Where have all the performing loans gone?

The last two weeks have seen suggestions that perhaps as much as €8bn of largely performing loans that were NAMA-bound will no longer come within the agency’s control, which would be very bad news for NAMA’s finances.

First we found out that NAMA had agreed not to transfer Paddy McKillen’s loans pending the outcome of Paddy’s judicial review proceedings which are scheduled for October 2010, though with appeals, could take considerably longer. This week we learned Paddy’s Metrospa Limited has sold a property on Old Bond Street in London for GBP £18.2bn and also that another of Paddy’s companies Maybourne has been “inundated” with expressions of interest to provide finance that might redeem the €600m-odd Anglo and Bank of Ireland loans apparently outstanding to the group. Come October, Paddy mightn’t have any NAMA eligible loans. Paddy has assured us all his loans are performing. Paddy has an estimated €800m outstanding to Anglo alone and exposures with at least one other NAMA bank.

Next up, we found out from AIB’s half year report that AIB has slated its UK operation for sale together with some €3.2bn of NAMA-bound loans. According to the 2009 accounts the UK NAMA-bound loans had an impairment provision of 6% (compared to 20% for the Irish NAMA-bound loans) and of course the UK has continued to have a modest recovery in commercial and residential prices in the first half of 2010. And yet the UK loans will be sold as soon as next month. So NAMA loses €3.2bn of what are assumed to be largely performing loans there.

And yesterday in an interview with RTE, Anglo CEO Mike Aynsley dropped the bombshell that €2-4bn of NAMA-bound loans are not now expected to transfer to the agency “by agreement with NAMA”. According to RTE “After talks with NAMA, Mr Aynsley said there were some Anglo loans which may not now be transferred to the agency. He said this could reduce the final figure for Anglo loans going to NAMA by €2-4bn.” I examined the three audio clips and one video clip on RTE’s website and could not find any reference to this agreement in respect of €2-4bn of loans. Now Anglo may not transfer loans for lots of reasons – NAMA is not obliged to accept any loan and perhaps some Anglo loans are so bad that NAMA won’t touch them, Anglo may have objected to certain loans transferring as it has apparently done in the case of Paddy McKillen’s loans which are subject to a review. However the fear must be that these €2-4bn of loans are performing and are possibly needed for Anglo’s NewBank. UPDATE 15th August, 2010. The Irish Times reported on 11th August, 2010 that “Anglo is due to transfer about €36 billion to Nama although the final figure could be lower as some loans in the UK and the US are likely to be reclassified”

And of course, we already know that Bank of Ireland had originally identified €16bn of loans for transfer to NAMA but in the revised NAMA business plan in June 2010 this had dropped to €12bn. A theme referred to several times on here is the apparent gap in the NAMA legislation which means that NAMA-banks may be selling relatively unimpaired NAMA-bound loans for what they can get for them as long as it’s more than NAMA would pay.

And why should we be concerned at NAMA not acquiring performing loans anyway? After all NAMA are valuing loans individually and will pay a lower price for non-performing loans. There are a number of issues:

1. NAMA charges the financial institutions 5% of loan values for “enforcement” costs that NAMA expects to incur. According to the EU Decision in February 2010 which approved the NAMA scheme “The costs associated with a full legal enforcement process are approximately 15.00%51. It is however very difficult to predict ex-ante the proportion of assets for which NAMA will have to go through a full legal enforcement process. The Irish authorities propose to apply  enforcement costs of 5% to all the assets. This corresponds to over 50% of the non-cash flow producing loans incurring a 15% enforcement costs. The Commission considers, on the basis of the information available, that this is a reasonable and prudent assumption.”

Now it is unclear what the “Irish authorities” told the EU but the draft business plan predicted that only 20% of loans would default so 20% of 15% is 3% and if NAMA was charging the banks 5% that might have been prudent back then (I don’t know if this is how the EU concluded the 5% was prudent but it would make sense). However if the performing loans are not going to NAMA and NAMA suffers a higher than 20% default rate then that 5% may be inadequate to cover NAMA’s enforcement costs. Is this the reason NAMA didn’t disclose the updated default assumption in its new business plan in June 2010? If NAMA is losing €8bn of performing loans then that means NAMA is not charging 5% of €8bn as an enforcement charge so NAMA is losing €400m that should be pure profit if the loans are performing and enforcement is not needed.

2. NAMA gets to lop a premium off of every loan dependent on loan quality but it is a minimum of 5% (the operation of this premium is unclear from the LEV Regulation and NAMA have never released detailed calculations even with headings but I think it is a reasonable interpretation of the regulation and the tranche 1 data that the premium is deducted from LEV values). So NAMA could be losing 5% of, say, 50% of €8bn (UPDATE: it has been pointed out that the haircut on performing loans is likely to be well-south of 50%, perhaps as low as 5-10% according to the data on loans in the first NAMA Quarterly Report)  of performing loans. That’s another (at least) €200m of lost profit for NAMA – “profit” because performing loans have a high probability of being repaid in full and because this €200m is 2010-money that should translate to a €200m NPV loss.

3. NAMA has operating expenses and also has to pay interest on its bonds and subordinated debt. How is NAMA going to fund these costs? NAMA’s main property market, Ireland, is still declining (and is now down some 20% from the Long Term Economic Values that NAMA used to value the loans). So if NAMA sells now it makes a loss on the loans. If it holds the loans then where does it get the money to fund its expenses and interest payable? FG Deputy Leo Varadkar has recently suggested NAMA might need a bailout if performing loans don’t go to NAMA.

4. In terms of the profitability of NAMA, probably the greatest risk of not acquiring performing loans is that the loans that are acquired will in fact default. So NAMA take over the assets. In that case NAMA will be totally dependent on a recovery in property markets to make a profit or even break even. NAMA has been paying an average of 11% over the Current Market Value of loans which of course are valued by reference to a Valuation Date of 30^th November, 2009. So we’re paying 111 for loans that were worth 100 in November 2009, the assets backing these loans have now declined in Ireland by about 10% so they’re worth 90. So even from today property prices would need recover by 25% from 90 to 111 so that we’d break even. Most commentators have a negative outlook on the residential market. Although there have been some positive noises from the commercial sector, the latest prices indicate that prices are still falling and the pace of falls is accelerating. So in the very worst case where there are no performing loans, then NAMA will pay out nearly €1bn a year in interest on NAMA bonds and subordinated debt and not have any interest coming in. NAMA will have substantial enforcement costs which will not be adequately covered by the 5% charged to banks, NAMA will have other annual operating costs. What recovery will there be in the property markets in the next 7-10 years? Impossible to say but we could conceivably have a long “Bottom” before prices recover. If prices stayed at today’s level we could be looking at losses of €8bn on €40bn of loans plus 7 years worth of interest and operating expenses. We could well be looking at €15bn of losses. Of course there could be a strong recovery in the property market but we are being placed at risk.