A debt-for-equity swap (bondholder haircut) appears to be the most realistic approach to tackling the Irish banking crisis. US Economists such as Joseph Stiglitz and Jeffrey Sachs have advocated this mechanism in relation to the subprime mortgage crisis. They argue (correctly) that there is no reason why taxpayers should bail out bondholders and share holders. Bank debt levels can be reduced by converting debt into equity. Converting debt into equity via bondholder haircuts MUST be the way forward for Ireland. By this means debt and interest payments are reduced whilst equity is simultaneously increased. Investors can then have more confidence that the bank is financially sound. This would address the bank solvency issue. Irish economist David McWilliams is advocating this approach also.
How would this work in practice in relation to an individual Irish bank ? Lets call the bank the Irish Ranchers Bank. Suppose that it owed bondholders €50 billion
A 25% haircut would reduce this debt by €12.5 billion. This would lead to the creation of €12.5 billion in equity. Thus the bank would be significantly recapitalised.
However for this to work it is a sine qua non that the Irish government pass a law (urgently) which compulsorily converts the existing creditors of the banks into shareholders thereby liberating the Irish taxpayer. As of now Ireland has no such law. Such a bank resolution law would protect depositors with an ECB-backed deposit insurance scheme.
Recalcitrant creditors tempted to overthrow the new arrangements would undoubtedly resort to legal action. On balance it is likely that they would lose out in the Irish courts.
The IMF’s involvement here means that Ireland will not return to the bond markets for three years. We NOW have a window of opportunity to resolve the banking crisis. NOW is the time for the government to take the bull by the horns and adopt this approach. It may not make us too popular in some quarters. Politicians are generally thick skinned and can wear this unpopularity. The alternative is too horrible to contemplate.