Loan-to-value ratios – The Irish Economy

The single strangest turn that the NAMA debate has taken is the sudden emergence of the claim that those who are critical of NAMA don’t know that it is purchasing loans rather than property assets. Take this quote from Damien Kiberd in the Sunday Times:

Are the agency’s critics aware that if we allow the European Central Bank (ECB) to fund the €60 billion or so that NAMA will pay for loans, we will be getting control of properties originally valued at €120 billion and not the €90 billion that is continuously cited?

Leaving aside the incorrect claim that the ECB are “funding NAMA” (the bonds issued will be debts that the Irish taxpayer will have to pay back), the answer to the question is, Yes, we are perfectly aware that not all loans have 100% loan-to-value ratios (though whether €120 billion is indeed the correct figure is uncertain).

I suppose it is possible there are many regular folk out there who don’t understand the distinction between loans and collateral but that can’t be who Kiberd is taking about. All I can say is that no economist that I have communicated with on this issue has failed to understand this distinction.

And here‘s the Minister for Finance, quoted in the Irish Times:

The crucial point about the €90 billion, which has not been reported, is that when you take into account average loan-to-value ratios, the property secured had a peak book value of about €120 billion. When people talk about reductions, they are ignoring that issue completely.

Really, who is this “they”?

One explanation for the sudden focus on loan-to-value ratios is that perhaps the government are confused by the fact that NAMA critics have focused extensively on property valuations. There is, of course, a very good reason for this focus. If a developer cannot pay his loan back, then the bank will have to end up seizing the collateral and the value of this collateral will be all the bank has to show for the money lent out. So, in most cases, the value of collateral will be the value of the loans.

Another explanation for this new talking point is that, rather than engage in a substantive argument, the government has decided that it may be an effective debating tactic to claim that forty six professional economists are unware of even the most elementary aspect of banking. Decide for yourself.

In interpreting the write down on loans that NAMA is intending to announce in mid-September, an important element will be the loan to value ratios. A commonly cited figure has been that original loan-to-value ratios on development loans were about 75%.

For example, this ratio would be consistent with a property purchased for €100 million with a loan of €75 million. If for instance, this property had fallen in value by 50% and the developer had insufficient cash flow to repay the loan, then bank would only recoup €50 billion, for a one-third loss on the original loan. A 70% decline in property value, as Anglo Irish noted for Irish property development land back in March, would imply a 60% loss.

So far, so simple. However, the real world is not so simple. Here are two complications that seem likely to have pushed loan to value ratios above 75%.

First, there is the fact that many (most?) development loans allowed developers to roll up the interest from day one. This then gets incorporated into the principal that they owe. So, to take the example above, three years of rolled-up interest at a six percent rate will have left the developer owing €88.5 million, leaving an LTV of only 88.5%.

Second, it’s my understanding that the average loan-to-value ratios generally quoted include a quite different form of loan to the one outlined in the fictional example above. For instance, a developer may have borrowed 100% of the money for the project. However, in addition, they have put up additional collateral in the form of another property they own. If this additional property was worth one-third of the value of the new property being purchased, then this would count as an LTV of 75%.

For example, the developer may have borrowed €75 million to buy a property worth that value and then pledged €25 million in additional collateral. In this case, not only is the property that the loan financed declining in value but so is the additional collateral (the “equity” component.) It is also widely reported that the same piece of property may have been put up multiple times as additional collateral in these types of loans.

From my ivory tower, I’m afraid I don’t know how much this stuff affects overall LTV rates but both practices seem to have been pretty prevalent and they both point towards higher ratios than 75%. I would really appreciate if those with more detailed knowledge of these issues could give us some estimates on the magnitudes at hand here.

Beyond that, I think it will be important that the mid-September announcement of NAMA’s intended purchase prices include information on true underlying loan-to-value ratios, including the amount of rolled-up interest and the valuation of additional collateral pledged.