In this blogpost I list the six basic reasons why NAMA might come into existence, and evaluate each of them.
Author: Gregory Connor
Sorry about the overly technical title to this little entry. I want to ask a question rather than make an informed contribution to the discussion. Here is the question:
Why is the Irish government effectively withholding information about house prices from the public at large?
As house sales prices began to fall in 2008, a relatively minor legal-technical glitch prevented estate agents and newspapers from publicly revealing the prices of completed sales. The government could have easily fixed this legal glitch with new legislation, and also could have improved the system to allow full, complete disclosure of all house sales prices. Rather than fix the legal glitch, the government has scrupulously maintained the new status quo, imposing an effective news blackout on house sales prices.
My question: why and for whom?
The absence of price information has probably slowed the house price correction, since it plays into the behavioural bias of potential sellers who psychologically tend to resist price falls (behavioural finance researchers refer to “framing” and the “disposition effect”). The resulting disequilibrium in housing supply-demand has slowed completed sales to a crawl. This, in turn, has done damage to a range of industries and occupations: home furnishings, real estate brokerage, the legal profession, and newspapers, among others. These industries/occupations would have been hit by the recession in any case, but the lack of house pricing clarity made the situation worse for them.
As a basic principle of economics, price information release is almost always welfare-enhancing. There are some special conditions when this is not true, but as a general principal it seems pretty solid. So not having house price information goes against the public interest. It must be done for the benefit or one or more special interests, or for political purposes.
One big beneficiary is bankrupt or near-bankrupt property developers. The lack of price clarity makes their true value more volatile and uncertain. This allows them to play for time even if, using true but unobservable house/property prices, some or all of their businesses are currently bankrupt.
Today’s papers note that banks are also see themselves as benefitting from house price obscurity. Perhaps, if revelation of true property prices also would make them bankrupt, they can use the lack of price clarity to play for time. But in the case of publicly-traded bank shares and debt securities won’t the investment community see through this obscurity and (if anything) over-correct for this obvious information blackout? See, e.g., Douglas Diamond’s classic piece, The Optimal Release of Information by Firms.
Are there other beneficiaries or other reasons? What is the true driver of this odd piece of (implicit) government policy, or should it be called non-policy? The economic competence of the government could be queried, so perhaps it is simply bad decision-making on their part? I do not know the answer.
Measuring bang-for-buck is crucial in cost-benefit analysis of government programmes. We need a reasonable bang-for-buck metric to evaluate the cost-benefit of NAMA and alternatives.
As I have argued in an earlier post, the main objective of NAMA is to increase risky lending to Irish businesses. This leads to an obvious cost-benefit metric for NAMA and alternatives: Euros of additional commercial lending by banks generated per Euro of risk capital provided to the banks by the government. I will call this the risk capital bank lending multiplier.
How big is the risk capital bank lending multiplier of the NAMA plan? It should be substantially higher than the banks’ normal equity leverage ratio to justify government intervention. If the multiplier is less than 10, then some alternative, perhaps do-nothing as a cautiously sensible choice, is preferable.
The multiplier is not a comprehensive measure since the type of induced lending also matters. If an injection of risk capital can induce the banks to change the composition of their loan books, with more high-risk entrepreneurial loans and fewer safety-first mortgages, this could be employment and growth-enhancing even if total loans do not increase. The multiplier does not capture this but it is still a useful, partial measure of policy effectiveness.
Risk capital is not identical to equity capital, although providing new equity capital is one method of risk capital provision. When NAMA purchases risky loans from banks for cash, it is injecting risk capital into the banks. The government’s blanket guarantee on bank borrowing is also a type of risk capital injection into the banking system.
Different types of risk capital can be standardized by scaling them using a reward-to-variability ratio. So if NAMA purchases a portfolio of risky loans with annual volatility of 20 billion Euros and we assume an equity risk-to-variability ratio of 0.20 than this is equivalent to 4 billion Euros of equity capital. This is only a rough guide since volatility is not a uniformly reliable measure of risk.
NAMA, NTMA acting on behalf of NAMA, or a government agency should provide a credible case that the risk capital bank lending multiplier for the NAMA programme is large enough to justify the trouble and expense.
This blogpost steps back from the details of the NAMA-nationalisation controversies and focuses on fundamental concepts. What policy goals are we trying to achieve and why are these goals important?
The key policy goal is to close what I call the risky lending gap – defined as the difference between the lending policy of a sound bank and that of a bank encumbered with an overhang of poor-quality loans. Filling this risky lending gap (if it exists) is important for jobs, growth and exports. Possible policy tools (as Patrick Honohan has made clear in earlier posts and his recent presentation) include a capital injection, or an asset switch, or a combination.
I will rely on a technical model whose details are given here. First I consider the case of “good bank” with equity capital Q which has to choose an optimal lending policy. The bank is faced with a supply of available lending opportunities, ranging from riskless up through increasing degrees of riskiness. The “safe” loans (which are the first loans that the bank will include in its loan book) might be mortgages to senior civil servants, the riskier loans might be loans to new entrepreneurs planning to hire recent graduates and open export businesses. As policymakers, we are concerned particularly about the more-risky (but economically valuable) commercial loans, since these are the source of new jobs, positive growth, and increased exports. For simplicity I assume that the riskiness of the bank’s loan book increases linearly in the amount of lending:
Making some technical assumptions (constant risk aversion, normally distributed returns on the loan book) one can derive the unimpaired bank’s total lending. I assume that this is the socially-optimal amount of lending, since the bank and loan markets are functioning properly in this case:
The model is calibrated to roughly approximate a medium-large Irish commercial bank such as Bank of Ireland or Allied Irish Bank. See the spreadsheet here for details of the calculations. The bank has equity capital of 10 billion Euros and optimal lending by the bank is 90 billion Euros.
Now I consider the case of an impaired bank. The bank “inherits” a stock of bad loans from earlier bad decisions and/or bad luck (a combination of these, obviously, for the case of Irish banks circa 2009). These developer loan losses D are an overhang of net losses on the bank and are unaffected by the bank’s choice of current lending. They are also risky in terms of their realized value, and this risk is correlated with the risk of the bank’s new lending. The next graph shows the bank-optimal lending level given this overhang of bad loans, and compares it to the socially-optimal bank lending of 90 billion derived in the earlier graph. Because of higher risk from the overhang of bad loans, the bank cuts back sharply on new lending. Bank lending fall from 90 billion to 73 billion Euros – this is the risky lending gap. Since small-business loans are riskier than mortgages, this represents 17 billion Euros of lost new business lending which otherwise would create jobs, spur GDP growth and increase exports. This is the problem that NAMA, the Irish government’s bank capital injections, the Geithner plan in the USA, etc., seek to address.
What policy ideas does this simply model clarify? Here are three:
1. How big is the risky lending gap?
New Irish bank lending has gone down since 2007, but this is not necessarily due to a risky lending gap. The supply of lending opportunities shifts unfavourably during a recession, so even socially-optimal lending will fall. Patrick Honohan spoke about this in his recent DEW presentation. The research problem requires more data on actual loan activity and more detailed empirical analysis, but is important to measure the risky lending gap in the current Irish recession. This is a worthwhile endeavour for government, academic or practitioner economists, given that the stakes are so high. Perhaps the true risky lending gap is near zero, and NAMA is a waste of time and money.
2. Should Policymakers Focus on an Asset Switch or a Capital Injection?
The source of the risky lending gap could be the expected size of the developer loan losses or it could be their uncertainty. The appropriate policy response differs in these two cases. If it is the absolute size of the expected losses, then the bank needs a capital injection, and there is no particular reason to have an asset swap. On the other hand, if it is the riskiness of the realized loan losses, then an asset switch (where NAMA takes bad loans in exchange for a fee or financial claim on bank assets) is the appropriate response. If both the size and uncertainty of the loan losses play a role, then perhaps a combination policy (asset switch plus capital injection) is appropriate.
3. Commercial Banks Are Information-Relationship Businesses Not Asset Portfolios
One important caveat is that, for the purposes of policy analysis, banks must be treated as information-and-relationship businesses, not simple asset portfolios. An asset switch removing D from the bank’s balance sheet and replacing it with some other liability is not like buying one share and selling another in a stock portfolio. The realized value of D can depend upon who is managing the impaired loans. Also, it is very important to avoid political interference in loan recovery management. If bank nationalization or NAMA might cause a big increase in the realized magnitude of developer loan losses then perhaps a do-nothing policy is better. Irish property developers are very politically powerful, due to their long history of generous political donations. When considering government policy and its effectiveness, it is important to keep in mind that Ireland is not Scandinavia. We may have a sprinkling of their fair hair and pale skin among the populace, but when it comes to standards of governance we are a bit more, um, carefree than the Scandinavians. We have a long and sorry history of political corruption associated with property development. This argues for a minimal-intervention policy when dealing with bank capital and property development, where the temptations are enormous for resource-siphoning to special interests.
References
Honohan, Patrick (2009) Presentation to the Dublin Economic Workshop, May 20th 2009. Presentation slides available at www.irisheconomy.ie.
The lending performance of Irish and other European banks might be improved by the creation of asset management companies to absorb banks’ toxic assets and replace them with cash or near-cash assets. The types of toxic assets held by banks differ across European countries; they are mostly bad property loans and collateralized-mortgage-based securities.
There will be a considerable decrease in banks’ accounting book value when it sells toxic assets for cash value since the toxic assets are being carried on the banks’ accounting books for more than their true market value. The decrease in accounting book value, which will come out of the banks’ book value of equity, has to be modest enough so that the banks are not declared insolvent after the transaction.
The Geithner plan offers a valuable template for Europe in designing a toxic asset transfer scheme. The Geithner plan invites private firms to bid competitively for the toxic assets of US banks. The funding for the bids come from three sources: equity provided by the bidding firm of 3% to 10% of total capital provided, an equal amount of equity funding provided and owned by the US government, and a non-recourse US government loan for the remaining 80-94% of capital provided. The required yield on the nonrecourse loan will be somewhat underpriced relative to its risk, so there is some degree of subsidy. This is necessary to make the plan work; this entire subsidy should in theory accrue to the selling bank and shore up its capital base. This is the only subsidy in the plan.
Since the US government will own up to 97% of the asset management companies’ assets, there is considerable financial/administrative/legal expertise needed by the government to provide reasonable oversight of these asset transfers and subsequent management of the assets. This could make such a plan problematic if implemented by Ireland on its own. Also, it is critically important that there are multiple bidders, competing aggressively against each other in the toxic asset auctions. Additionally, the nonrecourse loan must come from a government entity borrowing at risk-free rates (and then lending to the asset management company at a higher rate). It is a clever type of “targeted quantitative easing” (my own term). Ireland is not in a position to borrow vast sums to purchase the toxic assets of its own banks. The targeted quantitative easing should come from the sovereign issuer of our currency.
This is a great opportunity for the European Central Bank to play a role as a true regional central bank. It can easily provide the non-recourse debt in a European version of the Geithner plan. National governments can be responsible for the matching equity investment, and the ECB can provide the oversight, along with national governments. Implementing the Geithner plan in Europe would also appease the US government which wants to see some burden sharing by European governments in dealing with the credit-liquidity crisis.
Krugman feels that the Geithner plan, although moving in the right direction, is too weak to be effective. However if the EU joined the US and instituted a very similar plan there might be a positive-feedback effect on confidence and liquidity which could boost the global impact.