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.