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."
Thursday, October 15, 2009
Wednesday, October 14, 2009
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...
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...
Tuesday, October 13, 2009
Site Value Tax proposal draws an army of 'authors'
One particular trait of Irish policy research community is a troubling one – once a policy proposal is adopted by the governing party, the jostling and positioning begins to align various research bodies and policy advocates to claim the credit.
And so it is with the latest Programme for Government – no sooner did the ink dry out on paper as various august organizations and individuals have managed to stake a claim to fame as the authors.
I don’t know which proposal was finally used by the Green party leaders. All I know is that there is only one current proposal for Site-Value / Land-Value Tax that was produced in 2008-2009 period. This proposal was authored by me, sponsored by a group of research NGOs and is available on the http://smarttaxes.org website - a link to it here.
The proposal was publicized at a conference in April 2009 and at a public seminar in May, made public in Business & Finance, mentioned and cited in the Sunday Times and the Irish Times. I made the presentation on LVT/SVT available on my blog since April 07, 2009, and was a subject of a briefing for the Department of Finance in April 2009 which I attended. (Some links to these public domains: here, here, here).
The proposal (constituting the first volume of research on the issue) contained detailed estimates of the likely effect of the LVT/SVT on budgetary dynamics and revenue stability, as well as broad assessment of expected economic impact of such a tax.
The proposal was also delivered to the Taxation Commission as an official (and presumably logged) submission and the Taxation Commission report draws extensively in its section on LVT/SVT from this submission.
A second submission (see here), dealing specifically with the issue of using LVT/SVT to raise public investment funding was completed by me in August 2009 and made public then. It is also available on the http://smarttaxes.org website.
Both documents formed the submission on the Programme for Government by the Environmental Pillar member group, Feasta which was delivered to the Green Party and launched publicly at an event.
These are the matters of public record.
In the mean time, it came to my attention that a certain leader of one of the Social Pillar organization in the Social Partnership has been claiming authorship of the proposal. The irony has it, his own organization’s website contains no serious proposals for SVT/LVT despite having many detailed position papers on other policies. Other ‘authoring experts’ have been reported sending their CVs to the Green Party leadership in a hope of gaining a slice of action.
My research on SVT/LVT has been sponsored, kindly, by a group of private and NGO sources, cited on the submissions.
And so it is with the latest Programme for Government – no sooner did the ink dry out on paper as various august organizations and individuals have managed to stake a claim to fame as the authors.
I don’t know which proposal was finally used by the Green party leaders. All I know is that there is only one current proposal for Site-Value / Land-Value Tax that was produced in 2008-2009 period. This proposal was authored by me, sponsored by a group of research NGOs and is available on the http://smarttaxes.org website - a link to it here.
The proposal was publicized at a conference in April 2009 and at a public seminar in May, made public in Business & Finance, mentioned and cited in the Sunday Times and the Irish Times. I made the presentation on LVT/SVT available on my blog since April 07, 2009, and was a subject of a briefing for the Department of Finance in April 2009 which I attended. (Some links to these public domains: here, here, here).
The proposal (constituting the first volume of research on the issue) contained detailed estimates of the likely effect of the LVT/SVT on budgetary dynamics and revenue stability, as well as broad assessment of expected economic impact of such a tax.
The proposal was also delivered to the Taxation Commission as an official (and presumably logged) submission and the Taxation Commission report draws extensively in its section on LVT/SVT from this submission.
A second submission (see here), dealing specifically with the issue of using LVT/SVT to raise public investment funding was completed by me in August 2009 and made public then. It is also available on the http://smarttaxes.org website.
Both documents formed the submission on the Programme for Government by the Environmental Pillar member group, Feasta which was delivered to the Green Party and launched publicly at an event.
These are the matters of public record.
In the mean time, it came to my attention that a certain leader of one of the Social Pillar organization in the Social Partnership has been claiming authorship of the proposal. The irony has it, his own organization’s website contains no serious proposals for SVT/LVT despite having many detailed position papers on other policies. Other ‘authoring experts’ have been reported sending their CVs to the Green Party leadership in a hope of gaining a slice of action.
My research on SVT/LVT has been sponsored, kindly, by a group of private and NGO sources, cited on the submissions.
Economics 13/10/2009: Nama politicised
Update: a must-read today is Morgan Kelly's article in the Irish Times (here). As I have shown in my Business & Finance column well ahead of Morgan, buying equity in the banks to repair their balancesheets makes financial and ethical and economic sense.
So the Greens are now going on a methodical politicising of Nama. This was predictable, but it is nonetheless ironic, for it is normally the domain of FF to turn every economic policy into a political / interest-groups circus.
As a part of their Programme for Government, the Greens have promised 'protection' of defaulting homeowners. Instead of calling for a reform of our archaic bunkruptcy laws the GP is now considering several possible options for doing so.
Months ago, myself and Brian Lucey have told this Government (including our direct briefing of the Green Party leaders) that Nama will trigger a wave of households defaults and that this will induce a new run on banks capital. We were called scaremongers.
The IMF seconded our views. The Fund opinion was ignored.
Now the Greens are running for cover on this issue, having pushed through Nama in the first place. This ethically disastrous stance of the GP leadership is a glaring example of how not to do policy.
So the Greens are now going on a methodical politicising of Nama. This was predictable, but it is nonetheless ironic, for it is normally the domain of FF to turn every economic policy into a political / interest-groups circus.
As a part of their Programme for Government, the Greens have promised 'protection' of defaulting homeowners. Instead of calling for a reform of our archaic bunkruptcy laws the GP is now considering several possible options for doing so.
- Force the banks to purchase homes from defaulting homeowners, writing down existent mortgage. Assuming 5% default by homeowners (conservative number in my view) on roughly €82bn worth of principal residence-tied mortgages will yield a direct hit on the banks balancesheets of €4.1bn in 2010. Given the lags, one can expect this to be followed by a roughly 3-3.5% default rate in 2011, inducing another hit of €2.9bn, for a grand total of €7bn in 2 years. But this is not all - buying these mortgages out will imply the banks will take on assets that are worth significantly less than the outlays implied. For example, assuming 75% LTV ratio and 50% decline is peak-to-trough valuations (note: the first to default mortgages are more likely tied to lower quality properties, so 50% assumption is a reasonable one, if the average peak-to-trough fall was to be around 35%) the banks will be taking on an asset value loss of 0.5/0.75=33% of the mortgages assumed, or an additional €2.31bn. So capital base impact of this scheme will be around: 10% of RWA of 7bn-2.3bn = 470mln + 10%*(1+expected default rate+expected devaluation rate) of 7bn liability or ca 840mln. New demand on capital for banks will be in the region of €1.3bn immediately. Two questions to our GP friends: (1) Where will this capital come from? and (2) Where will the funding for acquisitions come from? If Nama is to be expected to generate commercial lending, what funding is available for buying out mortgage holders?
- The Greens are also considering US-styled scheme where lenders are subsidized to reduce payments by those in default. This would be a temporary (presumably) bridge. The problem here is that if you subsidise my neighbour, I will face a choice: (a) continue paying my mortgage at increased rates (someone will have to provide the 'subsidy') or (b) default and get subsidised too. Any guesses as to what a rational agent will do? Once again, who will pay for this scheme and how can it be made compatible with Nama objective of relaunching commercial lending. How will the banks exit this scheme in the long run?
- Measures to reduce the interest on mortgages: now this is ironic, given that this coalition has already swallowed IL&P increase in mortgages charges with Brian Lenihan saying that the banks are private enterprises and must be allowed to increase their profit margins.
- Banks taking equity in home loans - equity in what? In a negative equity asset?
- Mortgage terms extended. Given that we have been saying that 30-year mortgages at 100% LTV were reckless lending, making the same mortgages (now at 140% LTV) a 40-year contract will certainly be a prudent idea.
Months ago, myself and Brian Lucey have told this Government (including our direct briefing of the Green Party leaders) that Nama will trigger a wave of households defaults and that this will induce a new run on banks capital. We were called scaremongers.
The IMF seconded our views. The Fund opinion was ignored.
Now the Greens are running for cover on this issue, having pushed through Nama in the first place. This ethically disastrous stance of the GP leadership is a glaring example of how not to do policy.
Monday, October 12, 2009
Economics 12/10/2009: Ethics learning curve
Today, I received the following mass email from Trinity College Admin:
"On Mon, Oct 12, 2009 at 5:03 PM, Secretary wrote:
Dear Colleague,
I am pleased to announce that the Equality Fund 2009-2010 is now accepting applications for innovative and creative projects promoting equality and diversity in College. ...The themes selected for this year are:
What did catch my attention is the third bullet point above. The theme dictum is "Treat others as they would like to be treated".
Trinity College is packed with smart and erudite women and men. I wonder how many of them have thought this to be an unfortunate (philosophically-speaking) attempt to establish a moral imperative rule. Unfortunate because as with all moral imperatives, the nobility of intentions might lead to an unintended consequence.
Imagine you are facing a person who might wish to inflict self-harm. Should you 'threat him as he would like to be treated'? Or you are facing a person who wishes to engage in an act you find repulsive? Or morally objectionable? Or legally wrong?
In ethics, it is widely recognized that moral imperatives do not provide sound grounds for ethical judgments or action. May be Trinity's Administration can acquaint itself with philosophy 101?
"On Mon, Oct 12, 2009 at 5:03 PM, Secretary
Dear Colleague,
I am pleased to announce that the Equality Fund 2009-2010 is now accepting applications for innovative and creative projects promoting equality and diversity in College. ...The themes selected for this year are:
- Mental health and equality
- 'Treat others as they would like to be treated' (developing dignity and respect)
- Men and women in College: achieving full participation and potential
- Challenging Stereotypes..
What did catch my attention is the third bullet point above. The theme dictum is "Treat others as they would like to be treated".
Trinity College is packed with smart and erudite women and men. I wonder how many of them have thought this to be an unfortunate (philosophically-speaking) attempt to establish a moral imperative rule. Unfortunate because as with all moral imperatives, the nobility of intentions might lead to an unintended consequence.
Imagine you are facing a person who might wish to inflict self-harm. Should you 'threat him as he would like to be treated'? Or you are facing a person who wishes to engage in an act you find repulsive? Or morally objectionable? Or legally wrong?
In ethics, it is widely recognized that moral imperatives do not provide sound grounds for ethical judgments or action. May be Trinity's Administration can acquaint itself with philosophy 101?
Economics 12/10/2009: Bertie's quote of the day...
Help us, but as we deal with the fallout of the Green Party disastrous attempt to save face on economic policy, here is a quote of the day from our former Dear Leader (may I remind you that my sources suggest that the current Governing Party's largest fraction in the Dail actually lobbying for his return):
Irish Times (without irony): "Were they not the people you suggested should go off and commit suicide at the Irish Congress of Trade Unions (Ictu) conference in 2007?"
Bertie: "That wasn’t about a boom-and-bust issue . . . It was trying to get the Ictu to hold their nerve and keep productivity high. Anyway, it was the collapse of Lehman Brothers that did the real damage. That decision will in history be written as the biggest mistake that American administration ever made, because Lehmans was a world investment bank. They had testicles [sic] everywhere."
Oh, my, what can one add...
Full interview available here.
Irish Times (without irony): "Were they not the people you suggested should go off and commit suicide at the Irish Congress of Trade Unions (Ictu) conference in 2007?"
Bertie: "That wasn’t about a boom-and-bust issue . . . It was trying to get the Ictu to hold their nerve and keep productivity high. Anyway, it was the collapse of Lehman Brothers that did the real damage. That decision will in history be written as the biggest mistake that American administration ever made, because Lehmans was a world investment bank. They had testicles [sic] everywhere."
Oh, my, what can one add...
Full interview available here.
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