Don't repeat mistakes of Irish bailout, former IMF official warns Portugal

Wed Aug 13, 2014 1:00pm EDT

* Senior bondholders in Banco Espirito Santo spared pain

* Former IMF official Mody: bank bondholders should suffer

* Mody cautions that 'mistake' could prove costly for Lisbon

By John O'Donnell

FRANKFURT, Aug 13 (Reuters) - Portugal is making the same costly mistake as Ireland by rescuing a troubled bank and largely sparing its bondholders losses, one of the architects of Ireland's bailout has warned.

Shortly after finishing a painful economic overhaul in return for emergency loans, Portugal recently unveiled the surprise rescue of a major bank with an injection of almost 5 billion euros ($6.7 billion) chiefly using state funds.

Although Banco Espirito Santo's 'junior' bondholders and shareholders will suffer losses, owners of 'senior' bonds ranking higher up the list for repayment were spared.

Now Ashoka Mody, the former IMF official who helped design Ireland's bailout after its guarantee to savers and bondholders in troubled banks almost bankrupted the country, has warned against repeating such mistakes.

"Portugal is following in Ireland's footsteps," said Ashoka Mody, who, as a senior official at the International Monetary Fund, drafted the bailout of Ireland following its banking crisis.

"They are identical situations. It's a mistake not to impose substantial losses on senior bondholders. In America, they suffer losses. Why is Europe different?" Mody told Reuters on Tuesday.

Mody drew a comparison with Anglo Irish Bank, which was nationalised in January 2009, leaving senior bondholders untouched.

"Anglo Irish should have been closed at the start of the programme," he said. "As a consequence there would have been less fiscal austerity. Ireland would have had lower debt and faster growth than it has."

He cautioned that a similar fate may await Lisbon. "Portugal is a country which is still struggling to recover growth," he said. "Why does a country like this, already with significant debt, have to take on additional debt?"

Imposing losses on senior bondholders could, however, result in Portugal having to make good on guarantees that it gave for some of that debt.

Another complication is that the European Central Bank may hold such bonds as security in return for credit.

These could include senior unsecured notes issued by Banco Espirito Santo, and guaranteed by the Portuguese state.

Ireland's current government was swept to power after promising to impose losses on bondholders in Irish banks but dropped plans to target senior bondholders in the now-defunct Anglo Irish Bank at the insistence of the ECB.

Mody said the problem facing Portugal was similar.

More than two thirds of Banco Espirito Santo's 41-billion-euro debt pile is in the form of senior bonds or equivalent claims, according to Reuters data.

This is one of the highest ranking forms of unsecured debt and is among the last to suffer losses in a bankruptcy.

The ECB drew a distinction between the issue of it holding such bonds as collateral and the decision to impose losses on bondholders - known as bail-in.

"The Eurosystem, as any other central bank, provides credit to banks," said a spokesman. "It provides credit only against collateral. The issue of bail-in and the issue of collateral at the ECB are unrelated."

Portugal's finance ministry was not immediately available for comment. (1 US dollar = 0.7483 euro) (Additional reporting by Axel Bugge in Lisbon and Chris Spink in London; Editing by Ruth Pitchford)