Showing posts with label Nama value of land. Show all posts
Showing posts with label Nama value of land. Show all posts

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?

Wednesday, March 17, 2010

Economics 17/03/2010: Nama Estimation Procedures

Yesterday I finally got a few minutes to read through the latest Government documentation on Nama - "Determination of Long-Term Economic Value of Property and Bank Assets" regulations SINo88 of 2010 from March 5 (link here). This delightfully thin document is a treat for anyone who cares to study just how inept our authorities can be when it comes to measuring and assessing/pricing risk.

Timing

Paragraph 2 page 2 defined 'relevant period' - used in assessing long-term economic value - as 'the period that began on 1 January 1985 and ended on 31 December 2005'. Per para 5.ii page 3, this period will be used to estimate reference prices for land based on land hedonic (econometric) links to demographic variables (5.b.i), interest rates (5.b.ii) and GDP (5.b.iii).

The problem here is that there is no clear identification as to which time horizon (the full 21 years worth or some sub-set thereof) the Government will use. And this is crucial, as this period largely covers steadily rising market with almost no corrections. Which means that should Nama use dynamic trend for estimating the land prices, it would be rather accurate within the sample, but will be absolutely ad hoc outside the sample (per Lucas critique).

Of course, Nama won't take dynamic pricing - and as is clear from 5.(1).(a).(i) and (ii) it is going to take 'prices' and 'yields' - i.e. point estimates. Which most likely means some sort of an average. It is important, therefore, to have an exact idea as to within what sub-period of 1985-2005 is this average going to be taken. The note does not identify this exactly, leaving the door open for Nama to deal with the data as it sees appropriate.

Discount factors

There is an added complication to the entire valuations scheme. SSNo88 states in 5.(1).(a) that a discount (adjustment) factor for land located within the State will be based on a difference in price of land on valuation date (nearly absolutely unknown to Nama) and the Long Term (economic) Value (LTEV) price (also unknown to Nama). And this means that Nama will start its valuations process by applying an unknown discount factor to a risky asset it is buying. No data listed within SSNo88 as the basis for valuations allows Nama to escape this grim reality.

Discount Rates

There are other fundamental errors built into valuations process. For example, NAMA discount rates - equivalent to interest rates - on bank assets are (as listed in 2.(2).(a)-(b) on page 2: 4.54% for 3-year rate, 5.57% for 5-year rate, and 6.16% for 8-year rate. This presents a little bit of a conundrum. Firstly, are these rates annualized compounded or simple? Second, and even more important - why are these rates chosen for these maturities? What yield curve has been used to impute these? No clarity on this whatsoever.

ECB gives only two types of average retail rates for non-financial corporations loans: as of January 2010 (the latest), we have existent loans with rate fix up to 1 year are priced at 2.96% which, factoring in Government's 1.7% risk premium margin implies a rate of 4.66%, not 4.54%. Off the starting line, there is a built in subsidy from Nama.

And this subsidy is greater than 12bps spread between the above two rates. How I know this? Well, think - can assets we are buying into Nama attract any loans in the private sector? At any valuations? No. So what justifies that 1.7% risk premium the Government applies (per 2.(2).(a)-(c)) to all loans it will be buying? And why is the risk premium independent of maturity period? Surely it should be rising with maturity?

Let's take a look at what we have from the ECB: non-financial corporate overdraft rate as of January 2010 averaged in Ireland at 5.74%. Suppose this was the basis for our Nama valuations (I still think this is too low of a rate given the assets quality and given the fact that ECB reports 'offer' rates by the banks, not the actual rates on which loans were issued, but what the hell, let's use this as a base assumption).

With Government risk premium, this should imply a 3-year discount rate of 7.44% (still shy of corporate junk bonds, but much better than 4.54% built into Nama). This rate (per 7.(a)) will cover land-backed loans where land value has fallen just 10% below its LTEV - the high quality loans in Nama books. Now, using SSNo88-implied yield curve, 5-year discount rate consistent with our assumed base rate should be 2.08% and for 8-year rate, the risk margin should be 1.9%.

This means that if Nama were to use the riskiest loans rates we have - those for overdrafts by non-financial corporate sector, and use upward sloping risk margins (to reflect the fact that the longer the duration of the rate, the lower is the quality of assets to which it applies - per SSNo88 page 5 own admission), the rates of interest imputed on Nama assets should be:
  • 3-year money - at 7.44%, not Nama-assumed 4.54% (a loss to the taxpayer or a subsidy to developers and banks of 2.9% per annum);
  • 5-year money - at 9.13%, not Nama-assumed 5.57% (a loss to the taxpayer or a subsidy to developers and banks of 3.56% per annum); and
  • 8-year money - at 9.67%, not Nama-assumed 6.16% (a loss to the taxpayer or a subsidy to developers and banks of 3.51% per annum).
Let me give you a look at the Nama interest rate pricing generosity from another angle. Irish Exchequer is currently borrowing at 5% interest rate in the markets. This, presumably does not include Mr Lenihan's 1.7% risk margin. Which means that if Nama was buying loans from borrowers who are as credit-worthy as the Irish Exchequer, it should be applying a rate of 6.7% to these loans. My estimate of 7.44% is much closer to that than SSNo88 statutory fixed rate of 4.54%.

Proposition: under Nama, effective interest rate subsidies for defaulting loans (accruing to banks and developers) will range between 2.9% and 3.56% per annum.

Proof: see two alternative arguments above.

Estimation process

Another issue, related to interest rates arises when the SSNo88 outlines 3 sets of variables Nama will use to impute LTEV based on 'correlation' (whatever this means in econometric terms, I have no idea): 'between land prices and interest rates in the State' (5.(1).(b).(ii)). Can someone explain to me which interest rates Nama has in mind? Central Bank rates? Retail rates? Retail rates for non-financial corporations loans?

The same applies to paragraph (5.(1).(c)).

Valuations timing

The document SSNo88 was published in March 2010. Nama will not begin valuations before April and will not finish these before the end of 2010 (optimistic projections). So why are all valuations being made by Nama will take into account only market values of land prior to January 10, 2010? Surely, falling markets mean - and consensus forecast expects - at least 5%+ decline in house prices (what can one say about land!) over 2010. Is Nama going to ignore this reality and price the assets in buys in, say, November 2010 at prices valuations for January 2010?

Let me explain. In a year when I bought my house, within 11 months of my purchase, home prices fell roughly speaking 3%. Do I get to go to my bank and tell them - 'Folks, shave off 3% from my total original mortgage as Nama is doing for you?'

5% is a non-trivial number, adding up, over the loan book Nama id about to take up roughly €3.9 billion overvaluation, spread over 15 years with interest and market discounts accruing to it.

Use of GDP

SSNo88 applies to valuations of land and real estate assets. These are non-exportable. Why is then the Government planning to use the rates of growth in GDP, not GNP? Does our booming (1985-2005) pharma sector has anything to do with the fundamentals on which land prices are set? Using GDP for the estimation process instead of GNP introduces a distortion of between 12% and 18% depending on the range of years used. This distortion risks further overvaluing the LTEV for land.

Building in dreamy planning

Paragraph 5.1.d.ii states that Nama will use "existing and future transport planning and the associated supply and demand projections for land use" in its valuations of LTEV. What does this mean? Will Nama use full extent of NDP plans? Including the frozen and indefinitely postponed plans? There is significant divergence between what is planned and what is delivered. And in the next 10 or so years, this divergence will be in the direction of planned transport investment being well in excess of real investment. If Nama were to use the former as a basis for estimates, then there will be land with LTEV in excess of realizable value because its estimated LTEV will be based on excessively optimistic plans for transport investment.

At any rate - the current phrasing of the SSNo88 does not provide for a rigorous definition of what planned infrastructure will Nama actually factor in. This makes the LTEV estimation process outlined in LTEV completely undefinable under the current legislation.

Land based outside the State

The entire section 6 outlining the LTEV estimation process for land outside the State is simply a carbon copy of the valuation processes for LTEV within the State. This suggests that - given that assets being valued are different in nature (legal and economic), risk and geographies - the Minister has no idea how these different risks should be reflected in the estimation process.

The section does not even mention exchange rate risks or derivatives on Forex exposure attached to loans. There is no clear understanding as to what interest rates should apply and how to deal with the carry trades.

Operational costs

Section 8 of the note states that the assumed 'due diligence costs, incurred or likely to be incurred by Nama over its lifetime' is 0.25%. This is simply unrealistic. Industry average operating cost on performing loans - across all subheads - is equal to about 0.75-1% in times when operating conditions are deemed to be normal. As of the end of February 2010, Nama, reportedly already has blown through its entire 2010 legal budget. How can 25bps cover its due diligence cost over life time?


In short, SSNo88 is yet another document that shows just how exposed Nama remains to shoddy planning and poor estimation procedures, courtesy of the DofF that simply cannot deliver realistic and transparent operational guidelines.