Is the EU set to reject the NAMA Tranche 2 valuations?

Now that the tranche 2 transfer of loans from the five NAMA financial institutions to NAMA is complete, NAMA must seek EU approval for the valuations. If the experience of tranche 1 is anything to go by (completion of transfers to NAMA on 10^th May, 2010, EU approval granted on 3^rd August, 2010) then EU approval may take several months. The entry examines potential problems with tranche 2  that may lead to the EU rejecting valuations.

The first loan valuations were undertaken in December 2009 and delivered by the banks to NAMA just before Christmas 2009. NAMA had selected a Valuation Date of 30^th November, 2009 by reference to which the loans were to be valued. As we now know, the first tranche did not transfer until 10^th May, 2010. The delay has never been fully explained but the EU only approving the NAMA scheme on 26^th February, 2010 (and making some changes to the way loans were valued) and the worse-than-expected condition of the loan documentation must have played a part. Regardless over five months elapsed between the Valuation Date and the completion of the first transfer. During this time, it became apparent that property prices (residential and commercial) in Ireland were continuing to fall though the UK fared better with a robust recovery in commercial prices and a more modest recovery in residential prices. November 30^th, 2009 clearly though was not the bottom of the market. And that is one of the principles underpinning NAMA – NAMA buys distressed loans at the bottom, nurses them until there is a recovery and sells them at a profit (or at least enough to cover the long term economic value premium it has gifted the banks). The latest property indices for Ireland are for the quarter ending 30^th June, 2010 (the next Irish indices will not be released until the start of October, 2010 in respect of Q3) – the latest indices show that commercial and residential property in Ireland has dropped 8-10% compared with 30^th November, 2009. Whereas the EU might have accepted a Valuation Date of 30^th November, 2009 for the first tranche will it reject the second tranche and demand that NAMA re-base its valuations by reference to a more recent valuation date. Otherwise NAMA banks are getting far more State-aid than was envisaged – they were supposed to get a Long  Term Economic Value premium of 10-15% over the Current Market Values – in fact they are getting 25%-plus premia – is this just too much State-aid? UPDATE: 24th August, 2010. Professor of  finance at Trinity College Dublin, Brian Lucey, discussed the issue with NAMA’s Valuation date of 30th November, 2009 on RTE’s Morning Ireland – his contribution is about 15 minutes into the podcast. In particular he draws attention to the fact that Irish property prices have declined since last November.

The minutiae of NAMA’s valuation methodology has never been fully understood by the public or indeed academia. However both the Long Term Economic Value Regulation and the EU Decision indicate that NAMA will deduct from the Long Term Economic Value calculation a sum to compensate NAMA for the fact that on a proportion of loans NAMA will need foreclose and enforce the security. The deduction for enforcement authorised by the EU is 5% and in the EU Decision in February, 2010 this is what the EU had to say on the derivation of this 5%.

“The seizure of the underlying property by NAMA could be achieved in a number of ways, including by legal enforcement. The costs associated with a full legal enforcement process are approximately 15.00%. 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 I don’t know how the EU arrived at the conclusion that 5% was an adequate average contribution by the banks to NAMA for enforcement costs but I do recall that in the draft NAMA Business Plan the assumption was that a maximum of 20% of loans would default so perhaps the calculation was as follows

Industry standard enforcement costs x proportion of defaulting loans or

15% x 20% or

3%

And since 5% is greater than 3% and the 20% default rate was supposed to be prudent, perhaps that is how the EU arrived at its conclusion.

The problem is that in Ireland, the 20% default rate was seen by many as being too low. It was apparently based on the experience of Barclays in the UK in the early 1990s when the UK suffered a property crash. However the UK crash was not anywhere near the scale of Ireland’s (in nominal terms) and Barclays seem to have had better lending standards and practices than the likes of Anglo Irish and Irish Nationwide Building Society. The new NAMA Business Plan in July 2010 did not specify an up to date assumption on defaults. However consider the following:

(a) We now understand that the loans of Paddy McKillen will not transfer pending the outcome of an application by Mr McKillen for a judicial review of NAMA’s dealings with his loans. Apparently Mr McKillen’s loans are performing.

(b) We now understand that AIB is selling its UK operations which includes over €3bn of what are assumed to be peforming loans.

(c) We now know that the estimate of Bank of Ireland loans to be transferred has fallen from €16bn in 2009 to €12bn today and the understanding is that the difference, €4bn, related to performing loans that were redeemed.

(d) Anglo has recently stated that NAMA is agreeable towards €2-4bn of loans in the UK and US not transferring to NAMA. Again the assumption is that these are performing loans.

(e) NAMA itself has reduced its estimate of the proportion of performing loans in its portfolio from 40% at the draft NAMA Business Plan stage to 25% today.

In light of the above should the 5% contribution by the banks for enforcement increase?

And lastly what will the EU have to say about NAMA allowing apparently performing loans to be sold (in AIB’s case), retained (in Anglo’s case) or potentially not being taken over (in Paddy McKillen’s case)? NAMA is entitled to deduct a premium from the Long Term Economic Value to reflect the digout it is giving banks. Should that premium increase?

So in conclusion, I do not think that NAMA should be confident in getting EU approval of the second tranche valuations as it would seem the amount of State-aid being provided to the banks is significantly more than was envisaged when the EU granted approval for the NAMA scheme.