To its many critics, Dublin's blanket guarantee of past and future bank assets and liabilities was quite possibly the single worst decision of the entire global financial meltdown, which is saying a lot. (Lehman Brothers Holdings Inc. defenders would probably take umbrage at that characterization.) What shouldn't be in dispute is that the government created a kind of time-released calamity. Far from stabilizing Irish banks, the government's bailout has now come back to haunt not only Ireland, but also Europe as a whole.
There are disturbing parallels with Spain, in particular. While Spain's central bank by all accounts is taking decisive action to buttress banking, the question now is whether the bond markets will relax enough to give Spain time to clean up its property-related mess. "We're on the right track," says Orson Alcocer, a partner at the Madrid office of DLA Piper Spain SL, "but in the middle of a tunnel."
In the aftermath of last month's €85 billion ($112.4 billion) rescue package of Ireland by the European Central Bank and the International Monetary Fund -- €35 billion of which is headed to further shore up Irish banks -- the Irish are traumatized and angry, especially as senior bondholders of Irish bank debt escape unscathed. Many other Europeans are dubious and scared, wondering whose bonds and which economy will be targeted next.
Despite its guarantees, the Irish government was eventually forced to nationalize not only Anglo Irish, but once-stable Allied Irish Banks plc as well, pumping in ever more cash in a futile effort to stabilize them. The country's largest private bank, Bank of Ireland, is hanging on by a euro or two and is now reported to be on the block.
Amazingly, Anglo Irish still breathes. Dublin is only now talking about a wind-down. Give the government of Prime Minister Brian Cowen credit. It has created the world's most notorious, and longest-living zombie bank.
This year, the euro zone weakened, decayed and threatened to atomize. Yawning budget deficits and profligate government spending attracted the most concern and commentary, which was certainly the case with Greece. However, with some political gut checks, those are actually fixable, or at least able to be made less acute.
Private-sector banks and their bad real estate loans are in some ways more intractably problematic. Private-bank profligacy in Ireland mutated into sovereign debt cancer. Spain is fighting the same disease. "The debt crisis has paralyzed many of the banking solutions for our real estate problems," says Alcocer. Adds Alfonso López-Ibor, a name partner and insolvency specialist at Madrid-based Ventura Garcés y López-Ibor Abogados SLP, "It has become a public crisis."
Both Ireland and Spain "had extremely low levels of government debt. Private debt is the issue," says Jonathan Tepper, who heads the independent economic research firm Variant Perception, based in London and Charlotte, N.C. "As the crisis developed, the governments took on private-sector liabilities."
Those liabilities are overwhelmingly property-related. What's made this predicament far more dangerous is a web of bank loans that entangles the heart of Europe with the so-called periphery. Banks in both Ireland and Spain that inflated the bubble through dissolute lending did so by borrowing massively from financial institutions outside their borders. It's no surprise that the European Central Bank refused to allow some kind of haircut to senior debtholders in its rescue package of Ireland. Creditors are German, U.K. and French banks.
German banks alone are owed more than €300 billion by Irish and Spanish banks and private-sector companies, according to Bank for International Settlements data. A staggering construction and real estate binge sucked in the vast majority of that money.
In both Ireland and Spain, real estate values have fallen by about 50% since the height of the bubble in 2007. The terrain is littered with abandoned developments. Still, tens of billions of euros in bad debt remain on banks' books at inflated values.
According to Spain's Central Bank, bad real estate and construction loans totaled more than €120 billion as of June 2010. A further €57.6 billion were deemed "substandard." The country's regional savings banks, the "cajas," provided most of the loans. Spain is desperately attempting to get its financial house in order and finally appears to be succeeding. In January, the government established a Fund for Orderly Bank Restructuring, known by the acronym FROB. This provides up to €99 billion to support financial institutions, but the savings banks must first increase capitalization through consolidation.
After years of political foot-dragging, that consolidation process is finally at full throttle. By the end of this year, the country's original 47 cajas will have been reduced to 17. Alcocer, for one, expects the remaining cajas to eventually convert into commercial banks and undergo further consolidation.
However, the process of winnowing bad debt is only in its initial stages. The cajas already hold vast numbers of foreclosed properties and will likely end up with far more.
Spain, which has about 10 times as many people as Ireland and an economy more than 6 times as large, is much stronger and resilient, even critics agree. "The fundamental issue is whether Spain can convince its creditors of its capacity to repay its debt," López-Ibor says. The lawyer is asked whether his country will be given enough breathing room to succeed. "No one knows," he says.
Ireland ran out of time, having dithered for the better part of two years, all the while maintaining its problems were manageable.
Belatedly, in April, the Irish government set up a bad-bank repository called the National Asset Management Agency to buy at a discount property loans. It's been overwhelmed by the amount of debt and so far is limited to acquiring land and property under development, not touching residences. Most astoundingly, Ireland has yet to institute a bank resolution scheme, which would allow the government to put financial institutions into an orderly bankruptcy and protect depositors. "Everybody is screaming for it, but the government hasn't moved," says Brian Lucey, a finance professor at Trinity College Dublin's School of Business.
Under current standing, a bank is considered the same as any other limited liability company. A banking insolvency would imperil and possibly wipe out depositors as well as lenders.
While Anglo Irish was a classic bubble institution, with a loan portfolio heavily weighted toward land and building speculation, the Irish government and financial regulators alike treated the bank as a victim of global finances, not a reckless and profligate perpetrator. Management, led by the high-charging and politically connected chairman, Sean FitzPatrick, was allowed to stay. Anglo Irish was nationalized in January 2009, only after FitzPatrick admitted to €80 million in secret loans from shareholders. Shortly thereafter, an Irish insurance company revealed it had secretly deposited €7 billion to window-dress Anglo Irish's balance sheet.
Rather than "ring-fence" Anglo Irish and the other weak financial institution, the Irish Nationwide Building Society, and then wind them down, the government of Prime Minister Brian Cowen lumped institutions together and insisted they all be propped up. That put enormous pressure on the healthier banks. Bondholders over time made less and less distinction between one institution and another. "The state guarantee schemes were extraordinarily and recklessly expansive," says Lucey.
The government said it had no alternative but to issue the blanket guarantee of assets and liabilities. Not so. Banks elsewhere in Europe and in the U.S. stabilized after far more limited guarantees and forced mergers.
Ireland's ruling Fianna Fáil party has consistently asserted the need to save Anglo Irish to protect the country. Its state of denial was both egregious and enduring. On Sept. 30, exactly two years after the government's carte blanche guarantee, Ireland's central bank again revised upward the cost of bailing out Anglo Irish to €34 billion, calling that figure the "worst-case scenario."
Finance Minister Brian Lenihan, in an interview with the Financial Times that day, pronounced the country's banking system solid. "This brings the crisis to closure," he said. Not really.