Thursday, May 28, 2009

Economics 29/05/2009: NAMA debate: Part 1

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Full text of the Dail debate on NAMA is available here. But for some commentary-worthy passages, consider the following:

Brian Lenihan: [NAMA] will purchase the assets through the issue to the banks of Government bonds which will result in a very significant increase in gross national debt to be offset by the assets taken in. The cost of servicing this debt will be offset, as far as is practicable, from income accruing from the assets of the new agency. The debt will be repaid from funds raised through the realisation of these assets over time.

Thus we have it confirmed - NAMA will rely on ordinary Government bonds, not NAMA-own bonds. Brendan McDonagh confirms as much in his statement as well.

The potential maximum book value of loans that will be transferred to the agency is estimated to be in the region of €80 billion to €90 billion, although the amount paid by the agency will be significantly less than this, to reflect the loss in value of the properties. Initial work on the valuation methodology to be applied is under way and will be elaborated on by the interim managing director.

Hold on, folks, Mr Somers knows nothing of this rather important work, we heard nothing about either the models they plan to deploy or the market valuations they will rely upon, or both, so how can the valuation methodology work be ongoing, unless NAMA is being set up to operate in the climate of complete absence of transparency? And what does 'as far as practicable' mean in the context of off-setting the cost of bonds financing? 'Practicable' from whose perspective - the banks / developers or taxpayers, or NAMA itself?

It is important to note that the State will not assume all of the risk in the acquisition of these assets. The assets will be valued on a basis which is sustainable for the taxpayer. This will entail an assumption of losses by the financial institution whose assets are removed. In the longer term, if the agency were to fall short of recouping all of the costs, the Government intends that a levy should be applied to recoup any shortfall. All borrowers will be required to meet their full legal obligations for repayment. There will be a hardening of the approach to these borrowers as taxpayers’ money is at stake and the agency will be expected to protect it in a commercial way and with an independent remit.

So here we have it - assets will be valued on a 'sustainable basis' from the taxpayers' point of view. Does this mean market-value discounts on loans value? If yes, what recapitalization provisions the state is making and if no, how will the taxpayers value be protected? 'There will be a hardening of the approach to these borrowers' - how, if NAMA were to avoid foreclosures and forcing developers into bankruptcy? Furthermore, if NAMA were to operate in a 'commercial' way, will it be pursuing some sort of risk-adjusted return strategy in pricing the loans, enforcing loan conditions and selling the underlying properties? Once again, how can this be assured if NAMA were to avoid foreclosures, fire-sales of assets and pursuing individual developers for collateral? How will NAMA avoid writing down the underlying assets by at least 30-40% to reflect their fair value?

The establishment of NAMA will, no doubt, give rise to complex practical difficulties and it is important that we undertake the detailed preparatory work necessary before finalising the legislative and operational framework. The preparatory process is being overseen at this initial stage by a steering group made up of representatives of the Department of Finance, the Attorney General and the agency. Mr. McDonagh has been appointed as interim managing director to drive the implementation process forward. He will be assisted by an advisory committee to be appointed shortly which will provide him with a range of expert advice.

So they managed to do all this work already without actually publishing a simple version of a cost-benefit analysis of NAMA. An amazing level of ineptitude in basic management!

Mr. Brendan McDonagh: NAMA will, therefore, acquire both performing and non-performing loans. In return, the institutions will receive Government bonds issued by the NTMA and they may use these bonds as collateral to avail of ECB funding. It is envisaged that the interest payable on the Government bonds will be offset by interest flows and performing loans acquired by NAMA.

This is an interesting statement as far as the 'performing' loans go. Does Mr McDonagh term 'performing' include loans that pay interest only? partial interest only? or rescheduled interest only? This is important, for all such loans will be written against assets that cannot be realised at their loan value and thus, while yielding some interest flows, are distressed assets from the point of view of developers. How will NAMA convert these loans to fully performing (interest plus principal repayment) loans?

And of course, there is an admission that the entire scheme relies on ECB lending window, implying in effect that the issued bonds will have no value to anyone in the market except for the banks and the ECB, and the cost to us, the taxpayers.

We are realistic enough to recognise that there are institutions which will be outside of NAMA but which may also have provided loans for many of the larger borrowers within the NAMA framework. We envisage that NAMA and these institutions will have to work together in many instances to protect our common interests but this will be done at all times in a commercial way to protect the interests of Irish citizens.

This is unclear and undefined. Will NAMA have powers to compel these institutions to interact with its portfolio management of the loans? How? If not, how will the seniority of multi-banked portfolios be managed, given NAMA size and market power? And does Mr McDonagh see any conflict or contradiction in saying that the banks outside NAMA, NAMA, banks inside NAMA, and the developers will be working to 'protect common interests', yet the taxpayers' interest will also be protected? In addition, I wonder if Mr McDonagh actually has in mind the interests of all taxpayers or just the interest of Irish citizens, or whether he actually has a clue as to the difference between the two?

I advise the committee that it is not possible at this stage to determine what that discount will be as it is dependent on such a wide range of factors and also the fact that each loan will have to assessed and valued individually. This is because our current knowledge of the loan books suggests the majority of individual loans are bespoke and have different legal documentation.

Mr McDonagh is clearly a foreigner to finance. Bespoke or not, loans priced individually invite political interference (or perception of such), as well as opens up every set of terms agreed with one developer to a challenge by another. It is non-transparent pricing system and, yet, it underpins the loan value fundamentals. How will NAMA be able to avoid the same problem of valuing the individual loans that the banks have today? Further problem arises due to the absence of market pricing data. Given that there is only a thin volume of sales in the property markets, pricing loans collectively will be onerous enough to yield large deviations from the true expected values of the loans. Pricing them individually will be even less accurate.

In our Sunday Times article with Brian Lucey last week we argued that NAMA is equivalent of a blindfolded person buying an unknown object for an unknown price, while being unsure if he needs this object in the first place. How will Mr McDonagh - a highly paid public servant - ensure that his organization actually acts in the interest of the taxpayer if he cannot even tell us the pricing basics for his organization purchases?

Personally, I do not trust Mr McDonagh, his steering group and the entire state apparatus behind them to deliver value for money on their valuations of these assets. Nothing personal, I just need hard evidence that they are doing their jobs right. The idea that they will be using 'economic' value of property projects to value the loans implies that
  • the uncertainty (risks) relating to the property values
  • will be compounded by the uncertainty (risks) relating to economic forecasts
  • which will be further exacerbated by the uncertainty (risks) of NAMA capabilities to manage investment portfolios
  • which itself be subject to added risk to NAMA cash flows, and so on...
Do tell me that Mr McDonagh is qualified and experienced enough to run this risk pricing model... Would he even get a job of co-managing a Euro10mln property fund in London were he to try? I don't know.

Want the really scarry stuff?

NAMA’s potential powers including, potentially, compulsory purchase orders and powers in relation to borrowing and the investment of equity and working capital in joint ventures. NAMA will have three options in relation to the assets it acquires: it can dispose of them at an early stage; it can hold them with a view to disposing of them when market conditions have improved; or it can develop them to enhance the return. To do so, it is envisaged that NAMA will have the option of entering into joint ventures, partnerships or form special purpose vehicles with other interested parties to enhance the value of some of the acquired assets. The overall objective and foremost in the mind of NAMA will be what will achieve the optimal return and will be in the best interests of the taxpayer.

So NAMA will have a power to act as a co-developer in failing projects?! Dreamy stuff. But:
  1. How will NAMA raise financing for this venturing? By taxing you and me more? or by issuing more bonds? If so, NAMA is an open-ended ticket for the Government/NAMA to clean our pockets and transfer subsidies to the developers;
  2. How will NAMA manage such lending - is it now becoming a fully functional investment bank, well ahead of its original remit? If so, we are in deep trouble, for one has to imagine Mr McDonagh as the CEO of the soft-constrained state-run and state-owned non-transparent, non-compliant and totally secret bank;
  3. How will Mr McDonagh and his successors account for their 'success'? Will he lose his job if NAMA finances a wrong project and generates a loss?
  4. What will happen when a NAMA-co-financed project fails and NAMA goes after its partner in the development? What will happen when NAMA tries to recoup losses on such co-financed project failures from the banks at the end of NAMA lifespan?
  5. What will happen when a developer turned down by NAMA for co-financing goes to court and argues that his project is no worse than the one that NAMA co-financed?
Now, NAMA might not have done cost-benefit analysis yet, but, per Mr McDonagh, the institution that will protect taxpayers value has already met ...with senior members of the Irish Congress of Trade Unions who represent bank staff. Ah, the bearded men of ICTU are briefed, so nothing to worry about, folks.

Brian Lenihan: In respect of such an agency [NAMA], one must understand it is not about the taxpayer assuming the risk, but about ensuring the banks and developers absorb the pain. The taxpayer only enters the equation after this as the sovereign intervener to protect the entire banking system.

Once again, there is a contradiction here between NAMA deriving commercial value, NAMA not forcing developers into bankruptcy and the banks and developers absorbing pain. Furthermore, does this statement imply that Mr Lenihan actually believes that the taxpayers will not bear any pain in the process of NAMA? Does he really believe that NAMA will be self-financing and that he and Mr McDonagh will only borrow from us, the taxpayers some spare cash to get NAMA rolling, repaying us in positive real rates of return? Is this a sign of our Minister for Finance not getting the basics of NAMA right or is it a sign of him being in denial?

And what about the economic model for pricing risks and assets that NAMA will employ? Well, why not pick the most absurd one of the lot: the ESRI's politically palatable drivel predicting 6% medium-term growth for Ireland Inc: Lenihan clearly is impressed...

Still feeling well-protected by NAMA? I don't. Imagine paying a price that assumes that during the lifetime of NAMA, Irish economy will expand at 5-6% pa and then learning the hard way that the actual growth turns out to be 3% pa or even less. How much do you think we, as taxpayers, will overpay for the ESRI's errors?

The reason the full advice [by Bacon] was not published was it contained a great range of sensitive information which would affect the market valuations of financial institutions on the Stock Exchange. Dr. Bacon had access at the NTMA to a wealth of information on the work completed on assessing the exposures in the banking system from an accountancy, evaluation and auctioneering point of view. All of this information was at his disposal in drawing up the report. Placing that information in the public domain would have had an immediate impact on the market prices of individual financial institutions.

Hold on... I thought the entire point of the plcs is that any information pertinent to their pricing must be disclosed to the public. Is Minister Lenihan now finds himself in a position of concealing from the market market-sensitive information? Should you or I do the same, we would not be able to deal in the related companies shares. But Minister Lenihan and NAMA will be dealing in these shares. Who is supposed to uphold the securities law in these cases?

But dancing on the legal borderline is what NAMA and Lenihan will be doing often from now on. Here is a good one, in relation to why banks levy will not be imposed in the NAMA legislation but will have to wait for the Finance Bill:
Mr McDonagh: If there was a clawback within the NAMA legislation affecting the balance sheets of the banks, they would not be able to reduce the assets transferred to NAMA because effectively there would be an unpriced option in terms of what the clawback would be in the future. One cannot do this because it would not be possible to take risk weighted assets off the balance sheets of the banks if the levy was imposed in the NAMA legislation.

Enron's boys would be proud of this one. If NAMA levy is a charge against future losses, as it is, and it is imposed ex post NAMA legislation, would it not be a de facto expropriation of the expected future value of banks earnings? Take your pick then - either you have an option imposed under NAMA putting pressure on banks valuations, or you have a predatory state imposing ad hoc charges on banks post-NAMA... Good choice... markets-assuring.

Deputy Joan Burton's response to McDonagh statement is priceless: That is another critical valuation issue because the Minister has just said he has a guaranteed fail-safe device - a clawback in the event of the assets not realising whatever the taxpayer takes. Mr. McDonagh is actually saying - I accept what he is saying - that in fact that would be almost legally impossible because of the long-term impact on the balance sheets of the banks, assuming they remained quoted companies but the Minister is directly contradicting this. Gotcha!

Mr. McDonagh is saying there will still be a contingent liability which will remain unpriced for a period of at least ten years and that this contingent liability will relate to the €60 billion to €90 billion discounted on values that we do not yet know. How would any financial analyst decide to exclude this for a period of ten years from the liabilities of such a company? Gotcha!

I find it very worrisome that Dr Bacon provides deeply economically flawed rhetoric in arguing the NAMA case:
Dr Bacon:
There is a view expressed that this asset management approach has an inherent flaw, namely, that if one takes a big haircut there is a capital deficit which the banks have to deal with and if one does not do that and overpays, the taxpayer, if the members will pardon me saying so, gets screwed and the shareholder gets away. I do not see any trade-off. The reality we face, with which everybody is trying to grapple as a result, as the Minister said, of bad and disastrous lending, is that there are huge losses facing developers and the banking system and there is only person to pick up the bill, namely, the taxpayer. Regardless of what way the cake is cut, the loss does not change. To use other people’s language about the point of the discount, if the discount and gift shareholders are undercut, the taxpayer suffers because the recovery the Deputy spoke about takes place from a higher base. The taxpayer loses in that respect. If one gets it wrong on the other side and discovers that one has to make up more capital in the banks, who will make it up? In the current environment it is a brute fact that the banks cannot go to capital markets and replenish their equity. I have made the point previously that the loss is the loss. By whom will it be borne? It will be borne by banks and developers, to the extent that there is equity to do so in the case of the banks. One must then replace that equity. Who will replace it? The taxpayer will.

This is simply a case of b***t. Here is a clear trade-off, Dr Bacon: if you overpay for the loans at NAMA point, you do not take equity in the banks and end up with losses on NAMA and no new shares in the banks. If you price assets right, you end up holding lower loss-making NAMA and equity in the banks. Get this? It is that simple. It is, as I have repeated on many occasions, not only about NAMA losses, but about shares held in the banks.

The Deputy has also asked how do we know the taxpayer will not be caught at the end of this process... The first protection of the taxpayer with respect to the work-out is that the assets are being taken on at the bottom of the cycle, either at a mark to market price or at a normalised valuation. The second protection being offered to the taxpayer the potential that NAMA, as an institutional entity ...has the possibility of attracting third party equity. That is a fundamental disadvantage if we do not go this way in terms of maximising the work-out. How does one get the capital and finance to work out semi-completed projects which are fundamentally well designed, be they in Ireland, the UK or elsewhere, without the long-term capital which these entities have not had heretofore?

I find this amazing. In effect Mr Bacon argues here that NAMA will be simultaneously a developer and an investment bank. Did anyone in the Dail notice this remit creep?

Deputy Joan Burton provided an excellent set of questions to follow Dr Bacon's unimpressive discourse: The Minister and his Department ... why is he so confident the fair price NAMA will pay will not wipe out the core equity capital of the banks? Has the decision been taken on what price will be paid? Given the Minister’s confidence that the valuation to be arrived at will not wipe out the bank’s core equity, is it the case that the decision has been made in principle? That brings me to another point.
The Minister cited the case of Sweden. An independent valuation board was established there composed of independent economic experts, including individuals from commercial and academic life who were recognised as independent and acting in the public interest. The Minister has proceeded to appoint all the parties in secret.
Contradictions have emerged in what has been said. The Minister suggests there will be a degree of toughness shown to developers, while Mr. McDonagh suggests NAMA will work with developers and Dr. Bacon suggests it will be essential and may make good business sense to get other investors to come in and co-fund development projects with the taxpayer, whether these developments are in Ireland, the UK or elsewhere. Does the Minister agree that substantial State borrowings will be used to meet the requirements of the NAMA proposal? Is he seriously considering having much more of the country’s borrowing capacity reserved for the working out of the NAMA proposals rather than being invested in infrastructure such as schools, public transport and roads? I find that prospect extremely worrying.

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