Head to Head

 

Will Nama aid the ailing banks? Scott Rankinand  Karl Whelanargue the point

YES:The Government could have sat back and done nothing but that would be a recipe for a zombie bank scenario. This solution is the best way to ensure the recession lasts no longer than it needs to, writes Scott Rankin

THE PHONEY war is over. The establishment of the National Asset Management Agency (Nama) will mean that Irish banks can no longer sit on their property assets and hope for the best. In my view the Government has made the right decision here as this approach now stands the best chance of getting the Irish banking system back on its feet, while limiting knock-on consequences for the State elsewhere.

The plan to inject preference shares into AIB and Bank of Ireland was clearly not working, as the stock market had priced in full-scale nationalisation. The Government could have done nothing but that would have been a recipe for a zombie bank scenario. More importantly this would have had knock-on implications for the Irish sovereign debt markets and Ireland’s ability to fund its budget deficit.

Should the Government have considered the nuclear option – full nationalisation? In the absence of being forced to do so (ie being prompted by funding problems) the primary rationale for such an action would be to inflict losses on bond holders. Remember, as of last month the equity had already been wiped out (down 99 per cent). While many investors believe this is the road down which many governments are unwittingly heading, there were big risks associated with this option too. Sovereign spreads would have widened and with investors confused about Ireland’s balance sheet risks (granted, this confusion has ebbed in recent weeks), there could have been a buyers’ strike for government paper.

So why do we like the bad bank idea? Everyone knows that Irish banks are sitting on substantial unrealised property losses. These are not the only bad debts that the banks will experience, but they probably account for 60 per cent or even more of them.

The central benefit of the Nama scheme is that it removes the key problem from bank balance sheets and puts it on the State’s balance sheet, which is far stronger. The State can also take a much longer time horizon to work out these exposures than the banks.

Some investors have asked why we have chosen not to go down the insurance route as in the UK. For one, our problem is far more homogenous than the problems at, say, RBS. Also, experience suggests that property lends itself well to a bad bank/Nama approach.

More importantly, any solution which left these assets with the banks would just prompt them to continue sitting on them. That would not get them focused on lending money to viable businesses and consumers. That is not to say that we can expect credit to start growing again later in the year. In fact, we think the opposite will happen. The key point is that this solution is the best way to ensure the recession does not last any longer than it needs to.

The final reason why we favour the asset management approach over the insurance option is that the funds to deal with the banking capitalisation problem are readily available now in the form of the National Pension Reserve Fund. So why put the problem on the long finger and create another contingent liability for the State? There is no indication at this point that more than €4 billion of this fund will be used to support the banks, but we take comfort from the fact that it is there to use if necessary.

The Nama approach has its own risks, of course, and these are hard to frame right now as there are so many details that remain unknown, such as: What will the asset haircuts be? What further capital is required from government, if any? What will the “good” banks look like after this scheme is operational? One important point to understand is that if nationalisation is not an option, then the liability to the State from these assets does not necessarily diminish if a bigger haircut is agreed on transfer, that is, if it’s 35 per cent rather than 15 per cent. If Nama achieves a bigger haircut on day one (and hence saving for the taxpayer) this probably means more government capital required to recapitalise the banks.

Scott Rankin is financials analyst with Davy

NO: The Government has not addressed the crucial issue: what price will it pay for these assets? Without further clarification, I cannot understand how anyone could support this plan, writes Karl Whelan

INTERNATIONAL FINANCIAL rules require banks to maintain equity capital (the value of their assets minus liabilities) above a certain level, so that they can meet their obligations to depositors and bond-holders. Ireland’s banks have made many loans to property developers which are unlikely to be paid back in full. The losses on these loans are set to bring the capital levels of the Irish banks below these legally required levels. This under-capitalisation is the central problem underlying our banking crisis.

The Government’s plan to deal with this problem is to provide €7 billion in funds to our main two banks in return for a limited equity stake and also set up a National Asset Management Agency (Nama) to buy underperforming property assets from the banks. However, the Government has not addressed the crucial issue: What price will it pay for these assets? Without further clarification on this issue, I cannot understand how anyone could support this plan.

Consider the two major banks, AIB and Bank of Ireland. At the turn of the year, they had combined equity capital of about €20 billion. With financial markets requiring banks to have capital levels exceeding their pre-2007 levels, it is highly unlikely these banks could survive unassisted by government without maintaining their combined equity capital at something like this €20 billion level.

The Government’s €7 billion investment will clearly help to boost the equity capital of these banks. What about the asset purchase scheme? The Government said it will buy these assets at a discount from their book value, but the key question is how big this discount is.

If, for instance, the Government does not take a further equity investment in the banks beyond €7 billion, then maintaining equity capital of €20 billion would require the Government to buy the loans at a discount of €7 billion. With something like €50 billion in book-value loans from these banks going into Nama, this would imply a discount relative to book value of about 15 per cent, a discount that has been suggested by analysts at Davy Stockbrokers as appropriate.

What would this mean for the taxpayer? Goodbody Stockbrokers has estimated upcoming loan losses at these banks to be €19 billion. If the Government bought these loans at a discount of only €7 billion, this would imply the taxpayer taking on losses of €12 billion.

To put this in context, this week’s emergency Budget measures saved the Government a mere €3.25 billion this year. Even a plan in which the Government applied a more substantial discount and took half of the equity capital in these banks (consistent with the Minister’s comments that the State may have to take majority ownership) would still imply the State taking on losses of €9 billion.

One might hope that the Government would not expose the taxpayer to such an enormous potential loss but, unfortunately, its track record in protecting the taxpayer in its dealings with the banks is not encouraging. There is little in the Government’s outline of its plan that rules out overpayment of this extent. In fact, documentation for the plan refers to complying with EU guidelines which explicitly allow for paying above market value.

Perhaps some solace could be taken from the fact that the proposals suggest that a levy could be introduced to help to pay for losses in a case like this “if Nama make a loss over the long term”.

In other words, in 10 years’ time, the Government may end up setting a levy on banks that they can then pay back over time.

This levy may sound like a good deal but ask yourself this: would you borrow €100 at a 6 per cent interest rate to give to someone who then promised to pay you back €5 a year for 20 years starting in 10 years’ time? I doubt it. For the same reasons, this potential future levy would not be a good deal, particularly when you factor in the Government’s current high cost of borrowing.

The major banks are wholly reliant on the Irish Government’s liability guarantees and its willingness to provide capitalisation investments to remain alive as functioning institutions. In light of this, there is no need for taxpayers to have the terms of the solution to the banking crisis dictated to them in a way that leads to huge losses for them.

Karl Whelan is professor of economics at University College Dublin

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