Getting the asset purchase scheme right

As we wait for today’s budget announcements, it is worth reflecting on the challenges of getting the right design and pricing for the asset purchase scheme now being trailed.

Some bloggers have made up their minds that the government will overpay for the assets. How can such an outcome be avoided? I have a slightly novel suggestion for this.

As in the United States, there will be a huge gap between what the banks claim the assets are worth and the value that the rest of the market would place on them.

Finding a mechanism that places a generally accepted price on the assets is as difficult here as it is in the US. Any asset purchase scheme will require a further detailed scrutiny and evaluation of the assets to be purchased.

It is to be hoped that the initial announcement of an asset purchase scheme will not lock the government into prematurely firm commitments on pricing and financial restructuring of the banks. The worst possible thing would be to crystallize the taxpayers’ costs at too high a level.

Buying the assets at inflated prices would surely be politically unacceptable. Indeed, Government sources have clearly trailed that they will not pay current book value for the assets.

Each country’s situation is slightly different. If we were to subtract now the present value of all prospective loan losses (taking recent analysts’ estimates), the main Irish banks would be severely undercapitalized. Removing the problem loans at anything close to the prices implied in the analysts’ estimates will require the banks to take immediate write-downs that have the same effect.

Therefore implementation of the asset purchase scheme at realistic asset prices will create the need for a further recapitalization of the banks.

Injection of more preference shares by the Government will not do the trick. If the banks are to move forward in a sound manner, and be accepted as financially self-sufficent, they must have sufficient equity capital. In quieter times there would be enthusiastic private sector buyers for equity in such cleaned-up banks. Failing that, the residual equity investor is likely to be the government. When you do the sums using the analysts’ estimated, this has to imply huge dilution of the existing shareholders. No wonder many commentators have concluded that full, albeit temporary, government ownership is on the cards.

Given this background, it might be better to do something just a little more complicated: let the asset management company pay even less than fair price for the bad loans, and in return give the existing shareholders of the banks an equity stake in the AMC. This has the advantage of making sure that the surviving bank really is clean, and neatly defuses shareholder objections that they are being expropriated. Of course they are even less likely to own much or any of the surviving bank, unless they choose to contribute to its recapitalization. Other existing risk capital providers, such as the holders of unguaranteed subordinated debt, could also be compensated for write-down by acquiring a stake in the AMC.

Let’s hope this week’s statements do not shut off possibilities such as this which can protect the taxpayer without destabilizing market confidence by allowing well-adapted financial contracts to bridge the gap between taxpayer and shareholder.

Although my idea may seem novel, specialists will recognize it as only an adaptation into our current circumstances of the most conventional form of bank resolution mechanism. It can work.

28 thoughts on “Getting the asset purchase scheme right”

  1. How will we ever know what happens.
    We will never find out what assets were purchased from the banks, the price paid for the assets or how aggressive the new asset management company chases the debtors.

    Unless there is major private investment in the new vehicle it or our rules on confidentially are substantially altered I cannot see how this will be anything other than a black hole for taxpayers money and a support fund to developers.

  2. While I would like to disagree with the majority that predict the government overpaying for the assets, it’s just so so hard to imagine them getting it right. It’s not like they have a track record in handling the acquisition or disposal of state assets very well. I’d like to be optimistic, but I just can’t find it in me to really hope for a happy ending.

  3. This theoretically sound and eminently sensible and implementable approach is certainly worthy of consideration; and it might gain traction – but in more normal times. And these are not normal times. The allocation of losses is not so much between shareholders/bondholders and taxpayers, but between the former and all citizens and residents who will see every Euro allocated to the banks as a Euro less in current and future public services or a Euro more in current and future taxation.

    Most people seem to have an instinctive understanding that limited liability means what it says on the tin: you can’t lose more than you have invested, but you can lose all you have invested. There is genuine public anger that the inevitable collapse of the property bubble fuelled by the banks and by wrong-headed fiscal policies has left Ireland brutally exposed to an unprecedented international downturn. And many people are angry at themselves for allowing themselves to be sucked into this folly. The tardiness of the banks to “fess up” to the extent of the debacle and their attempts to save their skins has increased public anger.

    Irrespective of the merits of various proposals that may be advanced, the room for political manoeuvre continues to shrink. The die seems to have been cast in favour of some sort of AMC within the NTMA and we will have to await the details.

  4. Patrick, interesting idea. But it is not obvious to me how it solves the problem of a lack of equity capital in the original bank.

  5. @Patrick: Fully agree, the next step is governance of the AMC. This is a much tougher area than NTMA has ever been involved in, not least because of the high profile of most of the largest problem debtors. Major private investment would be great (though again the price will matter!) Transparency also crucial — this should be worked into the leguslation that will no doubt become essential.

    @Toyman: Trying to find the best way our of this mess does not presuppose optimism.

    @John: No it doesn’t in itself solve the problem of no equity in the bank. But it does make it easier for the government to dilute existing risk capital providers, which seems to be a major sticking point.

  6. As I have said before on this site (working in the sector) the toxic bank idea will not succeed. I am not saying this with any political or ideological bias (unlike some others in the media). It is simply a matter of practical considerations (some of which you have mentioned):

    Any transaction between companies (whether connected or othwise) must be arms-length therefore assets must not be seen to be transferred at an undervalue or overvalue in this case AND as you say this type of transaction if it is to pass this test would completely wipe out ALL of the regulatory and economic capital of the banks.

    This proposed AMC will be attempting to draw a line under the banks bad assets which are perceived to be mainly property development related loans. WELL the problem NOW is that there has been a serious spread of credit problems in this first quarter accross all asset classes (mortgage arrears, credit cards, investment loans etc.) SO the plan will fail in this regard as we will then need another AMC – or Toxic Bank part II, III and so on.

    I seem to hold the contrarion view which is to say that I would leave the assets where they are (with the banks left with the responsibility to sort out their own loans) however I would ring-fence the worst loans in some way through e.g. limited state insurance. AND whatever solution is used we must NOT be shy about burning sub-debt and equity AFTER ALL that is what it is there for. No?

    The last point I would make (although I could go on) is that when other international banks speak about their own plans for toxic banks we must remember that the exposures destined for their toxic banks are different to ours e.g. much of Barclays and RBS’s toxic loans are what they call ‘money good’ but have huge negative mark to market. In simple terms the assets in most cases are not expect to lose money or incur bad debts, but they are long term loans/bonds which have interest rates/margins which are significantly below where rates are today – but full recovery is still expected.

    In Ireland as Lenihan has said we have the old fashioned problem i.e. bad property loans which will certainly incur massive bad debts (if not total wipe out) and which will be exacerbated by todays budget and the expectation of unworkable property/land taxes later this year.

  7. valuing the assets: i don’t see the problem with discounted cashflows? It works in other assets, look at the current cashflow, the impairment expectation and then factor in the increased probabilities in future years and revise the values back.

  8. That’s fine but the discount translates into a capital cost for the vendor i.e. the participating banks. This cost will effectively cyrstalise an up front expected loss – which is good in one sense, but their existing regulatory capital would be wiped out as a result.

  9. An alternate way of getting, I think, close to the same place would be for AMC to buy the assets at the lowest possible “fair” price but for there to be an upside sharing arrangement in place between the relevant bank and the AMC. Keeping it very simple

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  10. An alternate way of getting – I think – to close to the same place is for AMC to buy the assets at the lowest possible fair price (as it appears to be today) and for there to be a risk/reward sharing arrangement in place with the relevant banks under which the latter share in the upside (and possibly also the downside – but that would seem to run counter to the loan being transferred to AMC in the first place). At its simplest level:

    1 Long term value of the loans cannot be determined today.
    2 Erring on the side of overpaying today benefits only the banks. Erring on the side of underpaying benefits everybody else.
    3 But the banks should have the facility to recover some of the heavy losses to which they will be signing up at the outset in the event that these have been too “heavily” appraised.

  11. I know you are correct that it does work much better on trading book assets (or available for sale books) where the exposures are properly or supposedly ‘marked’ which allows assets such as fixed income/bonds and credit linked notes etc. to be transferred in this way. But these development loans are held on a ‘hold to maturity’ books and are also huge in scale, so even if they could persuade the accountants that a small discount is acceptable the up front cost would still be too great given the existing reg. capital base not to mention – as I said above – the banks will need even more capital to counter the other credit problems beginning to emerge accross other lending sectors.

    This exact debate is taking place in NY, London and Frankfurt etc. and all are encountering similar problems. It may be that unless us Irish have unique confidence in being the first to pull this off (which BTW I dont have or should have) it may be better to wait and see what emerges elsewhere, because there will be no turning back once we hit the go button on this thing.

    AND finally I will say it again whatever formula is used, the subordinated debt holders and shareholders have to be first to take the pain not taxpayers. I say this because it is logical and it is necessary for public support.

  12. We don’t have to spend any time worrying about the price to pay for the bad assets. We simply shouldn’t buy those at any price. All that we care about is that we get some sort of functioning boring retail banks as a result.

    Given all the other pressures on the state, isn’t it time to consider simply letting the banks go bankrupt? That would wipe out the investors, leaving a moderately healthy bank that’s owned by the creditors. The only downside is that we don’t know what the new owners are likely to do. And also the guarantee should be limited to the bare minimum to protect Joe and Josephine Soap’s deposit. Nothing should be ruled out, evening backtracking on some of the guarantees, given the seriousness of the hole we’ve dug ourselves into.

    So, we don’t care who or what goes bankrupt, but we do want to ensure that any banks are run as a going concern in the interests of the wider economy. A question for you all: Could the Government allow the banks to go bankrupt and then assume full control of the remains? The new owners could continue to collect any income and to ‘own’ the bank, but the bank would be run under new state management. Any creditors that objected would be allowed to face a full bank run and find their new asset is worthless. They only way they’d ever see a cent of return is allow the state to run all the banks.

    In the face of a bank run, who’ll blink first? The bondholders or the government? Given how much pressure the state is under, I think Lenihan can credibly force the bondholders to assign their controlling interests to the state now.

  13. Don’t think its particularly novel (unconventional) – its sensible overall
    The debate about the price paid is, I totally agree, the critical issue
    Only one price-setter with the Government acquiring. In the old days, we would have relied on the market toset it right – given the vairous parties who would be affected (bond-holders, shreholder, etc) but Mr Market has let us down
    Not sure about doing below (at lower end of ) market price with equity particpation – unfortunately that would trigger greater capital needs for the banks

    One point of difference is that significant majority shareholdings are not the same as full ownership (ref UK). Its remarkablely difficlult to dilute away the remaining few percent held by sharheolders ! – although someone should check takeover rules obligaitons – may need a waiver from shareholders

  14. The asset purchase scheme is now announced.

    The wording of the FAQ leaves something to be desired in terms of precision, and assurance that taxpayer will be protected. Price of purchased assets by the AMC — to be called “NAMA” — is to be “appropriate”; any eventual shortfall in the recoveries made by NAMA will be offset by “levies” (on whom?).

    Defining the NTMA as manager of NAMA is one point of precision, but this could close off eventual sale to private sector managers.

    All of these points deserve careful consideration.

  15. There has been an enormous amount of energy expended on getting the “fair allocation” of losses between the bank shareholders and the taxpayer. It is certainly worth discussing, but there are other issues. I wonder if we should not be as much or more worried about the allocation of losses between property developers and the taxpayer. The FAQ Patrick cited has a very short and unconvincing statement on this problem. Unlike the remaining two banks, property developers have been for many years extremely close to the dominant party in the coalition, and substantially financed their election campaigns over recent decades. If there is a politically generated problem with loss allocation it will be in favour of the developers rather than the two remaining banks, I suspect.

  16. The idea proposed makes sense. Consider the existing bank shares and being composed of two parts. The first part composes fractional ownership in the institution in stable form. The second part of the bank share composes fractional ownership in the toxic debt. These two parts are joined at present. The proposal amounts to a partial spin-off of the bad debt. Could WI shares be issued and traded in the AMC?

    Three key points aside:

    First: the banks need to raise more capital if these assets were priced at the current level. This gets into the mark to market versus mark to model argument again. The fulcrum of this argument stems on liquidity in times of trouble for the bank. While marking to model may work, what happens when the model fundamentally changes? I would love to see a realistic model of global economic activity (or Irish economic activity for that matter) which allows for a significant recovery beyond the ones seeing a US recovery in late 2009 (which litter Wall Street right now) followed by the usual cascade.

    Second: given that the banks still need to raise capital, how much will the removal of pending losses assist the banks in raising capital from private sources? Private capital is the ideal solution. There are people with cash. Unfortunately, many with cash have already been burned by injecting before all the losses were tallied. If one could inject capital in the bank and receive what amounts to a call option on the bad loans as well, then one may have a compelling argument to take to the private market for investment.

    Third: Looking at some of the analysis of Meredith Whitney, the banking sector in the US still has some losses to tally. In extrapolating that analysis to Ireland, one would find some sympathetic reasons for such to be the case here. Private investors (e.g. Warren Buffet among others) are becoming more sceptical that the loss models are not correct. If there is a more pronounced economic contraction, then what is the correct final capitalisation level for the banks (n.b. the tie between Irish economic activity and Irish loan performance)? Because of the dynamics with regards to the economy, few want to wade into the loss-infested waters now without a better grasp of the uncertainty bounds at both the loss and economic levels.

    All things considered, I believe Honohan’s idea allows a framework which could lead to significant private capital assuming the uncertainty bounds on economic activity and loan losses narrows.

  17. @Aaraon McDaid Spot on!

    Take it further: there are no guarantees that any bank will lend money and it would be foolish to force them into bad bargains, making more toxic debt. There are no assets here. It is debt!

    Bankruptcy and liquidation (and removal of a banking licence!) are excellent stimuli and whatever banks lent craftily, should be rewarded with a greater market share. Instead the lunatics who corruptly lent to cronies of government will get more capital from, why yes, you and me, in order to make yet more loans directly competing with the toxic debt! It will drive the toxic debt even lower! Does no one care?

    We are hampering the bank system by allowing the management team to stay in business. Do we need all these bank offices? In a liquidation we would have a slimmer bank, bought a true market prices. But would they get a licence? This is where corrupt control comes in.

    Even if we get along with one or two domestically owned banks they can buy up more assets that suit their enterprize. The survivors get to make more profit for the rest of us. We do not need government to decide anything at all.

  18. Another question: How much business is going to exist for banks for the next decade? This massive public subsidy to non voters may be completely misplaced if we have room only for better capitalized foreign owned banks. Instead of keeping public capital for one profitable domestically quoted bank, we will have squandered it on trying to keep them all going.

    The only ones left standing are those who used their knowledge of what was coming and has arrived. So much for a three or four pillar banking solution. We can lose the lot! We must be more careful and that has to start right now!

    Anodyne pats on the back for any scheme that throws public money at this situation is merely applauding present policy accelerated by Methadrine!

  19. @Gregory Connor: I totally agree! The markets must be trusted now above all times going. Or else we go from the pan to the fire. There is not much capital left to waste, and I note that the plan is short on how it will be financed. Given the lack of realism shown by the public service as a whole, it will be unlikely to be realized unless the valuation process is dragged on for years, surely the worst possible situation increasing uncertainty and paralyzing all banking activity due to capital uncertainty.

  20. @ JohnD15: Do you see that delay paralyzes the system?

    We need a solvent bank. We need it now!

  21. If we wish to waste more capital, then the price is simple: what amount will leave each participating bank liquid and in conformity with CB guidelines? We cannot allow it to be less than this as the bank will then need capital, crashing the share price and affecting the sector.
    What is the upper limit? Why that is simple also: how much capital can we accumulate on this exercise? How much? Well we don’t know because no one wants to lend to this; they want to lend to a productive investment instead….. the banks lent too much to developers. It is not practical and this lot of dopes will take months seeing it!

    Rescue whichever bank has least exposure? Why not. Some problems are simple as we run out of choices, limited as we are.
    Never forget Iceland.

  22. The real purpose of this proposal is to rescue the developers by keeping non-performing loans going and backed by assets which may be bought out if a miracle occurs. The issue of who holds them and at what price is blather!

    Until then no one can use the asset!! All at the expense of you and me…..

    More corruption, pure and simple. Sorry for the pun.

  23. @Pat Donnelly: Sorry but I dont agree. Your position assumes that in our need for haste to fix the problem our ‘great plan’ (now known as NAMA) has a better than sporting chance of success. It has no chance.

    The NAMA proposal is about thickest proposal presented by this goverment so far – and that is saying something given some of their other blunders. NAMA is bad news for everyone all stakeholders: the banks, developers, economy and tax payer – as currently presented. And it will not lead to ‘solvent’ banks (by this I presume you mean can get back to normal lending) as you rightly hope and wish for.

    In addition to negative feedback from the FT and NYT, more importantly having discussed the detail (so far) on this with a number of people in the sector (not senior execs but those on the ground) the clear feedback I have is that, NAMA has very little prospect of success and furthermore, far from mitigating the problem it is more than likely to aggravate the situation!

    Even if NAMA proceeds, and I hope it doesn’t for our sake as taxpayers, this will not change the lending policy of the banks – in fact if anything they will become even more nervous about lending/taking credit risks! They of course wont lend for property development anymore, so it begs the question if NAMA take over these loans who is ultimately going to buy them back?

    Anyway as I said before: I would leave the loans where they are (with the lenders who originated the stuff on the hook and allow their equity/sub debt absorb the pain – and if that is burnt through, then the govt takes a greater shareholding etc – sadly traditional bankruptcy is not an option for any of our banks unless we want Ireland to revert to the age of druids and stone huts):

    You could also quarantine some bad exposures with government insurance if necessary – with shares handed over in lieu; also encourage the banks to offload the risks in the market – over time – as the exposures are worked-out (this is how many other European banks are dealing with their ‘toxic’ loans)

    AND when and if an international ‘bad bank’ solution is developed for this problem then lets consider it as a template – but not beforehand as the risks are too great. I also simply dont have the confidence that this administration with its advisors Bacon et al can get it right. AND for me and many in the industry the NAMA proposals released so far are proof positive of my scepticism.

    BTW one the reasons I have previously said that this goverment should be changed, is that in my experience the only way we can only sort out poxy loans with developers et al is actually with the developers (this does not mean letting those who can meet contractual obligations off the hook necessarily) but the fact of life in international debt recovery is that in most cases the best prospects for loan recovery lie with the original borrower(s). This may be politically difficult to accept especially if done under the leadership of FF and their infamous ‘galway tent friends’. You can already hear the cries of cronyism and corruption!

    This will be a huge handicap in successfully working out these loans/maximising recovery with NAMA because the threatened full and immediate enforcement of security (as emphasised by recent media reports and comments from Lenihan), this will actually yield the worst result for the tax payer – this is absolutely guaranteed!! So perhaps it would be be more pallitable if a change of regime took place (hope springs) this may allow the process of working out/selling exposures to be more acceptable to the public. Far better to just scrap NAMA – please before its too late!

  24. @JohnD15

    I have to say I echo most of your concerns on NAMA. It it is talk of many in the local and international financial industry and all the feedback I have received has been negative – albeit in some cases linked to ideology.

    We should not be surprised by this negative reaction because what has been proposed is nothing more than shifting bad loans from one state controlled entity (de facto the irish banking system) to a new one, NAMA.

    Furthermore it is not really achieving the stated aim of ‘cleansing’ the banks because (a) if it all goes wrong NAMA hit them with a claw back levy and (b) the economic situation has deteriorated rapidly since (and is continuing) which will mean that new toxic loans of every description will quickly replace those taken off the banks. I also agree with you that the banks after having been rescued will be even more nervous about lending.

    So NAMA is nonsense as per the detail released to date.

    For example, how are Dr Bacon and his colleagues going to fix these stressed loans? Do they really believe the political rethoric that the “developers will be pursued to hell” and that this policy will be the best chance of maximising loan potential? Nice fantasy, but from a corporate recovery perspective, this is actually the best way to ensure you get nothing back and spend years trying.

    So does NAMA have the political stomach to be seen to ‘bail out’ developers?

    The reason I ask is that I agree with some of the contributors above that in any loan work-out scenario, in most cases write downs are rarely avoidable, other outcomes include debt for equity swaps and nearly always done working closely with the original developer/borrower – this is not an Irish phenomen it is universal and is frequently the best way to maximise recovery. I wonder will the media and the public see it that way though?

    If NAMA is not prepared to recognise this reality it would be better for the banks to sell the loans into the market now at their fire sale value (which obviously be less than prices currently being bandied around) and spare us, the tax payers, the expense and frustration of another useless government quango.

    What is ideally needed (in my view) is third party/private investment, otherwise we are just rearranging deck chairs. In other words some new money which can genuinely share the risk with the tax payer – this is missing as far as I can see at the moment. But at least two major obstacles need to be cleared first (1) the risk/reward will have to be sufficient to attract expensive foreign capital and (2) it will be difficult politically. You can almost visualise the media frenzy trying to see if there is any link between the new investment and Irish developers.

    Maybe JohnD is correct, it may not be the best or sexiest option, but it could be the least risky and easiest option i.e. we just WAIT and see how the US and others fix their systems. While we are waiting as you suggest just leave the loans with the offending banks and possibly ring fence them in a way that lossess can be minimised and the at least the banks will remain accountable. At least this will show the markets that we havent given up and so on….

    At the end of the day we are kidding ourselves if we believe that we don’t already own the banks or their risks at least.

  25. John I agree it will not work as NAMA will not be able to overcome the political pressure to try to work out the loans with the borrowers. I am not they fully understand this.

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