Sept. 25 (Bloomberg) -- Ireland is providing a case study for what might have been if former U.S. Treasury Secretary Henry Paulson had gone ahead with a plan to buy banks’ hard-hit assets.

Irish taxpayers are guinea pigs in a government experiment to buy property loans from banks at prices higher than market values yet lower than the amounts banks carry them for on their books. Although markets are reacting favorably, there’s a good chance taxpayers will get stung.

If that happens, it will again show that governments need to confront head-on the troubles facing banks and economies, rather than hope time and taxpayer money will solve the problems. That’s especially important since some investors believe the Irish plan may provide a blueprint for banks across Europe.

So far, most nations have balked at making banks face up to their ailments directly. And they have been loathe to make creditors feel pain, wary of the mayhem that followed the collapse of Lehman Brothers Holdings Inc.

Ireland is no different. Banks such as Allied Irish Banks PLC and Bank of Ireland PLC are saddled with billions of euros of troubled real-estate loans. Rather than force bank shareholders or creditors to bear the brunt of these losses, the Irish government is trying the kind of switcheroo Paulson wanted to pull off.

Pricing Pickle

Recall that Paulson first proposed that the Troubled Assets Relief Program buy toxic assets from banks. The idea was that TARP would unclog balance sheets and revive lending. That’s also the stated purpose of the Irish plan.

Price proved to be the sticking point in the U.S. last fall. Pay too much for the assets and it’s a stealth recapitalization of banks, and their shareholders, using taxpayer money. Banks, on the other hand, didn’t want to sell at low prices for fear that resulting hits to profit and equity might wipe them out.

The issue was never fully resolved as the U.S. Congress needed two tries to pass the plan. Then Paulson did an about- face and decided to use the $700 billion in TARP funds to purchase equity in banks. Since then, the idea of the government buying assets from banks has fizzled.

Ireland is following the original TARP blueprint. Irish Finance Minister Brian Lenihan last week announced that a special agency would buy 77 billion euros ($113 billion) of assets from five lenders. In doing so, the government would pay about 70 percent of the assets’ carrying value, or about 54 billion euros.

No Good Options

While that seems like a big haircut, the price might be as much as 15 percent above the assets’ estimated market value of about 47 billion euros.

The Irish government has maintained that it has few other options. It believes that forcing losses upon bank creditors would hamper the government’s own ability to raise funds.

The government also sees the plan, which has yet to be approved by the Irish parliament, or Dail, as a back-door way to borrow money to absorb losses. After exchanging bank assets for government-backed bonds, banks can pledge the bonds to the European Central Bank in return for cash.

The catch is that taxpayers may be paying even more than a 15 percent premium for the assets -- and so taking on more risk -- if the current market values still have room to fall. The government doesn’t think that’s the case; it is counting on Irish property values rising 10 percent over the next decade, allowing the plan to break even.

Celtic Tiger Boom

That may prove tough. Ireland’s property market became wildly overvalued during the so-called Celtic Tiger boom of this decade. Home-price appreciation outpaced the rate of growth seen in the U.S. Overdevelopment was rampant, even in rural areas.

Today, the Tiger has been declawed. Ireland is undergoing the worst recession of any industrialized nation since the Great Depression, according to the Economic and Social Research Institute in Dublin. Unemployment is at 12 percent and rising, while emigration is on the upswing.

The real-estate industry prognosis is bleak. “There is still no evidence of a recovery in the housing market -- either in building activity or demand,” analysts at BNP Paribas wrote in a report earlier this week. “Residential property prices will likely fall for the foreseeable future.”

As Bloomberg News’s Dara Doyle reported last week, the office vacancy rate in Dublin is more than double that of other European capitals, while as many as 35,000 new homes may be vacant across the country. That has created what are being dubbed ghost villages consisting of newly built and still unoccupied homes.

Do Something

Keep in mind that if it weren’t for the fact that Ireland is part of the euro zone, the country now would likely be known as “the other Iceland.”

This backdrop makes it understandable that the Irish government felt it had to do something, anything to prop up the banking system. Still, there are alternatives short of nationalization.

Recapitalizations that make creditors and shareholders share in the pain, such as debt-for-equity swaps, should be an option. Ireland, like other countries, has to get over the notion that creditors are a sacred group who must be spared at all costs.

At the very least, the government shouldn’t ask taxpayers to wager so much on the hope that things will stop getting worse.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: September 24, 2009 21:00 EDT