A Briefing Note on Promissory Notes

Anglo & INBS Crash2008 – Irish property bubble spectacularly

burstsSeptember 2008 bank guarantee

◦ 2009 – Merrill Lynch states “Anglo is financially sound”

◦ 2009 – Anglo is nationalised◦ March 2010 – Anglo posts the largest loss in Irish

corporate history (€12.7 billion for 2009)◦ March 2011 – Anglo then breaks its own record

(€17.7 billion loss for 2010)◦ The INBS numbers are proportionally even worse

◦ Both banks insolvent

Now - The IBRCAnglo Irish Bank = €29.3 billion

◦ Defunct – no new deposits and no new loans◦ Insolvent◦ Under criminal investigation

Irish Nationwide Building Society = €5.4 billion◦ Defunct – no new deposits and no new loans◦ Insolvent

€30.6 billion promissory notes – to pay for ELA◦ Letters of comfort◦ Never brought before the Oireachtas

€4.1 billion exchequer payments

GuaranteeThe Anglo/INBS debts were originally

guaranteed by the Irish State in September 2008 as part of the blanket bank guarantee

The Irish Government made an initial payment of €4 billion to cover Anglo’s debts in 2009. This was paid out of the exchequer finances. €0.1 billion was paid to INBS

Over the course of 2009 and 2010 it became

increasingly clear that Anglo and INBS were insolvent

Averting Collapse If the insolvent banks were to collapse their debts

would have fallen back on the Irish State and become sovereign debt - a consequence of the bank guarantee

To prevent this the Irish Government had to obtain external funding – the Eurosystem of Central Banks was the only realistic source of this funding

Anglo did not have sufficient eligible (i.e. good quality) collateral to obtain the required amount of Emergency Lending Assistance (ELA) from the Central Bank

Emergency Lending AssistanceTo prevent their collapse the Government

negotiated a mechanism with the Central Bank of Ireland setting out the conditions under which the Central Bank would provide Anglo/INBS with sufficient Emergency Lending Assistance (ELA)

This required the implicit consent of the

European Central Bank (ECB) governing council. Any future changes to the agreed mechanism

also require the consent of the ECB governing council

Paying Back the ELAThe ELA provided by the Central Bank to

the IBRC is what enables the IBRC to pay-off its obligations

Most of the bondholders have now already been paid using this ELA

The ELA is also used to pay-off creditors/depositors and to enable the IBRC to retain its banking license

Eventually the ELA has to be paid back to the Irish Central Bank

This is done through promissory note repayments

Promissory NoteThe Irish Government negotiated with

the ECB governing council to create a ‘promissory note’ as a liability owed to the IBRC (Anglo/INBS)

The promissory note is therefore an asset of the IBRC

This asset can be used by the IBRC as collateral to obtain the necessary ELA from the Central Bank

This is because the Irish Government is backing the promissory note with ‘letters of comfort’

The priceA promissory note is a negotiable

instrument ◦ one party (in this case the Government) makes an

unconditional promise in writing to pay a defined sum of money to the other party (in this case Anglo/INBS – now called IBRC), on specified future dates or on dates to be determined, under specific terms

The State’s obligation is to pay down €30.6 billion over 20 years (2011-2031)

How it worksThe promissory note repayments are paid to

the IBRC – the IBRC then reduces its ELA obligations to the Central Bank

In practical terms the Irish Government has received a loan from the Central Bank to pay off the bondholders

It is ultimately a transfer of wealth from the people living in Ireland to the bondholders that lent to Anglo/INBS

The bondholders and other creditors continue to be paid using the ELA from the Central Bank – the promissory notes represent our commitment to eventually repay the Central Bank

How much it costs The Irish Government is scheduled to make over €47

billion of promissory note related payments between March 2011 and March 2031. This is composed of: ◦ €30.6 billion capital reduction – the €30.6 billion owed ◦ €16.8 billion in interest repayments

Much of the funding for this will need to be borrowed unless the State is running substantial fiscal surpluses. This is very unlikely in the medium-term

These borrowings will therefore also have to be financed ◦ at an assumed 4.7% interest rate on borrowings the total

cost to the State will reach €85 billion by 2031◦ Some of which will eventually return to us due to the

circular nature of the payments

What happens when the ELA is paid back to the Central Bank?Central Bank of Ireland (CBI)

Asset side of their balance sheet◦ CBI reduces its ELA assets by €3.1 billion

Liability side of their balance sheet◦ CBI expunges €3.1billion from the system◦ Inflationary impact if this is not done – increasing

the money supply (monetisation of debt)

Socio economic implicationsOver 2% of GDP will be drained out of the

State each year up to 2023 to make the promissory note repayments◦ this will be through an additional €3 billion to

€4 billion of fiscal consolidation (tax increases/spending cuts)

IMF research (Leigh et al, October 2010) indicates that each 1% of fiscal consolidation: ◦ reduces GDP by 0.5% to 1% and◦ Increases the unemployment rate by 0.3

percentage points

Socio economic implicationsThe €3.1 billion promissory note payment

due to be made by the state on behalf of the former Anglo on March 31 2012 is: ◦ greater than the total cost of running Ireland’s

entire primary school system for an entire year and ◦ greater than the estimated cost to provide a next

generation broadband network for all of Ireland (€2.5 billion).

€30.6 billion is equivalent to just under 20% of Ireland’s current GDP or €17,000 for each person working for pay or profit in the State. €47.9 billion is 30% of Ireland’s current GDP.

The issueThe interest rate is not the issue

◦A red herringThe real issues are:The size of the principal

◦Reduction in the principal – write down

When we are making the repayments

◦ Changing the schedule of repayment –holiday, postponement

Risks in promissory note suspension/postponement?1. “The ECB will cut off funding to our

pillar banks”2. “It will impact on the European

banking system”3. “It will undermine investor

confidence in Ireland”4. “It is a condition of the EU/IMF

Memorandum of Understanding”

Are these risks plausible?

Risks to suspension/postponement?“That the ECB would cut off funding to our

pillar banks”◦ Remove funding and the pillar banks will fall◦ But this would trigger the very contagion the ECB

has been trying to prevent◦ ECB cannot give the pillar banks inferior T&C to

other Euro zone banks

“Impact on the European banking system”◦ Promissory note payments do not involve the

European banking system◦ No precedent created as IBRC is not a functioning

bank

Risks to suspension/postponement?“Undermine investor confidence in

Ireland”◦ Not a sovereign default◦ Ireland is already shut out of the markets and

locked into an official programme of assistance until the end of 2013

◦ Amelioration of the Anglo/INBS burden improves Ireland’s debt dynamics and makes Ireland better placed to pay its other debts

“A condition of the EU/IMF Memorandum of Understanding”◦ The promissory note repayments are not a

condition of the deal agreed with the troika

Decision makers - ECB Governing CouncilECB concerns:

◦ Precedent regarding repayment of debt obligations – parachute drop analogy - floodgates

◦ Adherence to rules and protocols – is flexibility legal?

◦ Mildly inflationary – monetization of the debt

But the ECB need a success story◦ The Greek programme has already failed◦ The Portuguese programme is failing◦ Italy is in the firing line◦ Promissory note flexibility can help prevent the Irish

programme from failing

The need for a success story

What about the bond?€1,250m of Anglo Irish Bank

senior bonds◦Not covered by the guarantee◦Not secured against Anglo’s assets

Disingenuous to say we are not paying it

Moral hazard and the ECB