Synopsis: The Irish may just have slid sideways into sovereign default territory, but it’s not quite that simple. Read on.

A turning point in the evolution of the European union may have been reached tonight. The Irish government has either deliberately or accidentally triggered an esoteric legal crisis about the value of Irish bonds which could, if mishandled, trigger the European sovereign debt meltdown that three years and untold billions have been spent trying to avoid. If the French and the Germans take this Irish action the wrong way, it may force a reexamination of subsidiarity, the principle that European countries should manage as much of their own affairs as is compatible with the union. The Irish government’s rash, ill-considered actions may constitute a breach of trust between the financially stable nation’s governments and their own people: throwing good money after bad in basket case democracies. A fully integrated, federalized Europe has come several steps closer.

Here’s what has been done.

1. 1966 Allied Irish Bank is formed. A long, long time ago.
2. 2008/August Allied Irish Bank runs out of money having lent vast sums to people who speculated on property going up indefinitely and then got caught short when sanity started to prevail in foreign property markets. A series of bailouts begins.
3. 2010/November The Irish government has put 13 billion EUR (or so) into Allied Irish Bank to keep the bank from going bankrupt, and in the process winds up being the majority sharehold (i.e. owning 92% of the bank.)
4. 2010/November The Irish government passed the Credit Institutions Stabilisation Act (CISA) which gives it the power to do a variety of questionable things, including the Subordinated Liability Order (SLO) which is an eminent domain like right to strip bondholders of their property. This bill was long-suspected to be prone to abuse, but nobody expected it on quite this scale. It is expected when the CISA bill is passed that it will be used to force bondholders to accept reasonable terms for their bonds rather than insisting on full payments from bankrupt banks.
5. 2011/April/15 The Irish government issues an SLO on Allied Irish Bank bonds. This SLO compels affected bondholders to surrender their bond and have it replaced with a new bond representing a 90%ish loss on the face value of the original bond, with some extremely odd strings attached (which we’ll get to in a minute.)
6. The strings are as follows. The new bonds replace low-grade bonds which are mainly held by foreign institutions. These new subordinated bonds simply do not accumulate missed payments as a debt which is settled when the money is available, as a normal debt instrument would. If a payment due to the bond holder is missed, the money simply evaporates. This is unprecedented.
7. It gets worse. The higher grade, lower risk Allied Irish Bank bonds (preference shares, actually) are entirely held by the Irish National Pension Reserve Fund (NPRF). Normally these guys get paid after the subordinated bonds. But the government just rewrote the rules of the bond market – without asking anybody’s say so – to let them pay the local pension fund off before paying the foreign bond holders (mostly hedge funds). In effect they’ve seized property, albeit a particularly subtle and complicated form of financial right.
8. The bond holders have a cow. Two of them appeal to the Irish courts.
9. 2011/April/26 A third, UBS (you know, that big swiss thing that’s has a turnover of about a quarter of Ireland’s GDP) appeals to International Swaps and Derivatives Association (ISDA) which is the standards and regulatory body for the global derivatives industry. They’re basically the Internet Engineering Task Force for this type of finance, but with an arbitration operation and teeth.
10. 2011/April/26 Mysteriously, five hours after the appeal was lodged, which would basically have issued a Credit Default Event, stating that the Irish government had actually defaulted on its debts (sovereign default!) by issuing this SLO, UBS chooses to withdraw the complaint for as-yet-unknown reasons.
11. 2011/May/9 The Irish courts will rule on the two cases about the legality of this seizure of property.
12. 2011/May/15 The SLO will go into force, and the old bonds will cease to exist. Assuming somebody really heavy doesn’t step in and put a stop to the madness before then.

Implication: we’re seeing what amounts to a very soft and esoteric form of sovereign default here. The complexity of the play has left people confused about what is actually going on: is this simply a government which is out of its depth in a maze of twisty, turny financial instruments, or are they deliberately trying to pull a fast one, hoping that nobody in Europe will notice.

The IMF and ECB will doubtless take an extremely dim view of what amounts to overturning the 400 year old “hierarchy of credit” which defines who gets paid in events like bankruptcies and normal times alike. It’s as basic a piece of the financial protocols as IPV4 is and it’s not really something that mere nation states get to redefine when it becomes inconvenient – not if they wish to continue playing the game, anyways.

We live in interesting times. The truly bizarre aspect of these maneuvers is that the massive assistance provided by the EU and IMF to Ireland was largely done to prevent European and global contagion triggered by an Irish default. The ECB and IMF continue to dole out the money allocated to Irish relief on an as-needed basis, and the idea that the Irish would turn around and potentially trigger a sovereign default event by meddling in the small print to protect the local pension fund frankly beggars belief.

Is it reasonable to expect small countries to navigate the shark-filled reefs of the international financial markets on the same peer footing as large nations with sophisticated and rational native banking industries? Having a flag and a navy does not mean that the Icelanders or the Irish are nuclear-capable, and sovereign authority over property rights, in the wrong hands, is equally dangerous in a globalized world filled with unstable sovereign debt and constant, ever-present contagion risks.