It is clear that when the NAMA legislation is published later today, there will be a lot of focus on the question of long-term economic value and the European Commission’s guidelines for pricing assets transferred to government asset management agencies.
I have written about this issue before and don’t want to repeat myself. However, I’d like to emphasise two issues.
The first is that, while the Commission allows for assets to be transferred according to “long-term economic value” their preference is that assets be priced according to market value and the alternative approach should only be introduced where it is not possible to ascertain this value. On this issue, I am in agreement with Peter Bacon (discussed here) that the idea that there is no market value for Irish property investments is a dubious one.
It is true that there is very little activity in this market right now. But this partly reflects the fact that if developers sell at any reasonable price, they will incur huge losses and many will be bankrupt. In the absence of pressure from their banks (who are waiting for NAMA to take over the loans) the preference of developers is to sit, Micawber-like, hoping something will turn up that will get them back to solvency. However, despite the low levels of activitiy, one can, as Bacon has noted, use current residential house prices to come up with a maximum possible value for residential development land and in most cases this will imply a very large discount. Similar exercises can be undertaken for commercial development land.
This brings us to long-term economic value, which the Commission recommends be calculated “on the basis of underlying cash flows and broader time horizons.” I have taught asset pricing to Irish undergraduates on a number of occasions (in-depth notes here, shorter notes here.) The standard economic model that we teach for pricing an asset that you buy today and then delivers a sequence of cash flows D(t+1),D(t+2) etc is described by the present discounted value pricing model:
P(t) = D(t+1) / (1+r(t+1)+mu(t+1) ) + D(t+2) / [ (1+r(t+1)+mu(t+1)*(1+r(t+2)+mu(t+2) ] + ….
Where r(t) is the risk-free rate of interest and mu(t+1) is the risk premium associated with this project.
What we can see is that using this formula to back out the “long-term economic value’’ associated with an asset requires assumptions about three elements: The future path of cash flows, the future path of interest rates, and the future path of risk premia associated with this type of investment.
To give an illustration of the sensitivity of these calculations to assumptions, note that if D(t) is expected to grow at rate g each period and i(t) and mu(t) stay constant, then the formula collapses to the famous Gordon growth equation:
P(t) = D(t+1) / (r + mu – g).
As an arbitrary example, if we consider r=0.04, mu = 0.02 and g=0.02, then the long-term economic value for this income stream is 25 times current cash flows. However, if we drop the risk premium to mu=0.01, the multiple becomes 33 times, and if we drop it to zero, the multiple becomes 50 times. Similarly small changes in assumed risk-free rates or growth in cash flows can have major effects on the implied “fair valuation” of the asset.
My point here is that it will be very easy for any NAMA official who wanted to do so, to pluck out an appropriate set of assumptions about the future that will end up delivering whatever haircut is deemed desirable. In particular, I suspect it is possible that the valuations will completely ignore the risk premium element in pricing these assets and will make highly positive assumptions about future cash flows. And as long as the calculations are presented in a coherent fashion according to a model like the one above, I suspect that the Commission will declare that they have met the guidelines.
Finally, it should be remembered that this present discounted value model is just a model and very few economists have gotten rich over time using this model to detect whether assets are undervalued. All of these factors need to be considered before one could support taking €60 billion of Irish taxpayer money and investing it in these assets.