NAMA and Behavioural Finance

While there has been a lot of discussion of the draft NAMA legislation’s definition of long-term economic value, there has been very little attention paid to its clause discussing current market values.

There are two interesting aspects to the discussion of market value. First, there is the fact that it is being discussed at all. We know that there is a very limited number of transactions in the current market for development and investment property, so it might have been expected that the government would fall back on the claim that there was no market as a justification for moving straight to the dreaded long-term economic value. (And indeed, the Minister for Finance, did mention illiquidity on Morning Ireland despite its absence from the legislation.)

Second, there is the wording of what is meant by current market value. The legislation defines it as

the estimated amount that would be paid between a willing buyer and a willing seller in an arm’s length transaction where both parties acted knowledgeably, prudently and without compulsion

This sounds eminently reasonable doesn’t it? The parties are acting knowledgeably. They are being prudent. Presumably, then, they are aware of the stuff discussed in the long-term economic value definition—that the current crisis will abate and the financial system will become stable—and are factoring this into their decisions.

Why would we ever intervene to declare that this process would produce a price that is inappropriate for the government to pay? Even beyond the obvious objection that paying a higher than necessary price doesn’t feature in any advice book on investment strategies, what is the intellectual fig-leaf for the idea that the price being set by these knowledgeable and prudential people is somehow wrong?

The only argument that I can think of is the evidence that the market does not appear to price according to rational financial formulae such as the dividend discount model that I described last week or other variants of the so-called efficient markets hypothesis. I have taught asset pricing on a number of occasions and I always emphasise that efficient market models are highly imperfect.

In this week’s FT, behavioural economist Richard Thaler of Nudge fame has a nice article describing many of the failures of the efficient market hypothesis. However, what Thaler’s article does not describe is that his logic—that the market often gets the price wrong—is now being used around the world to justify programs that use enormous amounts of taxpayers’ money to buy (or insure) assets at well above their current market value.

This is the essence of the Geithner PPIP plan, which I never liked and, which thankfully, seems to be having trouble getting out of the traps. US government officials were arguing that the various exotic asset-backed securities being held by their banks were being valued below reasonable long-term prices.

I wonder how comfortable Thaler is with programs of this sort. It’s one thing to say that EMH doesn’t always work well; it’s another to say you can diagnose the extent to which these aberrations will correct themselves over time; and then another thing altogether to say that you’re going to bet large amounts of tax revenues on this diagnosis.

However, based on the legislation’s own wording, this systematic mis-pricing idea is the only potential intellectual argument that could be made for the idea that NAMA could break even.

We can all point back to various assets that, with hindsight, were clearly over-valued by the market. And of course there are cases where can look back and say that certain assets were under-valued by the market.

However, how comfortable should we be with the idea that Irish development and investment properties are good examples of assets that are being under-valued by the market? And how comfortable should we be that our government, lead by a man with a recent history of buying flats in Leeds, are the right people to detect the exact magnitude of this mis-pricing? Needless to say, I am not comfortable with this idea.

As for the separate idea that, even if our government does possess this great skill at spotting mis-pricing, the beneficiaries of this skill should be current bank shareholders rather than the taxpayer, discomfort doesn’t quite capture my thinking.

8 thoughts on “NAMA and Behavioural Finance”

  1. there are so many many biases being exhibited in NAMA….so many. Some stage must tabulate em all…

  2. Interesting snippet from article in Investopedia on values which could describe the course we are taking on LTEV.
    “Regulatory Response to Dubious Practices
    During the 1980s and 1990s, financial institutions, corporations and traders increasingly traded derivatives and other complex instruments – financial contracts with complicated valuation formulas that lacked an active market. Such instruments made it hard to objectively determine their respective values. Banks and companies began to use highly subjective, if not downright speculative, assumptions to assign values to these assets. Dubious values that were assigned were reflective of personal interests and objectives, and provided misleading financial snapshots of the entity to outside users of the financial statements”.
    Not much different from non-existent property market

  3. @Karl, Akerlof’s famous lemons and cherries in the second hand car market example shows how asymmetric information can distort a market.

    But, is the property market in Ireland, considering its illiquidity, not potentially an asymmetric market?

    By this I mean that because the market doesn’t currently exist – especially the ‘investment property’ market – that prices set in the market remain untested. The only information available is the asking price from the vendor, or the estimated market price decided by a valuation. Because there is no information from buyers, the market becomes asymmetric.

    Most hypothesis require a transaction, to have both a buyer and a seller. A market that has neither willing buyers or sellers escapes traditional analysis.

    So the government gets to guess the market value. Then they get to guess the ‘long-term economic value’. And pay somewhere in between.

    I did say this before, but half of this guess-work could be eliminated if the legislation allowed NAMA to decide on a value between zero and the ‘long-term BS’.

  4. This thread and the preceding and succeeding ones present images from a number of camera angles of a slow motion car crash that is made up of (a) an insolvent banking system, (b) increasing and largely hidden, but equally real, household and small business insolvencies, (c) government finances that are unsustainable even in the short term, but certainly in the medium term and (d) a political class totally incapable of taking any action to avoid or minimise the inevitable impact. Instead they are focused on making sure that all the personal safety mechanisms are in place so that they can walk away from the crash – without any consideration of what happens to the car or where it might end up.

    The world has moved on. The external benign and supporting factors of the NICE (Non-inflationary, Constantly Expanding) era in the 1990s (that gelled with domestic reforms) no longer exist. While Ireland took the last decade out to gorge on property speculation, other small economies learned from Ireland’s experience in the 1990s and are now positioned to ride the next wave.

    Ireland will muddle through, but at a huge cost in terms of blighted lives and crushed hopes. It is a recurrent cycle. We skinned the calves for de Valera in the 30s, built the motorways and airports for the Brits in the 50s and 60s, and put our shoulders to the economic wheels in Britain, the US and Australia in the 80s. All one is left with is fury at the avoidable waste.

  5. @ Paul Hunt
    Very well said.
    The Irish economy can be seen as “images …..of a slow motion car crash that is made up of (a) an insolvent banking system, (b) increasing and largely hidden, but equally real, household and small business insolvencies, (c) government finances that are unsustainable even in the short term, but certainly in the medium term and (d) a political class totally incapable of taking any action to avoid or minimise the inevitable impact.”
    The long boom was primarily debt driven. Internationally global prosperity was founded on a series of elegant Ponzi schemes. Our own “elegant” Ponzi scheme was built on a belief in perpetual asset appreciation.

    The FF/PD governments from 1997 were active facilitators of this Ponzi culture with their tax breaks and light touch regulation.

    Bertie, Charlie, Mary, Michael and Brian must all take a big share of the responsibility for this fine mess they have gotten us into. Their misguided and/or irresponsible approach to managing the Irish economy in the 1997- 2007 period rules them out of a credible role in sorting out this mess. I simply do not trust them. I suspect I am not alone in this.

  6. I submit that just about every square inch of this country’s residential property is vastly overpriced. Young families went to the wall to get on the “property ladder” (How I’ve grown to despise that term) by any means possible. The pressure to do this from all avenues – family, friends, government, the plague of property-related TV shows – was very intense. I’ve spoken to young couples who worked two jobs each, plus taking out loans from credit unions (seemingly the reporting rules are different) and representing them as a gift from Granny to the mortgage lender. So the prices skyrocketed.

    As the frantic build-and-sell progressed, the land areas became smaller (how is that possible? They were already the size of postage stamps!) and the houses built more poorly, but still the prices went up.

    The residential property here, were one to apply any reasonable valuation, will likely not approach those unreal values for many, many years to come. NAMA thinks it can wait a little while; I think that the Government will end up being Ireland’s largest landlord, not peoperty seller.

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