NAMA and Pricing the Bad Property Loans

I have examined the government’s banking proposals and will have more to say later about their substance. However, before discussing the details, I’d like to focus on some figures that will help shed light on a question that I’ve already heard many times today—how much will our National Asset Management Agency (NAMA) pay for the bad assets of our major banks?

Banks are legally required to maintain equity capital (assets minus liabilities) of at least 8% of their risk-weighted assets (RWA). The RWA figure is arrived at by putting a weight between zero (which applies to most government bonds) and one (which applies, for instance, to commercial property loans) on a bank’s assets and then summing the risk-weighted loans.

As of December 2008, AIB had total assets of €182 billion and RWA of €116 billion. As of September 2008, BOI had total assets of €204 billion and RWA of €134 billion. These banks had Tier 1 equity capital of €9.9 billion and €10.1 respectively. (For those of you who don’t know what the Tier 1\Tier 2 thing means, don’t worry).

Putting these figures together, our two main banks had RWA of about €250 billion as of late last year and had Tier 1 capital of €20 billion, implying an average Tier 1 ratio of 8%. The Irish government has decided to invest €7 billion in these banks, which would bring their combined Tier 1 ratio to 10.8%.

However, these calculations value the banks’ huge property loan portfolios (about €80 billion in total property loans, about €40 billion of this in the form of development loans) at book value. Today’s FAQ on the government’s plan tells us that the NAMA will be purchasing impaired loans “at an appropriately written down value” and would replace these loans on the bank balance sheets with government bonds.

This has two offsetting effects on the capital ratios of the banks. Good news for the banks is that government bonds have a zero risk weight compared with a weight of one for risky property loans. This would shrink RWA from €250 billion to €170 billion and raise capital ratios to a heady 15.8%. Bad news is that when NAMA buys the bad assets for less than book value, this reduces equity capital.

So, with RWA of €170 billion and a €7 billion re-capitalisation in place, how much of a discount relative to book value could the government pay for these property loans, while still keeping the banks well-capitalised? If the goal is to keep the Tier 1 ratio at 8%, then the answer to this question is the X that solves (27 – X ) / 170 = .08. The answer (drum roll ….) is €13.4 billion.

The meaning of all this is as follows. The minimum price the government can pay for the bad property loans with a book value of €80 billion, while keeping the banks well-capitalised and keeping its equity stake at €7 billion, is about €67 billion. This would imply purchasing the assets for a discount relative to book value of €13 billion. Given that Goodbody stockbrokers (a wholly-owned subsidiary of AIB) estimate the combined loan losses of these banks in the coming years at €19 billion, paying this price would almost certainly be widely thought of as over-payment.

Even if the government went ahead and overpaid by purchasing the assets for a mere €13 billion discount, this would not necessarily produce a healthy banking system. This is for two reasons. Firstly, the banks may have to get to a Tier 1 ratio of greater than 8% if they are to survive without the aid of a government liability guarantee. As such, the banks may still look to further shrink their balance sheets, with restricted credit being a by-product. Secondly, the government’s €7 billion investment is in the form of preference shares with a high interest rate. This will limit the attractiveness of the banks for the private equity investors who we might hope would provide this additional equity capital investment.

Finally, what happens if the NAMA pays less than €67 billion? And what happens if it transpires that the taxpayer significantly overpaid for the assets? It’s all pretty unclear, but more on this later.

Update: A couple of our commenters have questioned who is included in the scheme and what the €80 billion figure here.  AIB and BOI do have €80 billion in property loans but the use of that figure in the calculations above is probably wrong.  Most likely, the €80 billion refers to all participating banks and the figure for the two main banks may be closer to €60 billion.  This would limit the reduction in RWA to €190 billion and limit the magic X figure to €11.4 billion.  Either way, these calculations give some indication of the very limited room for discounts from book value while restricting further recapitalisation and keeping the banks well capitalised.

19 thoughts on “NAMA and Pricing the Bad Property Loans”

  1. After yesterday’s successful rights issue, HSBC is at Tier 1 = 10. Many observers, including Karl’s former employer Alan Greenspan, are on the record that Tier 1 is heading North, maybe to 12 or 14. For extra marks, factor in (a) banks’ pension fund deficits (b) re-definitions (upwards) of risk weights in Basle III, coming soon to a ci-nama near you.

  2. How certain is government its €7bn preference share holding will continue to rank as core tier 1 ? If the discount price is lower at say €29bn then this implies (without knowing what the deflationary balance sheet shrinkage will be) that both banks will need fresh capital triggering full nationalisation even at 8% – more will be required if Tier 1 settles at over 12%.

  3. @Karl. Thanks for the figures.

    Lets look at it another way. Current market cap of the two main banks is approx €2bn (I’m allowing for tomorrows bounce).

    let’s say their share of the €80bn is €55bn. (Is Anglo included in this?)

    So to allow the NAMA pay a reasonable 40c in the €, and using Karls formula above, where X now = bank capital

    (X-33)/195 = 0.08 makes X=48.6. So the banks will have to raise an extra €21.6bn of equity.

    If the banks choose this route, then, at tomorrow’s prices the only way out seems to be nationalisation.

    Guess it all comes down to a political decision. Which is the least worst road, over pay for the assets, nationalise the banks or allow them to go bust.

  4. The key sentence in the budget speech on this is

    “If the crystallisation of losses at any institution requires additional capital the State will insist on participation by way of ordinary shares in the relevant institution.”

    This has to mean that the pricing decision for asset purchase will not be based on how much capital the banks need.

    Indeed, given what analysts are saying about the likely recoverable value of the loan portfolio, we should be speaking of this as an asset purchase plus equity injection plan.

  5. What is the point of insisting on these capital ratios in such an enormous downturn, in particular given the difficulty of “correctly” pricing the toxic loans?

    What is the point of insisting on these capital ratios for banks that have explicit and specific government guarantees?

    Holding a lot of capital will help a bank entering a downturn, but high capital requirements are lethal for banks that do not have such a cushion when we are in such a depression. The requirements make things worse so I’d like to know what benefit they bring right now?

  6. @Patrick
    You are correct : but the minimalist and glacially incrememtal approach of the government means that they will try to seperate the two issues. The incentive from their perspective is to overpay so as to NOT require immediate recapitalisation. They have an incredibly high marginal rate of time preference ; injections next month are zero in their mind, it seems.

    Its a bad plan.

  7. the chances of attracting external investors to a rights issue is much greater once the property loans are removed. BOI and AIB are still the strongest retail banking franchises in ROI and have a much lower exposure to more esoteric risks once these bad property loans are removed. also, charging a 200bps spread over EURIBOR for new mortgages at c. 80% LTVs against substantially reduced house prices means that its core tier 1 will be built up pretty quickly once they can get back to doing their day job.

    that said, i still think that outright nationalisation is the best route for the entire irish banking system.

  8. Karl, I see you have worked out a an appox cost for nama in purcahsing the impaired assets as above, but would nama be purchasing assets of other banks than AIB and BOI, like ultimate UK banks with subsideries here who gave out loan to on irish properties?, And has ANGLO’s debt been written off at this point or will the majority of the neg assets held there be transfered to NAMA?, although the concept of the toxic bank has been aroound for a while, should the government keep banks like anglo going along side NAMA, potentially perpetuating the issue.

  9. @Patrick Honohan: Well spotted and that means I should revise one of my earlier posts. But the net effect is the same.
    @David: Excellent point in that this increases the cost and likelihood that the plan will damage itself, by taking on toxic assets that will have the effect of damaging one another, like overkill of nuclear warheads, interfering with one another. Oh I overlooked the unattainable capital implied increase….or did I?

  10. @Brian Lucey: Yes! Yes! This is just designed to keep crony assets in play and owned by them. And time is the key, Gov is praying for a miracle, and will delay liquidation at immense cost to us all.
    Mogambo moment coming on…must retain objectivity..terminate…

  11. @Paul Power
    The real economists will be along to give you the real answer soon, but in the meantime: banking is all about confidence. As in con trick. Seriously.

    If you know a bank is insolvent, why give them an asset to destroy when you might need it for your pending redundancy? So, we tell all and sundry that we have confidence in the system…. and get them to give such assets telling them that we will guarantee it.

    To do so without ruining our own borrowing capacity we have to get the big swinging whatevers, that rate government loans, convinced that we won’t ever need to pay out on the guarantee. So we need stringent rules.

    But we can let our banks lend to one another and pretend that this is a deposit….We call it flexibility. It is not corruption. It is flexibility and weraing the green jersey.

    Banks are all lent out and economic activity is declining, so fewer loans will be made (although there may be refinancing, putting less profit into the banks) but we need all the banks we started with otherwise the ratings agencies will think we are careless….. and then the cat will be out of the bag…game over!

  12. @Enrique
    Agreed, but to nationalize is to take on loans. They should be repudiated where there are grounds and it really would be best to put all but one out of our misery. Nationalize that sanitize it, (ensuring that the secret off Balance Sheet shenanigans, I know I was a tax inspector,) are all regularized and then let it back out to the playground.
    But onl;y one. We can’t afford any more.

  13. I found the following sentence from the budget speech interesting:
    “The stream of income from the assets and the proceeds from the eventual sale of the underlying asset will accrue to NAMA. The State will incur a loss only if the assets transferred to the State cannot over the long term repay the investment made by the State in their purchase from the banks. However, if NAMA make a loss over the long term, the Government intends that a levy should be applied to recoup the shortfall.”

    Assuming that this levy will be on the banks, does this not answer a lot of our concerns?

  14. Sorry, not sure if its been mentioned here, but i would also assume the bad debt provisions would go against the crystalised capital losses on transfer to NAMA, and so would act as another buffer before capital ratios went below threshold levels? Also, the taking off the books of these loans would free up capital set against these risk weighted assets? Anyone any ideas of what bad debts provisions + RWA capital would amount to?

  15. NAMA is only good for the Banks!
    August 16, 2009
    NAMA is only good for the Banks and their shareholders!

    Minister for Finance Brian Lenihan has said“Nama” will pay a price for the loans which reflect the long-term economic value of the properties – in other words, the agency will pay the banks the market value plus a certain premium. This has to be unconstitutional
    http://www.machholz.wordpress.com

    surely we the people have the right to vote on any government measure that will enslave us as a nation for the remainder of my life and that of my children

    to put it another way Let’s say a sale of Mr. Liam Carroll’s nets €20 million, for a building on which there is a €100 million loan. How can Nama defend paying much more than €20 million for it?

    this is exactly what MR. Brian Cowen and Lenihan are trying to do and the Green Party are supporting this criminal attempt to bail out crooked bankers and unscrupulous developers

    In fact, the Greens’ position is not unlike the banks’, as it happens. Both know that they are facing enormous potential losses in terms of Dáil seats.

    In both cases, they have an interest in postponing an event that would crystallise those losses – in the banks’ case, liquidation and fire sale of the developers’ loans and their assets, and in the Greens’ case, a general election.

    The Greens in government believe that, distasteful as it may be, there is no alternative to saving the banking sector. They also understand that this may be the ruin of their party. The local and European elections were a pretty clear signpost in this regard.

    But the Greens also believe that, if they can avoid an immediate general election, give the Nama plan some time to work, give the several Green initiatives some time to bed in, and maybe even give the economy some time to recover, they may get some credit for doing what they believe to be the right thing.

    Supporting a measure that will enslave me for the rest of my life and that of my children will never be right

    We need a General election so that the people can decide themselves no other way will be acceptable!

  16. Let’s stop bitching about nama and accept that no matter what the powers to be might say about how they are going to protect the tax payers interests “THEY’RE NOT”. We have always allowed our selves to be led up the garden path for the let downs we richly deserve.

    Look at the doing away with rates on homes. Firstly we paid it as a 1% levy in vat and now we are paying it twice with the waste, water etc charges. (double payments)

    The health levy is another one that was supposed to be for a year or two? (double payments)

    Car tax is supposed to pay for the building, upkeep and maintenance of the roads?
    Instead it’s wasted on so many other things that are already paid for the TAX PAYER. (double payments)

    All we have to do is look to recent history to see how we were screwed before.
    For e.g.: in the 80’s when the TAX PAYER saved Road Stone! How did they pay us back? By Road Stone been given a lucrative contract that allowed them to TAX us for the use of a bridge that we the TAX PAYER had paid for in spades by contributing to their survival when they going to the wall.

    The Irish Life Insurance Company like wise was bailed out by the TAX PAYER and once again the payback was increased premiums.

    Why should things be different now? We’re screwed again and there is nothing that we can do about it. As with everything in the past we complain about it over a pint and come up with great ideas to sort it all out that will blur with the haze of the hangover the next morning. Exactly in the same way we have rallied around every cause, 2 what can I do about it?
    “IT’S JUST THE WAY THINGS ARE”
    Well guess what it’ll always be “JUST THE WAY THINGS ARE” because we as a nation are too damn lazy to get up off our arses.
    Some day some one will sort it all out and “WE’LL ALL LIVE HAPPILY AFTER”
    We’re a joke and once again we don’t see ourselves as the laughing stock of Europe.

    I say forget about nama bitching and nationalising the banks. Lets nationalise the government instead and then maybe we’ll get the country on the road to recovery that won’t cost not just us, our children and our grand children dearly. (OH I FORGOT THE GOVERNMENT IS ALREADY NATIONALISED. SURE DOESN’T EVERY DEPARTMENT HAVE ITS OWN DICTATOR?)

  17. Both the IMF and the EU are well aware of the under pricing pitfalls.

    I’m not an expert but I attempt to blog here about it 🙂
    http://colmbrazel.wordpress.com/2009/08/27/another-fine-mess/

    Can I draw your attention to Annex 4 of http://ec.europa.eu/competition/state_aid/legislation/impaired_assets.pdf

    Proposed legislation for NAMA flies in the face of nationalization safeguards recommended by IMF and the detailed safety clawback, risk sharing safety methods supported by the EU mentioned in above doc.

    Ahearne ignores just about every good authority there is out there on helping to solve the mess.

    rgds

    Colm

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