Bet the house, then hope for the best

Nama is projecting into an imagined future in order to value property today. But what price will we pay if it gets this future wrong, asks Bill Hobbs

The British Academy recently assembled an expert group of eminent people to respond to the Queen’s simple but powerful question “why had nobody noticed the credit crunch was on its way?”
In response its letter, in summary said it was “principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole”.
Commenting on people who thought novel financial instruments virtually removed risks altogether the letter said “It is difficult to recall a greater example of wishful thinking combined with hubris”. A novel financial instrument that tries to replicate the future is a controversial feature of the NAMA strategy to rescue banking.

The novel concept being used to fix the banks is called “long term economic value”. Asset management companies similar to NAMA have been used worldwide to rescue banks but none appear ever to have deployed it to value bad loans. Government is claiming ECB endorsement for its use in its recent letter.
Yet others reading the ECB letter say it clearly warns against overpaying for loans. The ECB is also concerned that any process should ensure bank’s should start lending again and not engage in risk adverse behavior. Whilst not a fan of nationalisation it does accept greater public ownership may be necessary and says risk should be shared between tax payers, banks and their shareholders.

So far the Minister has provided scant insight into how it will work. NAMA intends buying billions in loans, some good but most bad, at a price yet to be determined. The price will be based not on the value of these assets today but their value some time in the future calculated using a “statutory formula”.

Some claim the intention is to financially engineer the value of the loans and their property collateral to remove the risk of insolvency from Irish banks and having to take them into public ownership. If the Minister pays too little for the loans the fix won’t work, so he has to pay a price for it to work.

The fix works as the banks do not have to write off all of their losses, they improve their capital ratios and can swap the bonds used by NAMA to pay for their loans for cash. The Minister says they will then start lending again. Will they? The evidence from other credit crisis is loan starvation lasts long after banks are rescued.

It’s said that once banks are freed of their bad loans, investors will be happy to invest equity in them again. But will they? No one knows for sure in the case of Ireland’s experience of what the IMF has called the deepest recession of all advanced countries.

Good science fiction writers tell plausible stories by projecting today into an imagined future. NAMA will use a formula designed to project loans and property into an imagined future economy to value them today. The Minister is betting his formula may get it right. Yet its very use amplifies the risk of getting it wrong. Should he overpay for loans, the economy grows too slowly and property stagnate in value for years, then NAMA will incur massive losses. Should he pay the going rate he faces taking the banks into public ownership. For now all have to wait for the 16th September when the Minister will unveil his statutory formula.