Perhaps the most contentious issue in NAMA planning is the distinction made between the long-term economic value and the current-market prices of bank assets, particularly developer loans collateralized by Irish property portfolios.
Optimists see a strong case for a liquidity-related price bounce in these bank assets, that is, low current-market prices recovering to higher “true economic value” prices over coming years, as financial market distress dissipates. This optimistic view, forecasting a bank asset price bounce, provides a strong justification for setting up NAMA, and also justifies paying the banks more than current-market prices for their bad loan portfolios (but still much less than accounting book value).
Pessimists forecast either flat or declining market prices for these bank assets over coming years. This pessimistic view implies that NAMA (if it comes into existence) should pay current-market prices or less for bank assets.
I think that the optimists might be over-extrapolating from the current US environment. There are important differences for the case of Irish bank assets. In my opinion, the market prices of US bank assets will bounce up strongly sometime during the next few years, whereas the prices of Irish bank assets will recover more modestly or not at all.
The reason for my bold prediction has to do with the prevalence of securitized loan assets (collateralized mortgage obligations, collateralized debt obligations, credit default swaps on securitized assets) on US bank balance sheets, and their near-absence on the balance sheets of Irish banks. There is now a wealth of empirical and theoretical work on the severe liquidity crisis in securitized asset markets in the US, including the effective closure (no meaningful prices) in several key markets such as the mortgage-security-related credit default swap market. There is also an emerging academic consensus about the basic causes of this market collapse: see Diamond and Rajan, Gorton, Acharya, Gale and Yorulmazer, and Heider, Hoerova and Holthausen (German case). The securitized-asset market breakdown combines market-for-lemons failures plus dynamic trading failures related to the hot-potato paradox (a rational player will only accept a hot potato if he is confident the next player will accept it from him). The interbank lending market liquidity freeze-up was related to that in securitized loan assets. See the four papers cited above.
The liquidity-related market failure evident in US securitized asset markets now seems explicable based on economic theory and empirical analysis. This type of market failure is most likely to occur in asset markets which are information-demanding (collateralized mortgage and debt obligations require detailed, accurate forecasts of prepayment and default rates and technical analysis of the cash flow implications of these forecasts for each tranche) and/or in which natural holders of the assets have typical holding periods which are short relative to the cash flow lives of the assets (also very true of CMOs and CDOs which can have 30 year maturities when most natural holders want an assurance of quick access to their capital).
With the collapse of attainable prices, US banks have done the rational thing and are hoarding their mortgage-related and debt-related securities. If they sell they can only receive firesale prices, but by holding them they can await eventual price recovery, or just keep them for ongoing yield.
To arbitrage the expected price bounce requires long-term risk capital and sophisticated expertise in valuing the securities. There is not enough of either of those to get the market going again, yet.
The nature of troubled Irish bank assets is different. The banks lent recklessly to property developers who purchased land and existing property at bubble prices and then built extravagantly. This is not 50-50 hindsight of an academic; this reflects the regret-filled view of thoughtful participants among both bankers and developers.
Why should these Irish property assets experience any strong price recovery? There may be some liquidity shortage in the market for Irish development properties, but the situation is quite different from the US case. Property asset markets attract buy-and-hold investors rather than investors planning to trade quickly. The valuation of property assets seems not that technically sophisticated. This market has neither of the two properties that give rise to liquidity-based market failures. Reinhart and Rogoff find that property asset prices tend to trend downward for six years following banking crises. So what are the grounds, in the Irish case, for forecasting a price recovery?
16 replies on “Bank Asset Price Bounce: Irish versus US Banks”
there is something that might actually fix a lot of this: the yield curve – presently its in a goldilocks position, really low short term money with a steep right hand side, that means banks can make some mega money for the next few years, the loans that do perform will really make up for a lot of lost ground. forebearance might win out on its own. (and the line holds for US libor and GBP Libor too) with everybody hoarding individually it means there is also a massive increase in zero rated funds for fixed rates which will price off the steep curve but lend in the now.
“So what are the grounds, in the Irish case, for forecasting a price recovery?”
The grounds are that if we wish hard enough it will be so.
If we build it, they will come.
I would be very interested to hear the views of the heavyweight economists on this site about the approach which the UK and US governments have taken with their damaged banking sectors.
I appreciate that the circumstances in these two countries are not identical to Ireland but there are lots of similarities, and given that the majority of people on here are very critical of the current NAMA approach, I would be very interested to hear views on the efforts of these other jurisdictions.
I would assume that the authorities in the UK and US have done a much better job, given their vastly superior resources in terms of numbers of skilled professionals they could throw at the problem.
Apologies if this has been done already.
The Reinhart and Rogoff study makes for interesting reading. If I am reading it correctly we are in year two of a six year property decline or could we go the way of Japan for 17 years.
“US banks have done the rational thing and are hoarding their mortgage-related and debt-related securities. If they sell they can only receive firesale prices, but by holding them they can await eventual price recovery”
The difference in the US, surely, is that banks have failed via FDIC enforced sale to a stronger outfit, rather than being liquidated with a resulting disposal of securities at firesale prices. In Ireland, the notionally stronger outfits are the ones with the biggest problems.
There is one fundamental problem with these academic studies: They make no attempt to assess the value of the underlying securitized products. The value of any security or derivative ultimately depends on the cash flows that will be received over the life of the product. Initially, these products were created and sold using models that failed to take into account the possibility of a broad-based decline in housing prices. When this happened, most financial services companies lacked the ability to accurately estimate the value of these products. While I agree that the “hot potato” effect prevented many public companies from buying or selling these products, the reason that many of these products declined in value was because they were, and remain, utterly worthless. Because so many of these securitized products were jumbled together haphazardly, a broadbased ABX index fails to accurately capture their value or the degree of impairment. Those who profit from these products are those with the ability to estimate cash flows at cohort or near-cohort level. Global models failed two years ago, one year ago, and I can assure you that they will continue to fail today and in the future. There is no replacement for doing your homework. The same must be said for NAMA. You have to bring smart folks in to assess the value of the loans in a granular fashion. Otherwise you’ll get it wrong. Again.
Here are links to two economists that I have respected for years: Henry Liu and David Goldman
Their articles are hosted on asiatimes.com, an internet based ‘newspaper’
that I would rank as the best online analysis out there.
There are others hosted on the main site
Yes I have read Asia times for years. H K Liu is a mensch!
You will know this already, but there are people deliberately closing their eyes, Admiral Horatio Nelson-like, and saying that this is a recession. They deny that excessive credit caused it because that clearly indicates where the economy is going. All that credit will have to be liquidated either by rerpayment or by loss. As the rate of savings reasserts itself, credit can be re established. Given the state of drunkeness at the punch bowl, that will be in a decade or two, possibly three as they adopt the Japanese tactic of supporting banks at all costs!
You have tried to allow others access to a world point of view. It is too late now for much capital, but there is astill precious capital that can be saved by disbelieving the MSM, the main stream media. Please dear reader, realize that this is far worse than it appears!
I guess the crux of my question is – have the US and UK authorities, in dealing with their respective banking crises, engaged in the kind of bailout of private shareholders with taxpayers money that the commentators on this site are railing against in the case of the proposed NAMA structure?
Or did they come up with a superior structure which adequately protected their taxpayers and properly punished shareholders?
Very interesting that Rabobank/ACC are expecting losses of 20% of their loan book based on price falls of 50%. They may write off more but they estimate 20% will cover losses.
This is very relevent for the NAMA discount discussion as Rabo are not part of NAMA and have been quite aggressive in extricating themselves from Ireland.
I agree with Mr. Connor. So when will Irish house prices recover? First – look at the UK bubble 1988 to 1991. Prices only started recovering in 1996. Second – only when yields on property revert to the long term mean, let’s say an acceptable 5%. I don’t have the facts but believe that yields in 2007 were running at 1.5% to 2% and today at 2.5% to 3%. Just on this alone there is a long way for residential property prices to fall because rents are certainly not going to recover for a very long time.
Last week, Colm McCarthy referred to distressed non-property loans.
In the context of bank losses and the NAMA debate, shouldn’t there be realistic estimates of expected losses on non-property lending over the coming 3 years?
US commentator Larry Levin says bank executives have a lot of leeway in how and when they recognize credit losses.
“Some are actively engaging in ‘extend and pretend,’ a practice in which banks refinance deadbeat borrowers to avoid reporting loan losses,” he says.
“Recall that bank executives have lots of control over the timing of loss recognition. Evidence that banks are delaying loss recognition is springing up all over the place. For instance, some banks that provided unsecured revolving lines of credit to highly indebted REITs have waived some restrictive loan covenants. In residential mortgages, we’ve seen lots of instances where banks are stringing along underwater homeowners with modifications that do little more than kick the can down the road.”
IMHO: their banks are property crashed like ours are.
But they have carried more of the subprime.
Implicit in what you have identified, is the UK USA control their own currency, and hence can print their own money, which they have done.
We cant print our own as part of the Euro.
So in the short term they have bought their way out of the here and now.
But as to the cost of this in the longer run will most likely be reflected in the value of their currencies, which of course should decline.
Time for a return to the gold standard!!!
Ps: Highly recommend Henry Liu.
The reality is that the ECB is bankrolling the irish banks by providing UNLIMITED liquidity (as long as the collateral is eligible). Nama will be funded the same way; the goverment bonds will be pledged to the ECB by the banks and they’ll get cash in return.
This CANNOT continue indefinitely. Come mid 2010, the European economy on the whole may well have recovered enough for the ECB to want to start hiking rates, but first they will start by draining liquidity from the banking system. The first 1 year ECB repo operations (“LTRO”, eur 442bn last june 24th ) will expire in June 2010. There will still be some liquidity provision by the ECB, but this is likely to be on a short-term basis only, and definitely not unlimited. This could lead to huge pressures for term funding (i.e. Euribors rising). Together with the Irish bank guarantee expiring around that time, we could be in for a real credit crunch.
You’re not wrong there are some important distinctions. Starting with the known fact that we are talking about loans made for investment in residential property on the whole and that Ireland is grossly over-capitalised in this area.
At the time of the last census, when we were still pumping out close to 90,000 new units per annum, it was found there were around 250,000 empty residential dwellings in Ireland (not holiday homes). This is a non-tradable asset – we can’t ship it to markets abroad – in which the country is grossly oversupplied.
Worse, the famously income elastic Irish labourforce is now kicking in and the likelyhood of a spike in household formation is remote at best.
I wouldn’t be too disheartened to have to debate a motion that the “long-term fundamental economic value” of these NAMA assets is somewhat BELOW current mark-to-market prices. And here we are trying to justify a premium.
Bank share prices can be and are manipulated. Long term it is bad for quoted shares to be allowed to be manipulated. But in the short term it is possible and perhaps to some, justifiable, if something turns up. If it doesn’t at least jobs were kept going for a while longer. Just look at Japan, zombie banks still alive after 19 years.
But back in the real economy, deflation becomes rampant and irreversible. How do you offer a negative interst rate? As incomes fall, so does inclination to borrow. Asset prices are falling so why buy and take a loss on the asset? So borrowing goes slowly into reverse and capital slowly builds up. Very slowly. Very, very slowly.
But what the heck, why not take on 100,000,000,000 euro borrowings in order to keep failed banks afloat so they can sack all staff, sell off all branches. Joint stock companies are not meant to be universal and eternal.
Liquidate now! The directors of the banks all have a duty to cease trading while insolvent. Ask them to do so!
All just as the baby boomers are retiring in the West.