Ireland defended its dramatic move to nationalise Anglo Irish Bank, as fears over its impact on an already wounded economy hiked the cost of protecting against a sovereign default to record highs.
Dublin abandoned plans to inject 1.5 billion euros into the commercial lender late on Thursday and opted instead to take it over amid fears it could collapse, triggering a state guarantee for around 80 billion euros ($106.2 billion) worth of deposits.
"The worse thing that can happen from Ireland's point of view is that a bank can fail. If a bank fails the damage to the country, the reputational damage to the country, in trashing deposits and refusing to honour obligations, would be enormous," Finance Minister Brian Lenihan told national radio on Friday.
But analysts warned exposing the taxpayer to Anglo's rising bad property loans would ramp up an already expanding debt pile.
The cost of protecting Ireland's debt against default hit record highs and spreads on credit default swaps for Germany, Spain and Austria also hit new peaks.
"At worst it's going to lead to fresh worries about how the Irish economy survives this crisis and how they can service their increasing debt burden," Deutsche Bank's Jim Reid said.
Ratings agencies have warned that Ireland's exposure to the banking sector's bad debts and a sharply contracting economy could affect its AAA credit rating.
Brian Lucey, an associate professor of finance at Dublin's Trinity College, said he expected national debt to double. "As time has gone on it has become abundantly clear that there are so many unexploded land mines in Anglo that the government had to throw something on it … Unfortunately they have thrown the Irish economy on to these exploding bombs."
IN THE DARK
Anglo Irish, a former poster boy for Ireland's "Celtic Tiger" economy, is one of the banks most exposed to the country's crumbling property sector. Anglo's shares were suspended but other banking stocks dropped.
Allied Irish Banks (AIB) was down 11 percent at 1.719 euros and Bank of Ireland was down 5.8 percent at 0.847 euros.
Anglo had shocked the financial industry in December when then-chairman Sean FitzPatrick said he had kept shareholders in the dark about 87 million euros of loans he had received from the bank, triggering a purge of senior management and prompting the early retirement of Ireland's chief financial regulator.
Lenihan said the top two lenders AIB and Bank of Ireland, which unlike Anglo Irish have significant retail operations, were well capitalised and would not need to be nationalised.
The government plans to inject 1 billion euros into both AIB and Bank of Ireland and will underwrite their plans to raise a further 1 billion euros each in capital.
Lenihan also said the government may examine the possibility of creating a "bad bank" to park toxic assets now held on lenders' balance sheets.
One Dublin-based analyst said Anglo Irish would be a perfect vehicle for such a plan, which has been mooted by the head of the Federal Reserve as a way of retooling the U.S. bank sector.
"When we have severe economic downturns a lot of losses for banks come from the commercial property side of things and Anglo, given that is its speciality, is actually probably a very good vehicle," said the analyst.
Anglo's non-performing loans represented 1.3 percent of its book at the end of the year and analysts fear that total will rise sharply, as Ireland faces its worst recession on record with the government predicting a 4 percent contraction in economic output this year.
Ireland was already forecasting a jump in its general government debt to GDP ratio to 53 percent this year from 41 percent last year and 25 percent in 2007, when cracks first started to appear in the domestic property market.
The Irish government tied the state to the fate of the banking sector last October when it agreed to guarantee all deposits of major Irish lenders and foreign banks with a significant Irish presence.
The amount covered, up to 485 billion euros, is more than twice the country's annual gross domestic product.
