Are the small savers guaranteed?

Yillan

My understanding of the Irish Economy is that the Irish banks gave loans to foreign creditors and bankers. The creditors and bankers lost the money that was given to them by the Irish Banks and could not pay them back. The Irish banks had therefore lost the money that was invested in them by Irish people and businesses, but also had lost the money they had borrowed from Peter to give to Paul - The foreign bankers and creditors. So no money in the banks.

The government went for advice on what to do from Europe. Europe, those people whose countries had given loans to banks like Anglo Irish Bank and didn't want to see their money lost, told the Irish government that rather than have the foreign creditors pay back the banks, the debt should be brunt by the Irish people by way of austerity cuts. The Irish Government went back and guaranteed the loans in the banks, i.e. the money owed to Peter, at huge cost to the Irish people.

So let's say an Icelandic banker wants to borrow some money for an investment, he asks a French banker. The French banker agrees and goes to Anglo Irish Bank for the loan where he can get an advantageous rate of inerest. Anglo Irish Bank have already a lot of debt, but figure they can get a good interest rate from a German banker if they play their cards right. The German investor also reckons he can stand to make a few euro from this arrangement. So then the times get tough. The Icelandic banker loses all his money on that investment. The French banker wants to be paid, but Iceland have no money, so France tells Ireland it can't pay them back. Next day Germany come knocking on the door asking Ireland for its money, but Anglo Irish Bank have lost it to France. The German says you're going to have to pay that back and Brian Cowen steps in to say, 'No Problem'. It's like a game of 'pass the parcel' but we're not sitting in a circle and when the parcel is passed to Ireland at the end of the line, the music stops, the lights go out and everyone runs out of the room.

My question is, if Ireland were to say, 'Bollocks to this, I'm not paying you the money Germany, I got sold down the river by France, who were set up by Iceland', the Germans lose their money and the bank is declared bankrupt due to defaulting on the debt, would the small savers, the Irish people and businesses who had money in that bank have their money guaranteed? I read somewhere that they would, but I'm not sure if it is true.

If it is indeed true, it seems like the Irish people are paying for a debt that has been caused by a fairly disconnected chain of events between bankers and creditors acting unscrupulously across Europe.

Please correct me where I have gotten mixed up, or don't have my facts or ideas straight.

Anonymous1987

Yillan wrote: »

My understanding of the Irish Economy is that the Irish banks gave loans to foreign creditors and bankers. The creditors and bankers lost the money that was given to them by the Irish Banks and could not pay them back. The Irish banks had therefore lost the money that was invested in them by Irish people and businesses, but also had lost the money they had borrowed from Peter to give to Paul - The foreign bankers and creditors. So no money in the banks.

Irish banks gave loans to Irish property developers who then failed spectactulary with the burst of the property bubble. At the same time Irish banks borrowed from European banks, made possible by a low interest rate set by the European Central Bank. Other than that you are right that the banks faced losses on their investments (i.e. the loans).

When the banks faced these losses they ran the risk of insolvency (i.e. they can't cover their losses). The government stood in by investing in bank shares. Investing in bank shares allows the investor ownership of the bank but the bank doesn't have to face interest repayments like it would if it borrowed the money. This means that the bank can now absorb the losses and avoid insolvency.

Yillan wrote: »

The government went for advice on what to do from Europe due to contagion effect to European banks. Europe, those people whose countries had given loans to banks like Anglo Irish Bank and didn't want to see their money lost, told the Irish government that rather than have the foreign creditors pay back the banks, the debt should be brunt by the Irish people by way of austerity cuts.

Like I said above, the Irish government took the initiative itself to recapitalise the banks (i.e. invest in the banks to absorb their losses) although there might have been pressure to do this. Basically the taxpayer will take on the bank losses.

Irish banks borrowed heavily from European banks for short-term liquidity (basically cash flow management, kinda like getting a short overdraft while you're waiting for next months pay check). When this lending seized up, the ECB stood in to lend to the Irish banks and at present the Irish banks are heavily dependent on the ECB, approximately 25% of the ECB bank lending goes to the Irish banking system about 17% to Irish banks.

Yillan wrote: »

The Irish Government went back and guaranteed the loans in the banks, i.e. the money owed to Peter, at huge cost to the Irish people.

The government guarantee was different, it was a guarantee that deposits and bondholders would be covered if the banks failed. The reasoning for covering deposits was to prevent a run on the bank, for example you call into your bank and they basically say sorry we lost your money! Bank guarantee are actually common but normally have a limit of between €50,000 and €100,000 internationally. The Irish government decided to guarantee all deposits.

What's more the government guaranteed the bondholder which was a questionable move. The bondholders made investments which clearly failed and should thus face a loss but in the interests of preserving the Irish banking system the government said it would cover the bondholders. As far as I know we don't know the identity of the bondholders but they are likely large foreign institutional investors.

Effectively these two actions tied the fate of the banks with the government; if the banks fail the government fails.

Yillan wrote: »

So let's say an Icelandic banker wants to borrow some money for an investment, he asks a French banker. The French banker agrees and goes to Anglo Irish Bank for the loan where he can get an advantageous rate of inerest. Anglo Irish Bank have already a lot of debt, but figure they can get a good interest rate from a German banker if they play their cards right. The German investor also reckons he can stand to make a few euro from this arrangement. So then the times get tough. The Icelandic banker loses all his money on that investment. The French banker wants to be paid, but Iceland have no money, so France tells Ireland it can't pay them back. Next day Germany come knocking on the door asking Ireland for its money, but Anglo Irish Bank have lost it to France. The German says you're going to have to pay that back and Brian Cowen steps in to say, 'No Problem'. It's like a game of 'pass the parcel' but we're not sitting in a circle and when the parcel is passed to Ireland at the end of the line, the music stops, the lights go out and everyone runs out of the room.

True but I think most of the loses faced by Irish banks were Irish developers going under, hence NAMA. Though I'm open to correction here.

Yillan wrote: »

My question is, if Ireland were to say, 'Bollocks to this, I'm not paying you the money Germany, I got sold down the river by France, who were set up by Iceland', the Germans lose their money and the bank is declared bankrupt due to defaulting on the debt, would the small savers, the Irish people and businesses who had money in that bank have their money guaranteed? I read somewhere that they would, but I'm not sure if it is true.

Yes but this means that Irish depositors money is guaranteed by the government which is the Irish taxpayer. In addition lending would collapse as our banks would be bankrupt and then our businesses would not be able to invest or even obtain short term lending for cash flow management.

Scofflaw

The situation of the Irish banks is very much simpler than that, and revolves around the property sector bubble.

Irish house prices started to rise sharply in the mid Nineties. The money for Irish people to buy houses was lent, as usual, by the Irish banks.

In normal times, when house prices rise more or less in line with inflation and wages, the way that a mortgage is covered by the borrower is from income. The banks usually, therefore, have an interest in ensuring that the borrower will be able to pay the mortgage out of their income. Thus, in normal times, the banks run a policy of prudential lending, where they won't lend more than 2.5 times the borrower's income plus the spouse's income. If the average wage is €30k, the average house prince should therefore be about €115k - €10k put up as a deposit, and €105k put up by the bank.

When house prices are rising a good bit faster than inflation or wages, on the other hand, it becomes possible for the borrower to be able to pay the bank back purely out of the rise in his or her house price. At that point, buying a house becomes an asset investment - if you have €10k spare, and you can expect to make €30k in a year on the price of a house, then buying a house becomes an obvious thing to do with your money. As long, that is, as the bank will lend you the bulk of the money. And the banks are very willing to do that if the expectation is that you'll be able to sell the house again for a good bit more than you paid for it in 6-12 months' time, because they'll be getting their loan paid back in full at that point - and since their loan is front-loaded with interest, the actual interest rate they're receiving on the short lifetime of the loan is a good deal more than you think you're paying.

For the banks to continue to profit from the rise in houses past the point where the average house price exceeds the average income, they need to stop worrying about your income, and consider only the rise in house prices when deciding whether to lend. They need, in other words, to abandon prudential lending, or redefine it - to be willing to lend a good deal more than €105k to someone earning €30k.

We know that this is what they did - there's a thread on this forum where a poster has an income of €32k (€27k after tax) and mortgage repayments of €1900 a month, which suggests a loan amount of somewhere around €415k between them and their partner.

Past that, the banks also allowed people to use one house as collateral for another, allowing people on quite modest incomes to build up small property empires. There was a case back in 2008 of a pilot who built up a small empire of about 10 properties based on his original semi-detached house in Glasnevin.

Naturally enough, the more the banks were prepared to lend, and the less stringent they were about the ability of borrowers to pay, the more house prices tended to rise. Bit by bit, all the customary restraints on lending were abandoned - the multiple of income became a joke, where the banks aided and abetted customers in fudging the figures, then the requirement for a deposit was abandoned to give 100% mortgages, then the ordinary maximum terms went out the window, and the banks were, towards the end of the bubble, suggesting multi-generation mortgages.

Simultaneously, of course, developing property for sale also became an enormously profitable business, and the banks also wanted a slice of that action, so they lent huge amounts to property developers based on values of land and development that only made sense as long as ordinary people were prepared to borrow extraordinary sums to buy quite ordinary properties.

So we wound up in a position where the Irish banks would lend a developer €20m to buy an acre of land, because the developer would be able to build 100 apartments on the acre, and sell them for €500k each, which the banks would gladly lend to the people who bought them, in the expectation of them being worth €550k in 12 months time.

Where the foreign money comes in is that the Irish banks were able to borrow money at low interest from foreign banks, and lend it to Irish customers at very much higher effective interest rates - the reverse of what you have in your first paragraph. There wasn't anywhere more profitable or 'safer' for Irish banks to lend than in the Irish property market. Irish banks borrowed heavily from other countries' banks in order to fund their own lending in Ireland. They borrowed at wholesale money rates from foreign banks, and lent at high retail rates to Irish customers - primarily property developers and house buyers. So on the liabilities side of the ledger the banks had large loans they'd taken out from foreign banks, while on the asset side they had large loans out to Irish developers. Being banks, though, whenever the large loans they had taken out from foreign banks fell due, they simply borrowed money to pay the loans, rolling the debt over.

Now, when the music stopped, and the interbank lending dried up in the 'credit crunch', the property money carousel came to a halt. The Irish banks could no longer borrow the money they needed to fund the property bubble. House prices went into reverse - and once house prices start to fall in an investment market, it immediately makes more sense to wait longer before buying, which means that they'll fall even faster.

Almost immediately, the Irish banks were in trouble. Their assets were largely loans to developers and builders - different amounts for different banks, 80-90% in the case of Anglo, 40% in the case of AIB. While ordinary people will try to pay their mortgages, a development company or builder will only do so as long as they're solvent. Being a limited company, the developer will simply go out of business - and then the bank can only recover the assets of the company. Unfortunately, the assets of a development company consists of land and properties - and they, of course, were falling rapidly in value. Indeed, they were falling so rapidly in value that you couldn't put a sensible price on them at all.

So now the Irish banks - and in particular Anglo - had, on the one side large liabilities to the foreign banks they'd borrowed the money from, and on the other side assets that weren't worth anything like what had been claimed for them - loans that probably wouldn't get repaid, based on land and property now worth a fraction of the original value.

That, in turn, meant that the Irish banks were insolvent to a greater or lesser degree depending on the extent to which they were exposed to the property market. What could have happened at that point is that lending to the Irish banks would have dried up entirely, because of the risk of being repaid, whereupon the Irish banks wouldn't even have been able to borrow the money they needed to roll their own debts over. They would then have gone into default, declared bankruptcy, and been wound up.

At this point the government stepped in, as it was pretty much bound to do. It could have done what Iceland did - separate customer deposits from the loan book, putting the former into 'good banks' and the latter into 'bad banks' - but instead it chose to guarantee the banks' debts, so that other banks would continue lending to them, because they could be sure of their money back from the Irish taxpayer.

It's worth pointing out that this is standard practice, whereas what Iceland did wasn't. It's what was done in the case of previous Irish bank failures, and it's also what every other country bar Iceland did. Iceland chose to do what it did because the Icelandic banking sector was so large compared to Iceland (over 1000% of GDP) that any attempt to rescue the Icelandic banks was clearly futile.

Could it have worked here? Yes - our banks were very large, but not quite as large as Iceland's in relation to our economy. If it hadn't been, that is, for one other thing - our deficit. We could afford either the banks or the deficit, but not both. Where did the deficit come from? Essentially, it was the result of the decisions taken by Irish governments from 1997-2007, which was to run a 'low tax' economy by moving the tax burden from income and corporation taxes to taxes on property transactions, while simultaneously running a 'high services' economy by raising pensions, social welfare, PS salaries etc over and above inflation.

So not only were Irish banks heavily exposed to the property bubble, so too were government tax receipts, and both, obviously, went down at the same time.

Should it have been done at all? Almost certainly, but not to the extent that it was done. It would have made sense to rescue everybody but Anglo, but there was never a point where rescuing Anglo made sense. To be fair to the government, at the point where they were deciding to rescue Anglo, Anglo lied about their difficulties, and once they had guaranteed Anglo, it was hard to go back on that guarantee without making the other bank guarantees lose all credibility. However, there doesn't seem to be any real doubt that rescuing Anglo was partly or largely the result of Anglo's connections.

Once the government had guaranteed the banks, we were in a position where the taxpayer was liable for the banks' debts - very large debts in relation to government income, and on top of a rapidly increasing government deficit and a rapidly contracting economy.

The question of whether we could have got through that without either a bailout or default was essentially one of confidence. If the money markets believed that the Irish government could do it without the money markets getting burned, then the Irish state would be able to borrow enough money to pull it off. If not, not. As far as I can see, their hope was that by backing the banks to the point where the markets regained confidence in the banks, the Irish banks could borrow on their own behalf, they could remain in business, and the government's guarantees wouldn't be called in.

It's worth pointing out that the government's guarantees of the banks - and indeed their recapitalisation of them through promissory notes - don't get called upon unless the banks actually collapse. They're effectively 'contingent liabilities' - if you can restore the banks to normal working order then you can get through the whole thing without actually having to stump up the money.

The government therefore embarked on things like NAMA and other exercises designed to bolster confidence in the Irish banks. Unfortunately, the bad news kept coming out in respect to the banks, and the government hadn't embarked on an austerity programme of cuts, for the very good (political) reason that that was the last thing they wanted to have to do. Combined with various noises coming from Europe - particularly Germany - that suggested rewriting the rules so that the financial markets would get burned rather than taxpayers, and confidence in the ability of Ireland to get through this without burning the financial markets collapsed.

That meant that Ireland was faced with a situation where the Irish banks were unable to borrow from anyone but the ECB (they borrowed €16bn in November alone), and where the Irish government was unable to borrow on the financial markets at anything less than punitive rates (9%+). In turn, concerns over Ireland's ability to repay caused concerns over the ability of other other troubled eurozone economies to repay. Despite the Irish government's perhaps optimistic view that we were fully funded until some time next year, and that presumably the markets would have settled down by that point, a bailout facility was arranged at rates somewhat higher than we would usually pay, and a good deal below what the financial markets were demanding. If the government is correct, and our current cash on hand is sufficient to last us until the markets settle down, we won't have to tap the bailout facility. If they're wrong, and either the money runs out more rapidly, or the markets take longer to settle down, then the bailout facility caps our exposure to the market rates.

So there are a few moral questions remaining, the practical question of whether we're taking on bank debt having been settled back when the government first gave the guarantee. First, whether the public should ever be liable for the debts of private financial institutions, the answer to which is obviously no. Second, whether the public bears any moral responsibility for the situation where they are liable for the debts of private financial institutions, the answer to which is a lot less clear cut, even though it seems to be a reflection of the first question.

cordially,
Scofflaw

T runner

Scofflaw wrote: »

The situation of the Irish banks is very much simpler than that, and revolves around the property sector bubble.

Irish house prices started to rise sharply in the mid Nineties. The money for Irish people to buy houses was lent, as usual, by the Irish banks.

.............So there are a few moral questions remaining, the practical question of whether we're taking on bank debt having been settled back when the government first gave the guarantee. First, whether the public should ever be liable for the debts of private financial institutions, the answer to which is obviously no. Second, whether the public bears any moral responsibility for the situation where they are liable for the debts of private financial institutions, the answer to which is a lot less clear cut, even though it seems to be a reflection of the first question.

cordially,
Scofflaw

Thanks for the very informative post Scofflaw.


I listened to a radio interview with Garrett Fitzgerald recently who was of the opinion that the governments failure to understand the consequences of joining the euro lead to rises in inflation, loss of competitativeness and more reliance on taxes from our own small consumer base than previously from exports. The government chose to use the property bubble as the main source of tax income rather than take unpopular deflationary measures to tackle our lack of competitiveness. Do you think our mishandling of the Euro inflated our problems by a significant degree?

Your last point about moral responsibility is very pertinent. I spent a little time in Germany in 2002 and was able to observe first hand their buying habits. Every seller or service provider had to explain why the price was valued as it was if asked. A regulatory culture existed with the consumers as regulators on price. If a high price could not be adequately explained, the product was not bought, or the over expensive shop had no choice but to reduce prices or go out of business.

Back in Ireland I witnessed no such consumer regulation.
I think you aluded to this in that we were prepared to pay the high prices for property.

It seems all the regulators were asleep during the Irish boom or looking the other way including the Irish consumer.

Permabear

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