Market versus Economic Values

When the NAMA Project was announced, Peter Bacon discussed the pricing process as follows on Morning Ireland:

Peter Bacon: It will be set by reference to the market. The market, as you know, has fallen dramatically. And I think people have overestimated the difficulties in estimating what these market values are.

John Murray: At the moment there is no market.

Peter Bacon: Well, there is a market.

John Murray: Nothing is selling.

Peter Bacon: For example, in the residential sector, you have monthly indices telling us how house prices have fallen by 1.4% to whatever level. We have information about yields on commercial properties moving out to 8%. I think a lot of people are saying “well, there’s no market” but really what they’re saying is “we don’t like the answer that’s there.”

At the time, I wrote that I was heartened by Bacon’s recommendations on this matter and, to his credit, Bacon has continued to put this argument forward.  See this piece from last week in the FT:

Mr Bacon would not be drawn on the mechanism for calculating the level of the writedown, which, he said, was “market sensitive, and sensitive to the dialogue that has to occur between the government and the individual banks”.

But he said it was wrong to suggest there was no market price, even though there were few transactions. “The peak-to-trough valuations in Dublin, Fermoy or Longford are not hugely different – somewhere in the range of 50 to 80 per cent. If you use 50 per cent and assume certain loan-to-value ratios, and that everything wasn’t done at the peak . . . you come back with a ballpark figure.”

However, when writing about Bacon’s Morning Ireland comments, I also said that I still wasn’t optimistic that this approach would actually be taken. And now, sure enough, today’s Irish Times reports that interim NAMA chief, Brendan McDonagh, has been talking about the need to follow EU Guidelines for pricing of assets “in the absence of market value” according to “longer-term economic value”.

Here are these EU “guidelines”—they contain no concrete guidance whatsoever on pricing assets.  Instead, they contain vague recommendations like the following (from page 10):

As a first stage, assets should be valued on the basis of their current market value, whenever possible … As a second stage, the value attributed to impaired assets in the context of an asset relief program (the ‘transfer value’) will inevitably be above current market prices in order to achieve the relief effect. To ensure consistency in the assessment of the compatibility of aid, the Commission would consider a transfer value reflecting the underlying long-term economic value (the ‘real economic value’) of the assets, on the basis of underlying cash flows and broader time horizons, an acceptable benchmark.

Note the curious nature of these recommendations.  We should use market prices where we can.  But when we can’t find market prices, we need to pay something that will be above current market prices (how would we know?)

What are these “longer-term economic values”?  We just don’t know. We can rely on markets to provide us with prices that investors are willing to pay for assets and that’s all we can be sure of.  Sometimes one can argue that the prices are too high or too low by appealing to “fundamentals” but, trust me, very few financial economists have ever gotten rich based on their fundamentals-based hunches.

If the argument here is that the Irish government are confident that current market prices for development projects are below their “long-term economic value”, let me outline some reasons to be less confident:

  1. There are good reasons to expect that even after recovery, we will never return to the rates of growth seen prior to 2008.  The slides from my talk at last week’s TCD event provide evidence.
  2. Even if labour force participation and unemployment rates return to their 2007 levels, we will face higher tax rates than 2007 levels for very many years, thus reducing people’s abilities to pay rents and mortgages.
  3. There is an enormous excess supply of properties that will take years to work off. 
  4. Tighter financial regulation will rule out a return to the high LTV loans of recent years and funding of speculative property projects will be particularly closely monitored.
  5. A less competitive mortgage market will most likely mean higher interest rates on average.
  6. Property mania is probably gone for many years to come and future investors will probably look for higher average yields on commercial property investments.

In light of all this, can we really be sure that taking an over-market-value punt on a bunch of development properties is really going to pay off?  And what business of any government’s is it to be engaged in this kind of speculative activity with the taxpayer’s money?

14 thoughts on “Market versus Economic Values”

  1. The market value of an asset is the price anyone is willing to pay,its as simple as that.
    If there few buyers or none then the market is illiquid so any pricing mechanism which even accounts for the intrinsic costs such as the materials and the land value is still going to fail.

    So then ,whats the purpose of NAMA?

    Withdraw the blanket guarantee to the Banks Bondholders.
    Zombie FF politicians can look to obama for ideas .He has effectively ruled the bondholders in GM will get about 10 cents on the Dollar in its impending bankruptcy whilst the autoworkers will take a hit much less proportionate.

    Give the bank Bond holders here the option of an equity swap for their bonds or offer them 10 cents on the euro in a winding down of the banks.

    We have two welfare systems which are out of control due to the rampant corruption of FF…the welfare system for people and the corporate welfare system for developers and banks.
    Neither system is sustainable ,together they will accelerate the bankruptcy of ireland.

  2. Karl,

    That’s an excellent summary of the core problem.

    I’ve being working on a mechanism to achieve genuine price discovery in this area (rather than taking a crazy punt or setting up a “predictive market” which I believe would be as relevant/useful as a CDS market in US treasuries).

    It runs as follows:
    1) You buy the banks (all equity and LT liabilities) with all equity and liabilities being priced at a discount to book value but at (or in the case of senior debt, perhaps slightly above) market price
    2) The price is paid partly in cash (say 75% of consideration in cash to senior bondholders and 50% to sub-debt holders) using government bonds (20 to 25 billion max for AIB and BOI)
    3) This grows bank equity by the, substantial, difference between the book value of debt and the cash paid.
    4) Genuinely impaired loans (and not performing loans, as you pointed out yesterday) are dropped to subsidiary bad banks,
    5) You write down the assets in these bad banks brutally (60 to 70%) to achieve a lower quartile estimate of discounted cash flows.
    6) Government guarantees 50% of the cash flows of these subsidiary bad banks (being 50% of about 1/3 of face value)
    7) If the bondholders feel that you’re being too hard on them, you give them a right to use their cash to buy into future bad bank cash flows using the cash you gave them for their receivables on the banks.

    There are loads of legal and accounting bells and whistles but that’s the core economic argument.

    It would save the the taxpayer:
    1) North of 15 billion being the equity contributed by holders of debt (discount, mainly on sub debt but also on senior debt, + the portion of the purchase price converted to equity)
    2) Probably at least 5 to 10 billion more as the banks retain “skin in the game” (50% of bad bank cash flows, unless the bondholders decide to buy in).

    Any takers?


  3. @ Sean O

    “look to obama for ideas .He has effectively ruled the bondholders in GM will get about 10 cents on the Dollar in its impending bankruptcy whilst the autoworkers will take a hit much less proportionate.”

    Lets look at the numbers here. Obama is saying that senior bondholders, who have a contractural right to seize the assets of the failed GM, should see ALL of their $27 billion in debt reduced to just a 10% equity stake. Meanwhile, the autoworkers medical fund, which has $20.4 billion in obligations due to it, will see those obligations reduced to $10 billion, and get a 39% stake in the company in return. So the bondholders pay $27bio for 10%, and the autoworkers pay $10bio for 39%, and also get to keep the rest of their medical care obligations.

    In summary, with GM probably only potentially worth a few billion dollars even after this restructuring, the debt holders see 99% of their obligations wiped out, and the autoworkers see 46% of their obligations wiped out. How exactly is this fair, unless we are suddenly rewriting contract law such that workers rights are greater than investors rights? Now thats fine if you want to do that, but don’t expect any investors to follow you into this socialists’ paradise.

  4. It’s a realistic assumption that long-term growth in the coming decade will be below the past decade in most developed countries.

    Mohamed El-Erian, chief executive of the bond fund manager Pimco says that potential growth for the United States is no longer 3 percent, but is 2 percent or under.

    Bloomberg says the last time US gross domestic product grew at an annual rate of under 2 percent over a decade was the 1930s, when it expanded at an average 1.3 percent.

    Average US unemployment of over 8% (the broad unemployment rate in April was 15.8% in April including part-timers who couldn’t get full-time jobs) wouldn’t be good news for Ireland as many US firms would be reluctant to trigger political reaction by moving US jobs abroad.

    Germany had its boom in the early 1990’s, which is continuing to impact economic thinking. besides the ever-present ghost of Weimar inflation.

    New Irish houses bought in 1981, were selling about 7% below the nominal price in 1987. Average annual consumer inflation in the period was about 10%.

    It’s interesting that the Germans are looking at a 20-year time horizon for its bad bank.

  5. The government shouldn’t think that it can do what it likes here. It can’t just use this as a cover for massive illegal state aid of existing banks in contravention of the EC Treaty. This aid would make it very difficult for new entrants to the market. I understand that the Department of Finance is already under notice on the state aid issue.

  6. Antoin — take a look at the URL for the Commission Document — notice the “state_aid”. As long as the government can say with a straight face that they’re paying “long-run economic value”, then the EU won’t care.

  7. Eoin:

    In response;I totally agree with your post.What I was saying is that governments can do whatever they want and in obama’s case he gave the shaft to GM bondholders in favour of those who helped vote him into office(the United Auto workes union).

    What I wanted to illustrate is that FF are supposedly beholden to the Irish people (as per the Constitution) NOT to the banks bond holders and to contrast their actions with Obama’s to show there is more than one way.
    FF have effectively relegated the senior debt holders in the Irish State (i.e. Irish citizens) to a subordinate position, in fact a servile position.

  8. Karl, I’ve glanced at the EU guidelines on asset valuation and my first impression is that it relates to hapless German banks holding CDO risk and other exotic toxins.

    With respect to Ireland and “longer-term economic values”, which crony is qualified to determine it? It would rule out banks because they couldn’t even figure out short-term property values. Ditto estate agents and valuers (who do crude mark to market pricing). Developers? I’m not confident that the department of Finance could. Dr Bacon could for a fee, but I’m not convinced it would be accurate. Maybe, the fellows from the benchmarking body could have a stab at it or some of the more bullish attendees of this conference back in 2005:

    I have come across methods to determine base (/conservative) values. In some cases, conservative values have proven to be optimistic. None of these assume an increase from the current market price.

    Unfortunately, crony capitalism is the only area of the economy showing green shoots of recovery. 🙁

  9. I would ask the experts here how any “long term economic value” can be calculated without reference to “historical values over the long term”

    So lets say long term is 15 to 20 years… The 2002 to 2006/7 period when things were crazy is only 5 maybe 6 years….

    And to have any appearance of probity, the extremes at either end (boom or recession) should be omitted…

    One way to illustrate what a long term economic value is through an exercise like this, but it wont give those in charge the answer they want….

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