* International lenders hold key to Irish banking recovery
* ECB has rejected Ireland's preferred proposal to reschedule bank debt
* Solution for loss-making tracker mortgages put on back-burner
* Next stress tests to use less severe model for mortgage losses
By Laura Noonan and Padraic Halpin
LONDON/DUBLIN Jan 28 (Reuters) - Ireland's banking recovery could yet be derailed by its international creditors.
The European Central Bank's refusal so far to give Dublin any relief on the 30-billion euro cost of bailing out Anglo Irish Bank is a major setback for government ambitions to exit an EU-IMF bailout this year and give the euro zone its first post-crisis success story.
The failure to agree a deal on Anglo Irish also overshadows the country's banks.
Nearly all nationalised in the wake of a property crash and with their liabilities guaranteed by taxpayers, the fortunes of Ireland's lenders are tied to the state and they need Dublin to strike a deal with the ECB to ensure they too can make a return to full market funding.
"The country is crying out for progress on a deal," said Jeremy Masding, CEO of rescued mortgage lender permanent tsb. "That would give a huge boost to the country's confidence."
As reported by Reuters, the ECB rejected Ireland's preferred solution for restructuring the cost of propping up Anglo Irish because it amounted to "monetary financing" of the government.
Under the current arrangement, Dublin must pay 3.1 billion euros a year until 2023 to service a promissory note it issued to underwrite Anglo Irish. Finance Minister Michael Noonan had proposed converting the note into long-term government bonds that would be taken up by the Irish Central Bank.
Ireland's creditors at the EU, the ECB and the IMF have also shelved a parallel plan to rid the Irish banks of loss-making mortgages that track the ECB borrowing rate, three sources close to the talks have told Reuters.
A deal on these tracker loans, which was meant to be part of the overall deal on Anglo Irish, would have given a huge boost to the local banking sector. Tracker mortgages typically charge an interest rate of about 1.8 percent - below the 3-4 percent banks pay to fund themselves in the market.
The proposal to remove about 36 billion euros of such tracker loans from Allied Irish Banks (AIB) and permanent tsb and put them in to a separate vehicle has been abandoned, amid disagreement over how to value the mortgages and fund their removal.
"The technical paper is dead, and it's not coming back," said one source.
Neither AIB nor permanent tsb would say how much their tracker books were costing them. Goodbody's Stockbrokers in Dublin has estimated that AIB was losing about 400 million euros annually on its 17.7 billion euros portfolio of trackers. Permanent tsb has a 22.5 billion euros book of trackers, suggesting a higher annual cost.
Irish officials are scrambling to come up with a fresh proposal on the Anglo bill that will be palatable to the ECB.
But a deal on the tracker mortgages looks more remote, with officials aiming to resolve them as part of efforts to have Europe's permanent bailout fund, the ESM, take over its equity stakes in bailed-out banks.
The possibility of the ESM taking over Irish bank stakes looks slim, however, as European states start to back away from a June 2012 pledge to deal with bank legacy costs.
For permanent tsb, a return to profitability will only be possible once its tracker mortgages, which account for 68 percent of its overall lending book, are removed.
"Certainly until that happens we're looking at significant losses as a result of legacy lending issues for some years to come," said Masding, who took over as CEO last year after more than two decades with Britain's Barclays.
Just as Ireland is the posterboy for sovereign austerity, so its banks have started showing that there is life after crisis.
Bank of Ireland, 15 percent state-owned, has been leading the charge, issuing an 1 billion euro covered bond late last year, and then getting new investors to buy a 1 billion euro contingent convertible bond from the state in January.
The more challenged AIB, which is 99.8 percent state-owned, followed up with a 500 million euro covered bond sold this week that was more than four times oversubscribed.
Banks are also upping their lending targets with KBC Ireland planning to roll out a branch network in Ireland, despite having to cough up 400 million euro to cover losses for 2008 to 2012.
The latest data from the Central Bank on mortgage arrears shows that while one in nine are still more than three months in arrears, the pace of deterioration is abating with a 6.3 percent increase in the third quarter compared to a 7.1 percent rise in the second quarter.
And while property prices outside the capital are still falling, sellers of Dublin real estate and loans say the market, already down 60 percent since the boom, has improved.
One vendor said he turned down an offer of 24 million euros for a property in Dublin's financial district late last year and got an offer of 28 million five weeks later.
"People who waved goodbye to Ireland in 2010 are now getting back in, they're afraid they're missing it," he said.
But a failure to get a reduction on the cost of bailing out Anglo Irish, currently equivalent to nearly a fifth of Ireland's annual economic output, could sap momentum.
Irish voters, fed up at having to swallow higher taxes and spending cuts to help pay for the banks, had been assured of a deal and if none materialises, the government could struggle to survive long enough to push through further austerity this year.
"If it doesn't happen, the oxygen would be sucked out of some of the buoyancy," said John Reynolds, head of KBC Ireland and president of the Irish Banking Federation. "Doggedness and stamina do need periodic injections of oxygen."
Another potential problem looming for Irish banks is the next round of stress tests, set for this autumn.
With the domestic economy still shrinking and mortgage arrears much higher than anyone expected, the banks may require additional capital.
The central bank will consider an array of factors before deciding if the three active Irish banks, which have so far swallowed 28 billion euros in state cash, need more.
On the negative side, are the tracker mortgages, weak loan demand and a high cost of funding.
On the plus side, the banks have largely managed to sell off assets at better prices than those envisaged in the 2011 stress tests and Finance Minister Noonan has said he will start winding down the state guarantee of bank liabilities from March.
As fears of a banking Armageddon abate, the state guarantee has become an expensive add-on for Irish banks, costing them a total of 2.6 billion euros as of the middle of last year.
Crucially, this year's stress tests will also use a less severe model for mortgage losses, a central bank source said.
U.S. consultants Blackrock, which oversaw the 2011 stress tests, controversially assumed all borrowers in negative equity defaulted and repossessions ensued.
"We're looking at a different way of doing the modelling," said the source, adding that the central bank may focus more on unemployment as an indicator of likely losses.
There is a reluctance however to say the worst is over.
"When it comes to the broader economic environment, mortgage portfolios, other portfolios - none of us know how that's going to play out," said Nigel Greenwood, Standard & Poor's financial services director.
"This is a journey that started way back in 2008 and unfortunately it's a long journey."