Shareholders should take part of Nama pricing risk
ANALYSIS:It is not too late to build risk-sharing between banks and providers of risk capital to banks into the Nama legislation, writes PATRICK HONOHAN.
EVERYONE IS agreed on one aspect of Nama – the need to get the valuations right so that it does not overpay for the assets it acquires from the participating banks.
If other kinds of difficulty should arise when it is up and running, mid-course adjustments will in most cases be possible. But in practice Nama will only have one shot at getting the asset pricing right. To be sure, there is a procedure for appeals and a final adjudication by the Minister, but, once that is done, the price will be fixed.
Fortunately, the risk to the taxpayer can be considerably reduced with a bit of ingenuity. It is worth tweaking the language of the Nama legislation to make sure that it can achieve this risk-reduction.
The proposed legislation makes it clear that the price paid for any acquired asset is not to be above what it calls the “long-term economic value” – essentially the price that the asset can “reasonably” be expected to attain in stable market conditions.
The legislative draft makes a fair stab at indicating what sorts of consideration should be taken into account in arriving at a number here. But no-one could disagree that there is a wide range of uncertainty about how much the banks’ problem assets will eventually realise.
If confirmation were needed, it has been provided by the discussion in recent days of what troubled property developer Liam Carroll’s portfolio might be worth. After all, this kind of uncertainty is the main reason that Nama is being set up: to enable the banks to exchange these problem assets for safe and marketable assets.
There is, if you will, a difference between the value that can “reasonably” be expected and a lower basic price that can “confidently” be expected.
Now that we are all pessimists, the gap is quite wide. If it pays a fixed price, Nama will absorb all of this risk. (Admittedly, it is not inconceivable that, if economic recovery proves to be more vigorous than is now foreseen, the assets might eventually reach a higher price.)
But removing the risk from the banks does not mean that it must all fall on the taxpayer. In particular, the banks and their shareholders are not one and the same. There is no good reason why the shareholders need to be wholly insulated from these risks. Besides, some shareholders may feel that the acquisition price is too low, and that the assets will do better than Nama expects.
Although this risk should be removed from the banks, there is therefore much to be said for having the providers of risk capital to the banks share the pricing risk with Nama.
Improved risk-sharing could be achieved in a number of ways. One simple approach is to have Nama make only part of the payment for the acquired assets in the form of bonds, with the remainder being made in the form of a claim on Nama’s future recoveries.
Thus, there would be a two-part payment. One part, representing the basic price that can confidently be expected to be attainable, should be paid in bonds. For the rest, the shareholders of the banks (and possibly other providers of risk capital to the banks) should be paid in the form of an equity stake in Nama’s future recoveries.
The current draft of the proposed legislation does not make any explicit provision for such an arrangement. It envisages Nama paying in the form of government-guaranteed bonds. It would be highly desirable to build in explicit reference to risk-sharing of the type here described.
I can well imagine that the hard-pressed drafters of the legislation may be reluctant to embark on incorporating this additional complexity. But we are not speaking here of an insignificant detail. The sums of money involved are so large that it is well worth getting the contract design right.
Although not a legal expert, I believe I can see some relatively straightforward ways of adapting the current legislative proposal to allow the risk-sharing I have in mind. For example, provision could be made for each participating bank to spin-off the assets to be acquired by Nama into a subsidiary before the acquisition is made.
With all the talk of Nama and how it will behave in the future, it is easy to forget that it is to the banks that the economy will mainly be looking to finance the recovery.
The initial asset acquisition by Nama will have the effect of crystallising the banks’ losses. Depending on the acquisition price, this is very likely to give rise to a need for further injections of capital. This is in order to ensure that they all comply with the regulatory requirements that, as a matter of prudence, every bank should have an adequate cushion of risk capital.
Since the banks will be relatively free of problem assets when Nama has finished its acquisitions, it may be possible to attract new equity investors to make these injections. Vigorous efforts should be made to find such investors. If they are not immediately forthcoming, the Government will, on an interim basis, be the backstop investor.
Obviously, the lower the basic price paid by Nama to a bank, the higher the additional injection of capital will have to be. But the overall initial outlay by the State and Nama will be no greater, and the risk of losses hitting the taxpayer will be greatly reduced.
It will take more than Nama to get the banking system back on its feet and to re-establish its collective nerve to provide the lending and other financial services needed to support the economic recovery. But, properly set-up and functioning well, Nama could be a key ingredient.
There is also much more to Nama than getting valuation and acquisition right. But protecting the taxpayer is a vitally important element and I recommend the two-part payment scheme for lowering the State’s risk as a potentially valuable addition to the proposed legislation.
Patrick Honohan is professor of International Financial Economics and Development at Trinity College Dublin