In today’s Irish Times, Fiona Reddan has an interesting short article about Nama’s planned mortgage-enhancement scheme. The scheme is intended to unload some of Nama’s large inventory of houses and flats without unduly lowering property prices. The scheme, at least as it has been described so far, will work as follows. Suppose that Nama wants to sell a particular flat for €100,000. It will offer a buyer the following deal. The purchaser must put down €10,000 in cash, and take out a mortgage from a bank for €72,000. Nama will pay (itself) the remaining €18,000 and record the flat as sold at 10,000+72,000+18,000 = €100,000. If after an initial period, say five years, the fair market value of the house is more than €82,000 (the amount already paid by the homeowner) than the homeowner must “top up” the difference to a maximum of €18,000. If the fair-market value of the house is €82,000 or less at this date, the homeowner has no need to pay the remainder.
The same logic works for any sales price scaled up correspondingly, I use a €100,000 flat for illustration. Essentially, the homeowner puts 10% down as cash and gets a 72% mortgage. Nama covers the other 20% of the needed financing (20% of 90% is 18%). Nama gets back its 18% after five years if the fair-market house price at that date has not declined; the homeowner must be prepared to refinance up to this additional 18% amount at that time.
In options terminology the scheme is simple. Nama has sold the house for €100,000 and, linked to this, Nama has purchased a bull spread from the homeowner. A bull spread is long a call at a lower exercise price (82,000) and short a call at a higher exercise price (100,000). Nama has paid €18,000 for this bull spread; the five-year payoff on the option spread is €18,000 or less, so in all cases Nama has overpaid for the bull spread valued separately. The market value of the mortgage enhancement scheme to the purchaser is always positive, so the “true” sales price of the property is always less than the stated €100,000 sales price.
It is easy enough to value such a sales package using the Black-Scholes model. Nama receives €100,000 for the property, pays €18,000 in its mortgage contribution, and owns a Bull spread with low/high exercise prices of 82,000/100,000. The value of the package depends upon the underlying market price of the house. Here is the “true” sales price of the package, for a range of true cash market prices of the house (and other parameters*):
Cash Market Price Stated Sales Price True Sales Price
€80,000 €100,000 €84,139
€87,231 €100,000 €87,231
€90,000 €100,000 €88,635
€100,000 €100,000 €93,213
Note that while Nama records that it has sold the property under such a scheme for €100,00, the true market-clearing cash price (taking account of the bull spread) is actually €87,231. This could lead to distortions and potential deceptions in the housing market. Suppose Nama is trying to sell two identical properties, flats 3B and 3G in the same development. First Nama sells Flat 3G under the scheme for a stated price of €100,000. Then, Nama’s real estate agent tells a potential cash-purchaser of Flat 3B that an identical flat was recently purchased for €100,000, not mentioning or downplaying that the other flat purchaser utilized the mortgage enhancement scheme. If the cash buyer does not adjust carefully for this, they could be tricked into overpaying.
How will Nama account for the transaction? There is a potential for “evergreening” or accounting chicanery with such a scheme. Suppose that Nama purchased the loans underlying the flat for 99,000. Will Nama record the €100,000 sales transaction as a €1,000 profit, or a €11,679 loss, or something in between? The transaction might look very good from the short-term perspective of a Nama senior manager, concerned with massaging earnings over the next few years, and willing to spend cash to improve short-term Nama profits. On the other hand, it is not clear to me that Nama’s risk capital providers (Irish taxpayers) want to take on potentially large, speculative positions betting on Irish property market price increases.
* riskfree interest rate = 4%, rental yield = 4%, property price volatility = 5%, all per annum.