Wednesday, March 31, 2010

Economics 31/03/2010: Nama funding scheme - Maddoffian Risk Pyramid

The saga of Nama continues, folks. Ah, and no, I do not mean the dumping of €8.3 billion to the Anglo which miraculously declared losses of €12bn = €4bn injected by taxpayer in 2009 + €8.3bn injected today. Had the Exchequer given Anglo €15bn last night, the bank would have declared losses of €19bn. And not even the admission on the public airways, by our illustrious 'public interest' director soon-to-be-chief of Anglo, Alan Dukes, that Anglo will most likely need more than additional €10bn promised to it by overly-generous-with-other-people-money Mr Lenihan.

Oh no - the really worrying thing is contained in the notes from March 26th issued by Nama (available here) that detail the financing arrangements that Nama will undertake to cover the purchases of the loans from Irish banks.

Some time ago it was rumored that the Government was setting on the following scheme:
  • Nama will issue 12 month bonds
  • With interest rate rest at Euribor-Libor plus a margin every 6 months
  • Which are to be fully unconditionally and irrevocably guaranteed by the state as ranking pari passu with the Nama other unsecured and unsubordinated debts.
At the time, myself and other analysts said that such a scheme would be a disaster. Now, per latest documentation from Nama - this is exactly the scheme chosen to finance Nama acquisitions.

Let me remind you what the problem with this scheme is.

Nama is buying long-term loans with work-out period stretched over 10-15 years. It will use short term financing to get these through. Problem 1: borrowing short to lend long is what got out banks into this mess in the first place. Now, Nama will have exactly the same risk-loaded funding structure as the worst of our banks. For example, at the peak of risk-loading, Anglo carried about 50% of its funding in short-term inter-banks loans. Nama will do the same for 100% of its funding requirement. Scared yet?

Nama will be loading up with short term debt as the yield curve for Libor and Euribor is pointing up. In other words, every progressive reset (6 months) and roll-over of the debt (12 months) will be more expensive to the State. My third year UCD undergrads last Fall knew that this is a bad risk. Nama, having paid millions to advisers and 'experienced' staff couldn't get it right! Trembling yet?

Nama will be rolling over bonds on an annual basis. This means annual transactions costs (making the entire borrowing much more expensive) and reliance on the ECB to re-collateralize the bonds (putting Frank Fahey's 'free lunch' funding out to new tender annually). Is anyone actually thinking about any of these risks out in the Treasury Building on Grand Canal Street?

Adding insult to injury - despite being issued by the agent different than the Sovereign, Nama bonds will be tax-exempt. In other words, issued at Euribor of, say 2.75%, the notes will effectively be priced at around 3.44%. Worse, the Guarantee statement obliges the Irish state to cover incidental and other expenses of the bond holders and exempts them from all and any taxes relating to the Guarantee. In other words, should the bond holders resell their Nama bonds at a profit (in part determined by the Guarantee), there will be no tax on such a resale.

In short, it appears that neither Nama, nor an army of its excruciatingly expensive advisers, nor DofF, nor the Government have any knowledge that normal interest yield curves are upward sloping - cost of borrowing, normally rises in time. Or may be they simply do not care. After all, its our money they are gambling with.


Anonymous said...

Everyone knows the economy is a catastrophic mess, but the government is pursuing the correct course of action. The banks blew themselves and the economy up and someone has to step in. Let's get back to basics; at the primary level banks are a utility - just like gas, water or elctricity. If there is no attempt to recapitalise them and shrink their balance sheets, monetary policy will continue not to function ad infinitum leaving nothing but the public purse to keep the economy going. That is wholly unsustainable. In fact, without government support there would be no financial system in ireland today, no cash points, no clearing system, no wage payments, nothing. The government is tackling a terribly sorry and difficult situation as best as possible. Arguing about a few billion in valuation terms for property loans misses the point. The deeper the haircut on loans, the more capital the state has to provide to banks and vice versa. What is important is that loans start to be sold and markets start to clear. Terribly painful in the short run, but hopefully the seeds of growth for the next generation. Public debt is a by product of Ireland's greed, arrogance and ignorance. May it be a lesson that is learnt. Ireland forgot that Rome wasn't built in a day.

Greg said...

@ Anonymous

“Rome wasn’t built in a day”

True. But it burned to the ground in nine days.

TrueEconomics said...

Iceland? Sweden? countries with no cash points, I would presume. while I agree that the state has to, in the end, provide capital for banks, I absolutely and ardently disagree that the means by which this objective is being achieved are 'the best we can do'. And I disagree that markets will begin to clear once the loans are sold. As well as that few billion in valuations do not matter.

Philip said...

What you have illustrated reminds me of Around the world in 80 days when they were at the last part of the trip racing across the Atlantic back to London. They started to burn the ship itself to keep the steam engines going. The trouble is that I do not believe we will make landfall to save the day. In fact, I believe we will default with an overall debt burden of 2 Trillion and nowhere to run.

What happens then? Can the ECB avoid a Euro banking crisis as we inevitably sink. I think we'll be cut loose proactively in an effort to firewall us off and protect the Euro. And this might be the cure this country needs - together with an awakened majority that might start thinking straight for a change.

John Muldoon said...

Your arguments are strong and many agree with you. But is everyone barking up the wrong tree? A letter writer in today's Irish Times questions NAMA's constitutionality. Clearly the government won't see sense on this issue, so maybe the law can stop them.

Unknown said...

well C. Apparently you and me are wrong. See Brian O'Neil (who knew, hands up, that NTMA/NAMA actually had a communications officer? I thought they employed trappist monks )in the Times today, letters page. Sure theres apparently no risk at all at all at all at all. he states
"The NTMA, acting on behalf of Nama, will execute Nama’s interest rate hedging strategies in the capital markets to deal with interest rate risks as appropriate. This approach is in line with what any business would do to manage its risks appropriately".
Which reminds me of Lear's words "i shall do such things, I know not what they be, but they shall be the terror of the earth".
Lear is a tragedy btw...

Anonymous said...

We are being told that the whole purpose of NAMA is to improve our credit rating. And why do we need a better credit rating ?? With a better credit rating, we can borrow more. This is like an alcoholic going easy on a Monday, so that he can drink on Tuesday, etc... We are a society that cannot stop borrowing money. This is because we cannot stop living beyond our income, on an aggregate basis. Some people may be doing cold turkey, and some people may have been frugal all along. But a sizeable proportion defines life itself by loyalty to an unsustainable lifestyle.

Our credit rating will determine the interest paid on Irish debt. Therefore the interest rates on the debt is
i) positively corelated to the level of debt (including 'non-national debt' national debt like Anglo and NAMA).
ii) positively corelated to the shortfall in the state's finances
iii) positively corelated by our weak competitiveness
iv) positively related to the size of the social welfare budget.
v) negatively corelated to our ability to increase private sector employment via exports (or even to hold private sector employment steady).

By continually borrowing we are breaking the old maxim of "When you are in a hole, stop digging !!!!".

Of course all this, makes it even more certain that at some point in the future there will be a default on Irish national debt.

And with regard to competitiveness, the performance of the government ministers in increasing bureacracy and costs that hold down the export sector, and the internal efficiency of the economy is pathetic. The Bertie Ahern approach to state patronage and interference has made tied the export sector up in knots.