In a welcome shift, the government has indicated that NAMA may pay for bank loans by issuing two claims to the participating banks: standard government bonds in the amount of the minimum fair value of the loan assets, and a continent claim against any realized underpayment (I explain these terms below). It looks like the contingent claim might be classified as subordinated debt against NAMA as a separate government-owned entity. What are the policy objectives guiding this security design problem, and what would be the best feasible security design? What about the other huge contingent claim held by the banks (the bank liability guarantee)? Bringing the liability guarantee into the picture, and examining optimal design in the current circumstances, argues strongly for short-term nationalization as the best policy. However, if nationalization is ruled out for political reasons, then we can search for a second-best optimum excluding nationalization. I hope to write a technical note on this interesting problem over coming weeks, but in this blog entry I just want to make a few general remarks.
Nationalization is Best: According to Table 6 in White and Rankin (July , 2009) as of this past July the six main domestic Irish banks had total tier 1 equity capital of €14.8 billion. As they note, this does not account for upcoming (as of July) capital additions, so adding a rough-guess 25% to the total gives tier 1 equity capital of €18.5 billion. NAMA plans to buy €90 billion original accounting value of loans from the banks. An accounting “hit” of 20.55% of the loans’ original accounting value would wipe out the Irish banking sector’s total tier 1 equity. Some proportion of the loans’ original accounting value has already been written down by the banks, so a 20.55% “hit” would correspond to a larger discount on original book value. My own very-limited straw poll of informed sources (excluding those in Irish brokerages and investment firms where there is strong vested interest in a small discount) seems to indicate that the appropriate discount is in the range 45% to 70%. I have been surprised that several knowledgeable practitioners have told me privately that Lucey’s suggested 70% discount is not unreasonable. Anything in this 45%-70% range means that a fair value NAMA discount will leave the banking sector with zero or negative cumulative tier 1 equity capital. The uneven distribution of the bad loans across the banks means that some will be deep into negative equity while some others would be limping along, extremely impaired.
The banks have positive market value of equity because of two assets which do not appear on their balance sheets. One, they all have very valuable government-backed liability guarantees. Two, except for Anglo Irish, they have valuable franchises. Both of these assets can now revert back to the taxpayer via nationalization.
It is difficult to put a fair price on the bank liability guarantee due to a deposit-insurance paradox. Without the guarantee, the banks would fail and most Irish bank equity would be worthless. However, letting the banks fail would be extremely bad for the economy and taxpayer, and so the guarantee cannot be removed. The Irish state needs to remove its under-priced guarantee without letting the banks fail – hence short-term nationalization, followed by a renewal of the liability guarantee if necessary. In this way, the taxpayer will receive the full value of the guarantee and the banks’ franchise values when new shares are issued.
Second Best NAMA plans: Ruling out nationalization, based on the government’s political preferences, how should NAMA payments for banks’ loans be structured? Paying with government bonds is essentially paying cash (courtesy of the ECB). What are the objectives of non-cash payment plans? Here are two alternatives:
1. Risk Sharing. This is the explanation that has been picked up in the popular press. The banks must share with the taxpayer (through NAMA) the risk that the bank loans turn out to pay less than expected. Looked at more carefully this is not a consistent explanation. Under the proposed plan, NAMA will pay for the bank assets with a package which is essentially cash plus a covered call option written on the assets’ realized values. This depends on the nature of the subordinated bonds but seems to me a reasonable interpretation. This is a sensible security design, but it is not risk-sharing. It means that the banks are given a claim on the upside potential value of NAMA in exchange for a lower cash payment. The taxpayer is still stuck with the downside risk of NAMA. The only risk reduction for the taxpayer is that the banks’ call option might expire worthless – that is not much of a risk reduction. Calling this risk-sharing is a slight misuse of that term. The term “share the risk” is being used informally to refer to something else. See the next explanation.
2. Information Asymmetries There are two information asymmetries in the fair valuation of the bank loans. The banks know more about their value than the government, and the government knows more about their value than the taxpayer-voters. The proposed cash-plus-call-option package is less sensitive to mis-prediction of the realized value of NAMA assets. So in this sense it “spreads the risk” from the taxpayers to the banks. Suppose the banks know that the NAMA assets will pay only 40 billion but the taxpayer thinks that they might pay 60 billion or more — the taxpayer is not sure. The taxpayer gives the banks 40 billion cash plus a call option (subordinated debt) with an exercise of 45 billion which is worth (the taxpayer thinks) 10 billion. The taxpayer thinks that he has paid 50 billion total value but the bank knows that the two-security package is really only worth 40 billion since the call option is worthless. The total package is fair value despite the information asymmetry. More generally, the cash-plus-call package tends to mitigate but not completely eliminate mis-pricing given asymmetric information between the two parties.
This explanation also works if the taxpayer does not trust the government as middleman, for example due to special interest influences. Under reasonable assumptions, using cash-plus-call puts the taxpayer less at risk of overpayment by the government.
Cited Paper: Scott Rankin and Rossa White “Government Finances and Banks” Davy Research Report, July 8, 2009.