Nama’s Property Price Insurance Scheme

A little bit more detail has emerged (via press interviews rather than detailed technical documents) about the Nama property price insurance scheme as it is currently proposed. The basic design was leaked to the press in early July, and was discussed in my earlier thread. The emerging details of the scheme as announced so far are not reassuring. The scheme has considerable potential to manipulate recorded property sales prices, to damage confidence in Irish property market openness, and to build up a hidden future cash flow liability for Irish taxpayers. The motivation given by Nama for implementing the scheme is not entirely convincing.

In essence, under the scheme, Nama sells one of its properties for say 100,000 and provides a property price insurance tie-in with the sale. If after five years the property has declined in fair-market value below its sales price, Nama pays the price difference back to the purchaser, up to a maximum payment of 18,000.  See my earlier thread for a description of the property price insurance scheme as a derivatives package, consisting of a bull-spread purchased by Nama, with a current purchase price of 18,000 and a maximum payout at year five of 18,000.  By construction, the tie-in always have positive value so the quoted sales price of the property is always over-stated relative to the “true” sales price.

Nama states that the purpose of the scheme is to get the property market moving again, arguing that without it potential property purchasers will not buy at fair prices due to their irrational concerns about potential price falls. This explanation is not entirely convincing. Property purchasers are always worried about potential price falls, and hopeful of potential price increases. The market-clearing price is the one which balances investors’ worries of price falls against their hopes for price increases.

Nama’s claim relies on the existence of a “reverse bubble” in property markets. Of course it is obvious that Ireland recently experienced a property bubble, with buyers irrationally believing that prices could only increase. Now in the aftermath of the crash, Nama feels potential purchasers have become irrationally pessimistic, a “reverse bubble,” and so this property price scheme is needed to convince purchasers to buy at fair prices, in their own true interests and that of the economy.

It is understandable why those inside Nama want to believe that Ireland is in the midst of a reverse property bubble. Another explanation for the frozen property market is that Ireland is experiencing market failure due the disposition effect – property sellers (not purchasers) are irrational in their inability to accept how much prices have fallen, and this is what is preventing market clearing.  Following from this, the behavioural explanation for the scheme would be that Nama has a strong institutional incentive to push recorded property prices upwards, and the property price insurance tie-in provides a (risky) method of doing that.  

Property sale tie-ins were popular during the subprime scandal in the USA.  Itzhak Ben-David has a superb field study of their use in inner-city Chicago. The photo below is from the Ben-David study (copyright I. Ben-David, used with permission). The selling agent tied-in a “free” car to the mortgage-based sale of these urban Chicago apartments. A nominally independent property assessor, effectively conspiring with the mortgage broker, provided an inflated valuation of the apartments to allow the “free” car to be absorbed in the recorded property sales price while still leaving them eligible for a mortgage. However, as soon as the purchaser takes possession of the tie-in package, the market value of the mortgaged part of the package (the apartment) falls by the market price of the car.  So the price of the apartment was only temporarily increased by the tie-in of a “free” car.

From Ben-David, Itzhak, 2011, Financial Constraints and Inflated Home Prices during the Real-Estate BoomAmerican Economic Journal: Applied Economics 3, 55-78.

This has relevance to the Nama scheme. The purpose of scheme is to protect purchasers against property price falls. Since the property’s recorded sales price is overstated due to the tie-in, there will be an immediate effective price fall as soon as the purchaser takes possession. This means that the property price insurance scheme (as outlined) starts out with a price deficit, and must experience market price gains, rather than the absence of losses, to eliminate Nama’s future liability.  This reflects a technical bug in the Nama scheme as it has been described so far. Since it does not acknowledge the market value of the price insurance that is implicitly hidden in the package sales price, it over-compensates for property price falls.  It compensates not just for true price falls, but also aims to return the entire insurance premium implicitly paid by the purchaser. That needs to be fixed before the scheme is rolled out.

How will Nama record the property sales price and report it to the CSO for inclusion in their national housing price index? The fair-market value of the property insurance tie-in should be removed, otherwise the recorded transaction will distort property price information. Also, purchasers should be made aware of the two components of the package that they are purchasing and the separate valuations of each, otherwise they might be misinformed about the value of their property ex-tie-in. Both of these price distortions plagued the market in the case of property ties-in in Ben-David’s Chicago field study.

The accounting for the transaction in Nama’s annual income statement is problematic.  With such a long-term (five year) derivative, calibration of the implicit rental yield can have a big impact on imputed market value, so the bull spread is difficult to price accurately. If Nama underprices the tie-in insurance component of the sales package, it will over-state its current profits and understate its potential future losses. This is particularly vexing given that Nama has entered into profit-sharing incentive schemes with its developer debtors, offering them a share of any profits on completed sales. Any such profit-sharing with Nama developers should be based on conservative accounting for future hidden liabilities associated with this scheme.

The scheme provides a hidden source of credit enhancement for the commercial bank funding the underlying mortgage. Property owners tend to default more often when they are in negative equity, and property price insurance substantially decreases the probability of negative equity. So the Nama scheme indirectly gives the lending bank a higher-credit-quality mortgage.  Will that be reflected in the bank’s lending terms?  

The scheme should be structured so that buyers can purchase any given property with or without the property price insurance, with separate price quotes so that the purchaser can choose between a standard purchase or a purchase with the tie-in. This would provide clarity about the true price of the property insurance tie-in, and test Nama’s claim that the scheme adds value in the current market. With this scheme, Nama is using an Irish taxpayer provided credit-line to bet against property buyers on the five-year path of Irish property prices. At a minimum, the Irish public should be told the betting terms of the gamble being placed on its behalf. 

15 thoughts on “Nama’s Property Price Insurance Scheme”

  1. Nice info, The Irish public has shown itself to be in clear favor of fixing house prices. Collusion in the housing market if fine by them if it means their property is worth more for the moment.
    They are joined by the real estate lobby and banks from Ieland and elswhere whose balance sheets are affected by Irish property values.
    Together they will spend as much as the states current and future incomes as possible to increase the value of their own properties.
    Ireland is a 2 wolf and 1 sheep democracy.
    One of the few countries in the world with no land tax and has really weak legislation protecting tenants. No legislation against hoarding of development lands. No legislation against multiple buys ups of properties and property speculation.
    The property owing population decide to use the states income to buy up all the properties to try and artificially hold up prices – NAMA. Now they are again at schemes to pump up prices artifically using everyones money.
    I would ask at least make this program only for 1st time buyers so at least it has some semblance of some sort of help for the sheep.
    Howver it seems its there for everyone, even speculators will be subsidised so that they can’t lose. Doesn’t make sense? Its not supposed to, its just suppoed to pump up peoples house values.

  2. Well done Gregory for exploring the NAMA scheme.

    NAMA will tell you that it is still hammering out the details of the proposal, and a lengthy list of questions from me recently was met with that response.

    As you say there appear to be technical bugs – personally I’m lost as to how NAMA can sell one house on a street for say €200k (and stop using €100k, I’m fairly sure NAMA want to keep the concept of prices of €200k in people’s minds!) using its product and the next door neighbour is also selling their identical home. Given that the next door neighbour doesn’t have the luxury of offering the NAMA product what is the clearing price for the next-door neighbour’s? Certainly less than €200k but €160k? So NAMA’s scheme might make sales of existing property impossible at current clearing prices and rival sellers to NAMA might have to slash their prices by 20%. There is a whole can of worms there.

    But then again, with a credit market that has largely frozen up (2,500 transactions per quarter) and with confidence battered AND with a requirement to sell 25% of the portfolio by 2013, what is NAMA to do? So you can sympathise where it’s coming from.

  3. A much needed article. The comparision of this NAMA scheme with some of the worst excesses of the US subprime boom is both insightful and justified. NAMA is engaging in risky and reckless market manipulation of Irish houses prices, using the taxpayers money. Chris said it better.

    The property owing population decide to use the states income to buy up all the properties to try and artificially hold up prices – NAMA. Now they are again at schemes to pump up prices artifically using everyones money.

    Quoted for truth.

    Chris’ point about “public” support for this scheme is also important. However, while it is clear that arguments against the plan are few and far between in the mainstream media, it’s clear from the comments seen on this scheme in this site and elsewhere that this plan is not washing well with the public.

    I would hold that this plan is designed and supported by the Property Ascendancy who still retain great influence over the apparatus of the Irish State. The big boom-time players and their support staff are all one trick ponies, knowing only how to buy properties with big mortgages and sell them at profit later. They are desperate to restart that pyramid scheme and NAMA—choc-a-block with former bankers, developers, and property agents—has become a 24/7 Galway Tent, where every chancer in Ireland can have his day, once again.

    And if NAMA loses a few billion in the process, so what? Sure, we can just hold a press conference and have a big chuckle over the whole thing anyway.

  4. It is disturbing that the information needs to be dragged out of Nama via a press release. Nama is a multi billion euro business, one of the most significant public policy projects ever undertaken globally, and certainly the most significant in Ireland. Nama now has sweeping powers, and market making size…yet it’s policy making mechanisms are unclear, and information woeful.

    A body of this size and novelty should be receiving professional advice from some of the top finance and economics professionals in the world… are they ?

    I think a PR campaign is needed, to ensure greater transparency and oversight.

  5. “If Nama underprices the tie-in insurance component of the sales package, it will over-state its current profits and understate its potential future losses”

    Would there be anyone that does not assume this is what they intend to do?

  6. Very useful Gregory.

    Consider also the position of a developer (still standing) who must sell in competition with this state-subsidised seller, or of a foreign non-NAMA bank with re-posessed property to sell. How does this scheme measure up in the eyes of the Competition Authority? Financial Regulator?

  7. NAMA is but one more example from Irish governments that have doled out the goodies to all and sundry since 1922. The Irish oligarchy expect to be supported in the same way that the unemployed, ill, very young and rather old are supported. The concept of government supporting the weak and vulnerable and the idea of the greater good have yet to permeate the Irish consciousness. In fairness I must say that the Irish oligarchy is conservative and conservatives everywhere are diligently searching for the moral philosophy that justifies greed and selfishness.

    The management of the economy leading up to 2007 was atrociously bad and cannot be excused by saying, sure twas only political opportunism just the boys and girls ensuring re-election. Then we have the bank bailout which will go down in history as the dumbest move ever made by a government anywhere, Dev’s protectionism pales by comparison.

    Now we have NAMA propping up property values as I read in the European press that Dublin still has the highest rents for retail space in Europe. The same mindset that cannot reduce the minimum wage or public service wages is propping up property values to ensure that the country will never be competitive. There may be a deep seated yearning to return to poverty which after all has been the lot of the country for centuries. The seventy day vacation entitlement of the quango employees is but a minor symptom of more widespread problems.

    The beneficiaries include property owners whose property value is now being supported by the taxpayer, the banks domestic and foreign, investors in Irish property and banks domestic and foreign and of course the politicians who are already on the receiving end of “campaign donations” from those that NAMA benefits.

    As the country heads for sovereign debt default there is something very familiar about the behaviour of our government in that they behave as I would expect without the slightest understanding that the first and foremost responsibility of a government is to remain solvent.

  8. Reply @ All

    Jagdip Singh above makes the point that Nama has an enormous selling task and there is very little credit flow from Irish banks at the moment, hence Nama feels it “must do something.” Is the scheme salvageable after the bugs are ironed out? Picking up on a comment by Colm McCarthy above: do the Financial Regulator and/or Competition Authority have any say in this type of scheme? It needs much more price disclosure than how it has been (informally) described so far. Perhaps other agencies can impose this as a requirement under financial regulation or compeition law? Presumably the CSO will be sensible and remove the value of the “free” insurance component before adding the sales price to its index?

    The scheme does have the advantage of providing indirect credit enhancement to the lending bank, in a frozen credit market. Perhaps if the scheme was scaled back to 10% (of property value not package value) and with full information disclosure about the component prices?

  9. If the price insurance is free, one seller (NAMA) is using state funds to compete unfairly with other sellers. This is anti-competitive on the face of it.

    If there is a credit famine, it needs to be addressed across the board, not just for buyers of properties owned by a state agency.

    This scheme looks like a thoroughly bad idea. If it is welcomed by opposition TDs and leader-writers, you will know for sure.

  10. @Gregory
    “It needs much more price disclosure than how it has been (informally) described so far.”

    It would seem to me that one of the primary reasons behind the design of the scheme is to obscure the true market clearing price.
    There are lots of smart people within NAMA and they should be able to value the option they are wraping up in the sale of the house.
    Why not just drop the asking price to the this level.

    The success of the recent Allsop auctions, where the sales prices were 65% to 70% below peak, and the failure of smaller auctions where the minimum reserves were only about 50% below peak would indicate that correctly prices property will sell, incorrectly priced property will not.

    The market can function it just needs correctly priced property.

  11. The orginal approval from the competition authority included this condition. Are NAMA about to breach this?
    http://europa.eu/rapid/pressReleasesAction.do?reference=IP/10/198

    Finally, the Commission relies on a number of commitments from the Irish authorities to ensure that NAMA, whilst it performs its goal of maximising the recovery value of the purchased assets, does not lead to distortions of competition through the use of some of the specific powers, rights and exemptions granted in the NAMA Act.

  12. In the real world it has been understood for centuries that it is not the job of government to prop up asset values. With the declines in stock values around the world, whether governments should prop up asset values is being discussed. I do not know of a single economist that is promoting the idea that governments should act directly or indirectly. In fact economists like Rosenberg of Sheff Gluskin and Sherry of TD Bank make it clear that governments should let fate unfold as it should. These opinions are held because there is nothing positive that can be accomplished by intervention and a lot of damage that can be done to the governments balance sheet.

    The Irish gov’t continues to throw good money after bad as if the Dail is now the Casino on Kildare Streeet.

  13. Would the IMF/EU not get involved as well?

    I agree this is anti competitive but it is also the tax payers of Ireland taking a bet on property prices rising. This is not in most their interests at all. So there is only upside in this bet for people involved in the property industry and arguably those currently in negative equity.
    For everyone else (the vast majority) this is a loose loose scenario.
    Seriously powerful vested interests involved though.

  14. Thanks for that Gregory. NAMA’s proposed scheme seems is consistent with what appears from the outset to have been an unrealistic bullish outlook. It would be good to see some of its own advocates defending it here.

    It is essentially a fancy property subsidy that will probably distort property statistics since their compilers will be unlikely to attempt to estimate and subtract the varying value of the insurance from sale/asking prices. From a certain perspective, this could be the principal rationale of the scheme since a more transparent scheme (such as a subsidy for housebuyers that wanted to purchase insurance against negative equity, which should help create a market for such insurance) would not achieve the same effect.

    Any ensuing distortion of property statistics may help to slow the decline of prices but it is difficult to justify subsidies, even if they were more transparent, while property is still overvalued. The case for some kind of intervention would at least be stronger if prices were now hitting their long-term equilibrium and were expected to considerably overshoot on the way down.

    On the subject, it is rarely acknowledged how difficult it is to calculate long-term equilibrium prices for Ireland given how little ‘ceteris paribus’ applies. Even if the rent to price ratio has a certain long-term average, the current ratio does not by itself tell us how much property is overvalued today. The expectations, volatility and uncertainty regarding future rent and house prices and/or supply of sale and rental property, interest rates, growth, migration, taxation, unemployment, pensions and stock markets, the euro and default are all additional factors.

    @Jagdip
    It’s not clear, to me at least, what direct effect the scheme would have on neighbouring identical properties (compared with a situation with no such scheme). If NAMA’s insurance against price falls were worth n if offered commercially (this amount – always less than €18,000 – would vary from property to property) and the market clearing price for the property would otherwise be p, then the NAMA property should sell for about n+p and the neighbouring property for p. If after any required waiting period, the market had not risen, then the NAMA property would sell for p or less, while the owner would recoup the nominal loss (which is likely to be less than the real loss) up to a maximum of €18k from NAMA.

    If NAMA properties were excluded from property statistics, I wonder would the scheme have any great effect on the rest of the market. Perhaps I am missing something.

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