Economics 31/08/2009: Myths of Nama's Parrots

The Sunday papers revealed to me the bizarre lack of independent and critical thinking amongst our senior journalists on the matters of policy.

The best example was the Sindo’s editorial on the subject of 46 economists’ signing the article in the Irish Times last week. In effect, Sindo is of the view that publicly employed academic economists and finance specialists cannot criticize Nama. What’s next? As PMD puts it: "Publicly employed physicists cannot assert existence of gravity?"

To his credit, Shane Ross stands tall.

In the mean time the Sunday Tribune article (here) exemplified some of the ‘new’ mythology of ‘official’ Nama position, while simultaneously revealing the lack of media’s ability to question the spin fed to it by the officials. These are worth dealing with in some more detail than Sindo’s article:

Myth 1: The ‘official’ version of Nama now claims that LTV ratios on Nama-bound loans were low, so the face value of the loans covers actually greater original value of the collateral. "But while the loans are for €90bn, the properties secured on those loans cost considerably more (we are not talking about 100% mortgages here).”

As far as I know, this 'arithmetic' was first floated at the official briefing for the journalists by the DofF. 

There is absolutely no evidence that the developers took 75% LTV ratios. Despite this, my earlier post (here) has dealt with this, showing that even at LTV ratios of 50-60% it is unlikely that Nama will be able to break even by 2021. Or for that matter, under majority scenarios until much later than that. Given that some people who’s incomes will be used to finance Nama will by then have lost their

• Savings;
• Pensions;
•  Homes

to Nama – due to the need to finance Nama costs out of our current income, implying much higher taxation – what measure of democratic accountability, equity, fairness etc can compel this Government and DofF to make such claims is simply unimaginable to me.

Contrary to DofF briefing claim on low LTVs, there is plenty of evidence from property consortia and from court cases (e.g Mr Carroll’s) that much higher LTV ratios were used in practice. In many cases the percentage that was not lent on the property directly was made up of additional cross-collateralised loans to the consortia itself, other members of this consortia or to the original borrower (developer) in a personal capacity. There were multiple cases of the same property being cross-collateralised for multiple loans.

Take a 'clean' (as in completely transparent, free of double-borrowing and cross-collateralisation) example. 

If a property was purchased for 100K in early 2005 at 50% LTV and rezoned, this ‘asset’ would have seen its market value rise 3 fold. In late 2006 this property would have the value of 330K and a loan of just 50K. The surplus value or equity of 280K could have been re-mortgaged at, say 50% LTV again. Total loans written against the property would total 190K. The surplus equity of 140K could have been borrowed against again in 2007 at, say 50% LTV ratio, resulting in a total loan volume of 260K. What is the overall LTV ratio on this property? At 2006 value of the property: we have LTV ratio of 79% in the end of these simple multiple loans trips each one of these loans was 50%.

Now, suppose Nama buys these at a 30% discount on the loan value, i.e. for 182K. Nama is instantaneously in the negative equity to the tune of 82K, or 45%.

The property market (depending on the type of property) is now around 2000-2004 (well below 2005 levels). How much below? Well, let us say 10% below. So the underlying property is now worth… 90K, and the negative equity is now 92K or 51%.

What is the rate of growth in the market we should expect to get back from this level of negative equity to a nominal break point on Nama? For 10 year horizon – an annualized rate of +7.2% per annum. For 15 year horizon +4.7%, for 20 year horizon +3.5%.

If inflation averages the ECB target rate of 2% pa over the next 20 years, we need a property prices growth of 5.5% per annum minimum for Nama to break even on this “50% LTV ratio loans package” in 20 years time!

Myth 1 is busted.

Myth 2: property crashes are benign… "Previous property crashes in London, Paris and Stockholm suggest that, within 10 years, prices recover to 30% below the top of the bubble".

I have shown in another post (here) that this is not consistent with the evidence from the past busts. So let me not repeat myself here. Furthermore, do any of us really believe we will get back to within 30% of the madness of the 2006-2007 markets ever again?

Instead, consider the statement itself.

First, this refers to nominal prices. Real prices (inflation adjusted) are much slower to recover.

Second, this refers to a simple price recovery. 

But Nama is about more costs than just the cost of loans bought. It is also about a cost of loans financing. So, suppose we take DofF and the journos for what they claim. 

Suppose our property prices will be back to 30% below the top of the bubble in 10 years from now. At 5% per annum the cost of bonds financing for Nama, 0.75% per annum cost of recapitalization financing (ca 8% shot – one off in 2010, taking into account the present value of this cash, recapitalization will actually cost closer to 1% pa over the 10 year horizon, but let us give the difference as a margin of error in favor of Nama). We have: the original (2007 value) 100K loan with LTV of 75% (DofF number) worth 75K on bank’s book today will be purchased by Nama at a 30% discount for 52.5K in 2010. Within 10 years time, property value is 70K. Nama can sell property for this amount and pay down 52.5K of the original loan purchase prices. Except, by then, Nama would have accumulated additional 33K in interest charges on bonds… 

Total loss to Nama on this transaction = 70K-52.5K-33K=15.5K, so Nama will still be posting a 30% loss on its operations.

Myth 2 is busted.

Myth 3: Bond markets do not like privatizations and they love Brian Lenihan’s policies. "Within five days of Anglo Irish being nationalised, the rate which Ireland is charged for borrowing money internationally had risen."

Firstly, while it is true that the bond spreads rose when the Government nationalised its not at all evident or even apparent that this happened

1. Because we nationalised Anglo or   
2. Because we had to nationalise Anglo.

In other words, did Irish Government bond spreads reflect the Government new exposure due to nationalization or did they reflect the fact that nationalization simply showed to the rest of the world just how sick our system really was.

Put differently, did the cardiogram go off charts because the patient went into a cardiac arrest, or did it go off charts because the patient was connected to the machine reading the cardiogram?

Recent research from the ECB (cited by me in the press and here on this blog before, you can find the original paper in the The Determinants of Long-Term Sovereign Bond Yield Spreads in the Euro Area.  Monthly Bulletin, pages  71–72, July 2009) showed no evidence that Ireland’s critically elevated levels of bond spreads at the time before, during and after the Anglo nationalization were somehow out of line with the general model. They were, per ECB model, reflective of the fundamentals in Ireland, not of the ‘nationalization’ one-off episode.

Incidentally, similarly, Greek, Spanish, Portugal’s and other APIIGS’ countries spreads rose at the same time as Irish and in similar proportions. They didn’t nationalize their banks… So what is the DofF talking about here and why is our media parroting this claim as some unquestionable truth?

Now, one of my TCD students has just completed a research paper applying the ECB model to Irish bond spreads. The break point in our bond spreads occurs about the same time that it occurred for other APIIGS -  October 2007. Not that close to Anglo event…

What is also interesting is that the current period of ‘falling spreads’ for Ireland – lauded as a sign that the Irish Government is being trusted by the international markets in all its hard work to destroy our private sector economy… ooops, sorry, to ‘correct our fiscal deficit’ in Leniham-speak, is really fully in line with just one factor – the overall improved sentiment in the global markets. Our ‘leadership’ clowns are riding the coat tails of the US and EU ‘bottoming out’ euphoria, not some miraculous change in sentiment to Ireland they are going to leave behind to the next Government.

Myth 3 is also busted.

Myth 4: "There is a reason why no country has nationalised its entire banking system."

Now, our own journalists simply do not treat other banks operating in this country as a part of the ‘banking system’… Just think two events in the recent past when scaring kids with ‘foreigners’ was en vogue:

1)    Anglo’s “shortsellers from New York and London are out to get us”. Of course it turned out that the shortsellers from abroad were spot on right about their reading of the bank’s position, while all the damage done to the Anglo was done from inside the bank – from its own senior management;

2)    American ‘vulture funds are swooping onto the wounded Irish banking system’. Of course were they to take our sick banks over, we wouldn’t have a need to cull family budgets for generations to come to finance Nama… wouldn’t we?

Every time someone says ‘we need to protect our national [insert any business-related noun here]’, I know I am smelling a rat. ‘Protecting national banking’ means, as Nama clearly illustrates, vast transfer of income and wealth from ordinary people of Ireland to shareholders and bondholders of these banks. I have nothing against the latter two groups of fine people and institutions, but I certainly do not love them enough to sacrifice my son’s college tuition fund and my own and my wife’s pensions to bail them out.

In reality, of course, the idea that ‘nationalizing’ 6 banks in Ireland will leave Ireland with no privately-owned banks is bonkers. Ireland has significant international banking sector that would be even greater in size were we not shielding BofI and AIB from competition through supporting their legacy positions. Furthermore, under my Nama3.0 proposal (see here), we would not nationalize any of the banks at all. We would simply change their ownership from that of the few who took wrong risks to that of the many who are now expected to pay for the mistakes of the others.

Myth 4 is busted.

 

Myth 5: "But the nationalisation option throws up enormous difficulties. The state would have to pay in the region of €5bn to shareholders of AIB and Bank of Ireland,"

Under my Nama3.0 proposal, we would first force the banks to take writedowns, then use remaining share holders’ and bond holders’ equity and debt holdings to offset these losses, then use private investors and swap-participating bondholders to recapitalize the banks. Only after that will there be a cost of the taxpayers. At any rate, this cost will be much lower than the 60bn cost of Nama purchases, plus tens of billions in bonds financing costs associated with Nama.

Furthermore, let us not forget that after Nama we will have to recapitalize the banks no matter what and that this recapitalization is likely to cost us well in excess of 5bn itself.

After all, we paid nothing for Anglo in excess of direct recapitalization costs involved, which are much lower than the cost of Nama buying Anglo’s loans and ‘managing’ them. Furthermore, the same costs were paid to AIB and BofI as well, despite these banks remaining 'private'.

Myth 5 is busted too.

Myth 6: "There is a reluctance to lend money to banks that do not have the transparency that stock market membership brings, and that are viewed as being open to political interference."

This is false.

1. Irish banks and banking institutions - listed or mutually owned - are not transparent already, as the Anglo saga clearly illustrated, as AIB repeated blunders in public statements have clearly highlighted and as the reluctance of all of these banks to take realistic writedowns on the loans attests. Were the Tribune folks actually to give it a thought - we know that AIB, BofI and the rest of the pack are artificially depressing expected losses on their loans in anticipation of Nama, since, by the entire Nama existence we know that absent Nama they would sustain losses much greater than their current capital reserves allow. So what 'transparency' are we talking about?
2. Irish banks cannot borrow without the twin ECB and Irish Government Guarantee supports, despite them not being in national ownership;
3. Irish banks will not be nationalized in Nama3.0 set up and their shares will be fully liquid;
4. Many private (Rabo, a host of Swiss banks and Belgian banks) and nationalized (Northern Rock) banks are capable of borrowing well better and cheaper than the Irish banks underpinned by full state guarantee.

Myth busted.

It is not the ignorance or the lack of knowledge amongst some of our leading journalists that defies my belief, but the innate lack of intellectual curiosity to question the spin they are being spoon-fed by the ‘official’ Ireland.

Hence, Mary Robinson is being paraded around the press as some sort of a ‘wise’ financial guru full of wisdom to breath new air into the debate about Nama. Spare me this nonsense!

NAMA 3.0 - more weight

My NAMA 3.0 - that includes also some proposals advanced first by Patrick Honohan, Brian Lucey and Karl Whelan - is gaining some speed. Here is a slightly more edited/updated version of it:

Step 1: Require banks to take full mark-to-market writedown on their loan book. This ensures that realistic valuations will be attached to the loans and it is fully consistent with the Swedish Bad Bank model (SBB-consistent);

Step 2: Travel down the capital ranks to draw down shareholder equity, deplete perpetual bond holders, subordinated bond holders and so on to cover the writedowns. This is a natural progression in addressing any insolvency and there is no reason as to why NAMA should be different (SBB-consistent).

Step 3: Force senior bond holders into debt for equity swap (exchanging their bond for shares at a discount), with a possible sweetener on equity conversion formulas relative to the Exchequer valuations (meaning we convert their bonds into shares with a small sweetener or shallower discount than actual valuations will imply). By retaining these guys on board as shareholders, we ensure that the banks will not be 100% state-owned and that potential lenders will have an interest to lend because they will be shareholders in these institutions. This is consistent with GM bunkruptcy proceedings earlier this year;

Step 4: Open enrollment for a share-participation in Irish banks recapitalization to SWFs and private capital. The Government should actively seek such external investors to increase private sector share of overall equity holdings (on top of converted bondholders - point 3 above). This should be done in the period while the banks are drawing down their capital funds to write-off losses to ensure that the banks are not fully nationalized;

Step 5: Cover all the shortfalls in capital base through recapitalization (as in Government's NAMA - or NAMA.G - proposal) after Steps 1-4 are completed and after an independent assessment of the value of the remaining loans is carried out to determine the true extent of banks under-capitalization (SBB-consistent).

To establish independent valuations – set up a Valuations Board of NAMA consisting of 9 individuals: 1 from DofF, 1 from NAMA, 3 valuations experts, 1 finance expert (banks), 1 planning specialist, 2 independents (economist and accountant). There shall be no post-NAMA levy expsoure for the banks as the state will take ordinary shares in those institutions (reducing future uncertainty for banks), thus creating an upside potential to shares (offsetting any losses on NAMA discounts).

Recapitalization, carried out jointly with new shareholders (past bond holders, SWFs, private investors, etc) will see Irish Government taking significant/majority shares in all main banks in Ireland. However, it will not be a nationalization, as the state of Ireland will not own these shares - the shares will be held in the name of Irish taxpayers in an escrow account or holding company called NAMA3.0 (below). Furthermore, significant shareholding in at least 3 banks can be private - through the private placements (step 4 above).

This is constent with SBB, but it is also consistent with the current NAMA-G proposal, as the Government has not explicitly rulled out a possibility of nationalization of the banks in the post-NAMA recapitalization. Furthermore, NAMA3.0 reduces the extent of state ownership of the banks by committing itself to attracting some private sector shareholders - e.g former bond holders and new investors.

Step 6: Hold equity in an escrow account (NAMA3.0) on behalf of the taxpayers, appointing

• The members to the Supervisory Board of every bank recapitalized by the taxpayers money. These should consist of one appointee by the Minister for Finance, 1 independent representative of the taxpayers, who is charged with explicitly guarding the taxpayers' interests, 1 representative of NAMA3.0. Each member (other than those from NAMA3.0 and the bank) will hold a veto power.
• A requirement that risk, audit and credit committees of NAMA3.0 include at 2-3 independent experts who cannot be employees of the state, NAMA3.0 or any other parties to this undertaking
• Set up an independent, bipartisan, NAMA Oversight Oireachtas Committee consisting of non-voting Chair, 1 representative of each Party, 1 independent TD.

Step 7: Accountability:

• no indemnity for negligence and incompetence for any employee or director of NAMA 3.0 organization - no one in the private sector has one (SBB-consistent);
  
• no cross borrowing by the Exchequer from NAMA3.0 is allowed, so Brian Lenihan and his successors cannot raid the nest egg by - at a later date - borrowing funds against NAMA-held assets to spend on other state commitments (current or new). This is SBB-consistent provision;
  
• ownership of shares in the account accrues to the taxpayers, not to the state or the public sector;
  
• NAMA3.0 cannot lend money to continue any of the banks' projects without specific recommendation of the risk committee (unanimous) and an authorization from the special Oversight Committee of Oireachtas;

Step 8: Transparency:

• full disclosure of all recapitalization actions and shares held in NAMA3.0 - on the web, updated live;
  
• full disclosure of all salaries, bonuses etc, CVs of all managers and directors and disclosure of all potential conflicts of interest;
  
• full disclosure and updating of the comprehensive NAMA3.0 balance sheet, cost/benefit analysis of the undertaking and live monthly mark-to-market report on the value of shares held;

Step 9: Operational Efficiencies: NAMA3.0 can, with consent of the Minister for Finance and in orderly (market-respecting) fashion disburse all or a part of its shareholdings so as to maximize the return to the taxpayers. This disbursal should be fully notified to the public immediately post execution, with prices achieved and hedonic characteristics of the properties sold (barring identification information) fully disclosed. NAMA3.0 will then have 60 days to issue every resident of this country - registered at the date of creation of NAMA3.0 as being tax-compliant - his or her share of the sale proceeds net of NAMA3.0 operating costs and a special withholding tax of 40% on Capital Gains, in a form of a cheque;

Step 10: Legal Remit Over Assets: NAMA3.0 in recapitalizing the banks will have a mandate to help the banks collect on outstanding loans by aiding them in seizing requisite collateral. In doing so, NAMA3.0 will have to agree a procedure to address problems of cross-collateralization of specific assets. NAMA3.0 will have a right to seize borrower's property (applicable only to developers) when such property has been legally shielded from authorities or banks at any time after July 2008.

Step 11: Conditions for banks participating in NAMA3.0: banks will be required to adhere to the following rules, including, but not limited to, the caps on executive compensation at the banks set at Euro500,000 maximum with share options not to exceed 75% of the salary, to be taken in long-term options – 5+ years, with the option price to be set as the Moving Average over the last 3 years of Bank’s operations prior to option maturity). Banks must set up fully independent, veto-wielding risk assessment committee with a mandatory requirement for a position of a taxpayers' representative on the board that cannot be occupied by a civil servant or anyone who has worked in the Irish banking or development industry in the last 10 years.

In addition (all below are SBB-consistent):

• the banks must set up independent fully shielded administration offices for managing NAMA-held loans;
• the independent offices must compete against each other in delivering the returns to NAMA loans;
• the annual performance of these offices must be benchmarked also against the annual performance of the banks' own books of loans with the NAMA offices within the banks achieving at least the same average rate of return on its loans as the rest of the bank (adjusted for quality of loans) without any cross-subsidisation of returns to NAMA loans from other loans managed by the banks;
• NAMA offices within each bank must report their results separately from the bank and at the same time for all NAMA offices - quarterly and annually. NAMA3.0 will be responsible for making these reprots public after approval by NAMA board and risk, credit and audit committees.

Step 12: Re-legitimising the public system of regulation in Financial Services: as a part of NAMA3.0, the Government must address the ever-widening crisis of markets, investors' and taxpayers' trust in the Irish system of Financial Services regulation. Many steps must be taken to address this problem, and these can be worked out over time. But in my view, there must be a stipulation that all and any regulatory authorities (and their senior level employees) that were involved in regulating the banking and housing sector in this country until now must be forced to take a mandatory pension cut of 50%, a salary cut to put them at -20% relative to their UK counterparts wages, and return any and all lump sum funds they collected upon their retirement. The Government must impose measures to prevent banks from beefing up their profit margins through squeezing their preforming customers. The measures to force the banks to reduce their cost bases by laying off surplus workers must be enforced. From now on, every regulatory office should be required to publish all minutes of its meetings, disclose all its voting, decisions and rulings to the public, create a public oversight board that must include members of the Dail from non-Governing Parties, a taxpayer representative and independent directors.

Economics 16/08/2009: Alan Ahearne on NAMA - not an ounce of sense

Alan Ahearne has decided to produce a definitive defense of NAMA in today's Sunday Business Post (here). And I would have to respond. As usual - Italics are mine.

The first half of Alan's article is saying absolutely nothing - nothing as in nada, zilch, nul, nil. He simply outlines in a tedious and lecturing fashion a litany of trivial observations as to why a banks crisis resolution is necessary. He does not show that NAMA is either a necessary or a sufficient condition for crisis resolution.

"Nama is also designed to ensure that the resolution to the problem of legacy loans is orderly. Nama can achieve this outcome because it will be patient in disposing of property assets which it has seized from delinquent borrowers." This is an unproven statement that can be argued to be untrue as NAMA can and is being shown to be likely to produce a prolonged period of highly uncertain property markets with buyers and investors holding back in anticipation of future NAMA disposals of property. The longer NAMA holds these properties, the longer it will delay new investment in property in this country. The longer it will keep banks uncertain about future NAMA losses (which - as we were told - will be clawed back from the banks), the longer the mortgage holders will remain in negative equity, withholding from consumption and investment and so on.

"Outside of Nama, a liquidator appointed to wind up a property company has a duty to sell off seized properties quickly. During an economic crisis, when markets are under severe stress and banks are not functioning properly, these properties may have to be sold at a discount to their underlying economic value." Again, Alan presents a dishonest 'extreme' alternative to NAMA as we know it. Outside of NAMA, there can be better mechanisms designed for systemic and orderly adjustment of the property bubble legacy. My own NAMA 3.0 is one. Karl Whelan proposed a similar scheme as well.

"Economists refer to the discount that the liquidator must pay for a quick sale as ‘the price of immediacy’. By design, Nama will not have to pay this discount because it will sell the properties at its own pace. It is important to note that the outcome for delinquent borrowers is identical, whether liquidation occurs inside or outside of Nama. Property companies are wound up and collateral is seized. The difference is in the speed at which the seized assets are re-sold to the market." Again, this is simply not true. NAMA will keep certain projects (and thus certain property developers) in business and will even aim to complete some of the projects. If this is not a rescue clause, I am not sure what is. And as far as NAMA not paying the discount due to long term nature of the undertaking to dispose of the properties, well, this does have a price -
the longer NAMA holds these properties on its books:

• the heavier will be taxpayers' losses on bond financing (interest);
• the longer will the property markets take to adjust;
• the longer will be the period of banks uncertainty as to their costs of NAMA;
• the longer will be the period of stock markets uncertainty about the banks profitability;
• the longer will be the period of subdued investment and consumption in Ireland.

There is no such thing as a free lunch, Alan. And NAMA is not getting close to one either.

"It would be impossible to dispose of ten of billions of euro worth of distressed properties in a short time under current conditions -and extremely destructive to even try." Again - no one I know of - neither Karl Whelan, nor Brian Lucey, nor myself have said there should be a fire sale of assets. Why is Alan Ahearne allowed to deflect public attention from the real issues that are being raised against NAMA? Has he morphed into a spin doctor for DofF?

"No wonder, then, that the IMF, in its recent report on Ireland, describes Nama as ‘‘pivotal to the orderly restructuring of the financial sector and limiting long-term damage to the economy’’." Well, IMF has not endorsed NAMA and was actually critical of its provisions. Alan knowingly distorts IMF analysis by selectively quoting its report.

"A key question relates to the value at which the loans will be transferred from the banks to Nama. Some commentators have mistakenly talked about the price which Nama will pay for land and development properties. Nama is not buying properties, but rather buying loans that are secured on properties and other assets -there is a fundamental distinction." Again, Alan uses this article to deflect the real criticism - not a single serious commentator said that NAMA will be buying actual properties. But in buying the loans, NAMA will acquire titles to underlying collateral. So - a play of words for Alan is a fertile opportunity to reduce public focus on the real issues.

"The transfer value will be in accordance with EU Commission guidelines on the treatment of impaired assets. The commission is very clear on this issue: the loans are to be transferred at values based on their so-called ‘real’ -or long-term - economic value. These are the terms used by the commission. Paragraph 41 of the commission’s communication published in February states that “ . . .the transfer value for asset purchase or asset insurance measures should be based on their real economic value’’. Annex IV of the communication states that ‘‘the objective of the pricing must be based on a transfer value as close to the identified real economic value as possible’’. Well, actually, a 'real economic value' is not the same as the 'long-term economic value'. Plus, as several of us have pointed out before (Karl Whelan, Brian Lucey, many others and myself) - 'long-term' economic value can mean anything. Absolutely anything. So what Alan is saying above, just as his masters did earlier is that 'the EU Commission allows us to buy these assets at whatever price we want to pay for them'. This might be good for the Commission. But it is not good enough for us, as taxpayers who will ultimately pay this price.

"Some commentators have claimed that Nama should instead transfer the loans at what they refer to as ‘current market clearing prices’. It is hard to see how this makes sense. The reality is that there is no price at which the market for land and development can clear under current conditions. This is not to say that land has no value, but rather that the market for these assets is not functioning." In the current markets we do have real valuations of land and development assets. There are sales, there are some investments, there are transactions. Furthermore, today's price can be taken as a short-term valuation based on standard hedonic valuations. The only problem - for the banks, developers and their guardians in the Leinster House - is that these valuations are too low. So they use an academic economist to argue nonsense about 'markets are not there, man, me doesn't know much about what value things might have'.

"There seems to be a misapprehension among some commentators that, for Nama to break even, property prices need to revert to the peak levels seen in 2006-07. This is not the case."
Well, do the maths, apply discount of a% on a property loan of X bought, assuming the loan yields y% annually. Hold it for T years. Assume that the underlying collateral appreciates at k percent per annum. The present value of this loan T years from today if the prevailing rate of interest is R is
(1-a)X{Sum([1+y+k]/[1+R]^i} where i=1,...,T
The cost of financing this loan is at R+g where g is the risk premium, taken over T years and discounted back to today:
(1-a)X{Sum([1+R+g]/[1+R]^i}
The break even on this deal requires that the first identity is equal to the second one. This in turn implies that to break even, NAMA will have to either

• enjoy property yields + appreciation on the capital in excess of the cost of bonds financing and the cost of running NAMA itself - which really means a property boom (in yields terms) will be required well in excess of the 2004-2007 one, or
• enjoy property price appreciation that will cover the cost of bond financing, plus the cost of running NAMA, plus inflation, less the discount a.

This is soo excessively optimistic, that actually it makes me believe that in making his statement, Alan reveals not having done even a basic estimation of NAMA likely costs and losses.

Now, it is also telling that Alan fails to even mention the problems of protecting taxpayers' interests, ensuring transparency of NAMA operations, or any other major issues for which NAMA has been criticised by many commentators, including myself.

I also find it extremely arrogant and outright rude that this public servant has managed to escape any scrutiny as to:

• why as the economic adviser to the Minister for Finance has he not produced any economic assessments of NAMA?
• why has he failed to consider the economic costs of NAMA (he does attempt something of an analysis - albeit extremely simplistic - of what would happen if NAMA was not enacted)?
• why is he allowed to simply claim - with no evidence or arguments to support such a assertion - that NAMA will restore functional banking system in Ireland?
• why is he allowed, unchallenged, to claim that all external analysts are supporting NAMA, while we know of several Nobel Prize winning economists, numerous other respected international academics, not to mention all internal independent analysts working in Ireland who unequivocally identified NAMA as being a bad idea?

In short, Alan's article is a waste of space - pure and simple, providing not a single fact, not a single logical argument, not a single ounce of economic reasoning to support his thesis.

Read my alternative to NAMA here.

Economics 04/08/2009: NAMA, Liam Carroll & Short Termist Bonds

I should make it a habit to direct every NAMA post reader to my proposal for NAMA 3.0 here.


Yeps, Supreme Court came in on the side of the Government, throwing a lifeline to NAMA and forcing taxpayers into deeper losses. My earlier note stand now (see here) with all the gory implications for losses on Mr Carroll's loans now being back in the NAMA court.

But two birdies have chirped to me that there is more brewing up in the land of NAMA-fantasy. Apparently, the rumor has it, the Government plan is to issue short term bonds to cover NAMA liabilities. Given that NAMA will start issuing bonds in 2010 for this undertaking, the short term nature rumored is for a 2011-2012 bonds.

This, if true, makes no sense for several important reasons. Here are some:

(1) Issuing short-term debt with maturity before 2013 is equivalent to a financial suicide. The reason is simple - there is no credible (or for that matter even an incredible one) commitment from the ECB that

• such issuance can be rolled over at the same or lower interest rates to cover maturing bonds; and
• the EU will allow these bonds to remain off the balance sheet of the Government upon the roll over.
  

(2) Issuing short term bonds will be a fiscal suicide, for their maturity, and roll-over date, will fall dead on in the years of heavy Exchequer borrowing and maturity of other - 2008-2009 issued bonds. Given that the market demand for fixed income paper worldwide will be thinner then (due to increased appetite for equities-linked risk), a flood of rolled over bonds can risk derailing the borrowing programmes for Irish sovereign debt. Now, if you are a forward-looking investor, expect Irish yields to run away from the benchmarks once again, then.

(3) Short term maturity does not take into account the main risk to NAMA valuations, namely that by 2011 or for that matter 2013, the assets taken over by NAMA will be priced at any significant upside relative to what NAMA will pay for them, implying that, under short-term issuance, this Government will face the need to

• engage in a massive refinancing operations
  
• at the time when its balance sheet liabilities will be almost at their peak (see Department of Finance projections);
• pay higher expected cost of borrowing than today; and
• potentially, load the NAMA liabilities onto Government own balancesheet, while
• facing market prices and demand for real assets that is well below the valuations applied by NAMA.
  

If you look at the latter point. DofF uses 7 year U-shape cycle as its basic assumption. Peter Bacon last week stated that the cycle is expected to be 5-10 years. My estimations, based on NBER research (here), show that the average duration of the U-shaped cycle in historical data for OECD economies for 1970-2003 episodes of house prices collapse co-measurable with the one we are experiencing today is between 18 and 23 years. This range is dependent on how you time the cycle, but it refers to a nominal price cycle, unadjusted for Forex devaluations that accompanied such cycles in other countries and inflation. Japan (in down cycle since 1989-1990), Germany (since 1972-73), Italy (since 1981) and Sweden (since 1979) have not recovered to date.

Considering rolled up interest charges on impaired loans, banks' restructuring of interest payment schedules on so-called 'performing' stressed loans that in any other country would be classified as having defaulted, NAMA will be purchasing assets from the banks at an extremely shallow effective discount.

For example, a discount of 30% applied to a loan with 1.5 years (since July 2008 through December 2009) rolled up interest at 10%, and a built in re-financing cost of 1% will be equivalent to an effective discount of just 18.1% relative to the original principal of the loan itself. If, in the mean time, the underlying asset value itself has depreciated by, say 40%, then
NAMA will be buying a Euro 60 asset for Euro81.86. Now, in order for NAMA to recoup the original cost of purchase (not counting the cost of financing the purchase and managing the asset etc), the asset value needs to appreciate by a compound 36.4% within the span of the bond
finance. Thus between now and 2011 when the alleged bonds should mature, the annualized rate of appreciation required on the assets for NAMA just to recoup the original loan amount would have to be 16.8% per annum!

If anyone in the Department of Finance thinks this is a sane bet on a market turn-around, God help us.

Short-term financing of long-term obligations, as we should have learned in the current crisis, is equivalent to giving steroids to an unfit athlete and sending him out to run a marathon.

Though to repeat once again - this is just a speculation at this moment in time although two independent sources have tipped me on this one.

Economics 02/08/2009: Liam Carroll's case

For those of you who missed, here is my article from Saturday edition of Irish Daily Mail

An Irish person recently remarked to me in the context of NAMA that “If any other electorate in Europe, nay, the world, faced this scandal, their citizens would be on the streets.” They would. We have been led to believe that NAMA is a necessary solution for the banks having to write down the odious development debt acquisition of which over the years past was cheered on by the Government through tax breaks and the stamp duty widnfalls. In reality, NAMA is Ireland’s own financial Chernobyl – a self-inflicted devastation of taxpayers’ finances perpetuated for the sake of doing something about the crisis.

By denying the examinership to Liam Carroll’s six companies, the Irish High Court has put itself out as the sole branch of State that stands between the innocent taxpayers and this redlining reactor.

First, let me clearly state that I have no objection to proper developers who build what is truly demanded by the market. They too will be the victims of the NAMA debacle.

Pursued by a creditor, the ACC Bank, Liam Carroll has been languishing in the High Court for a better part of this week, awaiting a decision on whether he will be granted an examinership for six of his companies. An alternative for Mr Carroll was to face an appointment of a receiver – a sure bet that his companies will be shut down. This alternative has now come to its logical fruition – denying Mr Carroll the examinership, the court has forced him to face the music. Receivership is now all but inevitable.

The motivation behind this battle was NAMA. Mr Carroll would like his companies debt to be assumed by the state, allowing for them to continue as an ongoing concern. Mr Carroll even hoped to convince the folks running the bad bank to give him few quid to finish some of his
failed projects. A pipe dream for a businesses that, by his Senior Counsel’s admission generates just €22-23 million in annual revenue against the debts of roughly €1.4 billion. Now, do the maths – a company that was supposed to be bought by us, the taxpayers into NAMA will not be able to cover even 15% of its annual interest bill.

Mr Carroll’s case has serious implications for us all – the Irish taxpayers – as the underwriters of NAMA.

Mr Carroll’s Senior Counsel Michael Cush told the court that the six companies in question, had historically been very successful businesses. But he said more recently they had suffered credit problems, the downturn in the property market, and some “problems with investments”. Per Mr Cush, the companies are clearly insolvent and if liquidated, their unpaid debts will reach €1 billion. This indicates that there is no hope for a recovery of the business and that examinership was rightly denied to them.

But it also shows that there is not a snowballs chance in hell that NAMA will be able to recover any positive value from Mr Carroll’s companies, unless it forces his banks to write down at least €1 billion of some €1.4 billion in loans amassed. That NAMA will do nothing of the sorts, preferring to continue the circus of pretending that these businesses worth something in excess of their debts is clearly something that the courts disagree with.

The NAMA legislation published this Thursday states that the taxpayers will be paying for the current values of the banks loans, while the developers will be pursued for the original loans amounts. Mr Carroll’s case illustrates that currently insolvent businesses continue to accumulate liabilities (rolled up interest and fresh demands for continuity funding) that simply cannot be repaid, ever. These roll up debts are odious, for they are extended to the clearly insolvent companies in the hope that NAMA will simply cover them at a higher rate than the markets would were the banks to go out into the open trying to liquidate these development loans.
Which means that NAMA will be using our money to pay for the rolled up interest on top of already grossly overvalued loans of insolvent enterprises.

Do a simple math, with a 50% fall in the value of underlying assets, 11% interest charge on the non-performing loans and a 25% NAMA discount, the taxpayers will be overpaying for the assets they by to the tune of 70% plus. Put simply, imagine walking into a shop and seeing a TV set on sale. The sign reads: ‘Sale! Original price €100. Sale price €170”. That does look like Minister Lenihan’s bargain for the taxpayers.

Liam Carroll’s case also shows that over the last year, soft budget constraints for insolvent businesses, like Liam Carroll’s empire, were accepted by the banks solely on the anticipation of a state bailout. If not, these banks actively engaged in destroying their shareholders’ wealth by undertaking knowingly reckless decisions. Take your pick.

I have absolutely nothing against Mr Carroll's enterprises, other than the simple argument that if they are insolvent today, the should be shut down today and they should not be allowed to accumulate additional liabilities at our, taxpayers' expense.

The examinership case for Mr Carroll’s companies was not warranted from day one of his application to the court. Minimizing losses to the economy and the taxpayers resulting from his companies farcical ‘operations’ required an appointment of a receiver and no restructuring period under the examinership would have done any good to their solvency. If only the same wisdom of the courts can be applied to NAMA itself.

NAMA 3.0: A real alternative

I was bemused to learn that a number of my economics colleagues are apparently starting to 'discover' the idea of resolving the banking crisis through the use of a voucher-styled equity acquisition in Irish banks and disbursement of these to the taxpayers. Oh, it makes me glad that potentially some of them - possibly including even those who would not give me a fulltime job in their august departments - are now coming around to accepting some of my original ideas.

So to clearly draw a line in the sand, I espoused the idea of voucher-styled recapitalization of Irish banks on the pages of Business & Finance, with Prof Brian Lucey (the only person who saw, amongst academics, any merit in this idea from the start) in the pages of the Irish Times, in the Sunday Times and in the Irish Independent, as well as, of course, on this blog. But my entire view on how the banking crisis should be handled is summarized here:

Step 1: Require banks to take full mark-to-market writedown on their loan book;
Step 2: Travel down the capital ranks to draw down shareholder equity, deplete perpetual bond holders and so on to cover the writedowns;
Step 3: Force the bond holders into debt for equity swap;
Step 4: Open enrollment for a share-participation in Irish banks recapitalization to SVFs, vulture funds and any other form of private capital;
Step 5: Cover all remaining shortfalls in capital base with Government bonds swapped for equity after Steps 1-4 are completed and after an independent assessment of the value of the remaining loans is carried out to determine the true extent of banks under-capitalization;

Step 6: Hold equity in an escrow account (NAMA3.0) on behalf of the taxpayers, appointing a Supervisory Board to every bank recapitalized by the taxpayers money. The SB should consist of one appointee by the Minister for Finance, 3 direct independent representatives of the taxpayers, who are charged with explicitly guarding the taxpayers' interests, 1 representative of the bank board, 1 representative of NAMA3.0 and 1 independent director. Each member (other than those from NAMA3.0 and the bank) will hold a veto power. A requirement that risk and credit committees of NAMA3.0 include at least 51% majority of independent experts who cannot be employees of the state, NAMA3.0 or any other parties to this undertaking;

Step 7: NAMA3.0 accountability: no indemnity for negligence and incompetence for any employee or director of the escrow organization; no cross borrowing by the Exchequer from NAMA3.0 is allowed, so Brian Lenihan and his successors cannot raid the nest egg; ownership of shares in the account accrues to the taxpayers, not to the state or the public sector; NAMA3.0 cannot lend money to continue any of the banks' projects;

Step 8: NAMA3.0 transparency: full disclosure of all recapitalization acts and shares held in NAMA3.0 - on the web, updated live; full disclosure of all employment contracts, wages, bonuses etc, CVs of all managers and directors and disclosure of all potential conflicts of interest; full disclosure and updating of the comprehensive NAMA3.0 balance sheet, cost/benefit analysis of the undertaking and live weekly mark-to-market report on the value of shares held;

Step 9: NAMA3.0 operational efficiencies: NAMA3.0 can, with consent of the Minister for Finance and in orderly (market-respecting) fashion disburse all or a part of its shareholdings so as to maximize the return to the taxpayers. This disbursal should be fully notified to the public immediately post execution, with price achieved fully disclosed. NAMA3.0 will then have 30 days to issue every resident of this country - registered at the date of creation of NAMA3.0 - his or her share of the sale proceeds net of NAMA3.0 operating costs and a special withholding tax of 25% on CGT, in a form of the cheque;

Step 10: NAMA3.0 legal remit over assets: NAMA3.0 in recapitalizing the banks will have a mandate to help the banks collect on outstanding loans by aiding them in seizing requisite collateral. In doing so, NAMA3.0 will have to agree a procedure to address problems of cross-collateralization of specific assets. NAMA3.0 will have a right to impose seize borrower's property (applicable only to developers) when such property has been legally shielded from authorities or banks at any time after July 2008.

Step 11: Conditions for banks' participation in NAMA3.0 banks wishing to participate in this undertaking will be required to adhere to the following rules, including, but not limited to, the caps on executive compensation at the banks and the requirement to set up fully independent, veto-wielding risk assessment committee at each bank with a mandatory requirement for a position of a taxpayers' representative on the board that cannot be occupied by a civil servant or anyone who has worked in the Irish banking or development industry in the last 10 years;

Step 12: Re-legitimising the public system of regulation in Financial Services: as a part of NAMA3.0, the Government must address the ever-widening crisis of markets, investors' and taxpayers' trust in the Irish system of Financial Services regulation. Many steps must be taken to address this problem, and these can be worked out over time - suggest away. But in my view, there must be a stipulation that all and any regulatory authorities (and their senior level employees) that were involved in regulating the banking and housing sector in this country until now must be forced to take a mandatory pension cut of 50%, a salary cut to put them at -10% relative to their UK counterparts wages, and return any and all lump sum funds they collected upon their retirement. The Government must impose measures to prevent banks from beefing up their profit margins through squeezing their preforming customers. The measures to force the banks to reduce their cost bases by laying off surplus workers must be enforced. From now on, every regulatory office should be required to publish all minutes of its meetings, disclose all its voting, decisions and rulings to the public, create a public oversight board that must include members of the Dail from non-Governing Parties, a taxpayer representative and independent directors.

This is a sketch of NAMA3.0. Please feel free to build a bigger picture with me