OPINION: Funding is difficult and costly to attract because of concerns about loans on Irish banks' balance sheets
AMID THE furious debate about Nama, people appear to have lost sight of the fundamental problem with Ireland’s banking system. Banks are rationing credit to businesses and households because they do not have enough funding to lend in a normal way.
The simple fact is that every euro lent by a bank to a customer must be drawn from deposits or borrowed by the bank from somewhere else. In the case of Irish banks, somewhere else mostly means financial institutions abroad. Data from the Central Bank shows that the net foreign liabilities of the Irish banking system peaked at nearly 60 per cent of GDP in 2007, compared with the roughly 10 per cent of GDP figure that prevailed for more than a decade until 2004.
What happened is clear: bank lending expanded so rapidly that it outpaced domestic deposits, forcing banks to ramp up funding from international markets to meet demands for credit. The ongoing reforms of the financial regulatory system reflect the hard lessons learnt from this experience.
After US investment bank Lehman Brothers collapsed last September, cross-border flows of funds dried up as financial institutions stopped lending to each other. For a small open economy like Ireland with banks that rely heavily on financial institutions abroad for funding, the impact of the global credit crunch was devastating.
Thankfully, funding difficulties have eased some over the course of this year reflecting improvements in global conditions and growing confidence in the Government’s policies to manage the economic and banking crises. Nonetheless, funding remains difficult and costly to attract because of concerns about risky loans on the banks’ balance sheets. The potential losses that might arise from these loans are also creating concerns about whether the banks have enough capital to absorb these losses, if and when they occur.
The solution is obvious. As in other countries where risky assets are clogging the banking system and restricting the flow of credit, the State must intervene to remove the risky loans from the balance sheets of the banks. This is exactly what Nama does. It is hard to see how our economy can recover otherwise.
Relying on externally-owned banks to increase lending in Ireland could be a grave mistake, since most analysts expect reductions in lending by these banks over coming years as they bring loans more in line with deposits sourced here. For our economy to recover, we need clean Irish banks that are better able to attract funding and get on with lending to viable businesses and households.
I suspect the reason that the key issue of funding has been overlooked is that many people mistakenly believe that banks can generate a large amount of lending from a small amount of funding. In other words, people wrongly think that there exists some sort of automatic multiplier.
Nama will improve the banks’ funding position by forcing the banks to take losses on their most difficult classes of property loans now, rather than over time. This will leave the banks better able to raise funds for on-lending to the economy.
Providers of funds, such as foreign banks, pension funds, insurance companies and large corporations will have more confidence to lend to and deposit funds with Irish banks as a result of the Nama operation. Moreover, Nama will pay the banks for the loans using bonds issued by the Government. These bonds can be exchanged for cash on international markets and at the European Central Bank.
Importantly, this is not true of the loans themselves. In other words, Nama is a form of so-called “quantitative easing” for our economy, in which assets such as bonds can be turned into cash from the central bank.
A crucial question is how much Nama should pay for the loans. The Minister for Finance will provide to the Dáil on September 16th estimates of the price, but for the sake of illustration, let's work with the figures and assumptions set out by Cliff Taylor in the Sunday Business Posttwo weeks' ago.
The exercise assumes a book value of loans of €90 billion and a drop in property prices from the peak of the market of 50 per cent. Since information supplied by the banks indicates that borrowers typically provided about 25 per cent of the purchase price for the property and borrowed the other 75 per cent, €90 billion in loans would have purchased €120 billion worth of properties at the peak.
A 50 per cent fall in prices from the peak would value the underlying properties at €60 billion. This would represent a write-down of 33 per cent on the loans. Three points are worth noting about this exercise.
First, the estimated average loan-to-value ratio of 75 per cent will have to be verified by examining each loan individually, as required by EU Commission guidelines. The estimated figure is above the general practice in commercial lending of 70 per cent loan-to-value, possibly reflecting anecdotes about so-called “phantom equity” as well as banking practices such as rolling up interest on loans.
Second, the exercise understates the value of the properties since not all properties were bought at the peak of the market. The assumed fall in prices suggests that properties bought in, say 2001, are worth the same today as when they were purchased.
Third, many loans, especially to buy investment properties, might be worth more than their underlying properties since the borrower may be expected to pay off the loan, rather than default.
It is important to note that Nama is buying good loans as well as bad ones. Continuing with the illustration above, it should be clear that Nama will pay its own way in the sense that the interest received on performing loans will exceed the interest paid on the bonds used to buy the loans. Initial estimates suggest that half of the loans are paying interest at an average (variable) rate of 3.5 per cent. This would generate €1.6 billion in annual income for Nama. The €60 billion in bonds that Nama would issue in this illustration would require €0.9 billion in outlays at a (variable) interest rate of 1.5 per cent as indicated by the Minister for Finance. This means that Nama would generate a cash surplus of €700 million annually. Of course interest rates are expected to rise, but that will increase both Nama’s income and outlays.
By making prudent and realistic projections for future property prices, the proceeds on loan repayments and property sales can be expected to pay off the bonds in full. Of course nobody can foretell the future, so risk-sharing mechanisms and equity stakes in the banks can help to minimise the risks to taxpayers.
A rather surprising feature of the debate about Nama has been the heated reaction in some quarters to the concept of long-term economic value (LTEV) of assets. This basis for valuing assets was set in the EU Commission guidelines as far back as February.
As discussed in a new paper by Prof Philip Lane, head of the economics department at Trinity, the concept has solid economic underpinnings. Because Nama will dispose of properties over time, it is the path of prices over Nama’s lifetime that matters for some properties, not current values. Values for some properties might reasonably be expected to experience some uplift when the current extremely high cost of financing purchases of property eases.
Moreover, notwithstanding a temporary period of general deflation to restore competitiveness, prices for most things could reasonably be expected to be higher in 10-15 years’ time due to normal inflationary forces.
As recommended by the European Central Bank this week, any allowance for LTEV should not be unduly large. Nor, indeed, can it be unduly large as this would violate EU Commission rules on state aid.
The ECB also warned against blanket nationalisation of the major banks. Some commentators have argued that the write-down of the scale assumed in Taylor’s illustration would render the major banks insolvent. This is not the case. An example sometimes used is that a 33 per cent discount on €24 billion of loans sold to Nama would crystallise €8 billion in losses and wipe out AIB’s shareholder equity of €8 billion. But this analysis is flawed because it forgets that the banks have already set aside provisions for losses on these loans.
Full nationalisation would see the bank removed from the stock exchange. My own research with some of my former colleagues at the Federal Reserve points to the significant value of a stock market listing for the information it provides to investors.
Presumably this information is also valuable to the providers of funds to banks listed on stock markets, and eliminating it could prove damaging.
Alan Ahearne is an economic adviser to Minister for Finance Brian Lenihan