Wednesday, September 23, 2009

Economics 23/09/2009: Cost of Nationalization

Today's note from Davy Stockbrokers throws into public domain a challenge and an accusation:

"Regrettably, the public debate on NAMA has been anything but rational and dispassionate. Confusion, misinformation and, at times, rank deception has run riot over the past several months... Tellingly, the brunt of discussion has majored on an anti-NAMA rant, with scant exposition of any credible alternatives."

If Davy is so dismissive of the 'alternatives' - of which there have been several rather involved ones - then Davy should be even more dismissive of the Nama proposal itself, for the Government still has no estimates for costs, returns, time horizons, detailed haircuts, borrowing terms for Nama bonds etc - after 6 months of working on it with an army of civil servants, highly paid consultants and having the likes of Davy on their side!

"Nowhere is this more depressingly obvious than in relation to the nationalisation option, wherein protagonists have tended to confine their treatises to a short paragraph or three, and where the potentially ruinous funding consequences for both the banks and sovereign have been glossed-over..."

Of course, unlike Davy or other stockbrokers, it is the independents: Brian Lucey, myself, Karl Whelan and Ronan Lyons who actually bothered to estimate - to the best of our resources - the expected costs of Nama to the taxpayers. Instead of focusing on the benefits and costs to the taxpayers, Irish stockbrokers focus on benefits to the banks and their shareholders. This is fine, and I will not accuse them of doing anything wrong here - their clients are, after all, not taxpayers, but shareholders. But it is rich of Davy team to throw around accusations of us, independnt analysts, 'glossing over' aspects of Nama - we are not the ones being paid by anyone for doing this work.

The emphasis on 'estimate' and 'expected' is there to address Davy accusations of 'rants' or 'deceptions'. If estimates are rants, Davy-own entire daily research output can be labeled as such.

But Davy folks are correct in one thing - we, the critics of Nama, have not produced an estimate of nationalization option cost. Instead, it was, me thinks, Brian Lenihan who promised to produce such estimates. May be Davy note was addressed to his attention?

Seeing the eagerness with which Davy folks would like to see some numbers on nationalization, below is the summary of estimates of such an undertaking developed by Peter Mathews (you can see his article on this in Sunday Business Post (here) and confirmed and elaborated by myself and Brian Lucey. (Again, note, one can only assume that our Davy folks do not read Sunday Business Post's Markets Section.)

I have argued in my Nama Trust proposal (aka Nama 3.0) (here) that we can avoid nationalization by buying out equity in the banks to support writedowns and then parking this equity in an escrow account jointly owned by all taxpayers. The banks will, then be owned by the Trust, not by the Government. Their shareholders will be Irish taxpayers as individuals, not the Government. The Trust will be there simply to provide a time buffer for orderly dibursal of shares over time.

Now, whether you call it 'nationalization' or 'Trust' or anything else, the problem with the banks in Ireland is that they need to write down something around 40% of the troubled assets values. This can be done by gifting them bonds (as Nama will do), or by buying equity in the banks in exchange for the same bonds, except, as below shows, at much lower cost.

In the first case, you get a promise of repayment from the banks and a pile of heavily defaulting loans. In the latter case, you get shares in the banks.

In the table above, the first set of red figures refers to the amount of equity capital that will be need for repairing banks baance sheets today (it can be issued form of bonds, just as Nama intends to do, which will be convirtible through ECB repo operations at the same 1% over 12 months). The amount we will need to put into banks under 'nationalization' or Nama Trust option is Euro30.88bn.

The bondholders will remain intact (so no additional cost of buying them out).

This upfront cost is over Euro 23bn cheaper than Nama. And it can be further reduced if we get at least subordinated bond holders to take a debt-for-equity swap, which they might agree to as they will be taking equity in much healthier banks.

The second and third red figures refer to the expected recovery on this equity purchase in 5 years time (not 15 as in the case of Nama). And all assumptions used to arrive at these two scenarios are listed. The figures are net of the original Nama cost. In other words, under these two scenarios, we can generate a healthy profit on Nama Trust, which we cannot hope to generate in the case of overpaying under the proposed Nama scheme.

In addition to the table above, I run another third scenario that assumes:
  • 5% growth pa in banks shares (as opposed to 15% and 10% growth under scenarios A and B);
  • Banks fully covering 1.5% cost of Government bonds (as in scenario B);
  • Banks paying a dividend to the Exchequer of 2% on loans (net of bad loans) and charging 0.5% management fee, so net yeild is 1.5% on loans (as in Scenario B).
The bottom line in this scenario was ca €9bn in net return to the Exchequer on 'nationalization' within 5 years of operations.

Back to Davy note: "...the potentially ruinous funding consequences for both the banks and sovereign have been glossed-over..." Well, let me glance it over.
  1. Nationalization can be avoided per my Nama Trust proposal, so there goes entire Davy 'argument'.
  2. If the banks balance sheets are repaired with a 40% writedown of bad loans under the above costings while Nama would achieve only 30% writedown at a much higher cost, what 'ruinous' consequences do Davy folks envision for the banks? Their balancesheets will be cleaner after the above exercise, than after Nama!
  3. If Irish Exchequer were to incur the total new debt of €30bn (per above proposal) and will end up holding real equity/assets against this debt, will Exchequer balancesheet deteriorate as much from such a transaction as it would from an issuance of €54bn in new debt secured against toxic assets such as non-performing loans? Again, it seems to me that a rational market participant (perhaps not the Davy researcher authoring the note) would prefer to lend to a state with smaller debt and real assets against it than to the one with higher debt and dodgy assets in hand.
Back to Davy: "...the retention of impaired assets on bank balance sheets ...would continue to cast a deep pall over perceived solvency risks in the Irish banking system, leaving this country still bereft of the necessary refinancing flows from which green shoots might grow."

I would suggest that this statement is itself either a deception (deliberate) or a wild speculation (aka rant). There is absolutely no reason why fully repaired banks (with 40% writedown on the loans under the above costings and as opposed to Brian Lenihan's proposed Nama writedown of much shallower 30%) cannot have access to the same lending markets as banks post-Nama would. However, under the above proposal:
  • Irish Government will take much lower (24bn Euro-lower) debt on its books, implying healthier bonds prices for the Government into the future - some savings that won't happen under Nama;
  • Banks enjoy much more substantially repaired balance sheets (again, not the case with Nama);
  • There is no second round demand for new capital from the banks (not the case with Nama as proposed).
So, again: judge for yourself. When is the insolvency risk for Irish banking system higher:
Case 1: more substantially repaired banks balance sheets and more fiscally sound positioned Exchequer; or
Case 2: lesser writedowns of bad loans and more indebted Exchequer?
If you vote for Option 1 (as any rational agent in the market would do), you vote for the above 'nationalization' exercise.

Lastly, Davy note lands a real woolie: "When all is said and done, NAMA is not a bail-out of developers, or bankers, but of a banking system and its host economy. In that respect, it is a bail-out of ourselves."

Under Nama, developers will be able to delay or avoid insolvency declarations and subsequent claims on their assets. If this is not a bail-out, it is a helping hand of sorts.

As per 'repairing economy' - there is absolutely no evidence to support an assertion that Nama will have any positive economic impact, but given that it will impose much higher cost than alternatives on households, it can have a very significant negative impact on the economy. Perhaps, Davy think that households are simply there to be skinned and that our economy does not depend on them.

Then again, Davy folks thought CFDs and leveraged property deals were gods-sent manna.

Now, let us get to the more rational side of economic impact debate:
  1. Under my proposal above, banks get deeper repairs, so they will be healthier and their reputational capital will not be based on a handout rescue, but on actually having equity capital injection. This is a net positive that Nama does not deliver;
  2. Under my costings above, the Exchequer and/or households end up being investors with a strong prospect of higher net recovery value over shorter term horizon than in the case of Nama. This is a net positive that Nama does not deliver;
  3. Under the above exercise, the banks will not be able to unilaterally take liquidity arising from the injection overseas, so whatever liquidity is generated, will have to stick to our shores, and thus to our economy. They still can use this liquidity to pay down their expensive inter-bank loans, but at least they won't be able to run investment schemes with taxpayers' money abroad. Shareholders might look badly on this one, since the shareholders will be not foreign institutional investors, but domestic taxpayers. This is a net positive that Nama does not deliver;
  4. Under the above exercise, we won't have to pay Nama staff and consultants any costs - banks will continue dealing with their bad loans. This is a net saving that Nama does not deliver;
  5. Under the above Irish taxpayers won't have to face a massive tax bill of 54bn, but a smaller (though still massive) bill of 30bn. This is a net saving that Nama does not deliver;
  6. Under the above proposal Irish banks will be able to access the same ECB window on the same terms as any other bank in the Eurozone. The will also be able to do the same with Nama, so there is no additional cost when it comes to borrowing.
  7. Under the proposal above Irish Government debt will be €23bn lower (and adding the second round recapitalisation demand under Nama - €29bn lower) than in the case of Nama, providing potential easing to our cost of borrowing. This is a net benefit that Nama won't deliver.
I can go on with these arguments. But I am afraid it will be a bit too much rant for our Davy folks.


Unknown said...

A tax bill of €54bn? What are you on about??

How does the NAMA delay developers going into receivership? Is that an assumption or is there something in the legislation that says that NAMA will be softer on the developers than the banks? Currently the banks are all (bar the foreign ones) trying to go softly softly with the developers. I haven't seen anything that officially or formally or even factually indicates that NAMA will protect developers from going under.

The NAMA staff costs are tiny !! You know that but regularly pop it in to your "rants". The banks are being required to provided the dedicated staffing to look after the work on managing the book and the banks are required to pay them, manage them, HRM them etc. NAMA supervises only.

If you go with your approach am I correct in saying that ownership of the loans (and by extension the collateral) stays with the banks? If yes then you have to account for that difference when comparing the costs. There's hard assets that were once worth over 80bn involved here - whatever about the row over their current worth or LTEV - they sure ain't worth nothing.

There's a phrase that I can't quite remember but it goes something along the lines that if it walks like a duck, swims like a duck, flies like a duck and quacks like a duck then it's probably a duck - you nationalisation that isn't nationalisation because it's in a "trust" brings that phrase to mind.

TrueEconomics said...

Adrem, you got me angry.

If you think this blog is a rant (or a 'rant'), read something else, don't waste your time.

Now to your points.

(1) 54BN tax bill - do you think that issuing bonds today does not constitute a tax bill tomorrow? And can you take this belief to a bank and borrow free of charge? Why do you think we have to impose an interest rate on Nama bonds if we can borrow free of charge? If no one will pay for the bill? It is either to be paid out of future taxes or it will be paid out of foregone future tax receipts that underly returns on Nama assets, or both. Either way - there is no free lunch.

This, incidentally, the only point you raise that is close to being pertinent, which shows, really, how absurd your entire comment is.

(2)Nama costs are not going to be tiny - the state already managed to commit paying about 15mln in different Nama-related fees and this is before Nama became operative. Once it is, there will also be legal costs, further advisory costs and the fees to be paid to the banks (in form of foregone earnings on Nama loans, I presume) to compensate them for managing Nama loans (again, no free lunch there either) - banks historic conservative returns are around 2-3% on loans net of capital cost. Management fee about 0.5% (also conservative), so up to 25% of net yield traditionally goes to cover costs of managing loans. Under Nama, we do not know where this will come from, but that does not mean it won't have to come from somewhere. See one example (

TrueEconomics said...

(3) Read carefully before you jump with comments. If we do Nama, we get Nama loans - their value is important. In current market it is worth between 10 cents (for some projects/land) and may be 80 cents (for finished buildings in urban locations with loan vintage of, say around 2003-2004) on the Euro of face value of the loan before interest roll overs. The mix of what percentage of loans belongs to what category is unknown, vintage of loans is unknown, amount of rolled up interest is unknown, and seniority of loan over underlying collateral (cross-collateralization) is unknown.

However, it is clear to anyone involved, even to the Government claiming a discount of 30% under LTEV assumption that your absolutely absurd and careless allegation that it is worth 80bn is not even deserving a comment.

Now, if we do some sort of change in ownership per my balance sheet, we get an asset to hold as well. Unlike under Nama - it is not in form of loans we cannot price, but in form of equity in the banks that has market pricing today and can be estimated into the future on the basis of the future demand for financial services and market shares of the banks.

If you cannot understand the fact that banks shares (equity) are assets, don't bother commenting.

If you do not understand the fact that we know more about share prices today than about the loans we are about to buy into Nama, don't bother commenting.

If you do not understand that liquidity risk, operational risks, market risk, economic risk and so forth, are all lower under the costed 'nationalization' proposal than under Nama, I am not sure what I can do for you at this stage in the debate.

(4) Per your statement in the last paragraph: in Nama Trust legal (and effective - an I am not sure this can be really spelled out in more plain English) owners of the banks will be PRIVATE SHAREHOLDERS - individual residents of this country.

You will own, say 10 shares in AIB and 10 shares in BofI and 15 shares in Anglo. I will own the same. And so will every other tax resident of this country.

Not the Government or the State. You and me, and every other tax resident of Ireland.

For reasons of orderly disposal of shares, we will be restricted from selling these shares for some period of time required to work through banks management, business models, profitability. I suggest it will be 5 years. This is what Nama Trust will do - it WILL HOLD (not OWN - HOLD) shares for us in our names for that period of time.

Once banks are repaired reputationally and financially and economy returns to growth, the Trust, in our names will either sell shares or give them to us.

You will get yours based on your preferences - either in shares or in cash at disposal; I will get my; Joe next to us will get his (either in cash of in form of shares or both). We will pay CGTon these shares. Do you get it? I hope so.

Government WILL NOT OWN A SINGLE SHARE IN THE BANKS at any moment in time, so it is not a Nationalization...

Really, can you check definition of 'not' in the Oxford English Dictionary? Please?

Stop posting nonsense - I am frankly too busy to deal with this drivel.

Paul MacDonnell said...

Dr. G. When NAMA takes over the loans does it have any incentive to foreclose (ACC-style) on the developers....and realise losses that are bigger than it claimed....or does it make any difference? will they sit on the foreclosed property like a big zombie bank...waiting for LTV to materialise?

TrueEconomics said...

Paul, technically it can do either foreclosure, sale as distressed asset or work out (including up to completion of the project or even initiation of an entirely new/revised project). As a financial undertaking, Nama should have an incentive to write down as fast as possible the projects that have negative value relative to the cost paid. This can be done either via foreclosure or through distressed sale (sort of a 'fire' sale).

Of course, Nama is already being politicised and it is ambiguous as to what its objective might be. How I know that?
(1) It is not fully independnt as the Minister for Finance can act as a final arbiter of price and any future decisions on work out;
(2) We already have Green Party demanding 'social' dividends.
(3) There is no independnt oversight of Nama envisioned in legislation and
(4) There are no clear Chinese walls between NTMA, Nama, the Government.

All of this suggests to me that Nama is already at a risk of becoming a hostage to vested interests and to political objectives.

Will it foreclose on a development project that was approved as a 'bribe' to some local constituency that is politically connected (e.g the so-called 'independent' TDs) even if this project does not stand hope of generating anything but a loss? Will it intitiate a 'complete at any cost' for a social housing project that is, once again, politically sensitive to let go?

In my view, there is a very significant probability that Nama will simply 'sit' on many projects that should have been wound down ages ago in a hope of recouping some losses. This will, indeed, contribute to zombie development markets in this country for years to come.

But my concerns go further than that - will Nama politically decide what gets built and what gets thrown out to the vultures? Will it prop up some developers, giving them more time to recover losses simply because these developers are better connected?

Not to place these risks at the feet of FF, other parties, once in Government might be equally problematic.

The Galway Tent said...

@adrem >>"I haven't seen anything that officially or formally or even factually indicates that NAMA will protect developers from going under."
Here's a rant for 'adrem'.

Dublin Docklands Developers Autocracy (DDDA) could be considered to be the lab rat for NAMA. DDDA seems to be effectively bankrupt (no 2008 accounts yet).

Currently DDDA is buying flats near Sheriff St with magic-money from 'bankrupt' ZOE Developments. DDDA is firing staff and possibly getting the ex-employees files mixed up.

DDDA is waiting for NAMA to be established before DDDA cooks its books for 2008. NAMA will swallow much of DDDAs 'investments'.

DDDA's 2008 accounts are still not published; DDDA chairman is a psuedo-PD 'governance expert'.

** Joining the dots, this is one example of NAMA bailing out a developer. **

More importantly this rigs the prices for flats preventing the prices dropping to levels where honest front-line public workers can afford to buy flats.

More of rant:
Bankrupt Dublin Docklands Developers Autocracy Bails out Bankrupt Developer ZOE.

Paul MacDonnell said...

@Galway Tent, That's pretty interesting and very entertaining. So the upshot is that NAMA will be the Social Partners' Bank. Social Partnership politicized the economy when it was high on debt and NAMA politicizes the economy in withdrawal..

The Galway Tent said...

@Paul MacDonnell

Wealth Creation: Contrast our government run by a Lawyer, a Social Worker and an ex-Language Teacher with the Chinese one run by a team of engineers ...

Or contrast against Silicon Valley dominated by the Chinese and Indians with Masters/Doctorates in Elec Eng from Stanford, MIT, UC. Average pay in SV is in the $130,000 to $160,000 range, depending on high-tech sector.

NAMA will rack up our debt to Chinese banks. A new colonisation?


{this rant ignores the autocratic Chinese demolishing of private homes; human rights, etc.

And ignores the crass building 'architecture' such as ZOE allegedly done in IRL by engineers w/o artistic or social skills}.

spc100 said...

I dont know why the government is so anti an equity approach the problem.

As a taxpayer, this is the only sensible approach I would favour.

It is only as a sharholder, that I would prefer nama.

I would be interested in a FOI of how much key members of FF have tied up at a personal/familial level in bank shares.

The only problem I have with the equity approach, is that the price is getting higher, due to the assumption-that-nama-will-go-ahead premium that has been building in bank share price, and which would be used as a basis of valuation.