The slaying of the Celtic Tiger

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Anglo Irish Bank's unfinished head office pokes into the sky on Dublin's North Wall Quay, a silent testimony to the rise and fall of the Celtic Tiger.

The eight-storey shell of what was supposed to be Anglo Irish's glittering new headquarters is both a symbol of Ireland's ascent out of a wretched history of poverty and despair and a constant reminder of the massive housing and property bubble whose collapse has sent Ireland cascading into what is effectively national insolvency.

Riding the back of the Celtic Tiger, the once-tiny, private investment bank blossomed into arguably the most powerful financial institution in Ireland. Anglo Irish led the way as developers, its rival banks and the Irish people engaged in a frenzy of construction and speculation that will hang over the country for years if not decades.

Anglo Irish is now a ward of the state, a recipient of tens of billions of Euros in bailout money. Ireland itself is a fiscal mess, thanks to a budget deficit that makes Greece's look like spare change. The real estate market is a disaster, and interest rates demanded by bond investors are so high that the exchequer effectively can't afford to finance the country.

The Irish government has some breathing room - it doesn't have to return to the capital markets until next July. But if that bond auction fails, the country will almost certainly be broke and require a bailout from the European Union.

At that point, the ailing Celtic Tiger would become a dead kitten. Ireland is preparing to unleash a draconian combination of massive spending cuts and tax increases next month. But that risks an economic death spiral where the economy continues to shrink along with government revenues.

Ireland's virtually collapsed bond market is a painful reminder to investors, politicians, taxpayers and businesses that the euro zone's debt crisis, triggered by Greece last spring, is far from over. Quite the opposite: More bailouts are all but certain, and a permanent sovereign debt restructuring mechanism needs to be drafted. At a minimum, such a mechanism would extend the bond maturities of distressed countries, but might also impose "haircuts" on bondholders, as Germany wants, in an effort to shift some of the burden of rescuing an economy away from taxpayers and on to investors.

The soaring bond yields in Ireland, Portugal, Spain and Italy this week suggest investors expect debt defaults at some point, triggering multiple rescue packages and possibly shattering confidence in the entire euro zone experiment. On Thursday, as Irish bond yields surged to their second record-breaking day in a row, European Commission President Jose Manuel Barroso sought to curtail the bond-dumping mania by offering Ireland a European Union bailout, should it ask for one. So far, it hasn't.

Most economists do not fear a repeat of "Acropolis Now," the Greek-inspired near-shredding of the euro zone six months ago. Ireland's woes are not expected to lead to a bond- and currency-wrecking contagion that infects the entire EU. But Ireland is being closely watched in part because a bailout would be the first test of the new €440-billion ($608-billion) sovereign debt rescue fund, known as the European Financial Stability Facility (EFSF), devised for the Greek crisis.

And investors beyond Ireland and Portugal are getting increasingly nervous. On Friday morning, the yield investors demand to hold 10-year Italian bonds over benchmark German bonds widened to 1.86 percentage points, the most since the euro was born a decade ago. Spanish bond yields also rose to a record high, partly on news that Spain's hesitant growth had stalled in the third quarter as austerity measures kicked in. The euro sank to a five-week low against the dollar.

As Ireland moves closer to a bailout, the weakest EU economies - Portugal among them - may be forced to follow it, resulting in a costly bill to EU taxpayers and renewed questions about the wisdom of the euro's use in peripheral euro zone countries.

Ireland faces great uncertainty as it tackles its fiscal meltdown. On Dec. 7, the country will unveil a new budget, which will contain at least €6-billion of spending cuts. If investors view the budget favourably, bond yields could come down. Ireland doesn't have to sell new bonds in this tense market. It has enough money on hand to finance operations until next July. But after that, the cash could run out.

When times were good

The mess Ireland is facing now is in sharp contrast to the Celtic Tiger days, which lasted for most of the 1990s until 2003, when the country was a shining example of how to create an economic miracle.

It even came to the attention of the Saskatoon Regional Economic Development Authority, which summoned a managing consultant in IBM's global economics centre in Dublin to explain to a province blessed with abundant resources how a country without any had been so successful.

What Ronan Lyons, now an economist with Irish property website daft.ie, described to Saskatoon officials was the legitimate boom that transformed Ireland. Gross domestic product surged 9 per cent on average annually, turning the land that economic growth forgot into the Celtic Tiger. Multinational manufacturers such as Dell, Intel and Pfizer poured in billions of dollars in investment, lured by cheap labour, corporate income taxes of just 12.5 per cent and, eventually, access to the European Union.

While Ireland was the poorest country in the European Economic Community when it joined that precursor to the EU in 1973, the boom elevated the living standards of the Irish into the top ranks of Europe with per capita incomes exceeded only by those in Luxembourg.

Emigrants flooded in, including people from the vast Irish diaspora, reversing the centuries-old migration of Ireland's people to neighbourhoods such as south Boston, Toronto's Cabbagetown and other areas.

"The situation got crazy during those years," recalled Philippa McIntyre, a 20-something primary school teacher in Dublin. "Internet dating profile headlines would read: 'Looking for someone who can talk about anything other than the price of houses.' "

A property frenzy gripped the Irish. They bought tiny slivers of the fake Ireland that was part of the World Islands development in the Persian Gulf off Dubai. They snapped up property in Goa, India, buying from plans. They invested in developments in Romania that had no roads.

Over dinner in a noisy tapas bar in Dublin, Andrew Healy, owner of Re/Max Advantage Real Estate in nearby Lucan, described one buyer putting in an offer while "sitting in a pub on a Friday night, ringing me without ever seeing the house."

Patrick Honohan, now the governor of the Central Bank of Ireland, but in those days a professor of international finance economics and development at Trinity College in Dublin, recalled trying to hire someone from abroad.

"You'd get somebody. They're going to come, we think they're going to come, they're going to accept the job, she's bringing her husband over to look at the housing market and they're not going to come. Why? Because they can only [afford to]live in some remote suburb."

At the height of the boom, a 25-acre property called the Irish Glass Bottle factory in old, industrial Dublin, sold for €412-million or a staggering €16.5-million an acre.

Anglo Irish threw money at property developers and the construction industry. Its assets soared from one billion Irish pounds in 1993 ($1.8-billion Canadian at the time) to €96.6-billion in 2007 ($132-billion Canadian).

In September, 2007, loans to construction companies and property developers constituted more than 80 per cent of Anglo Irish's total loans.

As Anglo Irish's profits soared, older, established banks such as Allied Irish Bank and Bank of Ireland woke up. Mortgages worth 100 per cent of the value of a property became common.

"Although everybody knew the property bubble was reckless, they assumed the banks had looked after themselves and taken sufficient precautions in making loans," Mr. Honohan said in an interview in his seventh-floor office, which looks out over downtown Dublin.

The banks had not done so, and a catastrophic failure of bank regulators to pay proper attention allowed them to continue financing property developments and deals that were growing increasingly shaky.

It all came crashing down in September, 2008, when the global credit crisis hit.

Later that month, faced with the imminent meltdown of the country's financial system, Finance Minister Brian Lenihan announced that the government would backstop deposits and almost all of the debts held by banks.

The bank bailouts begin

Mr. Lenihan has been scrambling for the last two years to deal with a crisis that seems to worsen every day.

As Ireland plunged deeper into recession - the unemployment rate has soared into the teens - he poured €3-billion into Anglo Irish on June 29, 2009, €827.7-million six weeks later and another €172-million the next month. By May of this year, another €10.3-billion was added to the Anglo Irish tally.

In July, there was a brief spurt of GDP growth, and the storm enveloping Ireland seemed to dissipate. Some economists suggested that with time, the crisis might abate. "You kick the can down the road, hope you don't run out of road," said Brian Lucey, an assistant professor at Trinity College, said at the time.

On Nov. 4, the crisis deepened. Mr. Lenihan revealed that Anglo Irish needed another €25.3-billion, while Irish Nationwide Building Society required an infusion of €5.4-billion and Educational Building Society 350 million.

The total of €50-billion for the bank bailout compares with the government's forecast that its entire revenue will amount to €35.9-billion this year. The forthcoming budget cuts of €6-billion, equivalent to 3.8 per cent of GDP, will be followed by another €9-billion of cuts between 2012 and 2014. Wages for public servants have already been cut and their pension deductions increased, but in return for union acquiescence, the government agreed not to come after them again.

The country's budget deficit is expected to reach an astounding 32 per cent of GDP this year, mainly the result of the €50-billion bank bailout. The comparable deficit figure in Greece, which does not have a banking crisis but suffers from economic contraction, an uncompetitive economy and a tax evasion epidemic, is 9.3 per cent (Canada's is 3.1 per cent). Ireland's bond yields have been elevated since the spring, when the Greek debt crisis hit.

Evidence of Ireland's stunningly expensive hangover can be seen all over the country.

There are ghost estates of empty houses scattered throughout the land. Hotels that were built to take advantage of a tax break are now zombie hotels, sitting empty much of the time or operating at zero profit. There is even a ghost rapid transit station southeast of Dublin, built to service a housing development that got scrapped.

Prof. Lucey is no longer feeling as optimistic. "We need a complete economic restructuring," he said. His career has tracked Ireland's economic saga. When he graduated from university in 1985, he, along with all 25 members of his class, emigrated. He returned to Ireland during the boom years.

Thanks to the austerity measures, he has taken a 17 per cent pay cut. His wife, who is a teacher, had her wages slashed by 14 per cent.

Now, he says, Ireland has run out of road "and the can has gotten much heavier."

Nervous investors

Even the austerity program may not be enough to lure back bond buyers, whose confidence in Ireland's ability to recover has already been shattered.

The austerity measures themselves may contribute to Ireland's woes, by dampening GDP growth in the short to medium term and leaving the country's hefty deficit ratio to linger longer than originally expected. This week, Ernst & Young forecast that Ireland's GDP growth next year would come in at a meagre 1.1 per cent, compared to its last forecast, made in the summer, of 2.8 per cent.

Then there's the spectre of a bailout that could savage bondholders. In October, led by Germany and supported by France, the EU launched an effort to devise a mechanism that would resolve future sovereign debt crises. If Germany gets its way, the result could be catastrophic for countries like Ireland with ailing bonds. That's because the mechanism would force bondholders to take "haircuts" - discounts on the value of their holdings - in the event of a debt restructuring. In some cases, those haircuts could be 50 per cent or more.

Even though the plan is not finalized, and is being resisted by the European Central Bank, the German plan naturally has attracted short sellers to Irish (and Portuguese) bonds. Their rationale: Ireland seems headed for a bailout, the bondholders will have to take a haircut, therefore bond prices will fall, which they duly did.

As bond prices sank on Wednesday, the yield on Ireland's benchmark 10-year bonds rose by more than half a percentage point to 8.64 per cent, taking the spread over benchmark German bonds to 6.19 points - both record highs. On Thursday, the yield went to 8.76 per cent, another record. Bonds rallied Friday, recouping some of the losses.

That same day, LCH.Clearnet, a European securities-clearing firm, decided to raise the amount investors must set aside to trade Irish debt on margin. The change meant that anyone clearing through LCH would have to deposit 15 per cent of the value of the transaction, in cash, with LCH as indemnity against the risk of default. Many banks dumped bonds into the market to raise cash.

And the moribund Irish housing market remains a drag on any prospect of recovery. Almost 200,000 Irish homeowners, about a quarter of the total, are reportedly expected to be in negative equity by the end of this year, meaning their mortgages will exceed the value of the properties.

Among those keenly aware of the situation is Ms. McIntyre, the Dublin teacher, who is living in an apartment she paid €220,000 to buy, down from its original asking price of €305,000. It is now worth less than the amount remaining on her mortgage.

"I really believed I was getting a bargain; little did I know house prices would plummet even further in the coming years," she said. "I'm not alone though. Anyone who bought property in the last five years is in negative equity in this country."

She believes she can hang on, but not if Mr. Lenihan cuts public service salaries again.

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THE BAILOUT PIE

"The Irish banking system is at rock bottom today," Finance Minister Brian Lenihan said on Sept. 30 when the country raised the potential cost of its bank bailouts to €50-billion. Here's how it breaks down:

€34.3-billion

Anglo Irish Bank

€5.4-billion

Irish Nationwide

€525-million

EBS Building Society

€3.5-billion

Bank of Ireland

€1.8-billion

Allied Irish Banks

€25,000

Estimated cost of bailout to each of Ireland's two million taxpayers.

Sources: Bloomberg News, Graphic News