Banking on Nama to end recession may prove misguided

ECONOMICS:Assets agency may pay too much for loans, further depressing the property market, writes ANTHONY LEDDIN

WILL THE proposed Nama toxic bank prolong the recession? Assuming an average discount of 20 per cent on loans secured on property and other assets, the transfer to the banks in the form of Nama bonds could be in the region of €72 billion.

The intention is that the banks exchange these Nama bonds at the European Central Bank (ECB) for cash.

In a monetary union, this is a mechanism for “quantitative easing” (eg, printing money) at the national level.

The purchase of loans by Nama “cleanses” the banks’ balance sheets as cash replaces bad loans.

The main justification for the exercise is that the banks will then provide credit to viable businesses and households and facilitate economic recovery.

There is, however, no guarantee that the banks will lend to the domestic market.

The banks could, for example, find more favourable investment opportunities overseas or cautiously just sit on the injected liquidity waiting for more favourable investment opportunities to appear.

Second, bank credit is “demand-led”, in the sense that banks have to wait for customers to request loans.

However, the take-up is likely to be small as investors are reluctant to borrow in the current economic recession and, given the fall in prices, real interest rates are relatively high.

Third, cash-rich Irish banks may be subject to a takeover and the new owners would be free to dispose of the assets how they wish.

On the national balance sheet, Nama bonds of €72 billion combined with annual budget deficits would push the national debt to over €180 billion in 2010, up from €80 billion in 2008.

This rise in the national debt implies a higher burden of debt service on the taxpayer and also increased international concerns about the country’s economic prospects.

It can also have implications for domestic private sector demand. In Ireland in the 1980s, the rise in the fiscal deficit was associated with a rise in private sector savings as households anticipated higher future taxes to repay the increased national debt.

A heavy burden of public debt also undermines domestic business confidence and the propensity to invest. Thus an increase in the national debt can have deflationary effects that would prolong the recession.

The Nama bonds are, of course, backed by the loans secured by property developments at various stages of completion. If these properties could be sold, without Nama incurring a loss, then the national debt would be reduced back to its original level over time.

Critics of the Nama proposal are fearful that the average price paid for the bank loans will be greatly in excess of the market clearing price. If the Nama price remains above the present market price, a loss is shifted from property developers and bankers to Nama and ultimately to the taxpayer.

The Nama legislation specifies that the Nama loans will be valued at their “long-term economic value” without, as yet, explaining how this elusive concept will be operated.

Nama is currently seeking 300 pieces of information in relation to 10,000 loans to conduct individual loan evaluations between October 2009 and June 2010.

The assumption seems to be that this data can be analysed by professional valuers – who are already eyeing this lucrative business as a substitute for their largely defunct normal business – to arrive at the underlying, non-bubble, value of the properties. This assumption reflects a naive faith in the objectivity and rigour of property professionals who were up their oxters in rationalising the inflated values paid for property and development land during the bubble.

In this context, it is sobering to reflect that one of the richest sources of information on the very long behaviour of real estate prices relates to prime residential property on one of the canals in Amsterdam (the Herengracht).

An index compiled by Piet Eichholtz at the University of Maastricht led him to conclude that there was virtually no long-run trend in real, inflation-adjusted high-quality house prices in Amsterdam between 1500 and the start of the 20th century.

However, he noted that the deviation of house prices from their long-term values often persisted for decades.

Nama should bear this sort of research in mind when undertaking its assessment of “long-term economic values”.

An examination of the real first-time house prices in the period prior to the start of the boom in 1996 reveals a very small upward trend. Using this trend line, the projected inflation-adjusted price of a new house in 2015 is estimated to be 50 per cent below the current real market price.

It is notable that in the US, the Case-Shiller house price index has now reverted to its real 2002 level, having risen 50 per cent above trend in some cities.

Bearing in mind that commercial/office property and development land would have to be at a bigger discount to residential property, the wedge between the Nama price and the market price could be very substantial. A wedge of 20 per cent, for example, between the Nama and the market price leaves Nama and the taxpayer looking at losses in the region of €18 billion.

Furthermore, Nama is interfering with the psychology of the market and could drive the prices below the long-run trend.

Who will buy property knowing that when the price recovers Nama will dump yet another tract of its toxic portfolio onto the market, thereby depressing prices?

But whatever the precise differential between the Nama and market price, it seems blatantly clear that Nama is anti-competitive.

Most economists are of the view that the quickest way of ending recession in a currency union that rules out devaluations is to have downward flexibility of prices. Instead, Nama would serve to increase price rigidity in real estate markets and this can only prolong the recession.

The Nama objective is to sell the properties over a period of seven to 10 years in an orderly manner. The alternative fire sale option is, of course, a nightmare scenario for the banks and developers and mortgage holders with negative equity in their property.

But it is attractive to entrants to the housing and office markets and would improve the country’s competitiveness.

The Nama proposal, as presently understood, shines no ray of light on this front.

Sometimes, the unpalatable but best option is to have a sale.

Dr Anthony Leddin is head of the department of economics at the University of Limerick.