the quality of the assets at Irish banks. It was unthinkable that Merrill would be honest with the government, and it wasn’t.

Ireland’s bank-debt guarantee was a bit like AIG’s CDO guarantees, only much, much worse. The CDO guarantees were issued when the CDOs were trading at 100 cents on the dollar, and AIG stopped writing them in 2006. The bank-debt guarantee was issued as markets were plunging, at the end of September 2008, after Lehman Brothers had already gone bust. AIG genuinely believed, when it was writing its guarantees, that there was a negligible chance that any of them would result in payouts. Ireland, by contrast, knew full well that its banks were in trouble — the guarantee was a bit like offering free health insurance to someone who’s just been rushed to the emergency room, on the grounds that a Merrill Lynch report says the patient is in fine fettle.

Lewis makes another important point, too: substantially all those bonds which Ireland guaranteed have now been paid off, in full, at par, using money from the European Central Bank. There is no longer a pool of government-guaranteed bank bonds alongside another pool of government debt; everything is now pure government debt, and as a result Ireland is mired in a fiscal crisis from which there is no way out.

All of which is an important cautionary tale for Spain, which needs to work out what to do with its undercapitalized cajas. A blanket guarantee of caja debt wouldn’t be as disastrous as the Irish guarantee, but it’s still a bad idea. On the other hand, letting them go bust doesn’t seem very attractive either. The ideal solution, as Mohamed El-Erian says today, would be to somehow recapitalize them with private money — but there’s understandably little appetite in the private sector to come up with the tens of billions of euros needed to do that. And forcibly merging the cajas doesn’t help much either: as the cliché has it, you can’t tie two rocks together and hope that they’ll float.

The best-case scenario, for me, would be one in which some or all caja debt was turned into equity. Ireland should mark the end of the era of bank bailouts: given the fiscal straits of the European periphery, it’s time to draw a line in the sand. Ireland has avoided riots and chaos, and its upcoming political transition looks as though it’s going to go smoothly. But that’s no evidence that what it did was in any way a good idea.

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