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Unravelling the mysteries of NAMA
06 September 2009
Cliff Taylor presents a guide to everything you ever wanted to know about Nama, but were afraid to ask.
What’s the problem with the banks?
In short, they lent a lot of money to people who are not able to pay it back. Of course, everyone knows that now. The bursting of the property bubble has been spectacular and the fallout is evident all around us with collapsing prices, very little activity in the market and property developers such as Liam Carroll facing obvious financial problems.
To understand the National Asset Management Agency (Nama), it is necessary to consider two ways in which this crisis has hit our banking system. One is the impact on the banks’ balance sheets and the other is how it has affected their access to the cash they need to do their normal business. In the jargon, these are known as bank capital and bank funding or liquidity.
How has it affected bank capital?
The banks’ balance sheets have been hit because it is now clear that some of the loans they have issued will never be repaid and are based on security that is worth much less than the value of the loan. All the banks have had to write off money because of this.
For example, a developer may have borrowed €10 million to buy a piece of land for €12 million. This land is now worth, say, €5 million. The builder cannot develop the land because there is no demand for new homes. He has no cashflow to repay the loans, and the bank is looking at a significant loss.
Banks are obliged to keep certain levels of capital on their balance sheets to protect them when this kind of thing happens. So, for example, for every €100 a bank loans out, it would have been obliged to keep €6 or €7 in cash to account for the fact that some of these loans would not be repaid. This cash is known as the bank’s capital. Rules on how much banks must hold are set by financial regulators. There are different kinds of capital - cash, bond holdings, etc - and the regulatory rules are complex in ranking this capital and how much of it banks should hold.
The trouble now is that the scale of the looming property losses threatens to significantly diminish bank capital, and even wipe it out completely in some cases. This is why some banks have been nursing builders along, rather than putting them out of business for not repaying loans. If they put the builders out of business and seized the security for the loans, they would be left with assets worth much less than the original loans. The banks would then have to immediately realise - or count - these losses in their balance sheet. Some loans have been written down - in other words, the banks have cut their value on the balance sheet - but much more is to come. However, if the banks had to recognise the current market value of the property underlying the loans they gave out, they would be in big trouble.
Bank funding
As if the problem of loan write-offs was not enough, the banks have also suffered because of the huge problems in the markets where banks and financiers borrow and lend to one another - the wholesale market for money.
Banks typically get hold of cash in two ways. The first is through the traditional route of taking deposits from savers. The second is by borrowing it from other banks, or taking shorter-term deposits from big international businesses in the wholesale market.
This market more or less closed down for over a year because of the credit crunch, and is now only gradually starting to open up again, albeit in a much more restricted way. The Irish banks had relied on it to raise a lot of the money they loaned out during the boom. This over-reliance on the wholesale market led to a severe liquidity crunch for the banks last autumn, particularly for Anglo Irish Bank. This culminated in the government offering a guarantee on all the deposits and most of the wholesale investment and deposit money provided to banks.
Of course, international funders were particularly cautious about lending money to Irish banks because of their property loan loss exposure, so the two problems are interlinked. The government guarantee was a short-term fix for the liquidity problem, and Nama is the government response to dealing with the property losses. The two need to be tackled because, at the moment, with the looming holes in their balance sheets, banks are under pressure to literally shrink - to decrease lending to compensate for the fact that their capital base is being eroded.
They must also prepare for a new world where markets will demand much higher capital ratios, and where wholesale funding will not be as freely available as it was before.
Why has Nama been set up?
Nama is the government’s solution to repairing the bank balance sheets by removing commercial and development property loans from them. These loans will in future be owned by Nama. It will buy them off the banks by giving them government bonds, which are effectively government IOUs to the banks.
The concept of Nama is to pay a bit more to the banks for the loans than their current market value, by trying to assess what the property underlying the loans will be worth in more ‘‘normal’’ market conditions in five to seven years’ time.
This is one of the key areas of controversy. Nama opponents say that the banks may get too much money for the loans if the property market falls further or remains in the doldrums - and that the taxpayer will be left with assets which are worth much less than it paid for them. All will depend, of course, on what the government pays for the loans.We do not know what Minister for Finance Brian Lenihan will tell the Dail in relation to the average price to be paid for the loans. In ballpark terms, it appears that the loans that will be taken from the banks by Nama were originally for about €90 billion.
The figure which will be ‘bought’ by the state will be a bit lower, probably closer to €80 billion, because the banks have already written off some of the loans in their books. The government has said that, on average, developers and other investors contributed about 25 per cent in equity to the projects involved in the loans.
This would mean that the original book value of the property underlying the loans was probably around €120 billion. Critics have questioned this and asked whether, in fact, developers were borrowing money from one bank to provide equity for a project funded by another. No doubt this happened, but we do not know the scale of it.
The speculation is that the banks may be given around €60 billion in government bonds in return for the loans. This would be a 33 per cent write-down on the original loan value, and also a write-down of around €30 billion on the current book value of the loans. It would equate to, approximately, a 50 per cent fall in what the government says was the original value of the property assets underlying the loans.
A new twist has emerged in recent weeks, with the government saying it will consider a proposal put forward by Professor Patrick Honohan - who was named last week as the new Central Bank governor - to pay the banks some of the money up front, but hold back some of it to see how the property market develops. bank shareholders would be given a shareholding in Nama to provide the banks with an incentive to manage the loans as efficiently as possible. While Nama will ‘own’ the property loans, it will not have the resources to manage them, so special teams within the banks will do so, under Nama’s direction.
Whatever the precise price that is paid, it will be less than the current value of the loans in the banks’ balance sheet. This means that the banks will have to write off substantial sums of capital. In turn, some - or all - of them will need new capital for their balance sheets to be able to continue to operate. In the current markets, the government is seen as the most likely provider of this capital, although some private investment is possible. If the government puts in extra money, it has said that it will do so as an injection of ordinary shares. In other words, the state could end up with significant financial stakes in our financial institutions.
The state already owns all of Anglo Irish Bank, and has put in preference shares which give it a stake of 25 per cent in AIB and Bank of Ireland. Given the extent of AIB’s property lending, it is quite conceivable that the state could end up with a majority shareholding in the bank. There is some speculation that it will try to avoid doing this. We will have to wait and see.
The Honohan plan for staged payments would reduce the risk to the taxpayer of paying too much for the loans. This is because the banks would get a lot less in the long term if the property market did not recover the way Nama expects it to. However, because the banks would get less cash up front, their need for immediate capital would be all the greater.
So this route would be likely to see the government take a larger shareholding in the banks in the short term. There are different ways in which any deal could be financially structured, and the government is believed to be looking at a range of possibilities, in terms of how the risk-sharing would happen and the resulting impact on the capital needs of the banks.
The final thing to understand about the Nama process is that it would provide considerable access to liquidity - ie, cash - for the banks. This is because they can take the bonds they receive in return for the loans and use them as collateral (security) to draw down loans from the European Central Bank. The ECB generally requires collateral when it advances funds to banks, and it has agreed to accept the Nama bonds in this respect. This will give the Irish banks access to tens of billions of euro in fresh cash. Whether they choose to lend it out is another matter, and is something which may need to be addressed in the Nama legislation or in its operational procedures.
What happens to the people who took out the loans?
Some will make repayments in the normal way, for Nama is taking on good loans as well as bad. However some will struggle to make repayments, and others will be completely insolvent. While the developers will remain liable to repay the original amount of the loan, many clearly will not have the resources to do so. We are told that Nama will, in many cases, seize assets and pursue borrowers through the courts in relation to personal guarantees on loans. If this happens, a significant number of developers will be declared bankrupt. Nama will also need some developers or builders to work with it on finishing projects which it will hope to subsequently sell.
The indications are that it will use the more financially stable builders with longstanding reputations to do this, even though some of these will also be struggling at the moment because of the property downturn. Politically, this is a hugely sensitive issue. It has been complicated by events in the courts, where ACC Bank is opposing an attempt by Liam Carroll to put large parts of his property empire into examinership.
The government’s promise to come down hard on developers has been contrasted with a pledge, as part of these pleadings, by state-owned Anglo Irish Bank to advance at least €76 million to Carroll to finish a project in the Dublin docklands. The new building is intended as a headquarters for . . . Anglo Irish Bank.
What is the cost of Nama, and what are the risks?
Nama should not be a day-today drain on the exchequer. This is because it will receive interest payments on some of the loans it buys from the banks - they will not all be ‘bad’ loans. This should more than outweigh the cost of making interest payments to the banks on the Nama bonds which will be given to them. The interest rate on these bonds will be low, based a little above the current 1 per cent ECB base rate.
So the risk of Nama is not short-term; it is long-term. The real risk is that the property market could fall further, and that the assets are worth a lot less than Nama pays for them. The Honohan risk-sharing mechanism would lower this risk. The government has also said that it could impose a financial levy on the banks at some unspecified time in the future if Nama did not work.
Paying less for the loans, and then taking a larger state shareholding in the banks, could be a better deal for the taxpayers. This is because the bank shares could be worth more than will be paid for them in years to come, when the banking market and the economy recovers.
The group of academic economists who have opposed the Nama plan argue that the government should fully nationalise the banks first, before cleaning out the bad loans, aiming then to sell the banks back into private ownership some time in the future. This was done in the case of two banks during the Swedish crisis of the early 1990s, and has also happened elsewhere. The point of 100 per cent nationalisation is that it removes the risk of overpaying for the loans. This is because the state is on both sides of the deal - it owns Nama and the banks.
The economists say it is only fair that the shareholders are completely wiped out before the taxpayer puts any money in. Some also argue that many of the bondholders who invested in the banks - mainly financial institutions who lent money to the banks through buying bonds - should also take a hit, though there are different views of how best to achieve this.
The government has said that it is prepared, if necessary, to take a majority stake in the banks, but that it does not want to own 100 per cent of the equity. It says that there are advantages to the banks remaining quoted on the stock markets, and that this makes it easier for them to raise funding - and would allow the state to gradually sell down loans. It also says it has to be careful in dealing with investors and bondholders to maintain Ireland’s reputation on international markets. This is the other area of controversy surrounding Nama.
There are signs that the government has shifted its ground in recent months, and that it is nowset to go ahead with a risk sharing mechanism and the possibility that this will lead to it taking a majority shareholding in at least one of the bigger banks (AIB).
However, there is still a lot of speculation swirling around this. The picture should become clearer over the next week or so, in the lead-up to Brian Lenihan’s Nama speech to the Da¤ il on September 16, and in the speech itself.
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