On today’s RTE Radio News at One, David Murphy made a point about NAMA that I’ve heard many times recently but that I’m having great difficulty understanding. Murphy explained that the government bonds issued to purchase loans for NAMA would imply a large interest bill and that the idea behind NAMA purchasing good property loans as well as bad was so that the good loans could help to pay the interest on the NAMA bonds.
Let me explain why I don’t understand this.
Let’s imagine a portfolio of property loans with a book value of €90 billion. If these loans perform, then they pay an interest rate of R%. Then some of the loans start to under-perform: Let’s assume for illustration that €30 billion of the loans are just fine, while the other €60 billion have problems.
Now let’s imagine NAMA buys all of these assets for €60 billion, with the €30 billion of good loans bought at original book value and the bad loans bought for half price. One can assume that the bad loans have been written down to a market value so that they can, ultimately, yield the same long-run return as the good loans. At the same time, one can also perhaps assume that, for some time, they probably will not deliver much in the way of income (unfinished or empty estates, hotels etc. are hard to get much income from.)
Now let’s suppose that the government buys these €60 billion in property assets (good and bad) by issuing debt at an interest rate of I%. The current “cash flow” problem for the scheme is that the government is paying interest of .01*I*60 while it is receiving interest of only .01*R*30 (the interest on the good loans.)
So indeed, only the good loans are helping to pay the interest burden. However, is this a good reason to purchase good loans for NAMA? If the government only purchased the bad loans, then it would only have to pay out €30 billion and at that point it would have an interest bill of .01*I*30 but not be receiving any income on its properties.
Is the government better off purchasing the bad loans? The difference in net flow income between the two cases is .01*(R-I)*30. In other words, issuing debt to purchase good loans increases the government’s revenues if the rate of interest on these loans is higher than the rate of interest on government debt.
But if this is the argument for purchasing the good loans, then why stop at loans to property developers? Why not purchase corporate bonds or equities or any other security with a higher risk-adjusted-return than Irish government debt? Purchasing the good loans essentially amounts to the government deliberately running a huge property hedge fund and there is little good reason to want our government to be doing this. (Of course, we have a track record here because the Pension Reserve fund was exactly a hedge fund of this sort—our officials decided that it was a good idea for Ireland Inc. to go long on equities and short on debt.)
Two other points on this.
First, the above discussion starts from the premise that covering the flow of interest payments on NAMA bonds is the key concern relating to NAMA. However, technically, the NAMA bonds don’t have to pay interest at all—they could be zero-coupon bonds that pay off at a long-time horizon. Even if they are not, the bonds will be long-term in nature and they key issue will be that NAMA can cover the principal on these bonds when it needs to be paid back. The purchase price for the bad loans remains the key issue.
Second, it is my understanding that when AMCs have been used to solve banking crises, they have specialised in only taking on underperforming loans. The rationale for a different approach here has not been well articulated. I suspect the rationale for transferring performing as well as non-performing loans may well be partially a bureaucratic one—the government may want NAMA to just take over the property lending departments of the participating banks in full, rather than engage in sifting through the portfolios in a careful manner—and I don’t think is a good argument.
A more disturbing rationale would be that many of the “good” assets are not so good at all but that there are vested interests who like to see parts of the portfolios transferred without a discount. Even if one dismisses such stuff as mere conspiracy theory, the optimistic results from the PWC stress tests may well stem from classing various loans as “performing” even though their long-term recovery prospects may not be so good.