'Where we are'

The disconnect between the media and the markets in the last week or so has perturbed me. The coverage in the days following the bond auction last Tuesday gave the impression that all was well after investors ‘queued up’ to buy our bonds, as if such an event could only be positive. Some Sunday commentators did call BS on it but the conventional wisdom doesn’t appear to have changed. Similar reporting has continued over the last week.

The following is an attempt put a pin on where exactly it is ‘we are’ when Brian Cowen says “we are where we are”; an attempt to explain what happened in the days prior to the auction, it’s impact, and the current decisions facing the government.

It’s written in as plain language as I could muster. Wonks, I apologise in advance.

On Prime Time last Tuesday night Fianna Fáil TD Thomas Byrne ran the prescribed government line on the bond auction. He gave the impression that the bond holders queuing up to buy our bonds was proof-positive of the viability of the State.  “If they didn’t think our economy was manageable they wouldn’t be investing in our bonds”, he said, “they wouldn’t be five times oversubscribed on one of the bonds and the three times oversubscribed on the other. They are willing to put their cash into this country because they believe we can pay it back.”

The mechanics of bond auctions aren’t all that difficult to understand and an understanding undermines those claims.

The country’s authority – in our case the NTMA – sets a bracket for the sale total (this time it was between €1bn and €1.5bn); investors submit private bids with the interest rate percentage they are willing to buy the debt for from the State; the investors who bid at the lowest rates get the bonds first. The NTMA only continues to accept the next lowest rate bids until they reach a point at which they wish to close the auction. This point is always between the minimum and maximum sale total (the aforementioned €1bn and €1.5bn). If the authority does not sell enough to reach the minimum the auction ‘fails’, which is an indication the market has lost confidence and everyone should GTFO.

Yes, on Tuesday investors did queue up. However, they were submitting bids for 8-year bonds at 6% and four year bonds at 4.5%, both extremely high rates. That such numbers of investors submitted such high bids and were successful says more about the ‘success’ of the auction than the number of total bids.  No data is released on unsucessful bids, so we don’t know how risky other investors were viewing Ireland (i.e. we don’t know how high the unsuccessful bids were).

Anyway, the State paid top dollar to shift the bonds; the investors weren’t standing below a flatbed truck waving cash up at the NTMA. That should noted, I’m not sure the media coverage reflected it sufficiently, the on-the-day coverage in particular.

These are not normal-day close-up-shop-afterwards-and-grab-some-ice-cream trading days either. We’re on a knife-edge now – and have been for the last few weeks – and traders know it. Still, the market is aware of two important factors which influence the fluctuations in yields and demand for Irish bonds. Firstly, the ECB will not allow an Irish auction to fail. This is accepted. There is a pattern for this and the traders – collectively, the market – can’t see the ECB changing it.

Secondly, the ECB Securities Markets Programme holds 22% of foreign-owned Irish debt, it has very real vested interest here, beyond the more disconnected position as overseer for That Lot from Away Beyond. The market was – and is – aware of this too. This knowledge further increases investor confidence that Ireland will not be allowed to default.

The ECB cannot intervene directly on the primary market to prop up a sovereign state – something some people point towards to give credence to idea that market confidence was supposedly being portrayed by the ‘successful’ auction – but it can operate on the secondary market to effectively backstop one. Through various mechanisms and devices, from backstopping to the longterm repo operation, the ECB can ensure liquidity. These devices combine to form what is effectively a continuous course of artificial market confidence injections being shot into Ireland’s arm. They’re not long-term solutions, in fact, they can be somewhat detrimental in the long-term, depending on subsequent events. The investors know this too.

Confidence in Ireland was also boosted further by more opaque means prior to the auction… through the tentacles of the department of finance. They took the charm offensive to various international journalists and influential experts.

As P O’Neill pointed out, some accepted – usually-informed – industry sources were under the impression that the economic statistics scheduled to be published two days later would show continued growth in GDP and GNP, in line with the two prior positive quarters. Forecasts were for between 0.1% and 1% growth.

With all that in mind who wouldn’t have looked to buy bonds which will return about 6% of their value? All these factors brought through the auction ‘successfully’.

However, the economic stats published the following Thursday were negative, even if Lenihan did claim they showed a ‘remarkable turnaround‘ in the economy. We should note that the game the department played with journalists and analysts (infering positive growth figures to be published) is not one it will be able try twice. That it was tried at all is perhaps indicative of the desperation of the finance experts and Brian Lenihan in recent weeks.

Anyway, in the days following the ‘successful’ auction – which was supposed to have shown confidence in Ireland – investors sold the bonds off at a loss, something Dan O’Brien was rightly puzzled by in The Irish Times. Very strange, but it happened. This pushed our bond yields back up above the pre-auction value, they’re now worryingly (to put it mildly) close to 7%. Last year 5% was seen as unmanageable. As an aside: one must wonder who could afford to take such losses on such investments so soon. I haven’t seen much comment on that outside Dan O’Brien’s column in the media. Maybe I missed something.

On the same Thursday the market went dumb-dumb on the daily newspaper coverage. Investors mis-read ‘Anglo Irish Bank’ for ‘Allied Irish Bank’ and misinterpreted senior debt and subordinated debt in this Irish Examiner story. The result was Conor Ryan, the journalist who wrote the story for De Paper explaining on CNBC how the article had nothing to do with senior debt or AIB and it was simply market jitters gone wild. Such volatility could be seen as an indicator of how tetchy the market was with Anglo, which is seen as wedded almost irreversibly to the Irish State.

The whole sorry incident sent Credit default swaps (CDS) on Anglo – basically insurance against the government defaulting on the subordinated debt it holds through the bank – tipping above 5%, reaching record highs. In more recent days talk about the Government plans for Anglo have seen Moody’s downgrade Anglo’s credit rating near junk status.

Whatever the reasons for their current value, if the state is going to continue without seeking external support the bond spreads need to narrow. They’re currently at 6.7% having climbed steadily since the auction. This is due to fears about the cost of the bank bailout being too much for the State to handle.

This means Anglo. The market is wondering if Anglo will drag the State under.

A value needs to be set on the cost of bailing Anglo out. It’s speculated the Government will do this tomorrow.

The problem; the cost of bailing out Anglo relies on knowing the value of the loans on its balance sheet. And Anglo’s balance sheet is full of property loans.

NAMA was designed to value those loans and set a floor on the property market. 18 months later it has yet to do so sufficiently.

How can you value a loan book full of property when you can’t put an accepted value on the property itself?

Tomorrow it appears the Government will announce a ‘final figure’ for the cost of Anglo. They’ll try not to shock investors of the markets but the number needs to be credible. Too high and the market will see the Anglo bailout pulling us under. Too low and we’ll be laughed out. Like Goldilocks’s porridge, the figure needs to be just right.

And that’s one of the many reasons why the figure won’t be accurate. Though it will be important because to the markets perception is often reality.

Just another catch 22 in the Irish banking crisis.