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Archive for July 8th, 2010

Even with the dreadfully poor standard of information disclosed in the NAMA Business Plan, there was always the risk that it just wouldn’t add up. And it doesn’t. There is an error in the application of NAMA’s methodology used which overestimates the haircut to be applied to the remaining tranches and, which when corrected, means that NAMA will spend €41.7bn on €81bn of loans, and not €40.5bn as stated in the Business Plan. The effect of this increase in the cost of loans to NAMA is not entirely clear but the increased cost may not secure increased revenue so the effect on NAMA’s central plan NPV of €1.0bn could be that it is wiped out completely.

First the numbers that NAMA has produced. On page 20 of the Business Plan, the most uptodate breakdown of the nominal values of loans to be transferred to NAMA is provided which shows (Column A)

On page 25, NAMA shows the three scenarios for Net Present Value with Scenario A now being the central (or base) scenario and shows a Net Present Value of PLUS €1.0bn and a consideration for the NAMA loans of €40.5bn.  Why €40.5bn? Well that’s 50% of the book value of the loans in the banks’ books (€81bn * 50% = €40.5bn). Simple, yes? Actually no and this is where the error has occurred.

NAMA says on page 26 that the approach (I would term it a methodology) used to build the business plan was to take the experience of the loans in tranche 1 (helpfully set out on page 22) and apply that experience to future tranches “Based on the Tranche 1 weighted average discount of 50%, it is assumed that NAMA will issue €40.5bn as consideration in securities to the participating institutions for the €81 bn of eligible assets acquired from them – €38.5bn (95%) in senior debt and €2bn (5%) in subordinated debt. The overall NAMA

discount on the €81bn portfolio will depend on the results of a loan-by-loan valuation.” . Whilst the average haircut for tranche 1 was 50% (49.67% to 2 decimal places, to be accurate), the haircuts ranged from 34.72% (BoI) to 58.21% (INBS).

Where NAMA have made a mistake is that the future tranches don’t have the same distribution between the banks as tranche 1. As you can see, if you apply the haircuts in tranche 1 by bank to the remaining balances to be transferred in future tranches, the overall consideration to be paid by NAMA is not €40.5bn but €41.7bn. To arrive at NAMA’s plan consideration you would need apply a 50% haircut to all loans. But to do that would be to say that the quality of the loans at Anglo and INBS (which attracted haircuts of 55-60% in Tranche 1) was the same as the loans from AIB and BoI (which attracted 34-43% haircuts). If NAMA are being true to their methodology of using the experience from tranche 1 then you would apply the haircuts by bank in tranche 1 to the remaining tranches. Not only is this consistent with the methodology used by NAMA but it chimes with the expectation that Anglo and INBS will suffer bigger haircuts. To stick a cherry on the argument, our Financial Regulator, Matthew Elderfield has told banks to determine their capital requirements by assuming the discounts in tranche 1 apply to the remainder of their portfolios. So not only have NAMA apparently not bothered to sample the loans and assets of the remaining 1400 borrowers to see if they have different profiles to the euro-billion borrowers in the first tranche but they haven’t even accurately applied the experience of the first tranche to the remaining tranches.

So NAMA’s consideration for the loans, using its own methodology, should rise from €40.5bn to €41.7bn. Does this increase of €1.2bn wipe out the €1.0bn Net Present Value? Actually it is not clear because there is still a lack of clarity over how NAMA is calculating the LEV and CMV of property and how that relates to the consideration paid (and indeed how NAMA calculate the Net Present Value). In fact NAMA have changed the figures in an historical document  on its own website

http://www.nama.ie/Publications/2010/NAMATranche1.pdf

The above document was an overview of the Long Term Economic Values (LEV), Current Market Values and Consideration paid by financial institution for Tranche 1. NAMA have substantially altered the figures, for example in March they were showing the LEV of property at €10.44bn and the CMV at €9.44bn (an 11% difference). They have now changed that document and show LEV at €8.27bn and CMV at €7.45bn (still an 11% difference). I am not aware of NAMA issuing any correction. One day the document on their website gives one set of numbers, the next day it has substantially changed. So could the underestimate of NAMA consideration in its new Business Plan wipe out the €1bn Net Present Value? Potentially yes.

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NAMA Net Present Value: A tutorial

Condescendingly this is aimed at everyone who is describing NAMA’s profitability by reference to Net Present Value (NPV) and that includes some financial journalists who should know better. This entry will explain NPV and will compare what NAMA were saying in their draft Business Plan (page 10) in October 2009 and the Business Plan published on Tuesday. It will expose some dangers in just being presented with a single NPV value without the underlying calculations and in particular full financial statements (P&L, Balance Sheet and Cashflow by year).

Profit

The common meaning of profit is the difference between what you buy something at plus your costs compared with what you sell it for. Accountants have very specific standards for calculating profit and auditors ensure those standards are complied with when they’re giving a company’s accounts the all-clear. Profit over the life of a business (ie when a business is wound up and all provisions, reserves, accruals and prepayments are realised) will be the same value as cashflow.

Cashflow

Now this is a fairly straightforward concept. It is the difference between the cash you spend in a business and the cash you receive. It mightn’t be the same as profit because some of your suppliers will provide you with services on credit and some of your customers will not pay you when you provide them with goods. Accountants have rules on provisions and reserves which might also mean profit is different to cashflow for a particular period.

Net Present Value

Net Present Value is cashflow expressed in today’s money. So say your plan is to generate €1,000 in cashflow this year and the same next year, you know that inflation will mean that the €1,000 next year won’t be worth as much in today’s money. In addition to inflation the rate by which you discount future cash flows (called the discount rate) might incorporate your own personal requirements for a return. For example you might think that inflation in the next 5 years will be 2% per annum but you don’t want to get involved with an enterprise just to get a return equal to inflation, you want something that will give you more. In the draft NAMA Business Plan, the discount rate was 5%, on Tuesday it was 5.5%.

So what were NAMA saying about NPV and what are they saying now?

Here are the NAMA cashflows by year and NPV calculation in the draft Business Plan.

The Business Plan on Tuesday doesn’t show the cashflows by year but does tell us that the discount rate used was 5.5% so here are two possible profiles for a €1bn NPV which are designed to illustrate the difference between profit and NPV.

In the first example, the cashflow is positive at the start of NAMA’s life and becomes negative later on. The overall cashflow and profit is MINUS 3.58bn but because the cashflow is positive in the early years the overall NPV is PLUS 1.0bn.

In the second example, the cashflow in the early years is negative but becomes strongly positive later on.The overall cashflow and profit is PLUS 3.76bn but the NPV is still only PLUS 1.0bn because the positive cashflows only occur in the later years.

So based on the above examples NAMA could have a profit and cashflow of PLUS 3.76bn or MINUS 3.58bn and still have an NPV of PLUS 1.0bn.

Now you would expect the early years of a plan to be more predictable than those further out. But because NAMA has not provided a cashflow by year, it is not possible to see (in the most risky case) whether the positive cashflows are in the early or late years. That is a worry because if positive cashflows are weighted towards the later years then they will be more risky.

And just one last note to those who are saying NAMA has produced three NPV scenarios, that is correct. The so-called best case is PLUS 3.9bn, the base case or central case is PLUS 1.0bn and the worst case is MINUS 0.8bn – remember that the worst case is supposedly gross NPV of MINUS 1.9bn which is reduced to MINUS 0.8bn by the non-honouring of the 5% subordinated debt (5% of €40.5bn = €2bn in 2010 or €1.1bn when expressed as a NPV). This is what NAMA say in the Business Plan (page 4 “the asymmetry is due to the fact that NAMA will not redeem subordinated debt unless it has made a cumulative gain over its lifetime”). However if you look again at the calculation of NPV in the draft Business Plan, you will see that the issuing of debt (NAMA bonds and subordinated debt) of €54bn and the repayment of same is not regarded as a cash flow. This looks curious but without detailed P&Ls, Cashflow and Balance Sheets by year, you can only guess at what is going on.

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With evidence of NAMA fatigue setting in less than 48 hours after NAMA published what it calls the Business Plan, you could be forgiven for thinking the above title to this entry is the result of delirium. Actually this entry will examine the NAMA Business Plan and explain why it is not in fact a business plan, using the widespread meaning of the term, and will go on to speculate why the document has been produced in its present form.

Many people will not encounter business plans in their day-to-day lives though they will be familiar with the expression. Entrepreneurs on the Dragon’s Den produce business plans to attract investment. Banks require business plans before they’ll lend money to commercial customers, take a look at NAMA’s banking adviser HSBC’s recommendations for the production of a business plan. Indeed NAMA require business plans from the developers to explain how they will repay their loans to NAMA – the plans are so detailed they have their own guidance notes and a “datapack” which sets out the financial statements required. Indeed if you want to have a wry laugh, take a look at the guidance given by Pricewaterhouse Coopers (NAMA tax advisor and global financial consultancy) for preparing a business plan. Now no-one is suggesting that a business plan is a standard document which must contain certain information, there is no accounting standard for business plans in the same way that there are standards for financial statements you’ll find in company’s accounts like a Profit and Loss account or Balance Sheet. So you can’t categorically say the document produced by NAMA on Tuesday evening was NOT a business plan. What follows below is subjective but is based on preparing not a small number of business plans in my time and is consistent with the requirements lifted from the HSBC principles and NAMA guidelines above.

What is missing from the NAMA Business Plan?

  1. Financial statements, in particular a Profit and Loss, Balance Sheet and Cash Flow by year.
  2. Key operational statistics, eg default rate on loans acquired, interest rate projections, property value projections
  3. Definitions of terms used, eg “performing loan”
  4. Details of remuneration to management, we know NAMA CEO Brendan McDonagh earns more than €500,000 per annum and that NAMA Chairman, Frank Daly earns €170,000 but what other aspects of remuneration, pension, bonus. And what about the rest of the senior team and in particular the board members? To use the language of the NAMA guidance notes for developers’ business plans, who are the Ultimate Beneficial Owners of the €51m third party investment in the NAMA SPV? Could they be tapped for more investment?
  5. Funding requirements, NAMA – out of the blue – received a €250m “advance” from the government in March 2010 to be repaid and to be used as a “working capital buffer”. Will NAMA need more hand-outs? Will NAMA take third party investment to complete developments? How will the €5bn development pot be drawn down – will it all be used, does NAMA see the MfF raising the cap from €5bn in accordance with the NAMA Act?
  6. Key financial risks, what about those €14bn of derivatives acquired for nil value. Is there a risk that these swaps may have a net cost to unwind? What is the minimum “performing loan” requirement so that NAMA can cover is outgoings? It is still far from clear the effect of future property values on NAMA’s profitability.
  7. Any evidence of forward sampling. NAMA seems to have based its entire business plan on its experience from tranche 1. To recap, NAMA originally expected to take over the loans for 1,500 borrowers. The Top 10 were to be included in tranche 1. Tranches 2 and 3 are presently being examined and are reported to be imminently transferred to NAMA but the reports thus far suggest that these two tranches will have less than 50 borrowers. What about the other 1,440 borrowers. Is the profile of their loans and security different to the profile of the bigger borrowers in terms of asset quality/loan documentation/ LTVs/ performance of loans/risk of default? At the very least you would expect a business plan to look over a sample of these loans before deciding to put all your faith in the experience of the first tranches.
  8. Details on the operation of NAMA. Demolitions, selling loans and property, disposals versus hoarding, firesales. How are loans valued (still a mystery despite the NAMA Act, LEV regulation, EU Decision and press releases)?
  9. Projections for the property markets in which NAMA will be active (growth, investment environment, costs, regulatory issues) and indeed interest rate projections (although NAMA tells us that typically borrowers pay ECB + 2%, if ECB rises then that might mean borrowers can’t service their loans so “performing loans” may decrease).
  10. Where the buck stops. One of the few things we can take from the NAMA Business Plan is that its plan for Net Present Value has fallen from €4.8bn last October 2009 to €1.0bn today. Who was responsible for the business plan last October? NAMA’s then interim managing director and present CEO, Brendan McDonagh? Was external financial assistance bought in? The banks seem to be getting all the criticism for the NAMA NPV dropping €3.8bn in 9 months but shouldn’t NAMA have been testing the data? Who takes responsibility for this present business plan?

So, what was produced on Tuesday was not a business plan if we adopt NAMA’s, HSBC’s or PwC’s standards for a business plan. Why did NAMA therefore produce the document in its present form?

In summary the NAMA Business Plan sets out some operational detail which might dampen down public unease. There is a commitment to pursue developers for their entire debt and the base scenario is that NAMA makes a “profit”. Perhaps that is the minimum that NAMA judged could be published without there being a sufficiently significant public backlash that its operations would be affected.

There is a blog entry on here from some weeks back in which there is a subjective and highly personal analysis of the many NAMA stakeholders, their appetite for information and their importance to the success of NAMA. And in this personal analysis, like it or not, the general public is not very important to the overall success of NAMA. If my analysis is accurate then NAMA’s officers will not be meeting today at Treasury Buildings to discuss the storm of comments on the blogosphere or the media, or indeed what academia or politicians think of its Business Plan. No, I’m pretty sure the only thing troubling NAMA deeply today is Paddy McKillen’s application to the High Court to judicially review NAMA’s involvement with his loans. If that application is successful NAMA potentially won’t have a business. At least this is my analysis based on what I believe to be the importance of the developer stakeholders to NAMA’s success.

So if you’re Joe Public this morning and are upset at the apparent disregard NAMA is showing you, then perhaps if you take an adult perspective on the NAMA Business Plan and understand the rules of the game and the importance of the various stakeholders, it might ease the umbrage. Or not.

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“That will go back on the banks’ liability as far as we are concerned”. So said the Taoiseach in the Oireachtas on Tuesday trying to bat away suggestions by Enda Kenny and Eamon Gilmore that NAMA would make a loss. Any NAMA loss, the Taoiseach was effectively saying, would be taken care of by the surcharge (or levy), the operation of which is set out in section 225 of the NAMA Act. The key section that this post examines is subsection 4.

“(4) The aggregate tax by way of a surcharge to be imposed on participating institutions on their respective profits (within the meaning of section 4 of the Taxes Consolidation Act, 1997) if any—

(a) shall not exceed the amount of the underlying loss, if any, incurred by NAMA (including NAMA group entities),

(b) shall be apportioned to each participating institution on the basis of the book value of the bank assets acquired from each participating institution concerned as a proportion of the total book value of the bank assets acquired from all of the participating institutions, and the surcharge so apportioned shall be imposed on each institution accordingly and paid by each of them over such period and at such times as provided for by the subsequent Act giving effect to this section and to which subsection (3) relates.”

The “book value of the bank assets acquired” is not a defined term but to me could mean the book value of the loans in the financial institutions’ books or the value (after the NAMA haircut) at which the loans are “booked” into NAMA. Here are these two positions using the NAMA Business Plan (Page 20) published on Tuesday for the split of the €81bn to be acquired and using the tranche 1 data for the haircut.

So if you define “book value” as the value of the loans at the financial institutions (FIs), then Anglo, INBS and EBS make up nearly 57% of the loans. If you define “book value” as the value of the loans upon acquisition by NAMA then Anglo, INBS and EBS make up nearly 50% of the loans.

So let’s say NAMA comes in at the worst case scenario in its Business Plan, a MINUS €0.8bn Net Present Value (and given the discount rate is 5.5% that could represent a maximum Net Loss of €1.44bn (if the cash flow for years 1-9 was zero and year 10 was minus €0.8bn)), then depending on your definition of “book value”, the surcharge for Anglo, INBS and EBS will be 50-57% of this figure (€0.4bn – €0.456bn). So these three financial institutions which will not survive without massive State financial intervention and whose injections will not be paid back (“black hole” is the common description) will be hit with a further levy of €0.4bn in 10 years if NAMA comes in at the lower scenario. This of course is a nonsensical situation and the next time a levy is mentioned by the government, this position should be put to them.

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