Wednesday, October 14, 2009

Economics 15/10/2009: NAMA Business Plan Falls Flat

Updated 09:01

Note: Karl Whelan's post on Nama Business Plan is available here.


So let us start with Nama Business Plan published tonight: the main claim is that Nama is expected to generate a net present value return of €4.8bn by 2020.

I beg to differ. Here is why in two steps:

Step 1:

This €77 billion is made up of approximately €49 billion land and development loans (€28 billion and €21 billion respectively) and approximately €28 billion in associated loans.” Of the latter, €14.2bn is in derivative instruments.

Now, land values have fallen by some 70% plus, with some land now valued at a 90% discount. What the recovery rate on these loans? Assume 30-35%, to the total loss of €18-20bn.

Development loans currently carry default and roll-up rates of well in excess of 40%. Suppose Nama buys an average portfolio of these and that the default rate rises to 1/3 of all stressed development loans. Expected loss here is therefore around €7-9bn.

Associated loans include second recourse and non-recourse loans and cross-collateralized loans. They have lower seniority on underlying assets. And this includes (50%) derivatives – instruments that actually cannot be priced directly without requisite information that has not been supplied by DofF. So suppose the default rate here is the average of the above two rates, or ca 50%, to the total loss on this part of the book of €14bn.

Add this up: total expected loss on Nama loans book value is €39-43bn before we factor in roll ups of interest. Day one of operation, Nama will be holding the portfolio of loans with expected value of €77-€41=€36bn against the liability of €54bn, which implies it will be in the red to the tune of €18bn.

Make another clarifying assumption. Assume that for the last segment of the book – the associated loans – derivative instruments are similar to the average market derivative contracts as stipulated in Table 3 of the BP. This pushes losses on this part of the book up by additional 25-35% of the derivatives segment value. The total loss Nama will incur on day one of its operations will then be a staggering €21.7-23.1bn.


The estimated aggregate average loan to value (LTV) rate for these loans is approximately 77% i.e. the value of the real estate collateral at the time the loans were originated was €88 billion. The loans were made over a number of years and not all were made at the peak of the market.”

Suppose this is true, although I have no confidence that this number is real. Suppose average vintage of the loans is 2005. Land is currently at below 1999 levels in pricing. Development projects are around 2001-2002 pricing and completed property is around 2004. Assuming we are at the bottom, average LTV on these loans today is around:
€28bn/0.77*0.3+€21bn/0.77*0.5+€28bn/0.77*0.85=42.7/0.77=€55bn
This is LTV ratio on Nama purchase as of today of 98.2%. Not 77%, but 98.2%.

If average vintage of Nama loans shifts to 2006 (a more likely scenario, as Nama will not be buying an ‘average bank loan, but a non-performing loans portfolio with so-called ‘performing’ loans to be mixed in coming from stressed loans side of the balance sheet), then the actual today’s LTV shifts to:
€28bn/0.77*0.2+€21bn/0.77*0.42+€28bn/0.77*0.81=37.1/0.77=€48.2bn
This is LTV ratio on Nama purchase as of today of 112%. Not 77%, but 112%.

Incidentally, Nama ‘Business Plan’ contains no sensitivity analysis of this sort or of any sorts – neither for expected inflation, nor for spreads on bonds, nor for cost of administration, or for any other assumptions.

Step 2: redoing Nama balancesheet:

Table 5 clearly states that Nama expects life-time default rates for all loans and derivative instruments transferred to be 19.35% of the book value of loans at origination! Business Plan admits (page 9) that in the last year alone the banks took a charge of €7.3bn on the book – just under 10%. Thus, DofF expects 2009-2011 default rate to be only 10% more. This is for a book that overall contains 40% non-performing loans already! It is simply a case of amazing degree of optimism.

Let us do the math for alternative scenario. Suppose the default rate overall will be 33%, in which case without challenging any other DofF assumptions in Table 5, the net gain of €4.8bn turns into a loss in present value terms of €10.2bn. Just like that!

Now, let us challenge the assumption on Nama yields. DoF data is shown in the Table below. The second table changes yield assumptions and retains my default assumption above:
Now, per table 2 above, combined assumptions of more realistic default rate and more realistic yields (consistent with current yield, adjusting for default rate expected through 2011), and recognizing that derivative instruments yields are unlikely to be achieved at all, bottom line Nama is now expected to yield an €8.6bn loss in present value terms.

Shall we move on? Assuming slightly steeper curve on the cost of bonds financing, table below shows that expected Nama losses can reach €11.5bn in present value terms (Table 3).

One last thing left to do. Recall that per Nama own Business Plan admission, 40% of loans are currently producing a yield. This implies that 60% are non-performing. If yield curve were to rise over time as Nama assumes, these loans are not going to start repayments at any time in the future. So suppose the default rate assumption goes to 45%. Table below shows the end game:
A loss of €19.1bn in real terms!

And this is before we compute the opportunity costs of this money.

Conclusion: DoF estimates for Nama make absolutely no sense. The best scenario I get is a loss of €10.2bn. The worst one yield losses of €19.1bn.

Note: the above do not include the cost of managing the Nama loans by the banks. These ordinarily range around 0.5% of the total loan value per annum. Suppose the banks will be able to pass these costs on their paying customers (you and me). The net effect will be an annual added cost to businesses and paying customers of €270mln.


Note: All Nama flows are targeted for 2013, which in effect saddles future Government with the entire obligation under Nama. A rescue package, then, for banks, developers (with a repayment holiday until 2013) and... FF...

17 comments:

Greg said...

I don't think the €14.2Bn of derivatives is included in the “Associated Loans”.

I think the €14.2Bn (notional value) is a separate issue.

The €28Bn of “Associated Loans” is hardly defined at all.

From Page 9.

“In addition to loans, about 1,000 derivative positions (mainly interest rate swaps) attached to commercial loans will transfer to NAMA:”

Dr. Constantin Gurdgiev said...

Fair enough - if it is not, just omit the paragraph re-pricing these separately.

More smoke from the Business Plan, then - no defined assumptions, not explained assets/liabilities. I wonder what the commercial court would have said if this Business Plan was submitted by Zoe Developments.

Greg said...

After several appeals they might say it was an abuse of process.

Greg said...

After several appeals thay might say it was an abuse of process.

The Galway Tent said...

Should costs for the NAMA-related bailout of Anglo-Irish bank be included in fully truthful NAMA business scenarios from the Finance Dept?

Would this add €4 billion to the NAMA losses?

[Assumption: BOI and AIB are not also effectively bankrupt property casinos like Anglo and will repay their taxpayer cash of a few more billion].

BLucey said...

This is a stunning document. To my mind the most startling issue is the timing. In effect, the only cashflow from NAMA in the remaining constitutional lifespan of the government is "pipeline" stuff. The real repayments etc come next government. Its what Doglas Adams called a SEP - Someone Elses Problem. Perhaps if the opposition simply had the guts to walk from the oireachtas, sayign they will not take part until a plan that is designed to torpedo the next government is withdrawn, that might get some international traction. Of course, that might "scare the markets"....

adrem said...

One question of clarification Constantin - you say that "Suppose the default rate overall will be 33%, in which case without challenging any other DofF assumptions in Table 5, the net gain of €4.8bn turns into a loss in present value terms of €10.2bn"

However in the DoF analysis where they do some fairly perfunctionary sensitivity analysis they do show a result for a scenario where the only factor changed is the default rate - they assume it's 31% (not far off your proposed 33%) but they say the result would simply be "erode in full NAMA's projected NPV gain" - ie 31% default = breakeven.

Leaving aside all the (however valid) arguments about the model and the discount rate etc that doesn't add up. Are they wrong or have you changed more factors than simply the default rate in coming to your 10.2bn loss?

Dr. Constantin Gurdgiev said...

Adrem, all assumptions changes are there - in the tables.

Martin said...

Given that a large proportion of the property underpinning the Nama loans are located in the US and UK, How will the fluctuations in the dollar and sterling against the Euro affect NAMA. Has this been factored into their calculations?

adrem said...

So. . . your numbers are wrong or your comment that the only change in table 2 is a movement in the default rate to 33% is wrong??

Or is the DoF breakeven of 31% wrong?

Paul MacDonnell said...

Dr. G., A question. I see that Irish bank shares have fallen back following the publication of the NAMA business plan. Could this be because the markets have figured out that - just as buying CDSs didn't protect your institution from dodgy loans if the CDS seller were themselves suffering from the same exposure - you can't expect the Irish economy (AND THEREFORE BANKS) to be economically separate from the citizens of the county. In other words - from the banks' point of view - blowing up the household economy through bad policy is the same as blowing up the banks with the only difference being that the former involves lighting a slightly longer fuse?

The idea of the DoF, Goldman Sachs' analysts, European Commission Executives, Alan Ahearne and Garret Fitzgerald sitting around agreeing: 'Well the taxpayer will have to pick up the tab so the banks will survive because the banks are the sine qua non for economic recovery' strikes me as the logic that's been employed to date. But of course Von Mises and Jesus are sitting at a table in heaven and they're saying 'Well, actually, No. The Sine Qua Non is the household and the individual within it.'

I suppose my question is that the Banks surely can't survive if the households are destroyed (in critical numbers). And therefore is NAMA not simply burning down our house so that it won't catch fire?

Dr. Constantin Gurdgiev said...

Adrem, no my numbers are correct - I even bolded out in RED the changes in each scenario, so sorry - I don't have time to deal with your querry as it is self-explanatory in the balance sheets.

Dr. Constantin Gurdgiev said...

Paul, you are 100% correct - the markets have now priced two things based on this 'Business Plan' -
1) Nama will not work, so subordinated debt and banks levy will hammer hard the valuations of the banks into the next 12 years or so; and
2) Nama will not be able to restore banks to profitability let alone drive growth in bank shares (profits).

The second point is what we have been saying all along - to make profit, banks need good lending (i.e lending that is repaid, lending that underlies healthy demand for credit from the corporates and the households). Now, with corporates up to their eyes in debt (short-term maturity predominantly against long term maturity liabilities acquired under M&A and other Celtic Tiger 'expansions') and households already drowned in the sea of debt - who will be borowing from Irish banks in the next 5-10 years?

The answer is - Brian Lenihan and his successors.

And that is not a sustainable profit growth model anyone can bank on. Hence the downgrades...

Whatever one can say about it - in the end, markets are rational and efficient. Even if it takes them time to get there.

Dr. Constantin Gurdgiev said...

Martin, very quickly - you are right, currency risk is there. This is what the 14-odd bn in derivatives is all about. The problem is that the banks might have not managed these derivatives actively, anticipating transfer to Nama, so all the currency swaps and other FX-linked instruments are most likely of older vintage, which makes them worth ZERO, in all likelihood, as the rates have moved dramatically in recent months.

One cannot tell for sure, as we have no information on these, but couple of people in finance I spoke to suggested that the market value of these derivatives is near Nil.

I agree.

Philip said...

The trouble with terrible news from these analysis is that people go numb. They feel powerless. I think if the Government slapped 100% tax on the whole populace, the outcome would not be any different and there'd be no resistance (aside maybe from the unions and public service). We are discussing the end of Ireland as an Independant Nation.

Then again, is any other country really coping that much better - just not as noticeable yet. I mean, we hear of NAMA as being a stopgap to prevent a dominoed Euro Bank collapse. If this is true, then maybe we should be thinking in terms of future relative performance to other countries rather than the current rather chaotic scene we are in now where relative measures are changing too fast. In effect, rational markets take hold and plot their inevitable course no matter what anyone does - maybe we need to look at that end state rather than plot the current rate of decrepitude.

Greg said...

Constantin,

Is it not also possible that the value of the derivatives is negative and that they are being dumped on NAMA.

As you say, “The problem is that the banks might have not managed these derivatives actively, anticipating transfer to Nama..”

We’ll never know because any loss will be buried in a mountain of spin and obfuscation.

Dreaded_Estate said...

I still haven't worked out how they predict that developers w ill make €74bn in capital and interest payments over 10 years from assets only worth €47bn right now.