€400 billion bailout: how we got there

05 October 2008  

From Northern Rock and Lehman Brothers to billion-euro bailouts and falling bank shares, David Clerkin and Pat Leahy examine the build-up to the government’s guaranteeing of six Irish banks to the tune of nearly €400 billion.

Minister for Finance Brian Lenihan has yet to explain at what point the Irish banking industry was transformed from one overflowing with ‘‘soundness and stability’’ on September 20, to one on the verge of collapse by last Monday night.

‘‘I want it to be known that the government is confident about the strength and resilience of the Irish financial system," Lenihan said just two weeks ago, when he announced a shock increase in the deposit protection ceiling. ‘‘The Central Bank and Financial Regulator have stressed the soundness and stability of the Irish financial system."

Fast forward to last week, however, and the same system was one that ‘‘would have totally collapsed," according to Tánaiste Mary Coughlan, unless the government issued an unlimited guarantee over the liabilities of AIB, Bank of Ireland, Anglo Irish Bank, Irish Life & Permanent and building societies Irish Nationwide and EBS.

The origins of the biggest-ever intervention by an Irish government in the financial markets had their genesis some 14 months ago. Ever since the credit crunch began in August last year, government ministers and top Central Bank and Financial Regulator executives have done their best to maintain a plausible poker face.

In public, they hoped for the best by signalling that Ireland’s banks and financial institutions were each strong enough to cope with the twin crises posed by the credit crunch and a property market implosion. In private, they kept their fingers crossed and worked out contingency plans to cope with the demise, sooner or later, of one or more institutions. It couldn’t last.

Although the Irish doomsday clock had successfully ticked through the early high-profile casualties of the credit crunch, such as British mortgage lender Northern Rock last autumn and US investment bank Bear Stearns in March, the countdown accelerated sharply just last month as the trickle of sporadic bank failures threatened to turn into a deluge.

The Irish banking sector moved ever closer to the firing line as the share prices of the four quoted banks - AIB, Bank of Ireland, Anglo Irish Bank and Irish Life & Permanent crumbled, falling around 80 per cent from their record highs of early 2007. As more banks failed, investor fears that Irish banks would join the list of casualties increased, and their shares were mercilessly dumped.

It was the collapse of legendary US investment bank Lehman Brothers four weeks ago that sparked the latest sharp falls in banking stocks worldwide. Within the space of a few days, markets had been left to digest a series of seismic events, each of which on its own would have been enough to spark panic. Piled one on top of another, however, they became a calamity.

The numbers involved were so big as to become close to meaningless. Lehman collapsed with liabilities of $600 billion. On the same day, fellow investment bank Merrill saw that the game was up and sought out the giant Bank of America to rescue it from a similar fate.

The nervousness this created on the markets was to be a key factor in building pressures on the Irish financial sector. Billions were disappearing, literally, as big companies withdrew deposits, financiers withdrew funds and fresh cash became impossible to source.

The liquidity squeeze was quickly intensifying. The Financial Regulator entered intense discussions with the banks. Their books were examined by the regulator and discussions centered on ways to package up assets to secure more funding from the European Central Bank.

Next, global insurance heavyweight AIG hit the buffers, forcing the US government to intervene with an $85 billion bailout that wiped out AIG shareholders and resulted in the company coming under Uncle Sam’s control.

This was just two weeks after US Treasury Secretary Hank Paulson had agreed what seemed at the time to be the mother of all bailouts by assuming the multi-trillion dollar liabilities of national mortgage agencies Fannie Mae and Freddie Mac.

Closer to home, the Irish market shook further as the sound of major banks toppling in the distance grew ever louder. By this stage the interbank market, where banks lend to each other, had almost closed. Irish banks had become more reliant on this market to raise funds in recent years, as lending grew exponentially.

But now, despite millions of air miles clocked up by senior bank executives in recent months visiting potential funders, money was simply not available.

As the pressure grew, HBOS, the biggest mortgage lender in Britain, teetered on the edge. The British government, still coming to terms with being forced into nationalising Northern Rock, presided over a shotgun marriage between HBOS and fellow heavyweight Lloyds TSB, bypassing competition laws to ensure that HBOS could be saved without being taken into government ownership.

HBOS’s near-collapse was a grim reminder of the vulnerability of certain Irish institutions. Its business profile was uncomfortably similar to that of a number of Irish lenders - relying on interbank funding to bridge the gap between the money it had lent out and that which it held on deposit from customers.

Investors began to fret even more that, if HBOS was no longer viable, any Irish bank with a similar profile would not be far from the abyss. Such was the worry at official level here that a senior group from the Department of Finance, the Regulator and the Central Bank were now working round the clock, monitoring events and sketching out contingency plans.

The pressure on Irish bank shares intensified as markets began to factor in fresh share-price falls. Following a similar move by US and British regulatory authorities, the Financial Regulator dramatically intervened late on the night of Thursday September 18 to outlaw the so-called ‘short selling’ of Irish bank shares.

Short selling - aggressively selling shares in the hope of buying them for a lower price at a later date - had been blamed for accentuating share price falls, as it was perceived as adding momentum to the declines. The ban on short selling had a remarkable effect, as shares of some Irish banks rebounded strongly in the hours after the ban was imposed.

The bounce was to prove short-lived, however, as what has become normal service on the Irish market was resumed and prices began to slide once more. A news agency report, later withdrawn, that Irish Nationwide was in financial difficulties added to the squeeze.

The continuing uncertainty prompted Lenihan to follow the regulator’s intervention to prop up bank shares with a move, two days later, to ease the fears of depositors and prevent a potential bank run.

By increasing the deposit protection ceiling from€20,000 to €100,000, he assured bank and building society customers that the government would step in, if necessary, to prevent their suffering major losses if their institution went bust.

The move came as rumours abounded that Anglo Irish Bank was considering buying Irish Nationwide, a development that fuelled fears over the future of both property-heavy lenders. For the first time, it appeared that behind-the-scenes talks were taking place to shore up ailing Irish institutions and potentially stitch some banks and building societies together - despite public assurances that all was well and each lender had enough juice in the tank to see out the journey through the credit crunch.

Behind the scenes, the two big banks were asked would they participate in a takeover of any smaller player who got into trouble. The answer was ‘‘no’’, at least not without some kind of state guarantee on the loan book of a troubled institution. But the really big fish was still only making its way downriver.

Bankers held their breath last weekend as news emerged of a $700 billion bailout plan proposed by Paulson and the Bush administration to breathe life into the US banking industry by converting toxic, As the mood in the markets worsened, it became clear that the Paulson rescue package might not pass in the House of Representatives.

This realisation was feeding into the European markets, and the Iseq index of Irish shares was in freefall. Leading the nosedive on the Dublin market was Anglo, reflecting the long-standing belief in financial and political circles that it was among the most likely candidates to become the problem child of the Irish banking sector.

Several times in recent months, rumours of Anglo’s imminent demise had swept financial and political circles in Dublin; TDs and ministers were as aware of them as anyone. They had always proved to be false. The rumours were always strenuously denied.

In the course of Monday afternoon, policymakers became concerned that the long, long series of rumours about an Irish bank going down was finally going to come true. Rumours had buzzed through London’s financial circles over the weekend about imminent events with the Irish banks; traders began to take positions in anticipation.

The market’s sharks had smelt blood in the water. All day Monday, Anglo was savaged; by the time the Stock Exchange closed for business, the bank had lost half its value. The funding squeeze was also hitting other lenders such as Irish Life & Permanent. And all the bank shares were tanking.

The heads of the two biggest Irish banks, AIB and Bank of Ireland, who had been in regular contact with the authorities in recent weeks, sought to see the minister. Their message was clear - this couldn’t go on. The banks had ongoing funding requirements. Lenihan would later tell the Dáil that matters were coming to a head because ‘‘maturity dates for loans to Irish institutions were becoming tighter and tighter’’.

Previously, the big banks had shown little concern about the fate of smaller rivals. But now all were feeling the strain and the big banks argued the whole sector needed support.

Immediately after the Dublin market closed, Taoiseach Brian Cowen, Lenihan, their secretaries general Dermot McCarthy and David Doyle, Central Bank governor John Hurley and Financial Regulator Pat Neary, went into emergency session. They were later joined by Attorney General Paul Gallagher, and senior officials came and went.

It was like a war cabinet; certainly, the Irish banks were under attack. As advisers and officials fumbled with position papers and projections, the men understood that they held the fate of the Irish banking sector - and possibly the financial system - in their hands. Their main worry was that, if one bank went, others could follow, possibly prompted by a strong market sell-off.

During the first meeting between Lenihan, Cowen and the senior officials, word filtered through that the American bailout had fallen in the House of Representatives.

Faced with the possible - probable, as some saw it - collapse of an Irish bank, they determined that they had three options. The first option was to do nothing, let events take their course and let the market fix the problem. However, they all believed that the consequences of this approach could be catastrophic, triggering a loss of confidence in the entire system. They could foresee queues outside banks the following morning, and a full-scale financial panic.

For months, officials in the Department of Finance and the Central Bank had been studying the financial crash experienced in the late 1980s and early 1990s in Norway, Sweden and Finland. Loose lending by banks facilitated an asset and housing bubble which burst with spectacular consequences. For the officials, it was a sobering process: in the first three years of the 1990s, Finland’s GDP fell by over 13 per cent; the rate of unemployment rose by a similar figure. Such an outcome for Ireland would mean unemployment topping 400,000.

The prospect had haunted finance officials for months, and they had been working out possible policy options to avoid a doomsday scenario of a general banking collapse. Lenihan had also been listening to independent economist David McWilliams, who had publicly and privately been advocating a broad bank guarantee.

The second option - and one believed to be favoured by some senior Department of Finance officials as the crisis deepened - was to nationalise an ailing bank, the approach that had been followed by the British government in the case of both Northern Rock and, last weekend, Bradford & Bingley. On the face of it, this was the limited option.

Finance officials felt it would be less risky for the state then a full guarantee. However the Central Bank was warning about a ‘‘systemic risk’’ - a total breakdown of the system. There was a strong possibility, the men were told, that the process of nationalisation wouldn’t stop with one bank. If Anglo was nationalised, they were told, others would not be far behind. The smaller institutions - Irish Life & Permanent and Irish Nationwide - were seen as vulnerable, though the latter had considerable liquidity.

Even the big banks were seen as susceptible if nothing was done by Tuesday morning to underpin the whole system.

‘‘If we nationalised one, they could all go," said one source close to the deliberations. So the third option, the one taken by the group, was effectively to guarantee the entire Irish banking system. This was settled on pretty early as the favoured option. The bank’s top brass were spirited into the Department of Finance all evening. One civil servant, seeing a senior bank executive entering the building, inquired what was going on. ‘‘For God’s sake, don’t say anything," he was told. ‘‘You’ll have a run on the banks!"

It was clear that some extraordinary action was going to be taken. A series of rolling meetings took place all evening, though sources with knowledge of the process say that agreement about the general shape of the government’s action was reached quite early in the process.

Officials crunched numbers, trying to estimate the possible exposure for the state in various scenarios. Though it would be presented as a ‘‘€400 billion bailout’’ for the banks, there was no sense in which the state could contemplate actually having to pay that sort of money - it simply isn’t there. Nothing like it is there.

Estimates swirled around, varying by tens of billions. Clearly, the €400 billion figure wasn’t the extent of any actual liability - that would mean that every loan that the banks had defaulted, and all deposits were withdrawn. Ultimately, the Taoiseach and the Minister for Finance were told that the greatest possible liability would certainly be less than €20 billion and, crucially, be under the ceiling of the €19 billion national pension reserve fund. It was still an unimaginable amount of money; but the risks of a general banking collapse made putting it on the line a viable option.

Faced with the biggest decision of their political lives, Cowen and Lenihan weighed the positives and negatives. One attraction for the government of this option was that if it worked, the state would have to pay nothing at all, whereas any bailout of a failing bank involved writing cheques immediately. The two men knew they would be accused of using taxpayers’ money to save greedy bankers from their own mistakes - they also knew there was an element of truth to it. They hoped that the exposure of the taxpayer could be minimised; but it was still a massive gamble.

Lenihan, Cowen and some senior officials engaged in a round of telephone contacts with key European policymakers to inform them what they planned, including the French finance minister Christine Lagarde, Jean-Claude Juncker in Luxembourg (chairman of the eurozone group of finance ministers), and the European Central Bank chief Jean-Claude Trichet. On the face of it, the move looked like favouring some banks to the exclusion of the others, contrary to European regulations. But they knew that the politics of the situation meant some rules were more important than others.

Ministers were roused from their beds by officials from the Department of the Taoiseach early on Tuesday morning. Dermot McCarthy, secretary to the cabinet and the most powerful civil servant in the country, briefed them quickly, and told them of the need for a cabinet decision to allow the plan to proceed. None demurred. The ‘‘incorporeal’’ cabinet meeting, when ministers were telephoned for their assent, took place between three and four am. By 5am, the text of a statement was ready.

The government press secretary, Eoghan Ó Neachtain, worked with the Department of Finance press office to formulate a rushed media timetable, tipping off the morning bulletins and arranging briefings. By the time reporters began to gather in the Department of Finance last Tuesday morning, everyone had drunk a lot of coffee.

‘‘We’re in the eye of the storm here," Lenihan told the hastily arranged press conference.

‘‘It’s time for action, swift and decisive."