Economics 24/8/10: Anglo Tranche 2 goes 'Boom!'

Two weeks ago in a post on Anglo (here) I provided a quick explanation of my forecasts for why the mid range expected capital hit on the entire Anglo book of ca €72bn worth of loans (original face value) will be in the region of €33bn. This estimate referred to the mid-range assumptions.

In the light of today's speculations/reports (here) that the final Tranche 2 haircut on Anglo loans will be 61.93% I am now more confident in my original lower- and mid-range estimates, though adjusting my upper margin loss estimate down a notch.

To repeat my projections are:

• Worst case scenario for Anglo requires €38.6bn (down from €38.9bn)
  
• The mid-range is €33bn in total hit (same as earlier)
  
• The best case scenario is €30bn (same as earlier)
  

Some details: Tranche 2 of Anglo loans was valued at €6.75bn. Combined total amount of loans transferred to Nama in Tranche 2 is €11.9bn on an average discount of 55.6%. Tranches 1 & 2 combined is €27.2bn of the total €81 bn planned with an average discount of 52.3%. If this discount stands, remaining Tranche 3 transfers of €53.7bn to be completed by February 2011 will incur capital hit of RWA-adjusted €28.1bn - to a combined Nama-induced capital loss to all 6 banks of €42.3bn. Nama expects further €12bn to be transferred by the end of September - a highly unlikely deadline, at least if Anglo-INBS stuff were to be included here. Provisions by the

As telling as the haircuts are the assumed LTEVs - in Tranche 1 the implied LTEV was 11 percent. In Tranche 2 this is down to 9 percent. Since Nama marks to November 2009, this change can be explained either by lower quality of loans being taken on board (bad news for Nama, better news for banks) or by Nama aggressive drive into raising cash flow (good news for Nama, bad news for the banks).

Now, to my valuations. Table below summarizes:
Notice, I allow for interest margins of 1.5% pa in my mid-range assumptions. This is rather unlikely. To end of 2009, interest margin on Anglo loans (performing) was roughly 1% and this did not reflect Nama costs. In addition, my mid-range scenario assumes Nama recovering 100% of the principal amount of the loans - something that I believe to be equally unlikely. Either way, mid-range estimate implies that Messr Aynsley and Dukes will be coming in with new demands for cash soon - to the tune of €8.5bn more based on my mid-range scenario.

Economics 11/8/10: Anglo saga continues

For about 24 hours I have resisted commenting on the Anglo latest twist in the capital hole - the EU approval yesterday of additional funding for the dead bank. But given the lack of straight forward and insightful analysis in the media, I thought I should throw int couple of direct comments on the affair.

First, consider the EU statement (available here):
"Anglo Irish Bank needs a third emergency recapitalisation to meet its obligations. ...there is no doubt that Anglo Irish Bank has to restructure profoundly in a way that effectively tackles the weaknesses of the past business model and ensures a sustainable future without continued State support."

Sadly, no Irish commentator noticed the irony that the EU is calling for a profound restructuring of the Anglo after 3 episodes of approvals of extraordinary funding for the bank by the taxpayers. Surely, if the Commission were to do its job and properly police national decisions relating to financial institutions stability, after the second call for capital from Anglo, Mr Almunia should have said something along the following lines: "Don't come back for any additional funds approval until you first provide a clear map as to how you are planning to shut down this insolvent institution."

Second, consider the timing of the approval. For some days before the approval, Irish 'analysts' and policy officials have been massaging public opinion. Various leaks and speculative statements that the bank will need more cash were floated around. Some of the Irish brokerages suggested that Anglo will need €2-4bn more in funding. Of course, while this circus was ongoing, the Government has been quietly labouring away at the submission to the EU Commission. The approval was issued on Tuesday, suggesting that the request for emergency funding extension was filed at the very latest - on Friday. This request was not subject to any parliamentary debate or other procedures that should have been deployed to ensure democratic participation in disbursing of the public money was adhered to.

Third consider Irish media and 'analysts' response to the Anglo call for cash. Of all stockbrokers, only NCB managed to comment on the Anglo call, despite the fact that Anglo's capital demands are indicative of the sector-wide problems. NCB guys actually did a good job in their morning note, saying that:

• "We had added €23bn to our General Government Debt to GDP ratio as a result of Anglo to leave it at 98.1% at year end 2011. This additional €1.4bn now needs to be added and will add approximately 0.7% to our debt to GDP figure at year end 2011." Yeps, with Anglo latest request for funding, Ireland Inc sovereign debt is set to be 99% by the end of 2011.
  
• The NCB guys are also aware, unlike, it appears Davy and Goodies, that Anglo can end up costing us (taxpayers) of sovereign bonds side as well: "The NTMA announced that its next auction on Tuesday August 17th it will tap the 4.0% 15 January 2014 bond and the 5.0% 18 October 2020 bond. The NTMA will be hoping that the Anglo issue is cleared up sooner rather than later and that clarity is given on the final requirement by the State. The uncertainty surrounding the exact amount of the transfer into Anglo is weighing on the Irish sovereign. The Irish 10 year is currently at 5.16% which is 274bps over the equivalent German bond and wider than the benchmark Portuguese 10 year which is yielding 5.079%."

Of course, most of the media have missed the two points of Anglo contagion to the broader markets:

1. Sovereign risk rising due to Anglo uncertainty, and
2. Corporate risk is also rising due to spillover from sovereign uncertainty to corporate assets valuations.

Finally, the whole circus around Anglo's 'news' missed the core point - Anglo started into the present mess with €71bn of 'assets' (aka loans). The total amount earmarked to date for the bank amounts to €24.354bn.

If Nama were to be believed in its LTEV estimates, Anglo's book is roughly 55% under water. This means that its post-Nama book is somewhere closer to being:

• 1/7 of the total book (€10bn) under water to Nama or better than Nama levels - say impairment of 30% due;
• 35% (or €25bn destined for the 'Bad' bank) is under water more than Nama haircuts - say 60-70% impairment due.

Translated to the full pre-crisis book, this implies the average recovery rate on Anglo loans of ca 43-47% across the whole book.

Let me explain the above numbers: €10bn recoverable at 70% and 25bn recoverable at 30-40% implies 14.5bn recovery on 35bn of assets left post-Nama, adding to it Nama haircuts implies recovery rate of 43-47%, ex-costs). This, in turn, implies across the book impairments of €37.6-40.5bn. Take the lower number - total through restructuring cost of Anglo can be expected to reach ca €37bn in the end or higher. Take 10% off for risk-weighting and restructurings of funding etc to boost regulatory capital.

End of the Anglo affair cost comes to roughly speaking €33bn. That's the amount we can expect to pay in the end. The latest €24.4bn count is, therefore, only less than 3/4 of the saga. So here's my forecast - by end 2011 Anglo will ask for ca €10bn more in our cash and by the end of 2012 - for up to €13bn more than the amounts already advanced. The only way these figures can be made smaller is if Nama grossly overpays Anglo for Tranche 2 and 3 loans.

Anyone noticed that? Not really. Just as no one noticed that Anglo is going to, in the end, cost every working person in this country something of the order of €19,600 - a hefty bill for rescuing Anglo's bondholders for every household of two trying to pay a (negative equity) mortgage and get kids through school.

Instead, our media keeps on asking Minister Lenihan rhetorical questions along the lines 'How much more?' and lamenting 'unexpected Anglo demands for more cash'. Per all publicly available information on this site, Peter Mathews' site and Irish Economy site, all I can say: "Expect more of the 'unexpected', folks".

Economics 20/7/10: Is Zombie Nama propping up Mummified Irish Banks?

As the independents – Brian Lucey, Karl Whelan, Peter Mathews and myself – have warned (actively denied by the Government and its backyard ‘experts’), Nama Tranche II turned out to be yet another unmitigated disaster.

Nama paid €2.7bn for loans that its experts valued at €5.2bn. Of course, these ‘experts’ include many who were responsible for some of the most disastrous valuations of the Celtic Tiger era and are now ‘entrusted’ as being ‘experienced’ with re-valuing their own errors, while collecting a handsome pay packet courtesy of the Irish taxpayers. The implied average discount these folks put on the loans this time around is 48%. Anglo failed to transfer its loans – some €7-8bn worth – due to delays caused, per what I am hearing, by a rather shoddy documentation quality.

Per RTE: “The biggest discount on the second batch of loans was for those from Irish Nationwide. NAMA paid the society just €163m for loans of €591m, a discount of 72% [an increase of 14% on Tranche 1]. The figures for AIB and EBS were 48.5% [on €2.73bn marking a 6.5% increase on Tranche 1], and 46.5% [on €35.9mln and an increase of 9% on Tranche 1] respectively, while the Bank of Ireland discount was 37.8% [on €1.82bn - an increase of 2.8% on T1].” Overall, Nama now has in its vaults €20.5bn worth of loans (or rather largely worthless paper few years ago labeled as loans) for which it paid at a discount of 50.7%.

The loans are concentrated - related to just 23 property developers who are deemed to be 'second tier' aka less flamboyant than those in Tranche 1 and most likely, less experienced too.

It makes me laugh when I recall how our stock brokerage 'analysts' were chirping a year ago that a 20-25% haircut would be warranted by market valuations of these loans.

However, the real problem with all of these numbers is that while the discounts might sound impressive, they are not reflective of any reality. Instead, they are now fully bootstrapped to the capital commitments issued to the banks by Brian Lenihan. You see, as we warned from the start – and this too was vigorously denied by the Government – the heavier the haircut, the greater will be banks’ demand for capital, the greater will be the share of bank equity owned by the taxpayers. Mindful not to take too much stake in BofI – for that would produce poor optics internationally – Brian Lenihan is content to oversee a 38% discount on its loans. Having pumped capital up to 50% of risk-weighted assets transfers to Nama for AIB, the Minister is equally happy not to impose heavier haircuts on AIB Tranche 2 transfers than 50%. Hence the ‘magic’ 48.5% figure. Ditto for EBS. Sounds precise – not 49%, nor 48%. But in the end – the number is most likely utterly bogus.

To put some fluff in the air about ‘Nama is a tough player with the banks’, Tranche 2 hammered INBS and most likely will hammer Anglo. Unless, that is, Anglo fatigue has finally reached Upper Merrion Street buildings. In this case, a discount can be less than that for INBS. Not because Anglo loans have miraculously become sterling in quality, but because the DofF might be just slightly concerned that the bank will come with a fresh capital demand.

So instead of pricing the loans to market, Nama now appears to be pricing them to keep required post-Nama recapitalizations at the levels consistent with earlier Government capital commitments.

In the end, however, a 48% average discount is still a gross overpayment on these loans. Let’s do a back of the envelope calculation here.

25% of Nama loans are ‘cash generative’ – i.e. paying some sort of an interest repayment on interest due. Suppose – just for the sake of making an assumption – that 50% of those cash generative loans are paying full interest due and 50% are paying ½ interest due. Assuming average interest rate on the loan of 8% (a generous assumption, given that banks were lending at lower rates than that) and cost of refinancing banks funds at 3% (well below current yields on banks bonds, even way lower than the latest Exchequer yields of 5.25%, but let’s be generous), if the cost of managing loans at 1% (consistent with Irish banks’ margins), then:

• 75% of Nama loans are losing have a negative yield of 12% (annual loss on interest alone);
• 12.5% of Nama loans are losing 2% pa in net costs, plus 8% rolled up interest, implying their negative yield of 10% pa;
• 12.5% of Nama loans are losing net 8% pa.
  

Expected average annual loss on Nama overall portfolio is therefore 11.25% pa. Value this at x3 revenue flow. Nama portoflia of loans would have a negative, yes, negative, - 34% break-even valuation in the market. Just on the back of interest and costs alone, the value of Nama purchased portfolio of loans should be no more than 66 cents on the euro of face value.

Next, subtract the percentage of loans that are unsecured – while allowing for the expected recovery, subject to the risk. Suppose that 20% of loans taken on by Nama are unsecured (again, likely to be conservative assumption). Suppose these are distributed across the same 12.5%, 12.5% and 75% sub-portoflia following a uniform distribution (again, this is a generous assumption as lower quality loans are more likely to be less secured in the real world). The value of the entire package of loans is now worth only 59 cents on the euro.

Secured loans are also subject to a recovery risk. In general, risk of recovery implies that over 70% for loans in arrears will be non-recoverable, ca 50% for loans under stress (e.g. failing to pay principal when it is due) and 20-25% for loans that are fully performing (e.g. those that are repaying principal and interest to the full amount). These are numbers consistent with the 1990s experiences in Sweden and UK. Translating these into our valuation, adjusted for risk of recovery implies the value of Nama-bound loans around 30-32 cents on the euro.

Other risks can be priced as well, but let us stop here.

Even with relatively rosy assumptions, the value of the loans being purchased by Nama should be at maximum 32 cents on the euro.

Allowing for assets appreciation of 10% over 3 years would imply a valuation of no more than 37 cents on the euro without applying a PDV adjustment.

We are told that Nama is being a tough buyer, paying 52 cents on the euro. Who’s fooling who here?

Incidentally, 30 cents on the euro is what independent banking expert Peter Mathews has estimated as recoverable for all development and property loans held by the banks. It is also the number that myself and Brian Lucey have arrived at in our previous estimates of required haircuts, which were based on analysis of underlying property markets.

What is now clear is that 24 months since the crisis fully exploded in our faces and 15 months after the independent analysts started telling the Government that it is committing a grave error in pushing forward the solution that, under the original name TARP was rejected in the US two weeks after it was put in place, the Irish Government remains hell-bent on pursuing this wrong approach to banks recovery. More egregiously, with Tranche II loans in, there is a strong enough reason to suspect that Nama has turned into nothing more than a façade for delaying even more capital demands from the banks until the end of 2010. The reason for this, one might speculate, is to keep our 2010 public deficit from exploding to beyond 20% of GDP.

A zombie institution (Nama) now is fully in charge of our mummified banking system. What can they do next to make things even more dynamic than that?

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 04/02/2010: Nama - riskier than Anglo?

I just came across a very interesting paper, written back in November 2007 and published by the Bank for International Settlements as a Working Paper No 238.

As a proposition: I will use the study results to argue that Nama is a more risky undertaking than the Anglo Irish Bank.

Authored by Ryan Stever and titled “Bank size, credit and the sources of bank market risk” the paper “…examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies.” The study is based on the US banks, with sample being a panel of ‘at least 339 publicly trades BHCs at each point in time” for the period of 1986-2003. “These range in size from American Bancorporation at $31 million in book assets (200 employees) to Citigroup at $1.26 trillion (over 280,000 employees).”

“Unlike the pattern for non-financial firms, equity betas of large banks are two to five times greater than those of small banks. In explaining this, we note that regulation imposes an effective cap on banks’ equity volatility. Because the portfolios of small banks are less diversified, this cap has a greater effect on small banks than large banks.”

In other words, there is plenty of evidence that even when effective, regulators can induce some unintended consequences onto the banking system and that these consequences, if unaddressed can lead to systemic failures. Here is how it works:

• Regulators (and/or shareholders through exercise of their voting rights) place a limit on the total volatility of each bank’s assets regardless of size, which tends to minimize bank risk; however
• Small banks have more idiosyncratic risk inherent in their loan portfolio “because they cannot diversify away idiosyncratic volatility as well as large bank” (practically – smaller banks are more specialized, making their loans books more exposed to idiosyncratic strategy risk).
• Smaller banks inability to diversify comes about in “a number of different ways – for example; less total loans held, less diversity in borrower type (they do not have access to large borrowers) and geographic restrictions (small banks tend to be more localized);
• Because their total equity volatility is limited by regulation smaller banks must then find a way to eliminate their idiosyncratic volatility that is in excess of larger banks’ idiosyncratic volatility.

To do this, small banks do not necessarily pursue higher levels of equity capitalization or lending to different sectors in the economy – in other words, they do not strive to become like larger banks, but instead they either

• make loans with less credit risk than large banks (Swiss private banks, for example). This has the effect of reducing idiosyncratic volatility (as desired) and also reducing the beta of each loan (and thus the equity beta of small banks); or
• demand more collateral (e.g. Irish banks).

Of course, the problem with selecting the latter path way (collateral beefing up) as opposed to the penultimate pathway (more conservative, risk-sensitive lending) – as Irish banks should have learned from the current crisis – leads to additional problem, not highlighted in the study. This problem is manifested in the selection bias induced onto collateral – smaller banks opting for higher collateral requirements will take on less diversified collateral that is more likely to be positively correlated with their own (risk-skewed) loans books.

Thus collateral risk becomes positively correlated with loans risk.

Just think of what type of collateral Liam Carroll was supplying for his property development loans? You’ve guessed it – property-based collateral.

In fact, the study does find that small banks did not lower their equity volatility through lower leverage. Instead, “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.”


What are the lessons for Nama from all of this? I am afraid not very positive ones. Nama is setting out to purchase loans on the basis of their collateral. Loans that are in distressed with collateral that has breached covenants due to precipitously declining valuations. Guess what – collateral risk is positively correlated with loans risk here from the start. Can this correlation be diversified? Yes, but not within Nama setting.

Remember, Nama promised to take good and bad loans together and mix them to derive cash flow. But these loans are all written against the same types of collateral as in:

• Same instruments;
• Same geography;
• Same vintages;
• Same currencies and so on.

In language of diversification – which loans returns are orthogonal to each other? Answer: none. Hence, no diversification is possible.

Take this back to the study findings and treat Nama as a sort-of-a-bank undertaking (with no deposits, but plenty of loans, although of course it does not matter, because Nama is not facing market funding constraints, courtesy of the state that is willing to give it your and my money with nothing definitive being asked in return).

Recall the last quote: “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.” But in Nama’s case – what borrowers with “lower credit risk” can they select? None.

This leaves only option for Nama – to raise the underlying quantity and quality of collateral. Again – can this be done?

Sure, if Nama can either increase seniority of its claims on the collateral, or if it can swap assets for higher quality assets somehow. Alas, this works in theory, but in practice, Nama is saddled with seniority and quality of assets that banks have. It cannot go out to the market and demand that senior debt holders out there step aside and let residual quality claims that Nama might hold to step forward. Nor can it go to the developers and demand that better or more collateral be pledged for the loans. It is neither legally possible, nor feasible, given the dire state of developers’ finances.

Now, step aside and think of the Anglo. Anglo is a bank that is saddled with exactly the same dilemma – poor loans risk diversification. Can it escape this conundrum, assuming it can get funding (remember – Nama has no funding constraint). Of course it can. It can diversify client base and start attracting clients with lower risk profile by offering cheap loans to selected clients. And of course, Anglo has done so in the past – perhaps not enough, but it did. It can go out and lend outside Ireland, to diversify via change of geographies (it has done so in the past as well). And it can load up on collateral – which, once again, Anglo did. And yet, despite doing all these things, Anglo collapsed.

Anyone still thinks Nama – with much more limited ability to diversify key risks – can succeed?

So here you have it – Nama is the ultimately non-diversifiable risk undertaking that is actually worse off in terms of risk profile than the Anglo Irish Bank…


One would hope their board and risk committee understand this. Not really - the board contains such experienced finance and risk people as town managers, and the risk committee - well, that one will be staffed by who knows who, for it will have no one from outside Nama on it.

And this, of course, is where Nama is so nicely reflective of the Anglo...