More Bad Signs on NAMA

Speaking on RTE’s The Week in Politics (about 16.20 minutes in) Minister for Health, Mary Harney noted repeatedly that NAMA would take on good loans as well as bad loans and then said the following:

This is an important issue. From the good loans they will get cash to run on a break even basis on a day-to-day basis. The ESRI has done a simulation study and they have suggested that over ten to fifteen years this will break even as far as the taxpayer is concerned and that’s the reason as well to take the good loans to raise the cash.

Two aspects of this statement are worrying—the discussion of good loans and the comments about breaking even.

The Good Loan Confusion

As I have written before, the “buying good loans to pay for the costs” statement, despite its regular repetition in the media, simply makes no sense.

It appears that the NAMA purchases will be financed with marketable interest-bearing bonds. Adding good loans to NAMA will increase the interest bill from these borrowings. If these good loans yield a higher level of income than the interest rate on government debt, then this strategy could be profitable in a risky, hedge-fund-like way, though it’s unclear why a government would engage in this kind of activity.

However, it is simply fanciful to imagine that the good loans would generate so much income that they can cover the interest cost associated with the funds borrowed to pay for them as well as the interest costs associated with purchasing loans backed by properties that are currently not generating any income. This is the intellectual equivalent of saying that you are taking out two mortgages for new homes and renting out one of them to raise the cash to pay for the cost of both mortgages. It would be a nice trick if you could manage it, but you can’t.

Breaking Even?

More worrying is Minister Harney’s characterisation of NAMA as likely to break even. To the best of my knowledge, the ESRI has not done a “simulation study” on NAMA.

I believe it is most likely that the Minister is referring here to a recent comment made by the ESRI’s David Duffy to the Sunday Tribune that those who bought houses at the peak of the boom in 2007 may have to wait until 2030 before they value of their homes return to what they paid for them (note that this does not mean that the home-owners will be in negative equity until 2030 as the headline implies, since they will be paying off principal.) I have been in touch with David and he told me that he based his comments on the perfectly reasonable assumption that house prices will grow in the 2%-3% per year range after hitting bottom.

My point here is not be harsh on Minister Harney regarding her understanding of what the ESRI did or didn’t say about NAMA or house prices—there are lots of reports published every week and it’s easy to get things mixed up on live TV. Still, let’s just accept that the Minister believes that the nominal value of the assets purchased by NAMA will return to the value paid for them by 2030.

Without doubt, if this came to pass, then some future government could characterise NAMA as having broken even, implying that it didn’t cost the taxpayer a cent. However, by any reasonable reckoning, this would be a gross mischaracterisation of the cost to the taxpayer.

The funds to purchase the NAMA assets will be borrowed, perhaps at an interest rate of about 5% per annum. This would mean that, over 20 years, the state would have to pay out €3 billion for year in interest on the €60 billion in NAMA bonds. The final return of €60 billion from sales of NAMA assets will cover the principal on the bonds, still leaving the taxpayer €60 billion worse off because of the interest payments. (And, of course, the interest rate that the government will have to borrow at in the coming years may be raised by the risk the government is taking on with the NAMA project.)

The substantial interest bill means that to fully cover the costs incurred by the taxpayer, the assets purchased by NAMA will need to significantly increase in value in the coming years.  This can only be achieved by purchasing them at a steep discount relative to their peak valuations.  Any suggestion, whether explicit or (as in this case) implicit, that the government can purchase assets for NAMA based on near-peak property prices without inflicting costs on the taxpayer, is simply wrong.

If Minister Harney’s comments are an indication of the thinking about NAMA from senior government ministers (and it’s hard to interpret them any other way), then things are every bit as bad as the most pessimistic among us have warned.

Update: Thanks to the ESRI’s John Fitz Gerald (and Michael Crowley — see comments below) for pointing out the more likely source of Minister Harney’s comment on breaking even.  In its recent Recovery Scenarios document the ESRI included a scenario in which NAMA purchased $80 billion in book value loans for €50 billion and ended up breaking even, after controlling for interest costs.  The document makes clear, however, that this scenario “is used strictly for the purposes of illustration.”  So, it is not accurate to say that the ESRI “have suggested” that NAMA is going to break even.  The key point, however, is that recovering the nominal value of the initial outlay should not be the appropriate metric for assessing the cost of NAMA to the taxpayer.

25 replies on “More Bad Signs on NAMA”

Below please see the text of the Sunday Times article by Constantin Gurdgiv and myself on the costs of NAMA. If anyone is interested in the spreadsheet underlying these estimates, email me please. Bottom line : it cant break even.

NAMA refuses to die. Despite not a single independent commentator approving of it, despite the man in charge (Michael Somers of the NTMA) apparently not having been told the details, despite mounting evidence that NAMA contains internal contradictions, despite all.NAMA rolls on.
In this regard it can be considered a zombie organization, dead but refusing to admit it, like the banks with whom it is is designed to interact. Perhaps more appropriate a demon would be a vampire: like a vampire NAMA will batten on the lifeblood of the irish taxpayer for decades, and like a vampire can appear as fair as required to induce the unwary. As we all know however, apart from garlic and crucifixes, what vampires hate most, what is certain death, is sunlight. Let’s let some into the crypt….
To calculate the costs of a venture such as NAMA we require estimates of cost and income. In cases such as these where the costs and benefits extend over many years we need to discount the value of these costs and benefits at some appropriate rate. In the calculations below we assume 3%, a longterm average for most governments. We take 15 years as an estimate of the life of NAMA. In the case of NAMA the main costs are threefold: the cost of borrowing the billions to take the toxic assets off the banks, the amount of said billions that would be required, and the cost of running NAMA during its lifetime. The income to NAMA is the yield which can be achieved on the toxic assets.
Using, one assumes, a similar set of imputs, Davy stockbrokers suggested that NAMA could perhaps be made to yield a profit, of some 6 billion. It is our contention that this is a significant overestimate and that the true cost of NAMA is much more probably going to be in the order of losses of tens of billions to the taxpayer. Lets look at the issues involved.
• How much of a haircut?

A key question for NAMA is the price that will be paid to the banks for the 90b loans to be transferred. In many respects this is the key question, and unfortunately is almost unanswerable. Discussions have suggested “haircuts” of between 15 and 30%, that is to say that the state would pay between 76.5b and 63b to the banks for these assets. This would of course mean that the banks would be left nursing losses of the difference between these figures and 90b, some 13.5b to 27b. Of course, the key issue here is the extent to which the assets, commercial and land related lending, have deteriorated. Figures upwards of 40% declines have been recorded. Our baseline scenario is that the NAMA assets will be sold to at a 20% discount
• What money will be needed to recapitalise?

The amount paid for the loans is intimately tied up with the amount that will be required to be reinjected into the banks. As losses are realised these are offset against capital, so the delicate balance for the government is between overpaying for the assets (say a haircut of 15%) and thus giving taxpayers money to the banks versus a too severe haircut (say 60% for illustration) and causing them to require massive recapitalisation. Irish banks total capital stands at approx 35b. As banks are required by law to have certain ratios of capital to loans there is little room for them to absorb losses above 20b, and we assume that 1/3 of the difference between the amount paid and 90b will be reinjected back as capital. Our baseline scenario above of a 20% discount would leave the banks facing a loss of 18b, and 6b would be required to be injected back as capital.
• How much trash in the barrel

Even when the 90b assets are taken over from the banks and paid for , say 72b, this will not be totally recoverable. Some portion of the assets will be simply worthless. At present the banks are taking between 3 and 5% of assets as bad debts, which is low given the experience of OECD Property crashes over the last number of years. Our baseline scenario is that 10% of the assets transferred will be worthless.
• How much yield from the barrel

Given that the NAMA asset pile will contain the good (performing assets), the bad (impaired assets) and the ugly (worthless assets), a key question is what yield can realistically be expected from these assets. Over the longterm the average income yield from real estate in Ireland (source : IPD) is of the order of 5-6%. If we assume that 2/3 of the assets yield this and the rest nothing we get an average yield of 4% on the basket of NAMA assets for our baseline scenario

• How much can we borrow at?

A major input into any analysis of a bond financed asset purchase scheme is the cost of funding. It is proposed (although like much about NAMA the details are unclear and we will have to wait for someone somewhere to tell us and then Dr Somers can read it in the newspaper). Earlier this week 1b of ten year bonds was issued at 5.2%. After a significant widening out earlier this year spreads against the bund have closed somewhat. Nonetheless it is inconceivable that tens of billions of sovereign backed paper will be issuable at no strain on the spread. Our baseline scenario is that for the first 5 years NAMA bonds will be at a coupon of 7%, thereafter at 6% and thereafter at 5%, an average of 6% over the 15 years.

• How much will NAMA cost to run.

The NTMA is a fantastic place to work if one looks at the average remuneration, which including expenses works out at over €166,000 per annum (170 staff at €28.3m for 2008). Based on international norms reported a number of weeks ago a NAMA sized commercial property fund would usually require 2 managers per 100m of assets, or 1800 staff. Were they to be paid NTMA salaries we would be looking at a wage bill of 300m per annum. However, its clear that the NTMA will not be allowed to do this, and will instead have perhaps 30-40 staff overseeing the bank property managers, so our baseline scenario has a running cost of approx 6.5m per annum, which can reasonably be expected to increase by 2-3% per annum

• Bringing it all back home

Taking all these elements into play then we can calculate the cost of NAMA. Note that this cost is of course subject to these assumptions above and we show below how sensitive it is. Under these baseline scenarios we find that the present value of the cost of NAMA is of the order of a loss of 20b, equivalent to about 9 months total tax revenue or 13% of GDP. This cost as a percentage of GDP is actually at the lower end of relative costs and is comparable to recent McKinsey estimates of the cost of the US banking crisis. World bank and IMF estimates of the costs of the Asian financial crises of the 1990s range towards 35% of national income.
If we take a pessimistic perspective on yields, and cut the average to 3% while at the same time assuming that an overpayment occurs and the haircut is only 15%, with then 15% of the loans being totally worthless, the costs rise towards the 40b mark, which while steep still is below the relative cost of the asian crisis. “

Karl, the Minister may have been referring to the ESRI’s ‘Recovery Scenarios for Ireland’, which has a section on The Banking System and the National Debt.

@Michael
Or, she may just have been
a) making it up
b) hoping or assuming it was so coz else she signed on for something uncosted
c) thinking of something else

There are legal issues which would encourage one to take in good loans as well as bad loans, expecially where you have much cross-colllateralisation.

However, it should also be noted that not only will NAMA have to borrow to buy performing loans but it will also have to manage such loans. One would hope that the NAMA management will try to keep NAMA as small as possible to ease staffing and administration costs and to speed up its ultimate wind-up in 20 years time or so.

KW’s point that the govt taking on the good loans is akin to the Govt engaging in speculation is well made. The logical thing to do would be to factor your estimated gain on speculation into the haircut on impaired asset values. We also need to keep an eye on our total borrowings in the long run.

Karl covers the main issues. I’d add that it seems to assume no “good” loans go bad. (We’d also need to see a definition of what good means e.g. BOI reclassifying billions of loans recently). I’ve posted before that if you want to create positive cashflows (and are willing to take risk in this asset class) purchase AAA european cmbs from desperate sellers.

Whatever about the difficulty in establishing prices for bad loans, why not parcel these “good” loans and get a price for them? Let’s see if they are worth face value.

Accepting Karl’s assertion that the “good” loans won’t create adequate cashflows, another problem is the repayment mismatch. The “bad” loans can remain (NAMA decides), “good” loans can get repaid or refinance elsewhere. I’d expect the terms of these loans are relatively short. If “good” loans are good, they’ll be gone in (say) 5 years. What will support the “bad” at this point?

In short, I wouldn’t buy the “good” loans.

@BL
I think the State accepts there is a risk that it won’t break even. The NAMA model, as I understand it, is to manage out the assets over 20 years to postpone and minimise losses and costs to the taxpayer.

Are you suggesting that the State will do better or worse if performing loans are brought into NAMA? (assuming for the moment that we will have a NAMA)

Of course they will do better if performing loans are brought in. Thats a given, I think. The state however is in deeep deeeep denial as to the cost of NAMA. Now, I agree we will end up with a NAMA. So lets get real on the costs of the hole into which we have dug ourselves.

@BL

I understand KW to say that the cost of financing the acquisition of performing loans is not justified by the possible revenue which such loans will yield. KW, as I read him, is suggesting that taking on the performing loans is a form of speculation which the State should not pursue. Would you have a view on that?

I have never been a fan of the good loans going out. That weakens the banks and surely the plan is to have something that strengthens the banks? Im not sure we can say that the payment for these per se will be overpayment but maybe

If Harney is claiming ESRI endorsement and they have not come to the conclusions she is claiming, then shouldn’t ESRI be issuing a press release to that effect, or telling her press officer to walk it back before one is issued?

You will find what I and my ESRI colleagues said in our paper published on 15th May entitled Recovery Scenarios for Ireland at – http://www.esri.ie/publications/latest_publications/view/index.xml?id=2774
In Section 3.3 of the paper we look at an illustrative scenario for the banking system. This is intended for illustrative purposes to show how NAMA and the subsequent recapitalisation of the banks would affect the national debt and the national accounts. In this illustration we assumed that NAMA would buy €80 to €90 billion of assets for the illustrative figure used by the NTMA – €50 billion. We assumed that this was the appropriate price so that when NAMA liquidates its assets (for illustrative purposes assumed to be 2020) they would recover the full amount paid plus the accumulated interest needed to fund NAMA. As was made clear in the paper, these figures were not a forecast but an illustration of how the NAMA process could be made to work at minimum cost to the taxpayer.
Of course, as so frequently discussed on this site, it is very difficult to be sure what is the price to pay that would ensure such an outcome. For this reason, Patrick Honohan’s suggestion seems the best approach – aim to underpay for the assets and then pay a dividend at some later stage if it proved appropriate.
With such a mark down on the assets, the banking system would need further capital from the state. Whether this would amount to nationalisation or result in the state merely owning most of the shares in the banks is a matter of continuing debate.
If properly managed the recapitalisation should allow the banks to be eventually sold off (at least Bank of Ireland and AIB). In the “illustrative” scenario we assumed that this sell off would occur in 2015, with the state realising the full value of its investment. However, some of this capital is likely to be needed not just to allow the banks to fund an economic recovery in Ireland, but also to cover permanent losses which exceed existing shareholder capital – especially in Anglo-Irish Bank. It is this permanent loss which will have to be carried by the tax payer. Obviously it will be many years before we know the size of that loss.
One of the conclusions of our study was that, if properly managed, the final cost to the taxpayer from the banking debacle is likely to add much less to the national debt than will the dramatic loss of output from the recession in the real economy (impacting on the public finances). However, if not rapidly addressed the banking crisis could prevent a recovery, greatly increasing the problems of the real economy and the eventual increase in the national debt.

I dunno lads are there some people with an agenda or just plain thick

[i]I think the State accepts there is a risk that it won’t break even.[/i]

Expecting NAMA to ever do anything other than lose billions is delusional or dishonest.

NAMA is being forced to
1) pay way over the odds for crap it doesn’t want
2) deal with people and banks who have in many cases committed fraud, in the rest been less than honest
3) borrow money in an environment where noone wants to lend
4) sell property in an environment where nobody wants to buy…
5) All with the invisible hand of the politicians lobbying on behalf of their favourite crooks and hard cases

And it is seriously suggested they can make the thing break even?

Pull the other one.

@JF

Thanks for that post. It really shows just how crucial the valuation issue is to the taxpayer.

@ John Fitzgerald

While appreciating that you have mentioned that the 50 billion euros is an illustrative figure, I think it’s important to consider that a discount of 30 to 40 billion to the nominal amount of the loans is completely impossible in an environment where the aggregate equity of the 6 banks covered by the government guarantee (ordinary shares + govt “preference” shares) is less than 22 billion euros.

A discount of this size would have the effect of demonstrating the banks insolvency and it is purely hypothetical to suggest that the government could inject the circa 25 to 30 billion euros of capital that would be required to bring the banks back to approximately 5% of their remaining assets. I believe it is purely hypothetical because all the cash (=NPRF) at the government’s disposal has already been spent/committed and any further recapitalisations could only occur through direct government borrowing for the purpose of recapitalisation. Borrowings of this size, for this purpose, would simply be impossible.

The (only) alternative, as denigrated with increasing frustration (and I can understand why) by Brian Lucey above is that the State simply pay 25 billion or so more than the assets are worth (being the circa 75 billion figure that the stockbroking community appears to consider as likely).

Its simply the only way they can get the cash to recapitalise as the figures don’t stack up under any other configuration.

I understand that you took the indicative 50 billion figure from a statement from the NTMA. I believe that given the resources at the State’s disposal, and the constraints on how they can be applied, it is a fantasy.

Joe,

Do you really think that gifting €25 billion to the current shareholders is the only way to recapitalise the banks? Given your previous contributions, I’m surprised you’d back that argument.

You didn’t say this explicitly but I’m guessing your argument for paying €75 billion rather than €50 billion is that the banks will take the additional €25 billion in government bonds in exchange for their bad assets while the bond market isn’t willing to take an additional €25 billion in government bonds to be used for re-capitalising the banks.

My question is why does this have to be the choice? Can’t the government re-capitalise the banks via giving them government bonds that can just be added to the asset side of the balance sheet?

Karl,

I didn’t mean to suggest that this should happen – merely that I feel/fear that it is what will happen.

I have to admit that I hadn’t thought of the possibility that the government could use additional government debt to recapitalize the banks (Up until now I understand that they have spent 4 billion of the NPRF money and 3 billion of 2009 and 2010 contributions to the NPRF – i.e., by borrowing this money through the NTMA – to finance the 7 billion of recapitalisations that have been made). This understanding is based on media reports and if it is incorrect I would be very interested in finding out how the 7 billion was financed.

I also haven’t seen any specific comment on how they government plans to finance the 7.5 billion that has effectively been committed to anglo.

In defense of my assumption (that as the State has no more cash in the NPRF, and that using standard exchequer borrowing to finance the recapitalisation would not be possible, that only a high transfer price for the NAMA assets would enable the circle to be squared), I would simply submit (perhaps weakly):

1) that I haven’t read any government commentary suggesting that government bonds could be issued for this purpose,
2) that if the government plans on issuing debt in the types of amounts that would be necessary (25 to 30 billion) to fund the capital gap in the banks if the NAMA assets were to be purchased for circa 50 billion, they are being extremely, and given the amounts involved I would suggest unreasonably, quiet about it
3) that an additional layer of public contributions of this nature (after the guarantee, nationalisation of anglo, the 7 billion recapitalisation and NAMA) could lead to a complete, and obvious, crisis in the public finances.

@Garry
Right on!

Liquidation of insolvent entities exists for a reason. What is so different about all of the banks, in a country of 1% of the EU by population? Start again.

So much has been written but it will all come to naught when they cannot borrow to fund it.

@ Chou en li
The “state”? Who is backing this, exactly?

@PD
In which context??? Karl Whelan used the term “the state” as id Brian Lucey. Why pick on Chinese (sounding) bloke?

@Zhou

L’etat, c’est moi….et tu ….et tu aussi….oui, tu dans la coin….

Note : given we are all shipmates in the good ship NAMA the familiar is appropriate. All together now : Bail…..Out…..

A really shameful guillotine of the Financial Measures (Miscellaneous Provisions) Bill 2009 in the Dail this evening. All about more money for banks and more public debt to be paid by ordinary citizens .

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