Irish bankers played fast and loose in the late 1990s and early 2000s, the booming Celtic Tiger years.
Along with its membership in the euro zone, the country gained access to a flood of deposits from foreign investors because Irish banks were willing to pay a higher rate of interest than local banks in countries like Britain and Germany.
Their ability to pay higher rates depended on what they charged for loans, and the amount of loans outstanding.
Making loans is quite profitable, as long as you charge sufficient fees, your lending rate is higher than what you pay for deposits, and you’re able to collect what your borrowers owe.
After that, it’s all about the amount of money that flows through the bank: The more money that flows through the system, the higher the earnings of the bank… and the bankers.
You can see how this situation grew out of control…
To keep the machine going, Irish banks (as well as those in other countries) had to continually make new loans as they received new deposits. The alternative — make fewer loans and/or turn away deposits — would have meant reducing earnings. No banker wants that.
So the Irish banks kept making loans — particularly those against real estate — long after the logic of such deals went out the window.
The next chapter of this story is well known: Borrowers began to have trouble paying back their loans and the banks faltered under the weight of all that bad debt. This erased their capital, requiring a bailout from the national government, which then risked default on its own debt and required a bailout of its own from the Troika (the European Commission, the European Central Bank, and the International Monetary Fund).
This left Irish banks nationalized, with a lot of bad debt on their books, the Irish property market in shambles, and the whole country on the hook for a staggering amount of debt.
From 2007 to 2010, Irish national debt increased from 25% of GDP to 91%.
Only now is Ireland emerging from its bailout status, even though much of its troubled past remains.
The economy is a fraction of what it once was… the property market is dead in much of the country… public services and pensions have been cut… and unemployment is in double digits.
Adding to all of this is the fact that the national budget is still running a deficit — around 7% — and the debt of the country has increased to 125% of GDP.
So why then would this country want or try to emerge from its status as a ward of the Troika?
Because it needs money to fund its annual budget deficit and Troika isn’t in a giving mood. So Ireland has reached out to the bond markets, which have proven to be willing buyers of its debt.
The now toothless Celtic Tiger recently issued bonds and had four times as many orders as they had bonds to sell. The interest rate on its 10-year government bond was 3.54%, a mere 0.65% higher than comparable U.S. bonds.
Stop and think about that for a second.
It almost defies logic that investors would buy Irish bonds at just a slightly higher interest rate than U.S. bonds, given that Ireland can’t control its own monetary destiny by printing more euros, and has yet to come close to a situation where the growth of its annual deficit is in the same range as its GDP growth.
So why are investors clamoring for the new Irish bonds?
There is only one explanation: No one is banking on the Irish.
If Ireland once again fell on hard times, everyone would expect the Troika to provide another bailout. (This is different from when private banks get into trouble, like in Cyprus, where the Troika demanded that private bank depositors take a haircut.)
It’s possible, and actually likely, that Ireland will fall back into recession along with the rest of Europe. This would send its budget gap soaring in the wrong direction, and cause Irish leaders to once again approach the Troika for bailout funds… which we expect they would provide.
Remember, the Troika isn’t in this game to save the Irish. It’s all about keeping the euro intact and saving private lenders in other countries — like Deutsche Bank — that hold bonds from countries such as Ireland.
The Troika could offer the Irish government more bailout money, but only on the condition that domestic holders of government debt — such as pensions, banks, insurance companies, and individuals — took a big haircut. This would make sure the Irish had some skin in the game, and keep foreign investors in line for full payback.
Another option would be to provide bailout funds under the condition that all private parties take haircuts, just as happened with Greek debt. (This was called PSI, or private sector involvement.)
Of course, before that happened, the Troika would be sure to buy all of the Irish bonds held by strategic private banks such as Deutsche Bank, thereby making the bonds immune from the haircut and leaving the losses at other institutions and with individual investors.
And that right there is why bond buyers clamored to get their hands on Irish bonds recently… no one is banking on the Irish to be the ones to pay them back.
If all of this sounds like a case of picking your neighbor’s pocket, it is. Currently, nations around the world are borrowing more money than they could ever imagine paying back.
Unfortunately, there are no good options for correcting this situation. Losses will be incurred. In the euro zone, without a massive amount of currency printing, the losses will be meted out through haircuts and outright non-repayment.
The name of the game when it comes to euro-zone bonds is either to make sure that you have a chair when the music stops, or simply never play the game at all.
Our view is that the game is much too risky, particularly when the reward
is only 3.54%.
Managing Editor’s Note: Harry discusses the issue of debt burdens around the world in his newest book, The Demographic Cliff. He breaks down the debt picture into four snap shots — government, consumer, corporate, and financial — and then compares American debt levels to dozens of other countries in Europe, South America, Asia… you name it. Most interesting (and useful) is he considers which countries face the highest risk ahead. Check it out for yourself.
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