Irish haircut, a gentle blowdry, or the fully-cropped Lehman?

In the sausage factory of dodgy lending that has engulfed the western economies over the past decade, what about those original suppliers of raw credit? Almost entirely, the institutions that lent money to the RBSs and HBoSs and Northern Rocks, and the Irish banks, that was then mislent, have got away scot free. But according to this Irish Times article, the IMF and EU might be about to change things with a “bail-in” of such creditors.

In Ireland’s case, German and British banks are the most exposed, the greatest holders of their bonds. Up until now, the senior bondholders have been assured that they are 100 per cent covered. Understandably a population enduring huge cutbacks is beginning to get suspicious.

Why are these supposedly sophisticated financial investors who handed mountains of cash to Sean Fitzpatrick to lend to Ireland’s property developers immune from the downside risks of capitalism?

The “bailout” of Ireland is clearly going to be helpful to those banks, such as RBS. I put this very point to British Chancellor George Osborne last week. He told me: “UK banks have passed stress tests, and our engagement in this is because we are good neighbours of Ireland and not because of particular UK banks.” He also said that there had been no concerns expressed by the FSA, BoE, or banks themselves, at that point.

Many in Ireland feel the real recipients of “Bond Aid” will be German banks, and that is the motivation behind the ECB’s pressure on Ireland. But that is rather difficult to explain therefore why it was Chancellor Merkel musing on making bondholders pay a price in the future.

So it may be a factor, but the fears over contagion are the real reason. Those fears are being realised now. And it was precisely this strategy that led to the Minsky moment in October 2008 after Lehman Brothers’ collapse. However, the Lehman logic has now gone too far. Mentioning Lehman has become a substitute for thought. The question is how much of a haircut should the senior bondholder take.

I blogged last week about how the Irish government had managed to get this to work with AngloIrish’s junior debt. The hedge funds capitulated. Take the Irish bank senior debt that is currently trading at around 75 cents on the euro, if the haircut negotiated is say 50 per cent, I have been categorically told by a market participant that this will save the Irish people about €10bn. This because only about €20bn of the near half trillion euro Irish banking balance sheet is actually unguaranteed senior debt.

This would be material to the Irish people, in the context of a €15bn fiscal adjustment by 2014. But it’s not much set against what it might do to bank funding costs across Europe. Why would you hold PIGS bank debt in these circumstances? And what about the recapitalisations of the banking systems, even in Greece? The private sector has been tempted back in to underwrite some of the capital raising programmes. This might be put at risk.

The question is: would an aggressive bond haircut/ burden-sharing leave Ireland up or down overall? And the initial answer might be that it could be better for Ireland in isolation, but worse for the Eurozone. And the real answer, is that post-Lehman, no one wants to be responsible for conducting that experiment. It offends natural justice at a time of fiscal pain for ordinary Irish people, but it is the reality. No one knows how close to crop.