Economics 21/10/2009: Ireland = the most leveraged SPV on Earth?

And so we now learn than Nama beast has mutated into a high-risk derivative game with ghost investors, imaginary assets and illusionary payoffs. We are, for all intent and purpose, in the BaNama Republic.

Here is the story: per Annex H of the original statement of intent to establish Nama (April Supplementary Budget 2009 : here), the state will set up a Special Purpose Vehicle (SPV) to issue bonds (Nama bonds) that will be guaranteed by the State. Per Eurostat analysis (here) these bonds will not be counted as Irish Government debt.

First point to be made – we are now the first developed country in history that is about to throw the weight of its entire economy behind a private undertaking of extremely risky financial engineering nature.

€54bn worth of Nama Bonds will be issued by this SPV. SPV will be 51% owned by private equity investors who will supply €51mln worth of capital. Total capital base of SPV will be €100mln. This SPV will be borrowing (by issuing bonds) €54bn – which means that on day 1 of its running, the SPV will be 54,000% leveraged or geared. This will imply that Irish Nama-SPV will be leveraged in excess of LTCM – the infamously riskiest of all major investment propositions that anyone saw in financial history before Nama SPV idea came to being.

Point two: the Irish state will be engaged in the riskiest derivative instrument undertaking of all known to man to date.

To cover up the farcical arrangement (with folks with €51mln buying €77bn worth of risky (but recoverable, by Minister Lenihan’s assertions) assets), maximum 10% of SPV value can be distributed in profits. 10% of what you might ask?

CSO submission to Eurostat states that: “The profits earned by the SPV will be distributed to the shareholders according to the following arrangement, which reflects the fact that the debt issued by the Master SPV will be guaranteed by the Irish Government:

• The equity investors will receive an annual dividend linked to the performance of the Master SPV.
• On winding up of the Master SPV, the equity investors will only be repaid their capital if the Master SPV has the resources; they will receive a further equity bonus of 10% of the capital if the Master SPV makes a profit.
• All other profits and gains of the Master SPV will accrue to NAMA.”

Two possibilities: 10% of expected (by DofF) Nama profits or 10% of Nama assets?

In the unlikely event of 10% of assets, the lucky ‘private equity’ folks can get 10%*€54bn*51% share – or €2.754bn – on the original investment of €51mln. They face no downside other than their initial capital injection less whatever dividends they collect prior to default, as bonds are guaranteed by the State. I assume this is a fantasy land. But one cannot make any rational assumptions about Nama anymore.

In a more likely event, it will be 10% of Nama profits. Ok, per DofF, Present Value of Nama profit is €4.7bn * 10% * 51% = €239.7mln. With principal repayment this means they will collect a cool €291mln on day last of Nama existence if DofF projections stack up.

We know nothing about the dividends, but we do know that the dividends will be paid out over 10 years. For some sort of decorum the Irish Government will have to allow SPV to appear to be legitimate and therefore it will allow it to pay a dividend on assets managed. Suppose the dividend will be around ½ of the standard management fee for assets, or roughly 100bps on revenue generating loans or 2.5% on net cash flow. Per DofF Table 5 of Nama business plan, this will add up to €12bn*1%*51%=€61.2mln using the first method or €61mln computed using the second method. In present value terms. Thus €51mln in initial investment will generate:

Scenario 1 – Nama works out per DofF assumptions = €352mln (inclusive of principal) – a handy return over 10 years of 690% or 21.3% annualized. Not bad for a government guaranteed scheme…

Scenario 2 - Nama loses money and is pronounced insolvent. Investors lose €51ml of original investment, but keep €61mln in dividends. 100% security, 0% risk...

Which brings us to the third point: as Irish taxpayers, we are now in a business of paying handsome returns to private equity folks (more on those below) in exchange for them covering up the true nature of our public finances. A good one, really.

Who owns this SPV? This is an open question. 51% will be held by ‘private investors’. 49% by Nama. 100% of liability will be held by you and me. Is this a Government throwing the entire weight of the sovereign state behind a privately held investment scheme? You bet.

But wait. Who are those ‘private investors’? Can Sean Fitzpatrick be one of them? Why not? Of course he can. Can Ireland’s non-resident non-taxpayers be amongst these? Why not? Of course they can. So as taxpayers we will be issuing a guarantee to tax exiles? Possibly. But wait, it gets even better – can the banks themselves be investors in SPV? Well, of course they can. Wouldn’t that be a farce – banks get to unload toxic waste on taxpayers and then make a tidy profit on doing so…

One way or another – parents struggling to put their kids through schools, elderly people struggling to pay medical care costs, single parents trying to balance work and raising family, young folks studying to better their lives – all of them and all of the rest of us will be bearing 95% responsibility of assuring that some ‘private investors’ will make a nice tidy profit, so Minister Lenihan and Taoiseach Cowen can go around the world claiming that Irish bonds that underpinned Nama were not really Irish bonds!

Which brings us to the fourth point: Why is Eurostat assured by this massive deception scheme to accept it?

Globally, G20 summits one after another have been focusing on how we will have to deal with the risks of the traditional SPVs and other ‘alternative investment’ assets classes that spectacularly imploded during the current crisis. Yet here, in a Eurozone country, a Government is actively setting up the most leveraged, highest risk SPV known to humankind. Surely there is a case to be made that the EU authorities should be actively stopping such reckless financial engineering instead of encouraging it?

The entire SPV trickery works because the Government has managed to convince the Eurostat that SPV will be fully operationally independent of the state. So far so good. But, Nama will sit on the board with a right of veto over SPV managerial and operational decisions: “The NAMA representatives on the Board will maintain a veto over all decisions of the Board that could affect the interests of NAMA or of the Irish Government.” Furthermore, Minister Lenihan and his successors will have veto power over Nama decisions and will be the final arbiters of Nama. Is that arms-length getting to finger-length?

At this point, there is only one institution still standing between the madness of the runaway train of Nama and the crash site of the SPV-high leveraged high finance gables with taxpayers money. That institution is ECB. The ECB will have to be concerned with non-transparent (Enron-like) accounting procedures that are being created by the Irish Government when it comes to accounting for Nama bonds. It has to be concerned if only for the sake of the Eurozone stability and its own reputational capital. Will ECB step in and tell this Government that enough is enough?

Economics 19/10/2009: A proud member of National Mediocrity

Sunday Sunday Business show on Today FM. Minister Lenihan commenting on the anti-NAMA economists (podcast here):

"What I notice about them is that there’s about forty of them. There is about two hundred economists in the state. Most of the rest of them have approached me privately and said that these gentlemen and ladies are wrong. But of course they are not prepared to say so publicly because in Irish academic class, people don’t criticise other people’s books. That’s part of our national mediocrity. ...If you look at the press in the United Kingdom or the United States, you’ll see robust academic criticism of others works but we’re reluctant to do it."

Karl Whelan has his view on this - read it here.

My view is a simple one. Want to have some criticism - compare publications records of Mnister's advisers to that of, ough, say Karl Whelan or Brian Lucey. Want to have some criticism - compare supporters and critics of Nama:
Supporters:

• Stockbrokers and Irish Banks' economists - all with a major conflict of interest implied in their positions as their respective organizations will be the intended beneficiaries of Nama. In my books, this does not invalidate their points and analysis, but it does raise a question or two;
  
• EU Commissioner who actually negotiated with Minister Lenihan Nama solution;
• Ghosts of other - possibly independent - economists who have spoken to the Minister in private?..
  

Critics:

• 4 Nobel Prize winners, several senior faculty members from the top 5 Finance Departments in the world, and one former SEC Board Member;
• 46 academic and practicing economists and finance specialists;
• 4 authors of comprehensive analysis of Nama proposals (myself, Brian Lucey, Ronan Lyons and Karl Whelan - in alphabetic order) that provided more detailed and more accurate costings of Nama and alternatives than the one supplied by Minister's own staff;
• 1 former banker - Peter Mathews - who has extensive experience in managing bad loans within a special division for such loans set up by ICC bank in the 1980s;
• A range of independent economic commentators some with extensive finance experience in the past;
• A number of top class finance entrepreneurs, including Dermot Desmond;
• Hundreds of people from finance, international finance and economics who comment on this blog and the Irish Economy blog;
• One Governor of the Central Bank who proposed significant changes to Nama that were subsequently taken out of context by His Intellectual Excellence's Government colleagues and reshaped into an unrecognizable watered-down versions to suit original Nama.

Not that excellence is measured in numbers (as Gallileo and Copernicus and many others have proven before), but you get the point.

As far as Minister Lenihan has a stomach to talk about mediocrity, I wonder how he feels sitting at the Cabinet table. Or how he feels about the Nama analysis being pushed forward by his staff - analysis that has been time and again proven as:

• coming after the mediocre Irish economists put forward their figures; and
• turning out to be wrong and proven to be wrong by the mediocre Irish economists.

Hmmm...

One real sign of intelligence and excellence is ability to listen, seek truth and change your views/plans in response to overwhelming evidence that disputes one's original proposition. To date, after months of factual analysis by many of us, this Government has been showing complete lack of ability to do either one of the above.

Let us all be judged, then, alongside Minister Lenihan, as to where the real mediocrity in this country resides.

Economics 15/10/2009: NAMA Business Plan Falls Flat

Updated 09:01

Note: Karl Whelan's post on Nama Business Plan is available here.


So let us start with Nama Business Plan published tonight: the main claim is that Nama is expected to generate a net present value return of €4.8bn by 2020.

I beg to differ. Here is why in two steps:

Step 1:

“This €77 billion is made up of approximately €49 billion land and development loans (€28 billion and €21 billion respectively) and approximately €28 billion in associated loans.” Of the latter, €14.2bn is in derivative instruments.

Now, land values have fallen by some 70% plus, with some land now valued at a 90% discount. What the recovery rate on these loans? Assume 30-35%, to the total loss of €18-20bn.

Development loans currently carry default and roll-up rates of well in excess of 40%. Suppose Nama buys an average portfolio of these and that the default rate rises to 1/3 of all stressed development loans. Expected loss here is therefore around €7-9bn.

Associated loans include second recourse and non-recourse loans and cross-collateralized loans. They have lower seniority on underlying assets. And this includes (50%) derivatives – instruments that actually cannot be priced directly without requisite information that has not been supplied by DofF. So suppose the default rate here is the average of the above two rates, or ca 50%, to the total loss on this part of the book of €14bn.

Add this up: total expected loss on Nama loans book value is €39-43bn before we factor in roll ups of interest. Day one of operation, Nama will be holding the portfolio of loans with expected value of €77-€41=€36bn against the liability of €54bn, which implies it will be in the red to the tune of €18bn.

Make another clarifying assumption. Assume that for the last segment of the book – the associated loans – derivative instruments are similar to the average market derivative contracts as stipulated in Table 3 of the BP. This pushes losses on this part of the book up by additional 25-35% of the derivatives segment value. The total loss Nama will incur on day one of its operations will then be a staggering €21.7-23.1bn.


“The estimated aggregate average loan to value (LTV) rate for these loans is approximately 77% i.e. the value of the real estate collateral at the time the loans were originated was €88 billion. The loans were made over a number of years and not all were made at the peak of the market.”

Suppose this is true, although I have no confidence that this number is real. Suppose average vintage of the loans is 2005. Land is currently at below 1999 levels in pricing. Development projects are around 2001-2002 pricing and completed property is around 2004. Assuming we are at the bottom, average LTV on these loans today is around:
€28bn/0.77*0.3+€21bn/0.77*0.5+€28bn/0.77*0.85=42.7/0.77=€55bn
This is LTV ratio on Nama purchase as of today of 98.2%. Not 77%, but 98.2%.

If average vintage of Nama loans shifts to 2006 (a more likely scenario, as Nama will not be buying an ‘average bank loan, but a non-performing loans portfolio with so-called ‘performing’ loans to be mixed in coming from stressed loans side of the balance sheet), then the actual today’s LTV shifts to:
€28bn/0.77*0.2+€21bn/0.77*0.42+€28bn/0.77*0.81=37.1/0.77=€48.2bn
This is LTV ratio on Nama purchase as of today of 112%. Not 77%, but 112%.

Incidentally, Nama ‘Business Plan’ contains no sensitivity analysis of this sort or of any sorts – neither for expected inflation, nor for spreads on bonds, nor for cost of administration, or for any other assumptions.

Step 2: redoing Nama balancesheet:

Table 5 clearly states that Nama expects life-time default rates for all loans and derivative instruments transferred to be 19.35% of the book value of loans at origination! Business Plan admits (page 9) that in the last year alone the banks took a charge of €7.3bn on the book – just under 10%. Thus, DofF expects 2009-2011 default rate to be only 10% more. This is for a book that overall contains 40% non-performing loans already! It is simply a case of amazing degree of optimism.

Let us do the math for alternative scenario. Suppose the default rate overall will be 33%, in which case without challenging any other DofF assumptions in Table 5, the net gain of €4.8bn turns into a loss in present value terms of €10.2bn. Just like that!

Now, let us challenge the assumption on Nama yields. DoF data is shown in the Table below. The second table changes yield assumptions and retains my default assumption above:
Now, per table 2 above, combined assumptions of more realistic default rate and more realistic yields (consistent with current yield, adjusting for default rate expected through 2011), and recognizing that derivative instruments yields are unlikely to be achieved at all, bottom line Nama is now expected to yield an €8.6bn loss in present value terms.

Shall we move on? Assuming slightly steeper curve on the cost of bonds financing, table below shows that expected Nama losses can reach €11.5bn in present value terms (Table 3).

One last thing left to do. Recall that per Nama own Business Plan admission, 40% of loans are currently producing a yield. This implies that 60% are non-performing. If yield curve were to rise over time as Nama assumes, these loans are not going to start repayments at any time in the future. So suppose the default rate assumption goes to 45%. Table below shows the end game:
A loss of €19.1bn in real terms!

And this is before we compute the opportunity costs of this money.

Conclusion: DoF estimates for Nama make absolutely no sense. The best scenario I get is a loss of €10.2bn. The worst one yield losses of €19.1bn.

Note: the above do not include the cost of managing the Nama loans by the banks. These ordinarily range around 0.5% of the total loan value per annum. Suppose the banks will be able to pass these costs on their paying customers (you and me). The net effect will be an annual added cost to businesses and paying customers of €270mln.


Note: All Nama flows are targeted for 2013, which in effect saddles future Government with the entire obligation under Nama. A rescue package, then, for banks, developers (with a repayment holiday until 2013) and... FF...