The Irish crisis had been building since late September 2008. To persuade creditors to continue to fund Irish banks, the government had guaranteed that it would repay their debts if the banks themselves were unable to do so.
That snap decision annoyed governments of other euro zone member countries that feared Irish banks would enjoy an unfair funding advantage. However, Irish banks found it ever harder to borrow to keep up their operations, and turned to the ECB. In September 2008 Irish banks owed the ECB €19 billion; by November they owed €40 billion.
But the ECB could only fill a temporary shortfall of cash. Irish banks had made bad lending decisions and had incurred huge losses. If not already bankrupt, they were heading toward bankruptcy as property prices continued to fall and construction projects went sour. In mid-December, the Irish government announced that it would inject capital into the banks to fill the hole on account of the losses.
But the worry persisted that this initiative was too late for the troubled Anglo Irish Bank, which had rapidly lost its dazzling reputation and its market value. From €3.84 on September 30th, 2008 (the day the government guaranteed the banks' debt repayments), Anglo Irish's share price had fallen to 35 cent.
On January 15th, 2009, fearing that depositors would flee with their money, the Irish government nationalised (purchased) Anglo Irish and became its owner. At this point the government had spent 5 per cent of the country’s GDP on banks’ recapitalisation and had guaranteed loans to banks worth 300 per cent of GDP. The free fall in property prices and construction activity had also caused a sharp decline in the Irish government’s revenues. Thus, in early 2009, the Irish government was making big promises to prop up its banking system but those promises were looking dubious.
In early 2009, I was responsible for the IMF’s relationship with Ireland. It fell on me to ask Irish officials if they wished to discuss the use of a “precautionary” programme. Under such a programme a country carries out major economic and financial surgery knowing that the IMF has set aside funds for instant use.
With the reassurance of an IMF line of credit for unforeseen expenses, the government can take aggressive corrective measures. I had special reason to believe in the value of precautionary programmes. Such programmes, my academic research had showed, helped financially vulnerable countries deal with their problems early and regain market confidence before a crisis set in. A precautionary programme worked best when a country was edging toward but not yet in a full-blown financial crisis. A precautionary programme was exactly what Ireland needed.
Such a sovereign-bank dynamic was a "vicious doom loop" because once it got started, financial and economic conditions could worsen rapidly
‘Structural hole’
In April 2009, my colleagues and I presented to the Irish authorities our assessment of Ireland’s principal vulnerabilities. One research paper showed that taxes and duties on frenzied property transactions had boosted the government’s revenues during the years of rising property prices; but not recognising that those property-related revenues were temporary, the government had made permanent expenditure commitments.
Even after the early 2009 effort to rein in the budget deficit, the “structural” hole in the budget was greater than 10 per cent of GDP. In other words, even after the economy recovered from its sharp contraction and began operating at near its potential, the budget deficit was likely to be around 10 per cent of GDP.
Moreover, while the government’s finances were demonstrably weak, the losses incurred by Irish banks were greater than the authorities believed them to be. IMF estimates at that time suggested that banks’ losses were around 20 per cent of GDP; these losses, because of the government’s guarantee, would likely become the obligations of the Irish government.
During that same visit to Dublin I presented a research paper to the Irish authorities and their invitees, in which I presented the possibility that Ireland would fall into the vicious “sovereign-bank” doom loop.
As the government used more of its limited funds to add capital to banks or repay their creditors, the fear would grow that the government, with its increasingly shaky finances, might not repay all its debts. That would cause the interest rate on government borrowing to rise, creating more stress on public finances. Investors would then question whether the government could keep its promise to support the banks financially.
That concern would cause banks’ stock prices to fall, and depositors would pull out their savings from the banks. The combination of weak banks and higher interest rates in the economy would depress economic growth, and the circle of distress would keep widening.
Such a sovereign-bank dynamic was a “vicious doom loop” because once it got started, financial and economic conditions could worsen rapidly. As the economy slowed down, banks would suffer more losses, and worried investors would dump stocks of banks and demand higher yields on government bonds. This process would become increasingly difficult to reverse.
The doom loop
The policy task was to break the doom loop early before it wreaked extensive damage. The task was either to recapitalise banks heavily, as Geithner had done for several American banks, or to close some banks down and require their creditors to bear large losses, as America’s FDIC had done for Washington Mutual and other banks.
A precautionary programme provided the cover to execute these complex transactions. But Irish authorities were not interested in a precautionary IMF programme in 2009. In late May 2009, the government added another €4 billion to Anglo's capital, and finance minister Brian Lenihan said at a news conference, "we are getting to the bottom of the problem and we are dealing with it".
At that time Lenihan also reported that buyers had expressed interest in taking over Anglo as a “going concern”. The €4 billion in taxpayer funds to recapitalise the bank could, he believed, earn the government a valuable return.
However, the likelihood that Ireland could manage its vulnerability was quickly diminishing. The economy continued to be battered. Irish GDP, which had declined by 2 per cent in 2008, seemed set to fall by another 8 per cent in 2009 and a further 3 per cent in 2010.
If these projections held, real GDP would be down by more than 13 per cent in three years. The unemployment rate, which had jumped from 6 per cent in 2008 to 12 per cent in 2009, was expected to continue rising.
Vulnerability
By May 2010, European leaders and officials were finalising the Greek programme. Financial markets were in a state of panic, the Greek economy was in a tailspin, the Greek public was revolting against the prospect of harsh austerity, and citizens of creditor European countries were upset that their money would soon flow into a bottomless Greek pit.
Few observers were paying attention to Ireland. The IMF, however, remained worried.
Before setting out on the annual trip to Dublin in May 2010, I had called Patrick Honohan, then governor of the Irish Central Bank, and again proposed discussion of a precautionary programme. I knew Honohan from earlier in our careers when we had briefly overlapped at the World Bank in Washington.
More important, Honohan could best feel the pulse of Ireland’s true vulnerability: its fragile banks. The September 2008 guarantee of banks’ debt was set to expire at the end of September 2010. Foreign lenders had tailored the duration of their loans to Irish banks to match the period of the guarantee. Irish banks needed to repay their lenders €70 billion (equal to 44 per cent of GDP) before the guarantee expired.
As Honohan later wrote, "all of Dublin knew" that once those funds were repaid, foreign lenders would not replace them. Irish banks had stepped up their borrowing from the ECB and from the Central Bank of Ireland under a provision that allowed for emergency liquidity.
For this reason Honohan took my phone call to him seriously, and followed up on it. But finance minister Lenihan was still not interested in a precautionary arrangement with the IMF.
At a time when businesses were shutting down and the ranks of the unemployed were growing, the Irish taxpayer was paying bankers and their creditors incredibly large sums
By the end of September 2010, the ECB and the Central Bank of Ireland had lent Irish banks €100 billion. To put that number in perspective, it was equal to 60 per cent of Irish GDP. Would banks be able to pay this money back? They were haemorrhaging from losses on their commercial property loans.
More losses were looming on residential mortgages as homeowners fell behind on their repayments. If banks failed to pay back the ECB, the government would be on the hook. Thus, as the banks borrowed increasingly large sums from the ECB, the risk that the government would default on its debts rose. The yield on the government’s 10-year bond increased along with the banks’ ECB borrowing. Starting at around 5 per cent in early June, government bond yields briefly paused in early August and then rose steadily to reach 6 per cent in early September, after which the yields raced to nearly 7 per cent by the end of the month.
In Washington on September 21st, Nathan Sheets of the US Federal Reserve briefed the Federal Open Market Committee on global financial developments. Earlier in the year Sheets had accurately diagnosed the Greek economy's problems. Now, he said, Ireland was becoming the global financial hotspot. Irish banks, he said, had suffered large losses in the first half of the year, and the losses were increasing by the day as borrowers were falling behind on their repayments.
Sheets reported that the S&P’s estimate of the Irish banking sector’s losses had crossed 50 per cent of GDP, up from the IMF’s estimate of 20 per cent of GDP in April 2009.
Lenihan’s brave words
On September 30th, Lenihan reported to the Dáil that tax revenues were continuing to fall, banks were soaking up more of the government’s scarce revenues, and the budget deficit was soaring. Recapitalisation of Anglo over the past couple of years had cost the government around €29 billion.
For the year 2010, recapitalisation funds for Anglo, Bank of Ireland, AIB, and other smaller banks would exceed €30 billion, equal to around 20 per cent of GDP. Moreover, with revenues continuing to fall, the normal budget deficit (taxes minus conventional expenditures) would be 12 per cent of GDP.
Thus, after including the unusually high costs of bank recapitalisation, the total budget deficit in 2010 would be a stunning 32 per cent of GDP.
And to keep credit flowing to Irish banks the government had no choice but to extend the guarantee of repayment to the creditors of Irish banks.
But Lenihan had brave words for the parliamentarians. The Irish government finances, he said, were strong enough to handle the stress, and all would be well: “The overall level of State support to our banking system remains manageable and can be accommodated in the government’s fiscal plans in the coming years.”
He added: “We must continue the fiscal consolidation we have embarked upon. This is the only course to follow if we are to ensure the future economic wellbeing of our society.”
Those words of hope offered no solace. To the contrary, the enormity of the scam sank into the Irish public’s consciousness. Lenihan’s latest elaboration of the sums being spent to cover banks’ losses was a jarring juxtaposition to his call for more “fiscal consolidation,” which meant higher taxes and reduced government support for those who were losing jobs and homes.
At a time when businesses were shutting down and the ranks of the unemployed were growing, the Irish taxpayer was paying bankers and their creditors incredibly large sums.
Reflecting the public’s dark mood, the Irish media dubbed September 30th, 2010, “Black Thursday”. “Burn the bondholders!” became the national cry. If citizens were going to have to pay drastically higher taxes and receive lower wages and benefits, they wanted the banks’ bondholders to share the pain.
In a trap
Lenihan was in a trap. A government guarantee was a magical instrument. If creditors had believed the guarantee, they would have kept funding Irish banks, and normal operations would have quickly resumed. But creditors did not believe the Irish government’s promise, and wanted to take their money and run before the government ran out of money. Financial stress on the government pushed interest rates up, and the sovereign-bank doom loop played itself out.
Lenihan understood that the guarantee-based financial strategy had gone badly wrong. He now also faced a political backlash. And so he introduced another theme in his speech that day, a theme investors focused on. Lenihan said that banks’ lenders would need to “share the burden”. He pointed specifically to “subordinated debt holders,” who were legally first in line, after equity holders, to bear losses.
“I expect,” Lenihan said, “the subordinated debt holders to make a significant contribution towards meeting the costs of Anglo.” During question hour, he said he was also “open” to the possibility that banks’ managements would negotiate reduced repayments to their senior creditors.
In early October 2010, Ireland crossed the threshold from financial vulnerability to irreversible crisis.
Thus, banks’ creditors and other investors were on notice that they could expect to bear losses. They were furious. During a conference call, Lenihan was “drowned out by a deluge of derision”. Callers yelled that they would dump Irish government bonds.
The financial crisis continued unabated. On October 5th, Moody’s placed Irish government bonds “on review for possible downgrade”. The rating agency said that the high costs of bank recapitalisation revealed by Lenihan on September 30th and rising yields on Irish government bonds would increase the pressure on the government’s finances. Moreover, the austerity measures would weaken demand and hold back economic recovery.
Downgraded
The next day rating agency Fitch downgraded Ireland from AA- to A+. The message was the same: the cost of recapitalising banks was “exceptional and greater-than-expected”, and the outlook was negative because of the “uncertainly regarding the timing and strength of economic recovery and medium-term fiscal consolidation effort”.
Thus, in early October 2010, Ireland crossed the threshold from financial vulnerability to irreversible crisis. Unlike their Greek counterparts, Irish authorities had not fudged their budget numbers. But, as was true for Greece, the Irish government and European authorities had remained in denial. Indeed, European authorities had not even perceived a looming Irish crisis.
To pull back from vulnerability to safety, Irish authorities needed, sometime in 2009, to have closed the worst-performing banks, imposed large losses on the banks’ creditors, and used European and IMF funding to tide over a rough transition.
Eurotragedy, a Drama in Nine Acts, by Ashoka Mody, is published by Oxford University Press
