When The Levy Breaks

When the levee breaks, I’ll have no place to stay.
Mean old levee taught me to weep and moan,
Lord, mean old levee taught me to weep and moan

Source.

The new Programme for Government document contains the government’s last approach to convincing the Greens, and to a lesser extent the general public, that NAMA will not be a costly exercise for the tax payer: A commitment to include a post-dated levy in the NAMA legislation.

I’ll try to boil the problems I see with this approach down to four observations.

First, NAMA plus an actuarially fair levy has the same effect as doing nothing. What does this mean? Suppose a bank has a loan originally worth €100 million which the government buys for €70 million. The loan turns out to be worth €50 million and the government imposes a levy of €20 million on the bank. In this case, the bank ends up with the same outcome as if it had originally held the loan. So, a levy of this type would mean that the NAMA policy does not achieve its aim of transferring the risk associated with bad loans away from the banking system.

Of course, this simple analysis doesn’t take into account time lags. For instance, if the government loses the €20 million today but waits ten years to impose the levy, then the banks would still be better off. This is because the banks have been able to keep €20 million which can be invested at an interest rate of r (reflecting both inflation and a real return) so that this money can be worth 20(1+r)^10 when the levy is introduced; similarly the government could have kept that €20 million and invested it. If the government chose to impose a levy that reflected the opportunity cost of money, then it would have to charge  20(1+r)^10.

Similar concerns apply to the idea of the levy being paid back over time. If you lend someone €20 and they pay it back to by starting in ten years time to pay you €1 per year, it is pretty clear that the economic value of the income stream paid back to you is going to be below the original €20. I calculated in my first post discussing the levy in April, that with an interest rate of 5%, an income stream of this sort would be worth less than 40% of the original amount.

Second, since the government doesn’t want to implement a plan that has the same effects as doing nothing, it is certain that any levy to be introduced will not be on an actuarially fair basis. Based on the discussion above you can see various ways that this can be done. One way would be to exclude any operating losses NAMA makes in terms of the gap between its income and interest payments (we will see if revised legislation makes this clear.) Another way would to have the money paid back as a fixed nominal amount over a long period of time.

Now, on the one hand, these tricks could be considered a good thing, since we don’t want a plan that’s the same as doing nothing. On the other hand, it means that claims that a levy will fully protect the taxpayer simply cannot be believed.

Third, the levy idea opens up a logistical can of worms. It seems likely that the levy will be based on NAMA’s total losses because the only thing we know about the subordinated NAMA bonds is that any contingency has to relate to NAMA’s aggregate performance. But this then exposes AIB and BOI to having to pay for the losses associated with Anglo’s loans, which hardly seems fair (though, of course, I’d guess that NAMA is applying far higher haircuts to Anglo loans than to AIB’s or BOI’s—not that they’re willing to tell us.)

The alternative approach is to have levies tied to the losses associated with each specific bank. But Brendan McDonagh told an Oireachtas Committee in May that this could not be done:

If there was a clawback within the NAMA legislation affecting the balance sheets of the banks, they would not be able to reduce the assets transferred to NAMA because effectively there would be an unpriced option in terms of what the clawback would be in the future. One cannot do this because it would not be possible to take risk weighted assets off the balance sheets of the banks if the levy was imposed in the NAMA legislation.

It’s unclear whether this would apply if the levy related to all NAMA-related losses. Still, if I was involved in assessing AIB’s solvency, I’d certainly want to factor in a potential future levy, even if it wasn’t listed in the bank’s official liabilities.

Fourth, I have always argued that the financial institutions would lobby hard to prevent future legislation to implement a levy. The levy being part of existing law will make thislobbying effort a little bit harder but not too much. The lobbying will just change form to become a request for new legislation to scrap the levy.

Finally, I would note that the NAMA plan is now moving farther and farther away from anybody’s ideal banking cleanup plan. The textbook approach to cleaning up a banking sector is to (a) write down bad assets to realistic values either directly or via transfer at low prices to an asset management agency (b) Recapitalise the banking system. This allows the banks to get back to playing their normal role without large contingent risks hanging over them.

The government’s approach of transferring the assets at unrealistically high prices while leaving contingent risks associated with bad loans hanging over the banks is a bad one all round.

I’d conclude by noting that there has been an increasing tendency on this site for people to attack me personally, so before people start writing in saying “you’re never happy, do you want the taxpayer protected or not?”, I’d like to point out that in April, long before any legislation was published, I wrote: I would strongly recommend getting the process of pricing and recapitalisation done correctly now and abandoning any idea of a post-dated levy.” So I’m just sticking to my original position on this rather than shifting it to oppose the latest changes.

35 thoughts on “When The Levy Breaks”

  1. Indeed, Ernie, perhaps my source citing was somewhat historically inaccurate. I can just see all my FF and banking friends now — “This shoddy piece, with its bizarre claim that Led Zeppelin are the original performers of When the Levee Breaks, completely undermines Whelan’s credibility as an academic. If he can’t get his Led Zep right, how can we trust him on NAMA?”

    😆

  2. We’re in a deep hole, if we get out of it with our skin & our money back, I’ll be happy.
    Talk of “the opportunity cost” at the moment is being just a little bit picky, don’t you think?

  3. @JMS

    Is it being picky? Well take the example above—if you lent a mate €1000 and he proposed paying you back €50 a year for twenty years, starting in 2019. Would objections to this repayment plan be picky?

  4. For once I agree with you Karl, I think (as a qualified actuary myself I can vouch for the actuarial aspect of your argument).

    If we are going to start pretending that the taxpayer is running no risk whatsoever then it’s just smoke and mirrors. Maybe what we will finish up with is that the taxpayers will not face a situation where they have lost big time whilst the banks are creaming it big time.

    That would leave the taxpayer bearing the risk that both NAMA fails and so too does the newly freshened up banking sector, but I suppose that is a nightmare scenario where no matter what the arrangements, Ireland inc. has gone down the pan.

  5. Hmm……
    Memphis Minnie died in 1973.
    Led Zeppelin IV released in 1971.
    Sales to date : 37 million.
    Probably sold millions before she died & she didn’t get a red cent from Zep.
    Off-topic I know, but it needs to be said.

  6. Any bad bank plan that doesn’t plan on losing money is either lies or stupidity. If anyone can point me to one that hasn’t lost money in constant currency terms (i.e. inflation and devaluation adjusted) I’d appreciate it.

    This in itself is not a problem, but it does need to be recognised. And as you say, the payback to the state should be in the form of equity, which may return some of the losses over time.

  7. Hard to see how you get investors to put money into the banks with an unknown contingent liability hanging over it in the form of a levy. At the very least it discounts the price you’re prepared to pay.

  8. The levy is not good.

    Both the government & the banking academics (including Karl) favored a single, central assets management agency which was advisable due to:
    1) systemic nature & large size of problem
    2) a specialist agency should perform better
    but probably mandatory due to
    3) Cross collateralization: if the problem had been left to the banks to fix they’d have been fighting for years, at great cost, in the Chancery Courts over who had better charge on common assets (especially personal guarantees)

    The disagreement was over pricing / risk sharing. The banking academics thought it would take more time to figure out and so 100% state ownership was the best way to avoid risk of over/under-paying.

    The government seemed to think it could get it right at the start… or else the ECB (+EC) warned them that they wouldn’t be allowed to own the banks

    Whatever flaws the government’s approach had… have now been added to. Clearly the levy creates a Sword of Damocles hanging over the banks. It will be interesting to see what international investors will want to go near the Irish banks now … and if they do, due to their factoring in the above risk, they’ll pay less for larger stakes….

    Also one point to Karl: I don’t think it is helpful to call for nationalisation unless you mean full state management, 100% ownership covers risk sharing and affords independent executive management.

    Also I think a 90% stake would be preferable and ask the ISE to amend its rule book to keep the banks trading. A continuing secondary market affords the advantages of :

    1) Independent market pricing & oversight
    2) A venue to dispose of the government’s stake in a gradual manner (rather than via a costly IPO)

  9. As I recall, Goodbodys or Davys did an analysis on Friday and concluded that from a figures perspective, the levy wasn’t particularly significant.

  10. Phew, thought we just had the beating of the Italians there, how disappointing was that.

    And Dunphy going on about Trap just like he was Jack Charlton.

    Great excitement and a welcome relief from the GP PfG stuff.

    Just a small quote from the said document:

    “Any such levy would arise only if NAMA has made a loss on its eventual wind-up or after 10 years, and would be carefully judged so as not to disrupt the stability and sustainability of the banking system.”

    Mmmm,

    “carefully judged”

    “stability and sustainability of the banking system”

    Levy my ass.

  11. Given the topic here emerges from the Zeps, and the love of the GP for Super(vicious) Furry Animals, an examination of the discography of tthose bards of cymru would be useful. Some of their more apposite tracks include
    God! Show Me Magic
    The International Language of Screaming
    Fuzzy Logic
    The Door To This House Remains Open
    and of course
    Vegetables

  12. The government wants us to swallow a sh!t sandwich, and they think that shoving some more lettuce between the slices of bread will make it palatable.

    Apologies for the imagery, but if the core structure of NAMA is misconceived, no amount of tinkering with the details is going to change that.

  13. Concubhar O’Caolai Says:
    October 10th, 2009 at 10:53 pm

    “We need to scrap Amhran na bhFianna and adopt this as our new national anthem”

    And it just got €25bn more tight. Black hole Anglo & Nationwide.

    God save us all from people who love small furry animals with teeth enough to eat your grandchild’s brain for breakfast and leave the body for you to dispose of.

  14. Does anyone know if the levy will be contingent on the bank concerned making a profit?

    If it was (eg take x% of future profits until any NAMA losses are covered), then it presumably would affect the banks ability to raise future equity capital due to lower future net profits, but not (directly at least) their ability to raise capital through issuing bonds, the coupons on which are paid before the levy or other taxes are charged. The levy would probably not appear on their balance sheets either.

    The overall effect of NAMA plus an actuarially fair levy in that case might then be to improve balance sheets at the expense of equity holders, which would be similar to forcing banks to raise capital by issuing equity.

  15. any levy would be a non balance sheet contingent liability. crucially wouldn’t hit the capital position of the banks now or over the next 5-10 years. potential new equity investors would pay little attention to it (good). i agree its not perfect but its a neat way of providing additional taxpayer protection without changing the current regulatory capital of the banks.

    prone to future lobbying? than ban all lobbyng on behalf of regulated business’s in the state.( the green can suggest it along with a ban on poltical donations.)

    if we took every part of the IRELAND INC balance sheet (and indeed the balance sheet of many countrys) and tried to account for every true asset and liability in a market based actuarial fashion, we’d leave the country and turn off the lights now. – ever seen a footnote to the country accounts with respect to public sector pension provision?

    ps. on a related note, did anybody read the piece in the indo yesterday ”We cant believe you pay us so much”. its looks like a mock article that you would read in the daily onion but its actually real. classic.

  16. Irish Pancake’s clarification of the caveats attaching to this levy thing show that nuffin’ at all has changed. Government always had and always will have the right to levy any sector and these would be natural caveats that would apply anyway. This is pure facesaving for the GP. Now a definitive requirement to recoup losses would surely be a contingent liability, and this most certainly is not such a definitive requirement.

  17. Frank Fitzgibbon in the S Times today notes

    “A meltdown in the financial markets tomorrow morning may have been averted following the Green party’s decision to back the National Asset Management Agency (Nama).
    If the party leadership had lost the vote, the share prices of Irish banks and other stocks would probably have fallen dramatically, as rejection of the new agency would have undermined the government’s €54 billion plan to rescue the banking system.
    Yesterday’s vote was secured following a commitment in the new Programme for Government that the banks will have a statutory obligation to make up any shortfall that may arise when the agency is wound up in 10 years’ time.
    While this was always the government’s intention, a failure to spell it out in the draft Nama legislation was one of the reasons why Green party members opposed the proposed state agency.
    Banking sources say that the legislation’s new wording will require careful consideration. Forcing banks to take on a potential multibillion-euro liability could affect their ability to raise funds.”

  18. Frank Fitzgibbon in the S Times today notes

    “A meltdown in the financial markets tomorrow morning may have been averted following the Green party’s decision to back the National Asset Management Agency (Nama).
    If the party leadership had lost the vote, the share prices of Irish banks and other stocks would probably have fallen dramatically, as rejection of the new agency would have undermined the government’s €54 billion plan to rescue the banking system.
    Yesterday’s vote was secured following a commitment in the new Programme for Government that the banks will have a statutory obligation to make up any shortfall that may arise when the agency is wound up in 10 years’ time.
    While this was always the government’s intention, a failure to spell it out in the draft Nama legislation was one of the reasons why Green party members opposed the proposed state agency.
    Banking sources say that the legislation’s new wording will require careful consideration. Forcing banks to take on a potential multibillion-euro liability could affect their ability to raise funds.”
    Sorry… forgot to say great post – can’t wait to read your next one!

  19. Frank Fitz singing the TINA tune I see.

    We can’t nationalise the banks for their current mistakes but we can tax future shareholders/customers for mistakes 10 years past. How does that make sense?

  20. It’s just a simple mental trick for naive public: personification of the banks.
    – “The banks failed us, but we’ll show those banks… They’ll pay us back!”
    What is generally missed is that banks are not people. The current owners/bondholders/cronies will quit by then, and any levy on “the banks” will be just another hidden tax on the public (who else do you think will pay in the end?!)… also putting one particular industry at a disadvantage.

  21. @ Mark

    This is the reason why private capital may baulk at providing new equity to the banks. However, the wording of the following para is so vague as to make you think that no levy will ever see the light of day.
    “Any such levy would arise only if NAMA has made a loss on its eventual wind-up or after 10 years, and would be carefully judged so as not to disrupt the stability and sustainability of the banking system”

  22. Perhaps another consideration is the number of households currently in negative equtity and the number who will default or have benign (at least for them) write downs which has already been implemented in the UK.
    I understand this forms part of the PFG agreement.
    Deflation ensures loans increase in real value.
    So ,necessarily a lowering of capital will occur making lending even more difficult.
    So how can a levy be imposed in such circumstances?

  23. @KW
    “But this then exposes AIB and BOI to having to pay for the losses associated with Anglo’s loans, which hardly seems fair (though, of course, I’d guess that NAMA is applying far higher haircuts to Anglo loans than to AIB’s or BOI’s—not that they’re willing to tell us.)”

    I was just dreaming of this crazy scenario where Anglo ended up much healthier than the other banks and with state backing. The other banks allegedly piled in to the property market because Anglo was gaining market share. UBS behaved similarly with sub-prime mortgages in the US and I’ve read came off worse than some of those who were in from the start. Furthermore, it sounds like this levy will hit all banks equally.
    AIB recovered unexpectedly well from their insurance corporation debacle. Since then, like the villains in horror movies, their top management have survived ordeals that would kill off any ordinary management team: DIRT, Rusnak, Tax Evasion and our current crisis.
    Also, the better Anglo does, the better the compensation case of its (politically well connected) shareholders. This zombie isn’t finished yet.

  24. What will be interesting to see is what the bank auditors make the banks put aside for the levy, if anything. This will tell us how much the bank auditors think NAMA is going to lose…

  25. Whilst I do not think that the levy is an effective risk sharing device, it is no harm to have the discretion to impose a levy enshrined in the legislation. The levy will be a useful weapon in the State’s armoury when dealing with the banks in the future.

  26. Morgan Kelly has produced another filibuster sure to titillate the NAMA nuts:
    http://www.irishtimes.com/newspaper/opinion/2009/1013/1224256508947.html

    I think I understand where MK gets the 2004 prices from – the estimates are suggesting an aggregate property LTEV of 30% below the aggregate nominal loan values drop so, assuming the real LTV is circa 100%, this means LTEV property = 2004 prices. However, in saying this he assumes that the estimate of 30% applies whether or not the LTV is 77%. This is despite the Minister’s comments to the opposite effect. The Minister has specifically said that if the real LTV is different or the real security and collateral is less valuable the NAMA process will ascertain this. Once again, a core part of an anti-NAMA piece seems to be that the Minister is wholly untrustworthy and that the NAMA valuation process will be artificially skewed to achieve approximately the figures set out in the estimates process.

    This lack of bone fides on the Minister’s and the Department’s part appears to be an article of faith for many. While such sceptisism may be healthy and indeed crucial to keeping us on the right path, it would be nice to see moe of the reasoning behind it (assuming that it goes beyond attributing base motives to the amorphous “Fianna Fail”).

Comments are closed.