Property Loans: Development, Investment and Rolled-Up Interest

Here’s a couple of issues relating to the property loanbooks of the banks that will have some bearing on interpreting the average discount paid by NAMA, but which I don’t have good handle on yet.

First, when the banks report their loan profiles, they divide property loans into commercial and residential development and commercial and residential investment. Page 181 of AIB’s 2008 annual report explains that

Loans for property investment comprises of loans for investment in commercial, retail office and residential property (the majority of these loans are underpinned by cash flows from lessees as well as the investment property collateral).

Whereas development loans presumably don’t involve the purchase of buildings generating cash flow. But what about the following scenario?  A businessman purchases a site of land in, let’s just say Dublin 4 for illustrative purposes, and the land already contains, let’s again say a hotel for illustration. Now suppose the businessman is still running the hotel and getting some income from it. However, his ultimate ambition, now temporarily thwarted, is to knock down the hotel and build a replica of the Taj Mahal.

By a narrow interpretation of the definitions above, this purely illustrative businessman has taken out a commercial investment loan. But because the prospective Taj Mahal development project promised to be so profitable, he’s actually paid far more than the hotel is worth. (Let’s just say he had more of a long-term economic value price in mind.)

This question matters because most of the analysis has focused on the loans categorised as “development” as being the main source of problems but if loans of this type are being counted as investment rather than development, then much of this stuff could also be pretty bad. And, to give an example, AIB reports having €7.9 billion in commercial development loans and €19.9 billion in commercial investment loans.

Do people have an idea how loans of this type are classified and how significant projects of this type are? More generally, how are true commercial property investments performing?

Second, Constantin Gurdgiev has been raising the issue of rolled-up interest on developer loans. It seems pretty clear now that delinquent developers will never pay back any of this interest. But if this rolled up interest is still being added on to the book value of the loans, then this will have to be kept in mind when interpreting the haircuts being applied by NAMA. Applying a 25% haircut to a loan for which 15% of the book value is rolled up interest is effectively applying a discount of only 10% to the original underlying loan.

So, again, do people have an idea about how large an issue this is? How much of the famous €90 billion or so of loans that we’re buying is likely to be accounted for by rolled-up interest?

Also, this is something to watch out for in the supposedly upcoming “detailed NAMA valuation methodology”. Will this methodology separate out rolled up interest and will it apply the correct discount of zero to this portion of the loans?

12 replies on “Property Loans: Development, Investment and Rolled-Up Interest”

This is probably the Irish bank’s version of the “Option ARM”

The rest of the option ARMs remain on lenders’ books, where for now they’re generating huge phantom profits for some lenders. That’s because, according to generally accepted accounting principles, or GAAP, banks can count as revenue the highest amount of an option ARM payment — the so-called fully amortized amount — even when borrowers make only the minimum payment. In other words, banks can claim future revenue now, inflating earnings per share.

Consider the Carroll case: the banks buy out creditors, agree to fund build completion and forebear on repayments for years- until the market price improves allowing for a sell down of property assets to repay loans – or restructure once again. Will NAMA be bound by similar agreements reached as it takes over loans? Is it not the case that NAMA will be bound by developer/banker restructured loan agreements? And could it not act as a clearing house for similar work out arrangements – just who are the people/entities who will subsequently buy its repossessed property assets and who will be funding them?

@Karl: Incisive analysis. The rolled-up interest problem and its effect on book value and haircut calculations (relative to collateral price falls) is important. Thanks for the reference to the Gurdgiev blog entry. The NAMA haircut should be calculated against book value without accrued interest. Potentially offsetting this effect, have some of the loans already seen a full or partial write-off? This would create an effect in the other direction, with current book value of the loan book falling below the sum of initial initial loan amounts.

It seems we should all be rooting for ACC Bank against Carroll and the domestic bank cabal, in order to get some clarity on Irish bank loan exposures and help give the taxpayers a better deal in the eventual (now inevitable) NAMA purchase.

Problem is that if we ignore the potential hundreds of millions of rolleupes then the banks are at the loss of these too.

I think anglo and inbs latest accounts provide detail of the proportion of interest income that is rolled-up. I think it was a third for anglo.

I thought I read a comment that nama expected 50% of assets would contribute towards the coupon. So perhaps it could be read as 50% roll-up.

With this type of product, you need to check the property purchase price against the valuation. There is a temptation to ensure the the loan’s ltv never goes above a conservative threshold 🙂

NaMa is not a foregone conclusion. The legislation may be amended or not passed, particularly as the political consequences become more apparent.

Liquidate all these loans and if the banks fall also then use the examinership process. We cannot afford to encourage speculation with the proviso that those involved will be rescued later.

Remember Easter Island!

It seems that a lacuna in the proposed NAMA legislation is identified in relation to the rolled up interest element of the toxic loans set to be acquired by the State. As the reports of the Zoe Court applications show, the banks have agreed to roll up interest and forebear for a period of three years. Thus, NAMA is saddled with this and possibly many more forbearance agreements of this type. If the Zoe loans are taken over by NAMA then Zoe management remain in the driving seat. With a high probability that our genius bankers entered into many more such agreements running NAMA is likely to be a nightmare of the type alluded to by Dr. Somers in his evidence to PAC. It is only the actions of ACC that have illuminated this dubious banking practice. Mr Justice Kelly aptly quoted the saying – if you owe the bank etc. He also

And for those of a paranoid disposition consider this : theres nothing to stop , it appears, loans being reclassified or allowed roll up to get over the 5m “its a NAMA” threshold.

“And for those of a paranoid disposition consider this : theres nothing to stop , it appears, loans being reclassified or allowed roll up to get over the 5m “its a NAMA” threshold.”

Indeed, it may even precipitate the bad debt situation further. It’s akin to throwing good money after bad, with the guarantee that you’ll get it back.

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