Risk aversion

Financial markets are having kittens at the possibility that the Ireland bailout package may require some of the country's creditors to take a "haircut" -- that is, to get back less than 100 cents on each dollar they have loaned. Here's Robert Peston's view, from the BBC website:

There is, as I've written here many times, a powerful moral case for imposing some of the costs of rescuing Ireland on those banks and financial institutions which fuelled Irish banks' reckless lending binge by lending to them.

It's not just a moral case. The case for bankers to take a haircut is firmly founded in the very financial theories that market participants always like to use to baffle outsiders.

Financiers pride themselves on their supposed ability to price risk, and Ireland (or Greece or Spain, or for that matter France) has always been a riskier credit than Germany, which is the benchmark for the Eurozone. Because of that, Irish (or Greek or Spanish...) bonds have always offered a higher yield than their German equivalents. The difference in yields is known as the "credit spread" and it's intended primarily to compensate investors for the fact that in buying Irish bonds, they're taking on a greater risk of default than they would if they bought Bunds. (I say "primarily" because the spread may also in part reflect a lower degree of liquidity in the market for Irish debt as compared to Bunds). Even the rating agencies, about whom I will not normally allow any positive comments on these pages, have figured this out, and rate Irish and other bonds below those of Germany.

So the very simple question is this: if investors have willingly accepted a higher yield on Irish bonds as the price of taking on the greater credit risk, what right do they have to refuse to take a "haircut" now that Ireland is in trouble? The wailing and veiled threats from banks look like an attempt to change the rules while the game is underway; or, to be less delicate about it, they look like blackmail.

This is not to suggest that imposing these costs on the banks now would be easy or pain-free. The banks themselves still have a way to go to restore their balance sheets, and another hit to their capital bases now would not be helpful. At the same time, if there can be no losses on higher risk assets, then the whole credit and risk system has arguably broken free of its moorings, whether moral (Peston) or logical (me). For the long-term health of the system, the IMF, EU and their bailout partners need to ensure that banks and investors no longer asume they can always lay off their bad decisions on the taxpayer.