As we wait for today’s budget announcements, it is worth reflecting on the challenges of getting the right design and pricing for the asset purchase scheme now being trailed.
Some bloggers have made up their minds that the government will overpay for the assets. How can such an outcome be avoided? I have a slightly novel suggestion for this.
As in the United States, there will be a huge gap between what the banks claim the assets are worth and the value that the rest of the market would place on them.
Finding a mechanism that places a generally accepted price on the assets is as difficult here as it is in the US. Any asset purchase scheme will require a further detailed scrutiny and evaluation of the assets to be purchased.
It is to be hoped that the initial announcement of an asset purchase scheme will not lock the government into prematurely firm commitments on pricing and financial restructuring of the banks. The worst possible thing would be to crystallize the taxpayers’ costs at too high a level.
Buying the assets at inflated prices would surely be politically unacceptable. Indeed, Government sources have clearly trailed that they will not pay current book value for the assets.
Each country’s situation is slightly different. If we were to subtract now the present value of all prospective loan losses (taking recent analysts’ estimates), the main Irish banks would be severely undercapitalized. Removing the problem loans at anything close to the prices implied in the analysts’ estimates will require the banks to take immediate write-downs that have the same effect.
Therefore implementation of the asset purchase scheme at realistic asset prices will create the need for a further recapitalization of the banks.
Injection of more preference shares by the Government will not do the trick. If the banks are to move forward in a sound manner, and be accepted as financially self-sufficent, they must have sufficient equity capital. In quieter times there would be enthusiastic private sector buyers for equity in such cleaned-up banks. Failing that, the residual equity investor is likely to be the government. When you do the sums using the analysts’ estimated, this has to imply huge dilution of the existing shareholders. No wonder many commentators have concluded that full, albeit temporary, government ownership is on the cards.
Given this background, it might be better to do something just a little more complicated: let the asset management company pay even less than fair price for the bad loans, and in return give the existing shareholders of the banks an equity stake in the AMC. This has the advantage of making sure that the surviving bank really is clean, and neatly defuses shareholder objections that they are being expropriated. Of course they are even less likely to own much or any of the surviving bank, unless they choose to contribute to its recapitalization. Other existing risk capital providers, such as the holders of unguaranteed subordinated debt, could also be compensated for write-down by acquiring a stake in the AMC.
Let’s hope this week’s statements do not shut off possibilities such as this which can protect the taxpayer without destabilizing market confidence by allowing well-adapted financial contracts to bridge the gap between taxpayer and shareholder.
Although my idea may seem novel, specialists will recognize it as only an adaptation into our current circumstances of the most conventional form of bank resolution mechanism. It can work.