Monday, October 5, 2009

Economics 06/10/2009: A stockbrokerage strategist on Nama

And so it comes to my attention that last week in a local Chamber of Commerce hosted a debate on Nama. Per my contacts, “a number of issues arose that may be of interest”.

These issues are important because they largely outline main arguments about Nama made by the proposal supporters out there.



1) Nama supporter (NS) was keen to distance himself and Nama supporters from ‘theoreticians’ and ‘academics’ who exclusively populate the Nama critics land. It is important to note that many of the people who signed the letter of 46 economists, as well as other members of the critics camp are actually practitioners of the same fine art of finance as NS. Many.


How many? Well, just a quick run through
  • myself – former business editor who brought finance coverage to the most respectable Irish business magazine, former director of research at NCB, currently head of research and strategy with an American brokerage.
  • Greg Connor – former director of research for Barra, Fed employee.
  • Karl Whelan – former Fed employee.
  • Other members of 46 run options desks, have been bond traders, worked in central banks and finance ministries... you get the picture.
  • Brian Lucey - former employee of the Central Bank;
  • Ronan Lyons - former economist wit one multinational company and also chief economist of Daft.ie; and so on.
NS might think we in academia are just performing random walks in various universities’ squares, but no, we actually advise governments, international organizations, businesses and have some relevant experience in the real world.


2) NS contended that the main problem with Irish banking sector was that after 2001 we had
"over competition" from (guess who?) the foreign banks. One assumes he means Rabo and KBC, for the British banks were here before 2001 and in addition we had our banks in their countries as well, aggressively lending to… yes, you’ve guessed it again – property developers there. So the foreign banks, thus, caused a property boom in Ireland. And the foreign banks forced our banks to issue 110% mortgages. And the foreign banks assured that most of our lending has gone to finance property deals of one variety or the other. Of course, it was the foreign banks that made sure that IL&P and Nationwide made strange dealings with Anglo. Why wouldn’t NS read Noel Whelan’s treatise on the crisis (see my comment here) – he might find out that in addition to the foreign banks, 46 economists also caused the crisis.


3) NS also allegedly claimed that as foreign banks leave Ireland, Irish banks will take a "more prudent, even oligopolistic approach to rebuilding their balance sheets". Oligopolistic? I hope the Competition Authority is reading this, plus the folks at the EU Commission. But for those of you who wonder what this means, let me explain. In the case of oligopolistic competition, banks would earn near monopoly profits by charging their customers (aha, you and me) excessive near-monopoly rents. Happy times, folks. A stockbroker calling for oligopoly? Surely not. Though it might happen if our regulators continue sleeping at the wheel. What’s next? Markets for shares becoming too efficient, so NS will call for regulated trade in equities? Incidentally, courtesy of Anglo, we already have had bans on shortselling - an activity that actually has been proven to aid price discovery in the markets.


(4)
Per NS, the main aim of NAMA is to get credit flowing. If this turns out to be a problem in a recessionary economy, the profit motive of the banks will induce them to lend after NAMA. Ahmmm, ok, I have one question – why would they seek profit opportunities in Ireland?
  • Because our margins are so high? Nope, they are low, Bloxham, Davy and other Irish stockbrokers said so. Can banks raise these margins? Yes, but only at the expense of already strained households, which will mean that their loans books will suffer more defaults. Surely NS wouldn’t call that an improvement in financial stability?
  • Will the banks have an incentive to lend post-Nama because our lending bears lower risks? No, we are among the worst performing economies in Europe.
  • Because the banks will simply have excess of cheap cash after Nama? Oh, no – they will still face some €130bn in interbank loans to repay (pricey stuff) (here).
  • Maybe because they can’t get better returns anywhere else than in Ireland? Well, they can get higher returns pretty much anywhere else other than in Ireland, given our domestic economy will be contracting through 2010.
So, the banks won’t be rushing to lend here. And, incidentally, there won’t be many borrowers rushing in to borrow either – the households will be scrambling to deleverage in the next two years, not to borrow more. What is most likely is that the banks will use our taxpayers’ cash to repay some of the interbank loans, plus buy some discounted debt of which they had €103.8bn worth of senior bonds and €17.7bn in subordinated bonds as of June 2009.


5) Per NS, Nama provides
asymmetric exposure to risk to the benefit of the taxpayer as the subordinated Nama bonds will take 1/3 of the risk. As far as I recall, the actual plan was to issue 5% of the Nama disbursed funds in the form of these bonds. Even if the risk weighting on them truly reflects the risk of Nama generating an end loss, this translates into just 5% of risk being shared. Of course, since we have no exact legally defined and enforceable criteria as to what constitutes ‘success’ or ‘failure’ of Nama, any future Government can ‘fudge’ whatever outcome achieved to be called ‘success’, so effective risk-sharing under subordinated bonds is NIL.


6) Allegedly, NS claimed that
current commercial property yields are at 6% nationwide and are heading UPWARDS. These numbers were presented as facts in contrast to the ‘nonsense’ figures being quoted by some economists. (See Ronan Lyons on this one: here).

Of course NS explained that higher yields will come about as economy is now in imminent recovery mode and that we will see a positive q-o-q growth in Q2 2010. Thus, Davy’s Rossa White, for example, is a pessimist compared to NS who was not sure what Rossa White forecasted for Irish economy just a day before this event. Hmmm…


Now, Nama is apparently about Irish economy. Which of course is about GNP – in case NS did not know. In this context, I don’t think anyone really expects the yields to go up to 7% or to even 6% any time soon. And, in addition, I presume NS is unaware of such things as lags – it takes time to work through the surplus properties out there in the market, and it takes time before that to get consumers spending again. So Q2 2010? More like Q2 2011 for consumption to uptick significantly enough for yields to start stabilizing.


Suppose NS is right and the yields are heading for North of 6%, say towards 8%. Does he believe that these yields improvements will be driven by rents increases? In the current economic environment, even if there is some nominal growth in 2010 of say 0.5% in GDP, this an unlikely scenario with vacancy rates in commercial sector of 21% plus, and in residential sector with some 200,000+ properties unoccupied. So the only way yields can hit 8% is by price of property dropping further, and dropping by more than 20%. What does this mean for the ‘haircut’ applied under Nama? It means the haircut is too low. Significantly too low. If the yields were to firm up, per NS’s assertion, property prices will have to drop and Nama will instantaneously be overpaying even more than it already does.

And, folks, there is no arguing against this point for the yield is, by definition, a ratio: rent to price movement ratio. Ratio can rise either if the numerator rises (rents) or denominator drops (prices).


7) The good thing is that NS is at least more
committed to some sort of accountability in Nama than the Government is. Per NS, allegedly, we will know if NAMA works within months, perhaps as little as three to six, as the restoration of credit would tell us that. And if not? What would NS do if Nama fails to deliver? Surely all stockbrokers have standard stop-loss rules to prevent reckless or rogue trades? Nama does not – and it always was a major part of my criticism of the current legislation. Surely NS would be familiar, therefore, with the need for a strategic Plan B? He is. And…


8) … of course – Plan B is to buy equity in the banks post-Nama – the Government already admitted this much. Which might lead to nationalizing of the banks or at least nationalizing a large chunk of them. But for NS this won’t work, as he said, allegedly, that people who advocate forcing the banks to face up to the losses are in fact advocating that not only should the equity holders bear the losses but also that the depositors should be expropriated. Of course, no one I know of in the debate on Nama has suggested that, not even unreformed socialists did. Furthermore, as far as I am aware, in every country where the banks were forced to face up to their debts – US, UK, Sweden, Denmark, Spain,... you name it – depositors remained intact.


Two more things come to mind here. Even post-Nama NS, taken at the face value of his argument, won’t stand for nationalization no matter what – in other words, should the banks need more capital he would, I presume agree to simply give it to them once again, with asking nothing in return. And also that post-Nama, when the banks ask for more cash we might be expropriating the depositors?


Is this for real? Is he suggesting that fully guaranteed depositors might face loss of their funds? Personally I think this is completely out of line scaremongering.



9) NS, allegedly, also stated, per my contact who noted it down as the meeting concluded for tea and buns, that NAMA will make a profit as the bonds will be euribor+50bps while the loans (apparently all) will be yielding at euribor+200bps. So the 44% of loans that are performing can easily take the strain of those that are not performing. Well, not so quick.


Assume for a second that NS is right. Banks pay the cost of managing the loans, so euribor+200bps is more like euribor+125bps once cost of managing loans is taken out. State pays the cost of issuing bonds, so euribor+50bps in bonds face value is more like euribor+65bps in gross cost to the state. Now, at 44% weighting, the average loans portfolio yield becomes euribor+55bps, which is below euribor+65bps. Nama makes loss even under NS’s rosy assumption of all performing loans paying euribor+200bps on average.


But here are two additional kickers:

(a) If interest rates increase, and NS should know this, more loans will go into non-performing category, plus, as I explained above. If NS’s assertion of 8% yield in near future is correct, again, more loans will go into non-performing category. Thus 44% of performing loans today, might drop to, ough say 35% or 30% tomorrow. This is what is roughly called interest rate sensitivity – as the cost of loans rises, more loans fail.

(b) NS’s assertion on euribor+200bps and on 44% performing loans rests on the assumption that the due diligence on these loans is straightforward, so Nama won’t make mistakes in buying up ‘performing’ loans. Again, any error, driving either 44% down or euribor+200bps margin down will hammer Nama bottom line figures.


10) NS asserted over some answers to specific questions, that there is a ten year property price cycle, in nominal terms. If he really did say this, this now provides yet another bogus ‘benchmark’ for property markets recovery – first there was a 7 year to 80% correction statement from one property specialist in the Dail, then there were 5 year turnaround time estimates from the Government advisers circles, now it is 10 year nominal recovery number from one of the stockbrokers.

Clearly NS is unaware of the long-term results for property market busts, and he is unaware that combined shocks to property market, plus to broader financial markets yield much deeper contractions than what his statement implies. I did some actual estimates based on OECD and IMF data and found that past busts across the OECD with an average magnitude being lower than that of expected Irish property prices contraction average 18 years in nominal terms. But what is even more surprising is that a stockbroker would care about nominal, not real, returns. Surely that is not what his usual client advices is based on, one hopes.
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