Economics 1/6/2010: Numbers game at Anglo

Last night, I sat down to run through possible scenarios for the Anglo's 'The Bad and the Ugly' Banks division. You see, something was telling me right off the start that the idea of a 'Good' Bank just doesn't really square off with our knowledge of the bank's operations to date.

So I posited to myself the following question: given Nama transfers and rumored split off of €12-15bn worth of loans into a 'good' bank, can the resulting entity be viable? Like a scientist in a lab, I donned on a white coat (well, really my favorite UofChicago sweatshirt), pulled out a Petri dish (my Excel) and started observing the split of that outright not-so-beautiful and very toxic (to the taxpayers) bacteria, called Anglo...

Here are the results, first in numbers and then in plain English:

Step 1: recall we have pumped €10.3 billion worth of promisory notes into the bank alone. Relying on my yesterday's analysis (see details here), I reproduced the demand that a 'Good' Anglo will generate for funding these promisory notes. Now, a reminder - these numbers (penultimate column) correspond to interest only charge on Anglo from the promisory notes. They exclude principal repayment and other recapitalization funding already in the bank.
Bah, I said, the thing in the Petri dish of mine looks pretty ugly. Ugly as in unable to cover the taxpayers-due interest on capital it receives at the first glance.

Ok, I said to myself, but may be were the new 'Good' bank to grow over time, it will become relatively viable with time? Suppose the 'Good' bank generates no impairments going forward (unrealistic assumption, but suppose it does), suppose that 'Good' Anglo grows its book at 5% (generating no new impairments). Further suppose that there's some value in the 'Bad' bank - so assume 20% of the loans transferred to it perform in the future (an extremely optimistic assumption, but what the h***ll, not much out of line with the general assumptions the Government has been making all through its management of the crisis).

The question I asked then was: with all these rosy assumptions in place, what amount of interest payments annually can Anglo afford?

To compute this, I took several scenarios:

1. I allowed 'Good' Anglo to take €12 or €15 billion in loans on board;
2. I assumed that it generates 2% of the loan book annually (another optimistic assumption - as it corresponds to an efficiently operating bank in terms of costs, book of business and funding costs - all of which are not exactly characteristic of the Anglo)
3. I then assumed three different potential burden levels on interest (recall, no principal) repayment at 30% of the total annual return by the bank, 25% and 20%. Let me explain here that a 30% number is utterly unrealistic, implying that almost a third of the entire operating revenue of the bank will be used to pay interest on a small share of its capital funding. This will, in effect, leave no surplus to pay bonuses (of any kind) and dividends (of any kind) as well as to finance bank's insurance etc. 25% mark is also unrealistic, while 20% is back-breaking for a bank, but can be probably sustained over a couple of years.

Table below shows the results by stating the amount of interest repayment that the bank can generate across both its 'Good' and 'Bad' divisions. Blue-bold numbers mark the first time that the annual interest funding requirement gets met.
All of this is fine, I said to myself next, but before the interest requirement is first met on the annual basis, there are years of the bank not covering the interest bills. These will cumulate.

My next question, therefore was: How soon can the bank break into the 'black' vis-a-vis interest repayment alone?
Table above shows the cumulated interest arrears from the €10.3 billion in promisory notes. It clearly shows that under all scenarios, save one (the most optimistic scenario) the entire Anglo operation cannot be expected to generate enough cash to cover even the portion of its interest bill. In fact, under the more realistic scenario (last two columns), Anglo - 'Bad' and 'Good' combined - will continue to accumulate interest arrears on the taxpayers funds (ex €4 billion in direct capital it received) through 2020.

There is no principal repayment charge in the above, nor is there a chance of receiving anything close to the interest bill, even assuming that we do not roll up interest on the cash we put in. In simple words - the entire Anglo operation is so fundamentally bust, that the taxpayer is likely to never receive even a few cents on the euro of the money we've put into it.

The only thing that grew in my Petri dish was a voracious bacteria capable of hoovering taxpayers money at a speed unimaginable to any other bank.

One wonders if that is what Mr Alan Dukes and our Government mean when they are saying that proceeding with keeping Anglo on a respirator amounts to minimizing the cost to the taxpayers.

Economics 31/05/2010: Anglo's latest cash call

This just in - the Government has decided to give Anglo, yes, that very Anglo which is Ireland's real zombie bank with no prospect - even theoretical one - a fresh capital injection of €2 billion (here). This brings taxpayers' capital injected into the bank to €14.3 billion to-date.

The official information by DofF claims that because the injection comes in a form of a promisory note, payable over 10-15 years, there will be lesser impact on the taxpayers today. However, although the official announcement does not say so, this term structure of payments means that our future deficits will be front loaded (pre-committed to the amount announced today), implying that for Ireland to reach required 3% deficit/GDP limit by 2015, we will have to face an increased funding requirement for Anglo over time.

This requirement must be provisioned today, since the notes work in the following way:

• At any point in time between today and 10-15 years from now, Anglo can waltz into DofF's offices and ask for any share - between 0.00001% and 100% of the amount issued on the promisory note.
• At that moment, the Government will have to come up with cash pronto, which means - no time to issue separate bonds.
• Which implies that the very second Mr Dukes asks for cash, our deficit goes up by that exact amount.

Now, prudentially, we should have set an escrow account and provided for this funding. In practice, as is clear from the DofF release, no provisions will be made. The entire, and I repeat, the entire risk of the drawdown therefore is leveled on the shoulders of taxpayers. The DofF in effect is praying to the forces of fortune that Anglo won't come in with a request for funds tomorrow, and/or that any request will not be for the entire sum of the promisiory note.

Now, let us revert back to the 'bank' called Anglo. The State has now committed €10.3 billion in promisory notes. These carry interest rate of... well, I am not sure... but suppose it is 5% to cover the cost of borrowing for these funds in the market, once the funds are disbursed. Assume that 10% of that (actually below a normal charge for a letter of credit for an insolvent company) is outstanding annually until a drawdown. Make a further assumption: assume that Anglo will draw the entire amount in equal annual installments over 5 years - an assumption that is also extremely conservative.

At 5% per annum, Anglo's liabilities to the taxpayers are:
Let me quickly and briefly explain the last 2 columns above. The penultimate column shows the sum of interest charges (at 5% on drawn funds), plus underwriting charge (at 0.5% for undrawn promisory note funds remaining) that Anglo should be paying over the next 10 years, assuming draw down is evenly spread over 5 years on both tranches. The last column then states the amount of loans that are performing that Anglo needs to have on its books in each year to cover the loans interest, not the principal, but interest, assuming that Anglo uses 0.5% of the loans to cover its interest rate, which would roughly amount to 25-30% of its entire interest income on the loans (note - that is really a severe case of the credit squeeze on a bank, but hey, suppose they manage without breaking the back).

How do I come up with this 25-30% estimate? In a normal year, one can expect a fully efficient bank to make ca 2% of their loans volume in revenue. If it pays 0.5% of that amount to cover costs of promisory note, it will be swallowing 25% of the revenue base.

Now, Anglo is transferring to Nama some €35 bn worth of loans, leaving it with ca €30 billion in remaining loans on its books. Of these, roughly 60% is expected to go into the 'bad' bank - in other words, roughly €18 billion worth of loans won't b performing. This leaves it with roughly 40% of loans or €12 billion on the side available for revenue generation. It needs ca €28 billion to cover the cost of the prmisory notes alone...

Get the picture? Even if you dispute my assumptions and half all the costs of the promisory note carry, you still can't get Anglo balance sheet to cover the cost (not the principal) of what it is borrowing from the taxpayers. This puts into perspective the DofF claim that: "As the Minister stated last March the overriding objective of the Government is to minimise the cost to the taxpayer of the restructuring of Anglo Irish Bank".

Economics 30/04/2010: Minister Lenihan's statements in the Dail

Some interesting points on Nama, coming out of Minister Lenihan's answers to Dail questions this Wednesday, April 28 (emphasis is mine):

"The NAMA SPV structure has a subscribed capital of €100m. As explained to the Dail at the time of the legislation, and subsequently agreed with the EU, 49% of this capital was advanced by NAMA and 51% by private investors.

Three private investors, namely, Irish Life Investment Managers, New Ireland Assurance and a group of clients of Allied Irish Banks Investment Managers, have each invested €17m in the vehicle. It is important to note that in each case the beneficial owners of the investment are pension funds or other clients of these investment companies and not the parent credit institution. [It is equally important to note that in each case the full owner of each one of these entities is an institution directly involved either in Nama or in Banks Guarantee scheme, which, of course, under normal rules of engagement would imply potential conflict of interest]

The SPV has been established in accordance with Eurostat rules. The Board of the SPV is chaired by the CEO of NAMA and has three NAMA nominated directors with the private investors retaining the right to nominate a further three directors. Thus the SPV is structured in such a manner that NAMA representatives will maintain an effective veto over decisions of the SPV Board. [Thus the so-called 'veto' is a de facto, not de jure. Should one of the Nama representatives on the board fall ill, be delayed in travel or be absent on some state-sponsored junket, in absence of the said member, it is quite possible - even if only in theory - that the veto power can pass over to the 'private' owners of SPV.]

Further:

"In line with my statement to the House on 30 March on the banking situation, I subsequently issued Promissory Notes on 31 March to Anglo Irish Bank and Irish Nationwide Building Society. These Notes will ensure that both institutions continue to meet their regulatory capital requirements. The initial principal amount of the Note that issued to Anglo Irish Bank is €8.3bn and to INBS it is €2.6bn. As I indicated in my recent statement, it is likely that Anglo will need further capital in due course but the extent and timing of such further support remains to be determined.

The terms of the Promissory Notes that issued to both institutions on 31 March are substantively the same and, inter alia, provide that 10% of the principal amount will, if demanded by the institution, be paid each year and that the first such payment will fall due for payment from the Central Fund on 31 March 2011. An annual interest coupon, related to Government bond yields, is also payable on the Promissory Notes which the Minister has absolute discretion to pay on the due date or to add to the principal amount. [So, in contradiction to the deeply-informed Dara O'Brien TD, it is the state who will be paying interest to the banks. Not the other way around]

This ensures that the Note meets accounting requirements to be “fair valued” at the principal amount in the annual accounts of each institution, consistent with the regulatory capital requirements. [This sentence is an example of Minister's habitual abuse of financial terminology, in so far as it makes absolutely no rational sense to anyone even vaguely familiar with finance. 'Fair valued' must refer to a benchmark, being a comparative/relative term. 'Fair valued at the principal amount' is gobbledygook as principal amount - the face value of the bond/note can only be valued in relation to the price of the bond or yield on the bond, none of which are referenced in Minister's statement. Furthermore, fair value concept does not refer to the regulator capital requirements. It refers only - I repeat, only - to the market value of the bond/note.]

In the event of a winding-up of either institution, the aggregate of the outstanding principal amount and any unpaid interest that has accrued on the institution’s Note falls due for immediate payment. [So, at least in theory, the Exchequer might face an immediate call for billions of euros in cash... what provisions have been made to ensure we will have this covered? How will Minister Lenihan be able to raise such funding even if the economy is not in crisis? What will be the additional cost of having to raise such funding in a fire-issue of a new state bond? Has the Minister established adequate pricing scheme to charge the banks for the taxpayers assuming such a risk or has he 'gifted' this risk premium away, thereby potentially exposing taxpayers to added hundreds of millions in new costs of such emergency issuance?]

The Deputy may also wish to note that, as indicated in my banking statement of 30 March, the use of Promissory Notes means that the institution’s capital requirements are met in a way which spreads the cash payments over a number of years and thereby reduces the funding burden on the Exchequer that would otherwise arise in the current year. [This statement clearly shows that Minister Lenihan does not understand the basics of interest rate/yield curve relationships. He implicitly assumes that in the future, the state borrowing costs will be lower than they are today. There is absolutely no reason for such an assumption.]

Economics 23/04/2010: Further details on Irish deficit numbers

More detailed analysis from the Eurostat on reclassification of the Irish deficit is available now. The link to the document is here. Go into Ireland file, spreadsheet for 2009.

Here is what is now apparent from the Eurostat analysis (italics are mine):

"In normal circumstances, under the National Pensions Reserve Fund Act, an amount equivalent to 1% of GNP (about €1.5bn) is paid by the Exchequer into the NPRF every year, in 12 equal monthly instalments. In May 2009, the total due to be paid under this arrangement for the remainder of 2009 and 2010 was paid in one tranche, in order to allow NPRF to fund the bank equity purchase entirely from liquid assets. (The actual 'extra' amount paid at this time was some €2.5bn, given the amount already paid or due to be paid under the normal Exchequer- NPRF funding arrangement.) The impact on Government D4_pay in 2009 is therefore the cost of borrowing this extra €2.5bn earlier than it would otherwise have to have been borrowed..."

In other words:

• The Government has by-passed voted-in Budgetary procedures to inject €2.5 billion in additional funding into Anglo by front-loading future NPRF funds into 2009 provision. There was no Dail vote on this.
• The Government pretended that the additional 2010 funds injected were not borrowed for under General Government Balance, thereby de facto claiming a right to transfer future expected receipts into 'liquid' current receipts. There was never any Dail vote to allow for this, as far as I know.
• This is not the only time that the Government exceeded its remit in by-passing the Dail vote in relation to recapitalizations. One can argue that the entire Anglo recapitalization was planned and committed in advance of the Dail vote on the issue.

Furthermore, under contingent liabilities section 7:

"7. Special purpose entities included here are those where government has a significant role, including a guarantee, but which are classified outside the general government sector (see the Eurostat Decision and accompanying guidance note for details). Their liabilities are recorded outside the general government sector (as contingent liabilities of general government)."

Per table 2 in the same spreadsheet, the above does not cover the Guarantees which amount to over €281 billion in 2009 (line 5). And in fact, these refer to Nama. Now, notice that 'imputations relating to the financing costs should be included' in line 4, which does count as a full General Government liability. Guess where the euribor cost of Nama bonds should be entered? Thus, Irish deficit might also include the 1.25%-odd payments to the banks from Nama bonds, or, assuming €35 billion issuance of these bonds - €437.5 million in additional deficit not accounted for in the Budget 2010.

Now, recall that in 2007 euribor has reached well over 4%. Suppose we go to a 3-3.5% euribor pricing on Nama bonds, rolled over annually. In subsequent years, if Eurostat retains this classification of liabilities, up to €1,225 million will be added to our deficits courtesy of Nama.

Economics 31/03/2010: An expensive joke called Nama

I must confess, the last thing I expected in yesterday's quadruple whammy of one Ministerial speech, one Nama document release, a Central Bank statement and the Financial Regulator's decision was a joke. But there it was. For all to see, for few to notice.

Armed with a law degree-backed mastery of logic, Minister Lenihan has issued a statement that he will be requiring Irish Bankers Federation to run courses for the benefit of our bankers on how to lend money to projects other than property. That statement, coming from the Minister after he announced that the Anglo will be provided with up to €18.3 billion in taxpayers cash, and the rest of our banks will swallow billions more was worthy of a comedian. In an instant - we had a Minister for Finance throwing money at the banks which, by his own admission, have no idea of how to lend.

Anything else had to take a back seat to this farce. And it almost did. If not for another pearl of bizarre twist in the Nama saga. Recall that this Government has promised the world an arms-length entity to control and legally own Nama - the Special Purpose Vehicle arrangement which, in order to keep Nama debts out of the national debt accounts was supposed to be majority (51%) owned by external investors.

At the time of the original announcement of this arrangement I publicly stated that there was absolutely nothing in the Nama legislation precluding parties with direct interest in Nama from investing in this SPV. And boy, clearly unaware of such pithy things like conflict of interest, Nama announced that its majority owners will be:

• Irish Life Assurance (a part of the IL&P that has been at the centre of the Anglo deposits controversy and one of the most leveraged banks in the nation),
• New Ireland (an insurance branch of BofI), and
• AIB Investment Managers.

In other words, the very institutions that will be benefiting from Nama's taxpayers riches will also own Nama and will comprise SPV board. They couldn't have given a share to Seannie Fitz and Mick Fingleton, could they?

Having a good laugh - even at the cost of tens of billions to us, the ordinary folks - is a great end for a day in the Namacrats land. So much for responsible and vigilant policies of the Government.


Now to the beef: Nama release figures.

In its note on the first tranche of loans transferred, Nama provides a handy (although predictably vague) description of the loans the taxpayers are buying as of March 30, 2010. Table below summarizes what information we do have:

Let us take a further look at the data provided in the official release and the accompanying slide deck.
Applying more realistic valuations on the loans transferred against the average Nama discount, while allowing for 11% assumed LTEV uplift (Nama own figure), net of 2% risk margin - the last column in the above table shows the amounts that should have been paid for these assets were their valuations carried out on the base of March 30, 2010 instead of November 30, 2009 and were the discounts applied reflective of realistic current markets conditions.

Thus, in the entire first tranche of loans, Nama has managed to overpay (or shall we say squander away) between €1.2 and €3.1 billion - a range of overpayment consistent with 14-37% loss under the plausibly optimistic assumptions. Returning this loss across the entire Nama book of business and adding associated expected costs of the undertaking implies a taxpayer loss of €9.6-25.3 billion from Nama operations.


In Nama statement, Brendan McDonagh, Chief Executive of NAMA said: “Our sole focus at NAMA is to bring proper and disciplined management to these loans and borrowers with the aim of achieving the best possible return and to protect the interests of the taxpayer. ...NAMA is willing to engage with an open mind to our acquired clients ...”

Pretty amazing, folks - Nama CEO clearly sees the borrowers as his 'clients', while claiming that his organization objective is to benefit the taxpayers. Would Mr McDonagh be so kind as to explain the difference? Is Nama going to serve the 'clients' or is it going to protect the taxpayers? The two objectives can easily find themselves at odds - the fact Mr McDonagh is seemingly unaware of.

Economics 04/11/2009: NAMA's first falls in the land of legal finance

International Swaps and Derivatives Association (ISDA) has issued an interesting opinion on Nama worth a read. Here are the main points (mind the legalese):

“…from an international perspective, a particular aspect of the NAMA Bill that has the potential to have a significant adverse effect on the transaction by participating institutions ...of domestic and cross-border financial transactions, including privately negotiated or “over-the-counter” (OTC) derivative transactions (“Relevant Transactions”).

ISDA’s main concern focuses on partial nature of property transfers under Nama.

“We note that ...the fact that the NAMA Bill envisages that partial property transfers – [i.e transfer of of some, but not all, of a participating institution’s rights and obligations arising under a Protected Arrangement, an arrangement with third parties legally protected under the international, Irish, UK, US or other national laws] - may be effected raises a significant risk of legal uncertainty for Protected Arrangements.” [In other words, what might be kosher for the Irish authorities under Nama might be violating international legal rights and obligations of parties related to Nama-impacted loans]

“If some, but not all, of such rights and obligations were “cherry-picked” for transfer pursuant to the NAMA Bill, the net position of that participating institution’s counterparty (and, indeed, of that participating institution) would be disrupted notwithstanding the provisions of Section 213” [of Nama legislative proposal].

“...During the UK consultations [on bailout packages] industry put particular emphasis on the possibility that the stabilisation measures provided for in the UK Banking Act 2009, which included a partial property transfer power (the power to effect a transfer of some but not all of the property, rights and liabilities of an affected UK institution), could be used to "cherry-pick" transactions, or even parts of transactions, under a netting arrangement, or otherwise disrupt the mutuality of obligations under a netting or set-off agreement... It is notable that, in the UK context, the validity of the industry concern in this regard was always acknowledged by the relevant authorities (HM Treasury, the Bank of England and the Financial Services Authority), so that the consultation process, in this regard, focused on how best to structure the relevant protections.” [This of course is not the case with Irish Nama case]

“As you are probably aware, the relevant protections were set out in Article 3(1) of The Banking Act 2009 (Restriction of Partial Property Transfers) Order 2009, as amended by The Banking Act 2009 (Restriction of Partial Property Transfers) (Amendment) Order 2009. Article 3(1) provides that a partial property transfer, within the meaning of the legislation, may not provide for the transfer of some, but not all, of the "protected rights and liabilities" between the affected UK institution and a third party under a "netting agreement". [Once more, in Nama case, no due diligence was even performed in this area – it appears from the note by ISDA that the Irish authorities have totally failed to consider the impact of Nama transfers on third parties]


So what does this mean for participating institutions and their counterparties?

“Risk management policies of parties to Relevant Transactions tend to require such parties to monitor credit exposure to counterparties under Relevant Transactions and, where relevant, put in place appropriate risk-reducing close-out netting and collateral arrangements. In the case of a party that is subject to prudential supervision (such as an Irish or foreign bank), whether it can treat its exposure to a Relevant Transactions counterparty as net, and take related collateral arrangements into account for risk reducing purposes, will also be key to the level of capital that the party is required to allocate to Relevant Transactions with that counterparty.” [So standard legal framework requires third parties to hedge risk vis-à-vis Nama-impacted institutions, but this process is at risk under Nama partial transfers. Which implies that Nama actions will spill over to third parties outside Nama jurisdiction. The legal bonanza that will be Nama is now risking crossing many borders…]

“A supervised institution will not be able to recognise close-out netting or a related collateral arrangement unless it can satisfy its supervisor that the close-out netting or collateral arrangement is enforceable with a high degree of legal certainty and with no unduly restrictive assumptions or material qualifications.” [This is the crux of the argument – if Nama will only partially impact security of collateral, this partiality will imply that counterparties to Irish banks’ transactions will not be able to properly assess the security of collateral held by the banks and in cases where such security is jointly held by an Irish institution and a non-Irish one, there will be no means for assessing the risks incurred by non-Irish institutions due to Nama take over of the loans or underlying collateral titles. Nama, therefore, will risk inducing new risk on unrelated institutions.]

Absent Nama “such opinions can be obtained in respect of potential [Nama-]participating institutions in respect of many industry close-out netting and collateral agreements. If the position in this regard were to change [a change which will be triggered by Nama coming into force], the commercial and financial implications for potential participating institutions and their counterparties to Relevant Transactions would be severe in that:

(a) supervised institutions [aka all non-Irish banks and credit providers] would be constrained in their ability to extend credit, or otherwise incur exposures, to participating institutions;

(b) supervised participating institutions themselves would find their own ability to conduct business constrained by much heavier capital requirements and their access generally to liquidity would be impaired”. [In other words, Nama will mean that participating banks will have to pay a heavy premium in terms of capital provisions due to the Nama-induced deterioration of their own collateral rights].

“…a concern remains that a [Nama-]participating institution’s counterparty’s net exposure could be disrupted by a partial property transfer of the type outlined [above]. If such a partial transfer of a bank asset by a participating institution to NAMA or a NAMA group entity occurred (or by NAMA or a NAMA group entity to a third party) occurs, the fact that the participating institution’s counterparty may terminate the agreement with the participating institution and enforce the close-out netting and collateral provisions will not provide comfort [at the immediate and massive cost to the Irish banks participating in Nama] if, as a result of the transfer, the transactions the subject of the netting/collateral arrangement have changed so that its net exposure differs from that which would have pertained but for the partial transfer.”

So, ISDA “strongly recommends that safeguards be introduced to the NAMA Bill to ensure that a Protected Arrangement may only be transferred as a whole under the NAMA Bill, or not at all, and that individual rights and obligations under the Protected Arrangement should not be vulnerable to cherrypicking.”

[In effect this will severely restrict two aspects of Nama operations:

1. this provision will increase the share of non-performing loans in the overall take up of loans by Nama, putting more pressure on Nama bottom line; and
2. this provision will also mean that some of the most toxic loans (with complex collateral rights, significant redrawing of covenants in the past, and/or substantial cross collateralization) will either have to be left with the banks as a whole or bought into Nama as a whole.]
   

But ISDA has expressed another concern: “An additional issue of concern to us is the proposal that, after acquisition of a bank asset by NAMA, …NAMA may change a term or condition of that bank asset where it is of the view that it is no longer reasonably practicable to operate that term or condition. ...the absence of legal certainty that would arise from this unilateral right to amend other contractual terms of Relevant Transactions – particularly when taken together with the provisions of Section 107 of the NAMA Bill – seems likely to have a negative impact on the ability of participating institutions to transact Relevant Transactions.” [In other words, if Nama is to have serious teeth in changing the terms and conditions of loans, it will risk freezing the entire future ability of the Irish banks to have meaningful access to international counterparties.]

[If anyone thinks things are tough in Irish financial markets now, wait till these aspect of Nama as an entity operating outside international norms and regulations come to play…]

Economics 30/10/2009: Reliance or dependency

Quick points on post-Nama recapitalisation, credit flows from ECB to Ireland and Frank Fahey encounter with an egg...

I have done some sums on demand for equity capital by Irish banks post-Nama. Assuming underlying conditions for loans purchases as outlined in Nama business plan, using 6% core equity ratio as a target (remember, this is a lower target by international standards) and assuming no further deterioration in the loans books quality post-Nama:

• AIB will require €3.2-3.5bn in equity capital post-Nama;
• BofI will need €2.0-2.6bn;
• Anglo will need €4.5-5.7bn;
• INBS/EBS & IL&P will require total of €1.1-1.2bn.
• Total system demand for equity will be in the range of €9.7-12.4bn.

Approaching the same issue from the angle of Risk-Weighted Assets, system-wide demand for equity will be around €10.8bn post-Nama. This will extend Nama-associated rescue costs to:

• €54bn in direct purchases;
• €5bn in completion 'investments' with estimated further €3-5bn in future completion additional funds;
• €1bn in legal, advisory and management costs;
• €9.7-12.4bn in equity injections;
• Past measures €11bn.

Net of interest costs and losses, total price tag looks now like €84-88.5bn. This, for a system that can be fully repaired through a direct equity-based recapitalisation at a cost of roughly €32bn.


Our agriculture is the heaviest subsidised in the EU (and indeed in the world). This fact has never troubled our policymakers, as if subsidies are a sign of industry viability and strength, as long as they are being paid by other countries taxpayers (as in the case of CAP).

Now, we have become the biggest ECB liquidity junkie by far. Table below from RBS research note shows the dramatic level of financial life support our economy requires.
Note that the above list of countries includes heavily crisis-impacted Spain, the Netherlands, Belgium, APIIGS (less Ireland), aggregated in the 'Other' grouping. And yet... they all have larger economies than Ireland and smaller demand for liquidity injections.

Does anyone still believe that Nama can add liquidity to our economy? Or that such an addition can improve lending conditions? Apparently, ECB-own lending operations were not able to do so to date...


And on related note, there is an interesting quote from Dr Alan Ahearne in a recent article in the Southern Star newspaper (here):

"As one economist warned last year, ‘buying the assets at inflated prices would amount to a back-door recapitalisation of the banks’. Best practice ‘is for the banks to recognise the losses on these loans up front and sell the assets at fair market value’. Whose words? Dr. Alan Ahearne – now economic advisor to Brian Lenihan and one of the chief advocates for NAMA. Go figure."

Well, not much to figure, really - call this miraculous conversion a '€100K effect' triggered by new employment...

Oh, and while we are on Nama, here is an excellent 'Public Anger at Nama' account of the latest Leviathan encounter by Peter Mathews. I wonder if Senator Boyle and Frank Fahey get the point - people are angry at the way the country is mismanaged, but they are even angrier at being pushed into Nama.

Economics 15/10/2009: Exclusive - Oh, We All Make Mistakes

Let me confess to you - we all make mistakes. DofF and myself and the rest of Nama analysts. Let me first outline the mistake we all made. List its expected impact. And then explain why some of us made it.

Mistake: The entire analysis by DofF (see their Table 5 or my Table 1 here or here) is based on the condition that between 2010 and 2013 - for 3 years - there will be no rolling up of interest on loans that are non-paying. Furthermore, starting with 2013 and until roughly 2017, the numbers produced by DofF on yields (again see my Table 1 reproducing and explaining their results), assume that only some of the previously non-performing loans will begin performing.

The size of this error: In reality, if 40-60% of the loans are not paying interest at all today, assuming things are not going to deteriorate into the future any more, 2010-2012 free-of-charge roll up interest on loans will be estimated at:
Principal: Euro77bn-Euro9bn=Euro68bn
Full yield: 6%pa (DofF own claim) - Effective yield 2.4% in 2010, 3% thereafter (DofF own figures), so that:
Roll-up rate: 2010=3.6%, 2011=3%, 2012=3%
Cost of roll-up: 2010-2012=0.036*(68bn-1bn)+0.03*(68bn-2bn)+0.03*(68bn-4.5bn)=Euro2.304bn+1.98bn+1.905bn=Euro6.189bn

Conclusion: DofF estimates and my own estimates in my previous post (see here) do not include additional roll up charge of at least Euro6.2bn!

Thus even under the DofF original projections, Nama will yield a real loss to the taxpayers.

Now, why we made this error? Because none of us on Nama-critics side could have imagined that the Government will give defaulting developers 3 years interest-free loan to sort themselves out! And yet, this is exactly what Nama appears to be doing... what else, but a 'gift' or a 'rescue' can one call an act that deed Euro6bn worth of rolled up interest to a defaulting developer?..


Parahprasing my favorite book of all times:

"Curiously enough, the only thing that went through the mind of the Minister for Finance as the NAMA losses mounted beyond the wildest expectations of the Department was "oh no... not again!" Many people have speculated that if we knew exactly why the Minister had thought that, we should know a lot more about the nature of the universe than we do now."

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...

Economics 10/10/2009: How not to do policy on banks

Corrected

Two independent sources have confirmed to me the following developing story. This is being reported as my sources alleged, with the following correction by an independent source.

Under the Environmental Pillar of the Social Partnership umbrella, several debates on Nama have yielded a wide-ranging support for two possible motions from the Pillar to the Social Partnership framework:

• Amending the Nama legislation to require Environmental Impact Assessment of the entire proposal;
• Opposing the current Nama legislation overall.

The first proposal is a standard procedure for undertaking virtually any policy directive. In fact, absence of explicit EIA study under the National Development Plan was in the recent past been used to launch an appeal against NDP to the EU Commission. The EU has taken the appeal for a review precisely on the grounds that NDP had no comprehensive EIA. Absence of a similar EIA implies that Nama is open to challenges on the grounds of violating required procedures for policy development.

So nothing radical was being proposed within the Environmental Pillar, especially considering the fact that Nama is likely to have significant environmental impact as it will be the final arbiter in deciding the fate of many unfinished property development projects across the nation.

Eight out of ten leading organizations comprising the Pillar are, allegedly, in favour of this proposal as are a number of smaller bodies.

However, despite this wide-ranging support, one Pillar member - representative of animal rights movement - has, allegedly, vetoed any Pillar proposal on Nama before it was even allowed to proceed to a vote. The organization in question is, allegedly, the Irish Seal Sanctuary.


On a related issue:
Per RTE report (here) "European Commissioner for Economic and Monetary Affairs Joaquin Almunia said he wants to see the Dáil pass the legislation to establish NAMA as soon as possible." I wondered earlier if the phrase is correct. Here is the quote: "My wishes for the next couple of months here is first that NAMA will be adopted by the parliament as soon as possible because it is extraordinary needed [sic] instrument to tackle the problems in the banking sector and to organise an orderly restructuring and consolidation of the banking sector here in Ireland, that is one very important issue, and second, I really wish that in December the Irish government and the Irish parliament will discuss and adopt the budget that is needed". Italics are mine.

So here is analysis of the quote:

1. Mr Almunia speaks for himself, not the EU Commission, thereby potentially presenting a private view, not that of a Commission. As a private individual Mr Almunia has no specific experience, factual or knowledge basis to make any statements about expected effectiveness, efficiency or fairness of Nama legislation;
2. Mr Almunia clearly states that in his view, Nama will pursue the objective of 'restructuring and consolidation' of Irish banking sector. In other words, in his view, Nama is not about the benefits to the wider economy but about benefits to the narrow banking sector. Furthermore, is Mr Almunia calling for 'consolidation' (i.e oligopolization or monopolization) of the Irish banking. This highly irregular for an EU Commissioner and cuts across the entire Government-own argument that Nama is needed to prevent nationalization, for, in the view of the Government nationalization can lead to infringement on competition in the sector. You can't really have a cake and eat it. Either 'consolidation' is desired, in which case nationalization cannot be ruled out on competition grounds. Or Nama cannot proceed to consolidation of the sector;
3. The EU Commissioner 'wants to see' a passage of a specific Bill by a sovereign Parliament of the Member State. It is a strange turn of phrase that might imply that the EU Commissioner is attempting to influence the internal affairs of the Irish state. Is that what we voted for in the Lisbon vote?
4. The Commissioner is clearly aware of the crucial Green Party vote on Nama tomorrow. The timing of his statement, its venue and the nature of its delivery suggest that Mr Almunia is either being used by the Government to influence the Green Party vote or he is attempting to do so himself. Either way, this is utterly unacceptable for the member of EU Commission.
   

Economics 29/09/2009: Nama Trust Full Costs

Full balance sheet for either a 'nationalization option' or my Nama Trust idea is here, now with bonds figures (courtesy of Peter Mathews):

Economics 28/09/2009: Aggressive pre-Nama re-writing of loans?

Corrected version (hat tips to Adrem for correcting my math and for suggesting a good question to follow up on)


So I was told today, by a senior banker, that banks have been actively re-writing non-performing loans (since at least April this year) under new contracts with extended principal and interest holidays in covenants. These, in preparation for Nama, are priced at higher rates so they can get more on the loans once Nama discount applies.

This makes sense.

Do the math - assume:

• 20% cross-collateralized Euro100mln loan (see explanation of this below), written in 2006
  
• 3 years rolled up interest at 19.1% accumulated at 6% pa - which gives us loan face value at placement on the bank watch list of Euro119mln
  
• New covenants set in April 2009 at 9%pa, with no interest yield or principal repayment required for the next 3 years.
  
• On the date of Nama initiation, then, the loan is performing with expected yield of 9% on Euro119mln.
  
• Now, suppose the LTV ratio of the loan is 75% of principal (meaning the value of the underlying collateral was 133mln in 2006)
  
• Assume that collateral value has fallen 30% (an under-estimate to be palatable to all optimists out there), which means that with 20% cross-collateralization writedown, plus 2% inflation annually since 2006 (cumulative inflation discount of 6.1%) collateral now is valued at 63mln,
  
• By the time new covenants on the loan kick in in 2011, the rolled up interest on the loan and principal will mean total loan value will be roughly Euro 154mln.
  
• Now, to break even on this loan Nama will have to pay 1.5% interest charge on bonds, plus 0.5% management cost (including bank fees), implying that 3 year average mark-to-market writedown (at 2% pa or 6.1% cumulative) plus inflation at 1% pa on average (3% cumulative) is (1-63mln/154mln*0.91)*(100%)=62.7% (assuming no growth in the property market between now and 3 years from now).
  

Remember that figure in the Irish Times article signed by 46 economists, including myself? It stated that the real value of 90bn worth of distressed loans is around 30bn. That implied a mark-to-market writedown of just 67%! When published it caused Garret Fitz to go ballistic and the entire pro-Nama crowd to shout "Extremists are at the gates!" Not that far off from 62.7%.

Of course, this is an illustrative example. But notice that it assumed very modest decline in underlying assets value (30%) to date, plus a very generous (75%) LTV ratio. House prices alone are already down by more than 30% from the peak.

Challenge the rest of my assumptions?

Whether you do or not, one thing is clear - if you are a bank you had no incentive to manage your stressed loans since the very least this April. And you had a massive incentive to push up the face value of the loan without forcing it to become non-performing. The latter can be done by re-writing the loan with new roll up covenants.


Cross-collateralization:

Banks gave multiple loans on same properties in several forms -

1. most commonly, a property was valued several times consecutively and whatever capital gains accrued on the property, these gains were re-mortgaged under new loans;
2. also commonly, capital gains were priced out of new building permits being extended to the properties. I am aware of several cases of mega deals (hundreds of millions borrowed) where a developer/investor bought a site with the site itself being collateralized for this first round of borrowing at the market value, then rezoned it, taking out a new loan against the site value after rezoning in excess of original loan, then obtained a planning application and re-collateralized the site again;
3. less commonly, the banks simply did not check if a collateral property has already been pledged elsewhere.
   

What happens here then?

Suppose a site was bought for 100mln at 75LTV, so that the developer borrowed 75mln for it. New zoning applied lifting the site value to 200mln, providing another 75mln loan facility at 75%LTV on 200-100mln capital gains. The building permission was then granted that, say lifted the site value to 300mln, and a new loan was taken out at 75LTV. Total value of the site was 300mln. Suppose each step in borrowing and capital gains took 1 year (a very short period of time), suppose interest rate was 5%. This means that:
Loan 1 now totaled Euro83mln
Loan 2 now totaled Euro78.8mln
Loan 3 now totals Euro75mln.
At loan 3 origination, LTV ratio on the entire site was 236.8/300=79%.

I assumed in my calculations on the blog that 20% of loans are written against sites that are cross-collateralized - so that other banks hold claims against the same site.

This assumption is based on a guess. It can be challenged if someone has any evidence on better numbers.

Now, that means in example above that some 20% of the site value was cross-collateralized with another bank. If it was the first loan that was cross-collateralized, LTV rises to (236.8+20% of 75)/300=252/300 or 84%. If all three loans were cross-collateralized at 20%, the resulting LTV is (236.8*1.2)/300=284/300 or 95%.

So here you have the maths on Nama - 75LTVs on each loan in reality can mask a 95% LTV of total loan package.

Economics 28/09/2009: Anglo moving staff & loans to Nama

Ahead of actual establishment of Nama, Anglo Irish Bank has internally been reallocating moving staff and loans to Nama - even before the debates in the Dail and the legislative vote on Nama.

Source close to the bank has informed me that Anglo management have internally established that

• 100 staff members are being transferred to Anglo Nama division to be located in their new offices on Burlington Road. The staff transferred is non-lending personnel and transfers might proceed even before the legislation establishing Nama is voted on.
• Anglo Irish Bank will face an 18 months moratorium on new lending (which begs the question as to what its staff will be doing if a large chunk of its business will be transferred to Nama, while another sizable chunk is expected to be sold in the US).
• Staff at the bank - on selective basis - were given a questionnaire as to their preferences for either staying with the bank, going to Anglo's Nama division or leaving the lender. This process - initiated some weeks ago - has now, allegedly, been completed.
• There has been no signalled decision on what will be the full number of staff transferred to Nama division and what staff cuts will follow at the main bank.
• Top 20 borrowers' loans are also being transferred (ahead of Nama establishment) to Anglo's Nama division, in effect providing for advanced transfer of loans to yet-to-be-approved entity. The source used the words 'unofficial transfer'.

To reiterate - this information comes from sources close to the bank.

If these developments are confirmed, they raise several important questions relevant to Nama:

1. Putting aside the issues of legislative process being pre-emptied by the beneficiaries of Nama transfers, what has been done to assure due attention has been given in the participating banks to managing the loans? If Anglo (and possibly other banks) are ready to unroll the entire infrastructure of managing Nama loans today, how much of their internal resources (that could have been used to properly manage stressed loans) have been diverted to the preparatory stages of Nama processes?
2. The banks cannot set up internal divisions to manage Nama loans unless they have had some certainty on who will pay them for this function in the future and how much they will be paid. Once again, to date, Government has failed to clarify these crucial provisions. A commitment to keep 100 staff in Anglo Nama would be expected to cost the bank around Euro 15-17mln per annum in staff costs, plus additional leasing and administrative costs.
3. Decision to move to a specified office location on new premises should be carefully vetted to avoid any potential conflicts of interest (e.g developer owning the building in which the new Nama-related division will be located should not be amongst those whose loans are being transferred to Nama). Again, has this work been performed already, suggesting that the banks are rushing off the start line before the start signal is actually given?

If I were either a Green member of the Dail or an opposition representative in the Legislature, or indeed a backbencher of FF, I would certainly like to know how commitments of resources, contractual obligations etc can be entered in with respect to Nama ahead of the forthcoming vote...

Economics 12/09/2009: More NAMA lies exposed

One interesting observation on Nama and a quick follow up to the developing story on ECB alleged unwillingness to deal with nationalized banks.

We, on the critics of Nama side, have expended much gunpowder arguing that there is a natural, legally binding order of rights contained in each asset class held by investors in and lenders to the banks. This order requires that first to take the hit in any balance sheet adjustment will be the shareholders. Then the subordinated debt holders and lastly the secured debt holders. This argument is used by myself and others to show that taxpayer must be last in the firing line - after all of the above take their dose of bitter medicine.

Yet in all of this excitement we forgot the humble contractors. Now, many of the loans Nama will buy into will be written against properties on which some work has been performed in the recent past, or is even ongoing today. The problem is, our heroic developers in many cases have not paid their bills to the contractors providing this work. As far as I can understand, these unpaid contractors are the holders of the priority right on repayment in the case of liquidation of the development firm - ahead of the bank holding lien on the property.

Of course, Nama can go and tell the larger contractors that, look guys, you forget your claims on work done, write it off as a loss on your taxes and we will look after you when time comes to finish the properties. Smaller contractors will be simply told to get lost - suing the state (Nama) is a very expensive business for them. This is dandy in the banana republic we live in. But estimated (rumored) 30% of the properties Nama will claim under loans purchases will be outside this state - in countries like the USA, UK, France, Germany, Bulgaria, Romania. Nama has no sway there and their courts are not going to toe Brian Lenihan's line of National Interest. So in these countries, the unpaid or underpaid contractors can seize the properties ahead of Nama, leaving Nama with loans devoid of collateral.

This should be fun to watch as our legal eagles from Nama fly over to, say,

• Newcastle to fight the UK system that treats people supplying work as real corporate citizens with real rights; or
• Plovdiv to fight Bulgarian courts, where a leather-jacketed Petar would have to explain to them that if you owe money to his cousin, you either should leave now and forget about that unfinished apartment complex 'with amazing views of the local dump' or risk never seeing your own little 4-bed in Howth ever again.

Have our Brian Twins thought of that little pesky complication?

Now to the issue of ECB. Several of us - again from the Nama critics or sceptics - have done some digging on the issue. What my colleagues now firmly claim is that per their sources, there is a mandate on the ECB to actually treat publicly owned banks in exactly the same way as privately held banks so as not privilege the former over the latter.

Here is what I have found:

Per ECB own research paper The European Central Bank: History, Role and Functions written by Hanspeter K Scheller (link to it here) (Second revised edition, 2006), Annex I provides excerpts from the Treaty Establishing the European Community, Part 3 Community Policies, Title VII: Economic and monetary policy, Chapter 1 "Economic Policy":
"Article 101
1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions."

Emphasis is mine. This clearly states that the pro-Nama supporters are simply wrong in claiming that the ECB will treat nationalized banks or Trust-owned banks any different from the privately held banks.

Further quoting from the same ECB publication:
"Article 21 Operations with public entities
21.1. In accordance with Article 101 of this Treaty, overdrafts or any other type of credit facility with the ECB or with the national central banks in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
21.2. The ECB and national central banks may act as fiscal agents for the entities referred to in Article 21.1.
21.3. The provisions of this Article shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions."

So the same stands. Now, last year, the ECB issued clarification on Article 101 prohibitions of financing (here) which actually stresses that this prohibition (restricting Central Banks from providing ‘overdraft facilities or any other type of credit facilities with the ECB or with the central banks of the Member States … in favour of …public authorities, other bodies governed by public law, or public undertakings' and Article 21.1 of the ECB Statute that mirrors this provision):

• also applies to any financing of the public sector’s obligations vis-à-vis third parties (so technically, either Nama as a state-own undertaking cannot borrow in the future from the ECB via debt issuance of its own - which will imply that Nama own bonds will have to be priced for sale in private markets only, implying horrific cost to the taxpayers of financing Nama work-out, or nationalized banks will have exactly the same access to the ECB lending in the future as Nama will) and
• crucially, that in dealing with publicly owned credit institutions there is no restriction of Article 1 under the ECB statues.
  

In fact, the legal opinion clearly states that Article 1 is designed to restrict National Central Banks' and ECB being used to finance 'public sector' - i.e to raise funds for the Exchequer, not for the credit institution operations.

Here is another interesting factoid. Chart below clearly shows that many European countries operate state owned banks. In Germany, for example the market share of state-owned banks is in excess of 40%.Source: http://ssrn.com/abstract=1360698

Are pro-Nama advocates saying that these banks have no access to ECB's discount window as well? Or will ECB treat them somehow differently from the nationalized Irish banks? If the latter is true, should this be kept hidden from the Lisbon Treaty debate? (Now, personally, I do not believe Irish banks, if nationalized, will have any trouble in raising funding either via ECB or via private markets, so the above question is a rhetorical one).

Now, logic of Article 1 as stated above, actually suggests that the ECB will have harder time allowing Nama - a state-owned non-credit institution explicitly prohibited from obtaining financing from the ECB - to swap its own bonds for ECB's cash than it would allow state-owned bank - a credit institution explicitly allowed to obtain such funding from ECB - to do so. ECB's own paper and legal opinions are confirming, therefore that it is Nama, not the nationalized banks, that would have much harder time getting support from the ECB!

Economics 11/09/2009: Nama gets some deserved bashing

Brilliant Nama analysis from DKM (available here). Please, do read the whole thing!

Few quotes and comments (emphases are my throughout):

On recovery sources:
“The best that Irish policy makers can do is cheer on the signs of recovery in the Euro area and in the US. Recovery in our main export markets – although far from certain – is likely to be the only source of real green shoots next year.”

And this is not because our banks can’t function without a bailout. It is because our economy has been demolished and demoralized by the public policy that wastes taxpayers cash in tens of billions and taxes Irish workers into consumption growth oblivion. Will Nama solve it or make it better? No. Nama will take tens of billions more out of taxpayers hands and put the money into banks. Banks can do the following with the cash that is surplus on their capital reserves:
1) Lend out to Irish – already heavily leveraged businesses, earning a rate of return on these loans of 3-4%pa at best (they currently earn around 2-3% on their past loans); or
2) Buy European corporate bonds yielding 5-7% pa (blue chips).

Anyone’s guess what they will do with cash? For DKM it is a no-brainer: “Certainly it is hard to see the reconstruction of the banking system through the creation of NAMA contributing much to short-term recovery in the economy. Indeed, it could be argued that there is a very real danger that the operation of NAMA, subject as it is bound to be to the political whims of the moment, could have a prolonged negative impact on construction capital spending in the economy for years to come.”


“It is a racing certainty that the 2010 Budget … will involve substantial cuts in government spending, especially capital spending, and increases in taxes and charges. This reduction in public spending will take place against a background of highly depressed private demand which shows few signs of picking up. ...justified by the need to curtail public borrowing for the sake of future generations (and for the sake of the interest rate margins Ireland has to pay over German borrowing costs). Yet at the same time the Government is proposing to borrow massive amounts – which could be more than all the existing government debt outstanding – in order to become the virtual monopoly developer of land and property in the State for the next decade. It is as if public policy is being determined by the mad offspring of Hugo Chavez and Margaret Thatcher.”

Well, Thatcher reference is overdone - Brian Cowen has shown no ability to deliver any serious cuts in public spending so far. Plus Thatcher actually lowered tax burden. Nonetheless, amazingly, this simple reality of an inherent unresolvable contradiction between two policies pursued by the Government did not occur to that brilliant legal (i.e logic-trained) mind of Brian Lenihan. How?


“Enduring economic hardship now so that the State can become the sole lender to the property sector is a difficult sell.” Yes, folks, ‘Nama will work’ slogan is equivalent to ‘Speculative development and investments will work’ slogan. And we learned a thing or two about the latter one, haven’t we?


“The concept of NAMA was born out of a report by Dr. Peter Bacon, an economist turned property developer.” A pearl!


On Nama effectiveness in terms of credit flow restoration:
“The most likely use of the funds supplied by the NAMA purchases will be to reduce reliance on overseas funding especially funding in the wholesale money markets. In effect the balance sheets of Irish banks will shrink as assets are transferred to NAMA and foreign liabilities repaid. This may lead to a more sustainable banking system but will not lead to an expansion in credit.”

But have they – Leni, Coweee, Ah!Earn & Co – listened to any suggestions for bettering Nama? “The official response to the criticisms of the original NAMA proposals has been ad hoc, indicating that policy is being made on the hoof.”

“The question of the bank valuation of a property related loan versus a “market” value becomes more acute when it is realised that NAMA proposes to acquire performing loans… …It will be difficult for NAMA to pay less than the value of the loan to the bank from which the loan is acquired without substantial risk of litigation. Even if the management of banks is cowed by the scale of the public shareholding in the bank there would be no such constraint on private shareholders especially bondholders who face losses due to the acquisition by NAMA of assets at too low a price.”

Now, Brian Lenihan has absolutely no understanding of either finance or economics. Fine. No one is holding it against him personally. But he is a lawyer! Can he not see this argument coming?

“Defenders of NAMA have pointed out that it is a requirement of the EC that the long run economic value be paid for the loans. … this requirement is designed to prevent national governments from over-paying for loans and so subsidizing domestic banks at the expense of competing banks located in other jurisdictions. In any event it now appears that NAMA will not be paying the long run economic value for loans acquired from the banks.”


“The most recent suggestion is that the banks will receive part of the consideration in the form of a bond whose value will depend on the recovery rate of NAMA. This risk sharing sounds attractive but it begs the question as to how the bonds will be accounted for on the banks’ balance sheets.” This is exactly what I’ve been warning about in my recent blog post (here).


“The more enthusiastic supporters of NAMA have begun to sound like stockbrokers promoting an IPO. [Well, it is an IPO for them, for absent Nama, real value of banks shares is near nil – they are insolvent!] NAMA, it is asserted, will be profitable. On analysis, some part of its profit will arise from arbitraging the yield curve. By borrowing short – through the issue of floating rate bonds to the banks – and by lending long through the acquisition of longer term property debt NAMA can make a profit. [Again, do you think this is a way forward after the current crisis lessons on maturity mismatch risks?]

"It is open to the NTMA to make a similar profit by issuing similar short dated securities and
investing the proceeds in long dated German government securities." [Brilliant! In effect, having Nama is like having a state-run hedge fund. We have truly arrived to Alice in Wonderland.]


“NAMA is also expected to make a profit because when the loans are repaid (or the security underlying the loans realised) the proceeds will exceed the original cost. If one assumes that what is ultimately realised is the long term economic value of the assets then NAMA can only make a profit by paying less than the long term economic value.” [And hence we have another contradiction: pay LTEV and you can’t get profit if your estimation of LTEV was correct. There is no free lunch, folks!]

In fact Nama has to realise the underlying properties or close the loans at

• (price paid today = LTEV) +
  
• (inflation cumulated over the holding period) +
  
• (the cost of borrowing over this horizon) +
  
• (the cost of administering the loans by the banks and Nama) --
  
• (cash flow during the holding period)

This, of course, implies that “most of the NAMA profits, if any, will be at the expense of the banks from which it acquired the asset.” How? You bought at LTEV, you sold at LTEV (remember - Nama will get the price right and it will pay the higher of two: current market price or LTEV). The only way you turn a profit is if your revenue stream during the period of managing the loan was greater than the costs of inflation, financing and administering/managing loans. But the latter are paid by the banks...


"In the case of the windfall tax the distant sounds of belatedly closing stable doors can be heard. And, of course, the best way to depress any recovery in future property values is to impose a high tax on appreciation". [So the Greens’ proposal is like shooting your leg off while running] "The requirement that NAMA responds to social and political demands highlights all too clearly the dangers of creating a state-owned virtual monopoly presence in development land and property.”


“The Government has rightly warned of the dangers – mainly in terms of price discovery – of a wholly nationalized banking sector. It does not appear to have the same concerns about a similar nationalization of property development.” Another brilliant point.


“Our best guess is that a recovery in investment in development related construction will be some distance off and some of the longer term economic growth projections which have not taken account of the radically changed institutional environment caused by NAMA are too optimistic.”

This is correct, and I will be revisiting my longer term forecasts for Irish economy to reflect Nama costs explicitly in days ahead, so stay tuned.


PS: Per earlier reader/follower request:

List of foreign ‘stars’ who criticised Nama:
Mr Bo Lundgren (a man with real experience handling major bank crisis)
ZEW President, Professor Wolfgang Franz
Robert Engel (Nobel Prize, Financial Econometrics)
Paul Krugman (Nobel Prize)
Professor Roberto Rigobon (MIT)
Professor Michael Goldstein (Babson College)

Domestically - at least 46 economists and finance specialists (many are finance specialists)

On pro-Nama academic side: one Alan Ahearne - an economist with no finance experience

Economics 09/09/2009: Has the Green Party Leadership Sold the Country for a Broom?

Gutless and short of any sort of vision!

The Green Party leadership (per RTE here) has announced a series of "significant changes" to the Nama bill. So what are those significant changes, then?

Before we dive into the details, here is what the papers are not telling you - Green Ministers, the birdie has chirped (hat tip to KOD), received a trade-off from FF: in exchange for introducing a Carbon Tax they signed off on Nama. Why this is the bad news for the Greens and the country? Two reasons:

• First a minor one - Nama is infinitely more important to this country than the Carbon Tax, so much so, that the Greens' leadership in effect sold family jewels to buy a new broom;
• Second a major one - Carbon Tax is simply another punitive unavoidable tax for this country. Do not confuse it with some environment improvement incentive measure. Here is why. If Carbon Tax were to be a true behavior modification tax, then at least in theory its introduction should induce people to opt for greener alternatives: use of more public transport (that should be less polluting), more telecommuting, more energy efficiency etc. All of these are good things. But the problem is that a family that works in Dublin and, because of past FF policies was forced to buy their house in Cavan (for example), there is no alternative to driving and there is no alternative to switch to 'cleaner' energy. Indeed, with ESB (legacy of FF) in charge of generation and Eirgrid (legacy of FF) in charge of the grid, we have no real less polluting alternative. So Carbon tax will be unavoidable to many of us and thus it fails as a real 'behavior modification' tax.
  
• (Note 1: Carbon Tax is not a punitive tax for middle class Dublin and Cork voters - core Green constituency, so the question I would ask Messr Greens - are you selling the entire country in hope that your small number of voters will swallow the pill?)
• (Note 2: Has the Green Party leadership signed off on Nama before their general party meeting in an attempt to prevent democratic process within the party forcing their leadership to take a more ethical position on Nama?)
  

Which brings us to the conclusion on this sad chapter in Irish Green Movement history - Ministers Ryan, Gormley, Sargent and Senator Boyle did indeed agree to Nama in exchange for being allowed to levy another consumer-abusing tax that will feed general budget hole left by the grotesque spending commitments of this Government.

Now to the news:

Just minutes ago Minister Ryan has told the nation that Nama is ok because Ireland will be getting money from ECB at a very low cost. This is the long-mulled 1.5% assertion. To remind you all - Nama supporters have for some time made the claim that Nama will come cheap - at 1.5% ECB financing rate. Of course, they won't tell us the term. We are in the dark as to how long will the maturity of these bonds be.

Here comes the flashlight: 1.5% charge is consistent with 9-month paper. This will be fine, if we are borrowing to cover short term liability. Or if we were looking at ordinary sort of repos volumes, so that rolling the bonds issued at 1.5% would not be a problem on an annual (or even less) basis. But hold your breath -

• We will be rolling over some €55-70bn in Nama paper annually! Plus whatever we get to borrow on short term to finance our ordinary deficits, say odd €15bn. Total amount of Irish bonds to be rolled over at the end of 2010 can thus be €60-85bn, in 2013 this amount will reach €104-120bn once interest is rolled up - that means that by 2013, 34-39% of Irish expected GDP will be rolled over in short term bond markets! I thought, honestly, that borrowing short to buy long term assets has gone out of fashion some time ago in the current crisis!
• A 1.50% is a premium of 1.25% over the ECB rate, and 50bps above the ECB fixed rate tenders. Back in Fall 2008 - amidst raging crisis, ECB rate was 3.25% and tenders were at 4.75% in October 2000. What happens if we go back there? In say 5 years time? By then, cumulated roll over will amount to €120-135bn and our 2016 interest bill on this Green Party legacy will be €5.3-6.4bn. That is interest charge alone!
  

Finally, let us look at the last set of news on the Green Party leadership shameful surrender. Per RTE site report: "Minister Eamon Ryan said the new measures would increase the protection afforded to the taxpayer." How? Apparently via:

• The introduction of risk sharing between the banks and NAMA: "in the case of a small proportion of the loans, the banks will not get all the money immediately. Whether or not the banks would get a further payment would depend on whether NAMA is successful.
• A windfall tax of 80% on profits will apply to developers where they gain from land that is rezoned.
• The amount of money NAMA can borrow will also be cut from €10bn to €5bn.
• The new agency will be obliged to report to the Minister for Finance every three months instead of the annually as included in the earlier draft legislation.

What does all of it mean?

First bullet point above: remember that 'levy' on banks that was deemed unfeasible because it creates an implicit option on the banks? Well, the same, in converse, applies to this risk-sharing scheme. If a share of proceeds issued to the banks will be held back, it simply cannot be brought into banks capital reserves without adjusting for the risk of Nama failing. What should such risk adjustment assume about the probability of Nama failure (which will mean banks don't get that extra cash)? Go back to my and other's estimates of the expected losses under Nama. Even Davy Stockbrokers earlier showed that Nama is likely to generate a net loss of ca 5bn. So even by Nama cheerleaders assumption, Nama cannot be expected to work. Thus, the proposed risk sharing scheme will never pay out that share of funds 'held back'. In other words, the expected value of the 'held back' share is Nil!

Further problem arises in the context of the Nama being lauded by various financial analysts (stock brokers etc) as the 'liquidity' event. In other words, it is supposed to solve the problem of our banks' balancesheets and inject liquidity into banks. Now, the amount to be injected will be reduced by exactly the amount of this 'held-back' payment. So if Nama was to be a success because it was injecting liquidity, holding this liquidity back certainly constitutes now a failure of Nama.

Lastly, Nama was supposed to reduce the risk of banks coming to the Exchequer and asking for direct recapitalization. The more 'risk sharing' is involved, the lower will be risk-weighted capital and the greater will be post-Nama demand for recapitalization. So, again, if Nama was in the first place to reduce secondary round of capital demand, new risk-sharing scheme will increase it.

Second bullet point: folks, I thought we were told that developers are not being rescued by Nama. So which profits are they taxing? You can't, Minister Lenihan, have a cake and eat it. Either Nama will rescue the developers (by helping them achieve profit in which case an 80% tax makes sense) or it will not rescue developers (in which case there will be no profits and an 80% tax makes no sense). I wonder if Eamon Ryan actually gave a single thought to this absurd proposal!

Third bullet point: this is irrelevant, because the proposed bill allows Nama to borrow unspecified (unlimited) amount of money in the future with approval of the Minister. So who cares if they can borrow 10bn or 5bn on day one of their operations if they can borrow 30bn more on day two of their existence? Again, have Ministers Gormley and Ryan actually given a single thought to what they were signing?

Fourth bullet point: reporting to the Minister for Finance (behind the closed doors and no public scrutiny) is simply short of proper transparency and accountability procedures. It does not matter how often it is done. Putting a phone connecting two windowless and door-less rooms ain't going to let any light into either one of them, Messr Gormley and Ryan.

So to sum up - we now have it on the record. Ministers Gormley and Ryan, alongside the rest of the Cabinet have signed off on a document that will:

1. Coercively take ordinary people's incomes;
2. Clandestinely pass the money over to the banks;
3. Creating a buffer of opaqueness and evasion of responsibility and accountability between themselves and us, the taxpayers;
4. The banks will have no incentive to lend to the economy, the households will have no money to pay the bills - a new wave of mortgage defaults and personal loans defaults will be rolling over the banks. The economy will stagnate. Property markets will stagnate. Emigration will be back with the 1980s vengence.
   

Full stop. Nothing else worth adding.