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Market commentary December 2010

By December 9, 2010No Comments

In summary, European banks lent capital to Irish banks, who in turn lent it out to inflate the Irish property bubble. But the banks got it all wrong. So the Irish government stepped in to guarantee the Irish banks. The Irish government then got it all wrong, the banks losses swamping the government and Irish economy. Then the EU stepped in to guarantee the Irish government. And the guarantee now sits with the Irish taxpayers/voters, as everyone else has decided they should foot the bill and pay the interest – effectively to bail out the European banks who lent the money to Ireland in the first place. Hmmm.

The events surrounding the bailout of Ireland are fascinating, not least who actually needed bailing out and who is paying the bill. If Ireland had over-stretched itself why couldn’t they just be allowed to default? After all it is a tiny part of the eurozone. It all began with the Irish banks getting way out of their depth, borrowing money from European banks which in turn resulted in an Irish property bubble. If these Irish banks were allowed to fail the damage would be felt by German, British and French banks to the tune of euro 109bn, 100bn and 40bn respectively. Some analysis has highlighted that they could have taken this hit – and why not, after all no one held a gun to their head demanding “lend to Irish banks!”. But it is more complicated.

For example, Irish banks are the fifth largest lender in the world to Italian banks. Similarly they are leading lenders to Portugal, Greece and Spain – even though Ireland is only the 15th biggest economy in the EU. This inter-connectedness is the problem, the web of debt that we set out in a graphic in the last edition of the TopFunds Guide. It gets worse – Japanese banks are the 6th biggest lenders to Ireland and Italy, and US banks are very exposed to Ireland and Spain (source BIS).

The intermediate step here was the Irish government making the mistake in 2009 of saying it would guarantee the debt of its banks. Then as the size of those debts began to emerge it was clear that the Irish government was out of its depth. So in recent weeks the EU (with a little help from its IMF friends) announced that it will, effectively, guarantee Ireland’s debt.

But who guarantees Europe’s debt? Who is paying the heady interest rate bill on $85 billion bailout?

The Irish taxpayer! So not the European banks who lent the money in the first place allowing the crazy property bubble to inflate. And who agreed to this? The Irish government. Hmmm. What will the Irish voters have to say about that? We will find out early in 2011.

Reflecting on the EU bailout of Ireland and the apparent loss of its independence and sovereignty, an editorial in the Irish Times of 18th November (“Is this what the men of 1916 died for?“ – Easter 1916 being the rising in Dublin against British rule) overlooked two inconvenient truths. In the two world wars of the last century, more than ten times as many Irish men died fighting tyranny on the continent of Europe than did so fighting for Irish independence. And, sadly, Ireland lost its independence some years ago when the euro was adopted.

Will individual Irish men and women now choose to fight a new continental tyranny, “the suits” in Brussels, who have decided that banks (in Germany, France, Britain) must be protected at the cost of Irish taxpayers? The thin green line protecting eurozone stability might hold its ground in a General Election early in 2011. But what about 2012 and 2013, as the pain becomes even more intense?

In the meantime no one should under-estimate the determination, and intellectual and financial firepower, of Jean-Claude Trichet and politicians in Brussels to hold the eurozone together. Yet history is replete with the obituaries of individuals and institutions that thought they could beat the markets which, more often than not, simply reflect the reality on the ground.

In the recent interim note we said “events of recent days have blurred the possibility of short term optimism”.  That hasn’t changed.  Key markets could certainly go higher in the short term – but there is considerable uncertainty. Sadly politicians (and voters) are now a key area of risk for investors and advisers – so we can’t avoid considering this rather prickly area.

Dennehy Wealth