What's wrong with NAMA

For those of you who missed the latest article on NAMA from myself and Brian Lucey in the current issue of Business&Finance magazine, here is the unedited version.

To date, the prevailing discussion internationally on how to rescue failed banks focused on repairing their balance sheets. This ignores the underlying cause of the problem – the deterioration of their asset base. In fact, in the case of NAMA-type ‘bad’ banks arrangements, the cure compounds the asset base problems.

Two major questions arise in the context of NAMA.

First, we do not know how the assets can be priced in order to align the NAMA objective of repairing banks balance sheets (with an incentive to pay high price for transferred assets) and its duty to safeguard taxpayers interest (requiring the price to be set below the expected risk-adjusted value of the loans total).

Second, we do not know how the impaired assets will be treated under NAMA. One option is to keep them alive as zombie development projects awaiting realization decades from today. Another is to shut them down. Which option will be pursued will, in the end, seal the fate of large scale development land banks and half-baked development schemes across the country. It will also underpin political legitimacy of NAMA. And this is before we consider the fallout from a virtually inevitable future creep of NAMA remit to cover defaulting mortgages on principal residencies, credit cards debts and bad car loans.

Extent of the NAMA-bility

With respect to the first question, the US Treasury Department identifies the bad assets before they are actually fully impaired using financial models that estimate future loan values under different economic scenarios.

Ireland is yet to make even this first step, but currently neither the CBFSAI nor the Department of Finance and least of all the infant NAMA have the capacity to develop and administer such model-based testing procedures. Even after years of operations, CBFSAI have virtually no real expertise in risk management and pricing, while DofF has no real economics, finance and analytical capabilities to oversee a minor credit union, let alone to control NAMA. Thus, ex ante pricing transparency is the only guard the taxpayers have to limit NAMA’s monopoly powers.

So let us consider the loans that are non-performing, stressed or rolled over with little chance of repayments any time soon. Banks provisions for future impairment charges are currently running at ca 4-5%. Independent and even in-house analysts are forecasting that some 12-15% of the entire asset pool of the Irish banks can be under stress by 2010.

In our view, this is a lower bound of the true state as:

• loans under threat to date will almost certainly remain under threat through 2010;
• the first quarter of 2008 saw a relatively benign trading environment, so 2009 is going to see even greater rates of impairment; and
  
• the economic troubles underlying the rapid asset quality deterioration are set to deepen in 2009.
  

We know nothing about the recovery rate on these risky assets. But globally, AAA rated CDOs carry the recovery rate of only 32% on face value, while for mezzanine vehicles the recovery rate is only 5%. The default rates on the US corporate junk bonds (which are less risky than Irish development-linked loans due to their higher diversification, liquidity and transparency) is estimated to reach a whooping 53%, with a recovery rate of zero. Given the perilous state of Irish economy, and the extent of the property-related exposure for Irish banks we see as reasonable (or potentially even generous) a 45-50% average recovery rate on the stressed loans. This implies that the expected final losses on the entire 6-banks pool of €165bn in property exposure (ex-Poland) will be closer to 25-30%, or €50bn. For anyone who thinks that this figure is unrealistic, a recent McKinsey study showed, that out of $2 trillion of impaired assets the eventual writedowns may total $1.5 trillion or 67%.

The above loss rate implies that NAMA will be purchasing the impaired assets at less than 28% discount to their face value, should the Government set the price to keep the 6-banks capital ratios at 8% minimum required levels. Such a discount will imply an issuance of €36bn in fresh bonds to the banks, underwriting only €25bn in risk-adjusted assets on NAMA-held €50bn book of loans. The implied expected loss to the taxpayers from such an operation is €11bn in capital cost, plus ca €11.5bn in interest costs for a 5-year bond to be covered out of tax revenue and higher cost of banking.

It is worth noting that these costs of over €22bn for NAMA operations assume that Irish banks keep capital ratios at the required legal minimum after deleveraging their balance sheets. In other words, these losses do not fully insure the banking system against future capital demands.

But 8% capital requirement is now considered to be insufficient for operating a private bank. Instead, markets are demanding a minimum 10% capital ratio, with 12-14% being a golden target. If NAMA were to keep Irish banks private, the recapitalization demand for the 6-banks system due to the NAMA assets transfers will add another €4-8bn in costs to the Exchequer bill.

Note: should NAMA buy into €80bn in loans, as discussed in recent reports, the associated required maximum discount rate will be 23% and the total losses to the taxpayers will be €43-51bn.

How can toxic assets be priced?
Generally, assets on bank balance sheets are valued either at hold-to-maturity value or at fair value. Both frameworks fail in the current environment.

An alternative solution is that the Government can set up a two-stage process of buying stressed assets into NAMA. The first stage will involve a quasi-voluntary scheme that would establish a functional resale market for the stressed loans to be used in the second stage of purchasing.

To do so, the Government should set a basic level of discount on the assets based on the publicly verifiable valuation model. The discount should be fixed on the date of the scheme announcement to prevent future manipulation of the fair value by the banks. It should apply to all systemically important banks regardless of who holds the specific loan or what project it is written against. This will avoid political interference in the pricing of stressed assets.

Loans with interest and principal non-payment of less than 3 months can be sold at a fixed discount of, say 15% (reflective of the current expected default rates), loans with non-payment of 3-6 months can be sold at a fixed discount of 25% (a rate that is more consistent with the US experience and the ECB discount lending criteria). Non-performing loans in excess of 6 months and repeated roll-up loans can be traded at a 50% discount equal to their estimated default risk. This first-stage transfer will remove the most toxic paper off the balance sheets of the banks.

After the first stage establishes quasi-market pricing of the assets transferred to NAMA, the Government can retain the face value discount on other stressed assets, while allowing for some recapitalization support to be given to the banks that need it. The second stage involves using the same discounts on loans as in the first stage with the Government using additional bonds to swap for banks shares to cover some fixed proportion of the discount. In other words, the banks will still sell most impaired assets at 50% discount, but they will have an option to receive a roll-back of say 10-15% of the discounted value in the form of the NAMA taking new shares in the banks. For example, a loan package of €10bn with average non-payment of more than 6 months will be sold to NAMA for €5bn, but the bank involved will have an option to sell €500-7500mln worth of new equity to NAMA at the same discount on the share price as on assets sold to NAMA.

The advantage of this scheme is that the clean up of banks balance sheets will be systematic and non-distortionary.

The disadvantage is that it still saddles the taxpayer with the task of recapitalizing the banks after they take a hit on their capital base under the NAMA. This, however, is inevitable under all possible scenarios for toxic assets removal. In our view, the only real option to avoid the need for endless rounds of recapitalizations is to nationalize systemically important banks outright. Nationalization option will allow the Government to keep capital base of the banks at 8% limit, outside the markets demand for higher capital reserves. In addition, under nationalization NAMA can choose and pick specific assets off banks balance sheets to create a blended portfolio of loans with lower expected default rates.

Avoiding zombie land banks
The second problem with the Government proposal is that we do not have any idea as to how the impaired assets will be treated under NAMA. Upon purchasing the loan, the Government will have an incentive to keep the underlying assets alive as a zombie development projects. This is so because as long as the development-zoned land remains ‘active’ as an investment project it will retain some notional value on NAMA balancesheet, creating an illusion of value to the taxpayer. Of course, much of the existent recent vintage land banks that NAMA will end up holding will cover speculatively purchased agricultural and industrial land with virtually no hopes of being developed in the next 15-20 years.

Another option is to shut these projects down, de-zone the land and either release it into the market as agricultural land or retain it as public-use land. This option implies NAMA writing down the asset value of such land.

In our view, the Government will be wise to opt for the second option, converting improperly zoned development land into a mixture of leasable publicly-owned land (useable for sustainable developments) and commons (for public amenities, such as parklands). Incidentally, our pricing scheme described above incentivises such conversion as most of speculative land banks will fall under the heaviest discounted price category, minimizing the value of the write down and maximizing land rents to be collected on leasable lands.

This process will only be further enhanced by imposing a direct land-value tax on development sites, mentioned in this column in the previous issue.

Box Out: 8 reasons to mistrust ba-NAMA-rama

1. The potential for politicisation of the property and land valuations, combined with further politicisation of planning and development.
2. The lack of adequate oversight capacity in the Oireachtas even with the enhanced committee structure.
3. The lack of transparency in the pricing and valuation process.
4. The monopoly which it is to be granted on development and land related activity which is backed by lending from Irish institutions. There is a prima facia case here for very careful consideration of domestic and EU competition issues.
5. NAMA is to be granted portfolios of assets, regardless of whether these are performing or otherwise. Will performing borrowers whose loans are transferred to NAMA injunct such transfers on the grounds of reputational damage?
6. The skillsets required to manage a fundamentally distressed asset portfolio (NAMA) are lacking not only at NAMA, but across the entire public sector and most of the private sector.
7. The portfolio approach, where all loans in a portfolio regardless of quality are transferred, leaves NAMA open to mission creep with for example the potential for credit card, or auto loan portfolios being transferred in the future.
8. Finally, and most important there is the issue of the price to be paid for the assets of the banks.