OPINION:It has been pointed out, but largely ignored, that Nama is likely to make a profit, or at least break even, from the outset, writes PAT McARDLE
THE DEBATE about Nama was fuelled over the summer by a small number of university lecturers in economics, henceforth referred to in this article as the “academics”. They are a vocal minority who have achieved massive publicity but little impact, given that bank share prices have risen, whereas they would have fallen had the market believed their proposals to nationalise the banks would be implemented.
On the one hand, the academics warn (Opinion and Analysis, August 26th) that Nama may pay €60 billion for impaired bank loans whose market value is now €30 billion, ie a “subsidy” of €30 billion, equivalent to almost a year’s tax take. On the other hand, I calculate that Nama might pay €60 billion for debt with a book value of €50 billion, ie a “subsidy” of €10 billion. These figures are so far apart that only one set can be right.
The quotation marks are used because the Government will not pay anything to the banks. Instead, it will issue them with IOUs the banks can use to get funds from the European Central Bank. At one stroke, the banks will be relieved of €85 billion of largely distressed loans that cannot be used as collateral to borrow in the money markets or from the ECB, and will have been given the ability to obtain €60 billion in funds for fresh lending or other use.
Hopefully, we have now debunked the myth that taxes are being raised or spending cut used to bail out the banks. In fact, as the Minister has pointed out, but it has been largely ignored, Nama is likely to make a profit, or at least break even, from the outset.
This is because the income it will receive from the loans it takes over – about half of them are being serviced by borrowers – should outweigh the cost of the six-month Euribor interest rate – currently less than 1.5 per cent – that it will pay the banks on the IOUs. There are two main reasons for the huge difference between the two sets of figures. The principal one is the loan to value (LTV) ratio. Unlike mortgage lending, banks typically require some “skin in the game” when lending to developers and investors.
The National Treasury Management Agency, in effect Nama’s parent organisation, and the Department of Finance have been going through the books of the banks for more than nine months now and the results indicate that the average LTV for the six banks involved is 75 per cent, according to the Minister for Finance.
The academics dismiss this, assuming that the 25 per cent equity was borrowed from other banks. You either believe the Minister, who has access to the information, or the academics, who do not. One side is making a major error.
This, in turn, has huge implications for the peak-to-trough price calculations. I have taken the mid-point of the €80 billion to €90 billion range given in last April’s budget as the estimate of the loans to be transferred to Nama. A 75 per cent LTV ratio means that the value of the associated projects at origination was €115 billion.
Nama property adviser John Mulcahy told the Dáil that property prices had fallen 50 per cent and were, perhaps, close to trough. It is impossible to form a view on this without going through a major exercise to analyse the multiplicity of categories of property involved from land to partially completed, to finished but unoccupied properties etc, etc.
Location is also important and one-third of the loans are in respect of projects in about 20 foreign countries. The vast bulk of this is in the UK where some parts are already recovering, some is in the US, which has bottomed out, and more in Germany where price falls have been modest. Also, one-third of the portfolio is commercial loans which are income producing.
There is a tendency to focus on the Irish market exclusively and ignore the rest. In reality, Nama valuations will range from close to 100 per cent where the loan is performing and the asset is unimpaired (remember Nama will take on good as well as bad debt) to a minus figure where sites have to be cleared to restore them to agricultural use.
I have assumed a (generous) two-thirds peak to trough fall in Irish and a one-third fall in non-Irish property prices. This gives an average 55 per cent fall, which brings the initial book value down from €115 billion to €50 billion, ie the current market value is €50 billion.
The academics argue that the State should only pay the market value, while the Government proposes to pay a higher “long-term economic value”. However, the principle of the State paying in excess of (distressed) market value is well established and there are numerous international examples. Indeed, the term “long-term economic value” first appeared in the guidelines issued by the EU Commission last February. The EU involvement is critical, but has been completely ignored. Because anything paid in excess of market value is deemed a State aid, the commission insists on first approving the valuation methods proposed by the member states – it even has its own panel of valuation experts – and then examining the actual results. Moreover, the ECB, which recently approved the Irish scheme, will be keeping a watching brief as well. The notion that Ireland can give its banks more favourable treatment than elsewhere is fanciful.
I have assumed that the discount to book value that will be announced on September 16th will be 30 per cent, in line with recent media leaks. This implies that Nama will pay €60 billion for loans which have a book value of €85 billion.
The difference between the initial value of the projects funded, €115 billion, and the current market value of €50 billion is split 45:40:15 with the borrowers losing €30 billion equity, the banks taking a hit for €25 billion and the Government putting up €10 billion.
For Nama to get the €10 billion back and break even, property values have to recover by 20 per cent over the next decade, ie an average of 2 per cent per annum. Moreover, after a 20 per cent recovery, prices would still be 48 per cent below their peak, ie close to the 50 per cent that another (pessimistic) academic, Morgan Kelly, is reported to have favoured in court recently. Nama is still a risky enterprise, but nowhere near as risky as some would have you believe.
There are many other angles to Nama but we can touch on only a few. First, banks, not developers, are being bailed out. Banks are only being bailed out to save the economy, for the economy cannot function without a banking system as borrowers are gradually realising.
The cost of the bailout is likely to be less than is generally supposed, but the large discount envisaged above would seriously erode bank capital, necessitating further recapitalisation and the Government would eventually own a much larger percentage of the banks than current broker estimates.
It does not seem to be generally realised that Nama will have to pursue developers through the courts or a similar procedure to get their hands on the assets and collateral. This could see up to half of all developers being declared bankrupt.
Unlike the banks, Nama has no previous relationship with developers and no incentive other than to act in the best interests of the taxpayer and recover the maximum amount.
Political interference is ruled out on two counts; one, Nama will publish all ministerial directions in its annual report and, two, the EU will be keeping a close eye on things.
Even if Nama is successfully implemented, there is no guarantee that bank credit will be sufficient. The EU guidelines are quite hot on this and it is, after all, the objective of the whole exercise. Much will depend on what the banks do with the new funds available. Obviously, the Minister will be in a strong position to influence them, as he is likely to end up owning substantial amounts of bank equity.
There is a need for transparency and for some mechanism to ensure that credit is made available for worthwhile projects. This is the most significant remaining gap in the draft legislation. To-date, two additional safeguards have been proposed.
The first is that the Government will levy the banks at some stage in the future to recover any shortfall. Obviously, this cannot be enshrined in legislation, as it would scupper the whole scheme given that there would be no risk transfer from the banks and nobody would invest in them.
The second has been proposed by Prof Patrick Honohan, who was yesterday announced as the new governor of the Central Bank. He envisages a two-stage payment to the banks, with part being held back lest the initial estimates on valuation etc prove too optimistic. Either of these would appear to safeguard the taxpayers’ interest.
Nama is still the “least worst” solution to the banking crisis.
Pat McArdle was until recently chief economist at Ulster Bank.