Economics 08/04/2010: AIB first Nama loans

Earlier this week, Nama had completed the first transfer of loans from AIB. Per official report, Nama bought loans with a nominal value of €3.29bn for €1.9bn in NAMA bonds, implying a discount of 42.2%. This was below the discount of 43% announced by the Minister for Finance last week.

But what do these figures mean? Without knowing exact nature of the loans, it is hard to tell just how much did Nama over pay for the loans. Here is an averages-based estimate, however.

First, let us reproduce the original claimed discount of 42.2% using averages. Table below does exactly this:
In the above, I assume:

1. Vintages of loans transfer running between 2005 and 2007;
2. 2 year roll up on interest maximum allowed in the loan covenants;
3. Roll up of interest commencing at a new rate in year 2008 and running through 2009;
4. 2 scenarios of average interest rates applied (Scenario 1: 5% pa, Scenario 2: 6% pa) – as you shall see below, these are optimistic rates;
5. Declines in values affecting different vintages as follows: loans of 2007 vintage – decline of 50% in value of the loan; loans of 2006 vintage – 40% and loans of 205 vintage – 35%.

As the last row shows, taking a simple average across all scenarios and vintages yields a discount on the loan face value of 41.7%, which, factoring in 0.5% Nama-reported risk margin yields the effective rate of 42.2% - bang on with the desired.

Having matched Nama numbers, let’s examine the assumptions and bring them closer to reality:

1. Let us use the actual average annual lending rates for non-financial corporations reported by the Central Bank Table B2 (here)
2. Let us also adjust the loans for security of collateral claims – remember, per official statements from Nama many loans (in the Anglo case up to 20%) are non-secured, with effective claims against the underlying assets of nil) – to do this, we induce the following security risk adjustments to value: 6% for vintages of 2005, 9% for vintages of 2006 and 12% for vintages of 2007. So the average is 9.9%. Although these are significant, remember – reports of 20% for Anglo loans are based on untested cases. It remains to be seen how higher these will go should other lenders contest Nama take over of the claims.
3. Since Nama valuations were carried out through November 2009, we must factor in further declines in value, so let us push up value discounts to 35% of 2005 vintages, 45% on 2006 vintages and 55% on 2007 vintages. Again, these are conservative, given evidence presented in the commercial courts.
4. Instead of running alternative interest rates scenarios (remember – I am taking actual rates reported by the Central Bank), take two different scenarios on vintages compositions: Scenario A assumes uniform distribution of loans across three vintages, Scenario B assumes a 20% for 2005 vintage, 30% for 2006 vintage and 50% for 2007 vintage split.
5. Finally, let us estimate two other alternative scenarios: Scenario 1 has no mark ups charged on average lending rates, Scenario 2 has a set of mark up reflective of higher risk perception of loans, especially in 2008-2009 period. Remember, lenders became unwilling to provide funding for property investments in 2008-2009, which means they would be expected to charge a higher interest rate (risk premium) on loans related to property than those reflected in the average corporate lending rates.

Tables below show the results of model estimation:
Alternative scenario 1: Nama overpayment over the current market value ranges between 42% and 51% or €561-638 million.
Alternative scenario 2: Nama overpayment over the current market value ranges between 48% and 57% or €617-688 million.

So averaging across two tables: Nama overpayment on AIB tranche 1 loans is estimated at between 42% and 57% or between €561 million and €688 million. At a lower estimate range, this suggests that Nama is at a risk of overpaying some €26 billion for the loans it purchases, should this type of valuations proceed.


Of course, some would say this overpayment reflects the expected long term economic valuation of these loans. Fine. Suppose it does – how long can it take for the LTEV to be realised to break even (real terms) on Nama assets then?

Let’s make two assumptions:

• suppose that Irish property markets see price increases of 150% of expected economic growth,
• suppose that expected long term economic growth will average in real terms between 2% and 3% per annum.

If Nama overpays 48% on the current value of the assets (lower range of my estimate), Nama will break even – absent its own costs of operations and funding – and assuming full recovery of the loans per their value – by the end of 2027 if the growth rate average 3% pa or by the end of 2035 if the growth rate averages 2% pa in real terms.

If Nama overpays at the top of the estimates range – 57%, then real recovery will take up to the end of 2039 if the average annual growth rate is 3% or up to 2053 is the average growth rate is 2% per annum.

Again – notice that these figures do not include:

• Legal costs of running Nama;
• Losses that might occur on the loans since November 30, 2009 valuation cut off date;
• 3 years long roll up interest holiday built into Nama;
• Operating costs of running Nama (inclusive of very costly advisers it contracts);
• Cost of Nama bonds financing
• Cost of actual working through the bad loans

Still thinking Anglo is the worst case scenario for us?

Economics 22/09/2009: Two further Nama points

Updated below:

Global Finance Magazine on the concept of ‘long-term economic value’ of distressed assets (here) and on effectiveness of bad assets purchasing schemes:

“Meanwhile, the passage of the Troubled Asset Relief Program (TARP) into law in the United States failed to alleviate strains in the financial markets...

The TARP empowers the US Treasury to buy troubled assets at heavily discounted prices, well below their long-term economic value. “No one yet knows what price will be paid for the toxic paper, or what the default rates will be on the underlying mortgages,” said Carl Weinberg, chief economist at High Frequency Economics. “

Over time, people will realize that all the underlying mortgages are not defaulting, and panicky market conditions should abate, according to Weinberg. “We have seen this game before,” he says. “In the 1980s highly indebted economies like Mexico, Brazil, the Philippines and Argentina bought back their own debt from panicked small banks at 20 cents on the dollar.”

20 cents on the Dollar, folks? Nama is buying defaulting developers loans (not sovereign bonds) at 79 cents of the Euro!!! I’d rather have Brazil’s and Argentina’s bonds, thank you very much.


Another interesting bit:

Robert Boyer’s paper “Assessing the impact of fair value upon financial crises” published in the Socio-Economic Review, 2007 deals with the expected effects of LTEV application to accounting standards, but the implications of this are pretty much the same for pricing (as in Nama). Boyer concludes that LTEV “gives at each instant a seemingly relevant liquidation value, but obscures the value creation process by mixing present profit with unrealized capital gains and losses. This discrepancy increases with an increased degree of uncertainty, which is at odds with widely held beliefs about the efficiency of existing financial markets. Fair value introduces an accounting accelerator on top of the already present and typical financial accelerator. …If fair value accounting is applied to banks, an extra volatility may be created...” What is this about? Three things, as far as Nama is concerned:

1. LTEV will simply translate future value (capital gains) on assets underlying Nama-purchased loans into monetisable value as if all future price appreciation expected under LTEV can be captured in full. This, of course is a matter of timing (knowing when to sell) and efficiency of sales (having zero cost of selling and no impact on selling price of the volumes of sales that Nama will have to undertake);
2. LTEV neglects to price in the effect of large asset holdings off the market (Nama holding vast portfolio of property-backed loans off the property market), which is likely to depress property prices over the life-time of Nama itself. The end result here – a gross overestimate of future expected prices.
3. As the two points above coincide in timing, they act to reinforce each other – an accounting accelerator occurs.
   

Who says you overpay only once?

Here is the rate at which the Government can currently borrow on a 6-months basis:
Let me explain:

• we can borrow in the form of ordinary bonds at 0.481% for 6 months period. These are convertible at repo window of ECB at a discount of 12% on face value and 1% interest rate. Total cost of injecting €1 into bank balance sheet is, thus, 15.2 cents; or
• we can issue Nama bonds at 1.5% with 5% in subordinated bonds, with banks taking these to the ECB repo window at 12% and 16% discounts respectively, borrowing at 1% against both. Total cost of injecting €1 into bank balance sheet is, thus, 16.4-18.1 cents depending on how ECB risk-weights subordinated bonds.

Cheap money in the Frank Fahey World of Stupid Economics?