The chancellor under Henry VII in 15th century England famously had a failsafe way of collecting taxes: if you appeared rich, you obviously could afford to pay; if you lived without luxuries, surely you had been saving money and could afford to pay too. In this way all of Henry's subjects were pinned by what became known as "Morton's fork" – a choice between equally bad options.
The Irish taxpayer is in a similar situation with regard to the banks and borrowing. The recently extended bank guarantee scheme and Nama are, we are told, absolutely vital to getting credit flowing in Ireland again. Without them, the domestic banks could not survive. But these rescue programmes impose significant costs on the exchequer. These are recouped in two ways: through taxes and by charging the banks, who ultimately pass the cost on to consumers. Either way, we pay.
And the price is about to get steeper. A consensus is forming in the financial industry that, by the end of 2010, the average variable rate mortgage holder will see a rate rise of at least 1%, even if the European Central Bank keeps the base rate steady for the whole year. That's because wholesale funding is still very expensive for Irish banks. Once Nama is in place, they plan to start increasing their margins to claw back the cost, with the first 0.25% increase before the end of the first quarter.
Less than two weeks ago, Irish Life & Permanent became the first covered institution to issue debt under the Eligible Liabilities Guarantee Scheme – the new guarantee – which came into effect in December. The bancassurer raised $1.75bn of three-year money after a successful roadshow for US investors. That's the good news. The bad news is that it was pretty expensive.
IL&P had to pay about 1.65% over the benchmark rate, according to a report by Bloomberg, plus a new 0.5% charge to the government for the protection afforded by the guarantee. This puts the all-in price on this money, according to estimates by NCB Stockbrokers, at about 5% – much higher than IL&P charges borrowers at the moment, meaning its profit margins are under severe pressure.
"IL&P are paying double what the sovereign is paying just to get it away," said NCB banking analyst Ciarán Callaghan. "They could be locked in for the foreseeable future."
If expensive funding is the new norm, it's only a matter of time before banks start passing the price on to customers. With Bank of Ireland and AIB both preparing their own issues under the new guarantee, a new reference rate for Irish bank borrowing could be established at a critical time for the banks as they seek to refinance their huge debt loads before the guarantee runs out. As they go looking for fresh capital, too, they will want to show they can offset these costs with interest income.
"They'll have to have wider spreads on the asset side to make pre-provision profits to offset loan losses," said Callaghan. "This will form part of the investment case for the banks when they go to raise capital."
Wider spreads is just another way of saying higher interest rates on loans, and probably lower deposit rates. Both IL&P and EBS have been very frank in the last six months about the need to hike interest rates, regardless of the ECB's plan. In August last year, the IL&P chief executive led the sector by putting up rates on standard variable mortgages by 0.5%, affecting about a third of borrowers. EBS held rates last year, but chief executive Fergus Murphy is on the record as saying the building society is going to tighten this year. Broker sources say 1% is the minimum increase EBS needs, while IL&P has less to do since it started earlier.
Privately, executives at the big two banks admit they have the same needs, but neither institution has publicly admitted they will raise rates. Both have some of the best value mortgages in the market, especially compared to their foreign-owned rivals such as Ulster Bank and Bank of Scotland Ireland, which have rates up above the 5% mark in some cases.
There is a widely held belief that Nama will help on the lending side but the only way we will see Nama bonds put to work in the service of lending is if mortgage rates rise significantly enough to make loans a more attractive asset than low-risk government bonds and other higher-yielding forms of investment.
"If we want to see genuine credit flow then they have to cover operational loss with operational income, as opposed to more bailouts, because that keeps them in hoarding mode," said Karl Deeter, operations manager with Irish Mortgage Brokers (IMB). "The only way to do that is to fire lots of staff, find efficiencies and raise margins."
IMB's Mortgage Market Trend Outlook 2010 predicts 1.5% of non-ECB rate rises by the end of 2011 as banks seek a way back to long-term health through profitability, and apply the lessons of the cheap-credit-fuelled, low-margin property bubble. But those increases won't be matched by increased lending, the report says, as there is a better yield on government bonds than on mortgage rates, which will lead to hoarding.
"The banks will repo the Nama bonds," said one Dublin broker source. "Sovereign debt has better margins, less risk and no risk-weighting for capital."
This is similar to what the banks in the US did with their Tarp bailout money and will be Ireland's version of quantitative easing, allowing the covered institutions to rebuild balance sheets without taking the kinds of risks that got them in trouble in the first place. The model shows you can nurse banks back to health and pay back the sovereign at the same time.
Yet while government can recover its costs by charging banks – the original guarantee brought in €720m – the customer's choice between no lending or higher rates makes it seem as if the taxpayer is being punished for saving the banks.