Tuesday, July 20, 2010

Economics 20/7/10: Is Zombie Nama propping up Mummified Irish Banks?

As the independents – Brian Lucey, Karl Whelan, Peter Mathews and myself – have warned (actively denied by the Government and its backyard ‘experts’), Nama Tranche II turned out to be yet another unmitigated disaster.

Nama paid €2.7bn for loans that its experts valued at €5.2bn. Of course, these ‘experts’ include many who were responsible for some of the most disastrous valuations of the Celtic Tiger era and are now ‘entrusted’ as being ‘experienced’ with re-valuing their own errors, while collecting a handsome pay packet courtesy of the Irish taxpayers. The implied average discount these folks put on the loans this time around is 48%. Anglo failed to transfer its loans – some €7-8bn worth – due to delays caused, per what I am hearing, by a rather shoddy documentation quality.

Per RTE: “The biggest discount on the second batch of loans was for those from Irish Nationwide. NAMA paid the society just €163m for loans of €591m, a discount of 72% [an increase of 14% on Tranche 1]. The figures for AIB and EBS were 48.5% [on €2.73bn marking a 6.5% increase on Tranche 1], and 46.5% [on €35.9mln and an increase of 9% on Tranche 1] respectively, while the Bank of Ireland discount was 37.8% [on €1.82bn - an increase of 2.8% on T1].” Overall, Nama now has in its vaults €20.5bn worth of loans (or rather largely worthless paper few years ago labeled as loans) for which it paid at a discount of 50.7%.

The loans are concentrated - related to just 23 property developers who are deemed to be 'second tier' aka less flamboyant than those in Tranche 1 and most likely, less experienced too.

It makes me laugh when I recall how our stock brokerage 'analysts' were chirping a year ago that a 20-25% haircut would be warranted by market valuations of these loans.

However, the real problem with all of these numbers is that while the discounts might sound impressive, they are not reflective of any reality. Instead, they are now fully bootstrapped to the capital commitments issued to the banks by Brian Lenihan. You see, as we warned from the start – and this too was vigorously denied by the Government – the heavier the haircut, the greater will be banks’ demand for capital, the greater will be the share of bank equity owned by the taxpayers. Mindful not to take too much stake in BofI – for that would produce poor optics internationally – Brian Lenihan is content to oversee a 38% discount on its loans. Having pumped capital up to 50% of risk-weighted assets transfers to Nama for AIB, the Minister is equally happy not to impose heavier haircuts on AIB Tranche 2 transfers than 50%. Hence the ‘magic’ 48.5% figure. Ditto for EBS. Sounds precise – not 49%, nor 48%. But in the end – the number is most likely utterly bogus.

To put some fluff in the air about ‘Nama is a tough player with the banks’, Tranche 2 hammered INBS and most likely will hammer Anglo. Unless, that is, Anglo fatigue has finally reached Upper Merrion Street buildings. In this case, a discount can be less than that for INBS. Not because Anglo loans have miraculously become sterling in quality, but because the DofF might be just slightly concerned that the bank will come with a fresh capital demand.

So instead of pricing the loans to market, Nama now appears to be pricing them to keep required post-Nama recapitalizations at the levels consistent with earlier Government capital commitments.

In the end, however, a 48% average discount is still a gross overpayment on these loans. Let’s do a back of the envelope calculation here.

25% of Nama loans are ‘cash generative’ – i.e. paying some sort of an interest repayment on interest due. Suppose – just for the sake of making an assumption – that 50% of those cash generative loans are paying full interest due and 50% are paying ½ interest due. Assuming average interest rate on the loan of 8% (a generous assumption, given that banks were lending at lower rates than that) and cost of refinancing banks funds at 3% (well below current yields on banks bonds, even way lower than the latest Exchequer yields of 5.25%, but let’s be generous), if the cost of managing loans at 1% (consistent with Irish banks’ margins), then:
  • 75% of Nama loans are losing have a negative yield of 12% (annual loss on interest alone);
  • 12.5% of Nama loans are losing 2% pa in net costs, plus 8% rolled up interest, implying their negative yield of 10% pa;
  • 12.5% of Nama loans are losing net 8% pa.
Expected average annual loss on Nama overall portfolio is therefore 11.25% pa. Value this at x3 revenue flow. Nama portoflia of loans would have a negative, yes, negative, - 34% break-even valuation in the market. Just on the back of interest and costs alone, the value of Nama purchased portfolio of loans should be no more than 66 cents on the euro of face value.

Next, subtract the percentage of loans that are unsecured – while allowing for the expected recovery, subject to the risk. Suppose that 20% of loans taken on by Nama are unsecured (again, likely to be conservative assumption). Suppose these are distributed across the same 12.5%, 12.5% and 75% sub-portoflia following a uniform distribution (again, this is a generous assumption as lower quality loans are more likely to be less secured in the real world). The value of the entire package of loans is now worth only 59 cents on the euro.

Secured loans are also subject to a recovery risk. In general, risk of recovery implies that over 70% for loans in arrears will be non-recoverable, ca 50% for loans under stress (e.g. failing to pay principal when it is due) and 20-25% for loans that are fully performing (e.g. those that are repaying principal and interest to the full amount). These are numbers consistent with the 1990s experiences in Sweden and UK. Translating these into our valuation, adjusted for risk of recovery implies the value of Nama-bound loans around 30-32 cents on the euro.

Other risks can be priced as well, but let us stop here.

Even with relatively rosy assumptions, the value of the loans being purchased by Nama should be at maximum 32 cents on the euro.

Allowing for assets appreciation of 10% over 3 years would imply a valuation of no more than 37 cents on the euro without applying a PDV adjustment.

We are told that Nama is being a tough buyer, paying 52 cents on the euro. Who’s fooling who here?

Incidentally, 30 cents on the euro is what independent banking expert Peter Mathews has estimated as recoverable for all development and property loans held by the banks. It is also the number that myself and Brian Lucey have arrived at in our previous estimates of required haircuts, which were based on analysis of underlying property markets.

What is now clear is that 24 months since the crisis fully exploded in our faces and 15 months after the independent analysts started telling the Government that it is committing a grave error in pushing forward the solution that, under the original name TARP was rejected in the US two weeks after it was put in place, the Irish Government remains hell-bent on pursuing this wrong approach to banks recovery. More egregiously, with Tranche II loans in, there is a strong enough reason to suspect that Nama has turned into nothing more than a façade for delaying even more capital demands from the banks until the end of 2010. The reason for this, one might speculate, is to keep our 2010 public deficit from exploding to beyond 20% of GDP.

A zombie institution (Nama) now is fully in charge of our mummified banking system. What can they do next to make things even more dynamic than that?
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