Archive for October 6th, 2010

I attach here the expert witness statement of who for many is the star witness in the Paddy McKillen case, Nobel laureate Professor Joseph Stiglitz.  Here is my precis of  the statement. It is worth reading the full statement itself as it was clear in writing the precis that each sentence had been weighed – there is much that is significant and convincing there, and given our more mature understanding of NAMA and the horrendous sums involved in the bailouts, I think this is a good time to re-examine some of the NAMA basics. The original position of this blog on the McKillen case was neutral though if NAMA were to lose performing loans then it needs to alter the enforcement cost contribution from banks from the present 5% and will need more working capital from the State in the early years. What I extracted as the most significant element of the witness statement was the claim of  destruction in value of performing loans when they are transferred to NAMA and this will be the subject of  a separate entry.

Nobel laureate Joseph Stiglitz submits a lengthy expert witness statement in which he acknowledges his duty to the Court. His central claim which he sets out in very great detail is that Paddy McKillen, the banks and the tax payer are likely to be injured by transferring Paddy’s loans to NAMA, that NAMA destroys value because a loan+long-term banking relationship is worth more than a loan + a workout vehicle that might encourage opportunistic behaviour. Professor Stiglitz deals with eight subject areas in his statement.

(1) Best practices in addressing bank insolvency

NAMA should focus on loans where principal and interest is not being repaid or there is significant risk of non-payment.

NAMA is incentivised to underpay for good bank loans to generate profits

If NAMA underpays for good loans then banks seeking recapitalisation will be worse off and so will the wider economy

(2) An analysis of the Irish banking crisis and the creation of NAMA

Moral hazard did not pose a problem to developers whose downside was limited

And after the crisis, the banks were less concerned with moral hazard as they were protected by State bailouts

The banks are insolvent but accounting standards have allowed that status to be hidden. NAMA forces the banks to crystallise the insolvency. And then recapitalisation needs follow.

NAMA will not allow banks access finance because NAMA forces banks to reveal their insolvency and until banks are recapitalised they will remain insolvent and unable to lend

NAMA leaves uncertainty eg the 5% subordinated bond (and presumably the levy)

(3) Why NAMA’s structure and incentives do not reflect best practices in addressing bank insolvency

NAMA’s processes are value-destroying which hurt the banks, borrowers and the wider economy. Moving a performing asset to NAMA will result in poorer management of the loan. The loan is moved out of a bank with superior experience to NAMA which has a longer time horizon and a better relationship with the borrower.

NAMA’s part-private ownership structure is not likely to be followed anywhere else in the world

Stiglitz places emphasis on the private investor ownership of the NAMA SPV and suggests these investors are not concerned with the societal role of NAMA

NAMA is seeking to make a profit from Paddy’s loans and inversely the banks will make losses

A profit at NAMA overall is unlikely

NAMA’s limited resourcing should be focussed on poorer value loans where extraction from the banks will prevent banks throwing good money after bad under the protective umbrella of the government guarantee

(4) The transfer will negatively affect Paddy from an information economics point of view

NAMA’s processes interrupt Paddy’s long-term real estate plan and will have an adverse effect on the value of his assets and hinder his access to long term credit

In normal times Paddy would transfer his loans to another lender, however there is presently a climate of high uncertainty and liquidity constraints

NAMA does not have the resources, knowledge or relationship to negotiate with borrowers like Paddy

NAMA has a short term horizon with accelerated workout objectives

If 25% of assets are to be realised in three years, then they will attract lower prices because the market is unlikely to recover in that period

Paddy’s assets are long term and his income will not allow 25% payback in 3 years

Lenders may infer that Paddy is, like other NAMA debtors, a bad credit risk

When performing assets are transferred to NAMA, they are being transferred to a less competent party than the bank

(5) Paddy’s loans are not impaired and do not represent a systemic risk on its lenders

Paddy’s loans are meeting all of their servicing requirements

Property valuation is problematic in the present market but there is evidence that the value of Paddy’s properties exceeds the value of the loans

Paddy’s loans are diversified geographically and by bank (AIB, Anglo, BoI)

Because Paddy’s loans have good rent cover and low loan to value, they don’t present financial risk let alone systemic risk

Paddy’s loans make up 1% of all loans at the relevant banks (I think he’s referring to the total of NAMA and non-NAMA loans)

(6) Due process would allow for an improvement to NAMA’s efficiency and reduce injury to the banks, borrowers and the tax payer

Compulsory state acquisition should be in the public good and the owner must be adequately compensated

Asset at the banks are worth more than the asset at NAMA because of long-term relationships

Abandoning due process carries risk to Ireland’s reputation for respect for the law

Paddy should be allowed explain to NAMA why he doesn’t present systemic risk

(7) Addresses the affidavits on the NAMA side (NAMA CEO Brendan McDonagh, NAMA Head of Tax and Legal, Aideen O’Reilly, Professors McAleese and Lane, Assistant Secretary at the Department of Finance, Anne Nolan)

The affidavits don’t explain why the transfers are good for BoI or Anglo

NAMA contend that original loan contracts allow for transfers of loans but this was not envisaged by borrowers and NAMA is not a bank, it is a workout vehicle

NAMA claim that GBP30m of a GBP472m loan to Maybourne is for development, Stiglitz says that makes the development loan incidental to Maybourne’s business

NAMA claim consultation with borrowers would be costly and wasteful

NAMA’s ability to change the terms and conditions of a loan render it different to other lenders

(8) The role of long-term relationships in the banking sector

NAMA does not have the reputation, incentives or information or ability to advance credit & therefore can’t replicate the normal long-term relationship typical of the banking sector

Paddy assembled his assets over three decades and NAMA won’t even meet with him to discuss the transfer of the loans

Long term relationships reduce moral hazard and adverse selection, essentially long term relationships equal trust

NAMA has a short span, and can’t meaningfully extend credit

NAMA and borrowers have an incentive to behave opportunistically

NAMA requires rapid sales even in unfavourable markets

Buyers knowing NAMA’s rule-based approach to disposals are in a better bargaining position

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If you ever go to central London, to Piccadilly, Regent Street and some other streets in Mayfair, you’ll come across quite a few clothes and rug shops selling mostly unbranded (in the sense that you won’t recognise the brands) goods at huge discounts. And I can say from personal experience that sometimes you can get good quality for a good price but that oftentimes the quality is second rate but you’re only likely to find that out some months down the line. The discounts however are eye-catching, jackets reduced from €999 to €199, that type of thing. And unless these outlets are open just to launder cash then they must do a decent trade to pay high rents. And I suspect they do. It’s innate in people that the higher the discount, the better the bargain, never mind about the fact that you’ve never heard of Giorgio Arnelli in the context of clothing before.

Following on from Moody’s statement yesterday, indicating a review of Ireland’s credit rating which signals a downgrading in a couple of months, one of the other two ratings agencies, Fitch, has downgraded Ireland’s debt one notch from AA- to A+. As NAMA’s bonds are State-guaranteed their rating has accordingly been reduced.

Fitch go on to say that they now see NAMA breaking even over the long term on the basis that the original haircut (discount to loan par values paid by NAMA) was 30% and the revised haircut is 58% (based on T1 + T2 and the forecasts last week and assuming INBS’s remaining tranche haircut to be 75% gets you to 58.14%). However like our friends in London selling cut-price rugs and clothing it is difficult to tell whether NAMA is paying realistic prices for the loans in the context of the next 7-10 years. Property values should be more dependable than some unheard-of rug producer but given the scale of the collapse in prices (in particular development land prices – 75 to 90% according to Savills), the extremely muddied outlook for the economy and even though NAMA has only uplifted values by 10% for Long Term Economic Value, it is still far from clear that NAMA will break even or be profitable.

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Laura Noonan in the Independent today provides an update on NAMA’s financial  prospects and intentions following last  Thursday’s announcements on changes to NAMA’s scope and operation.

NAMA apparently has said that they will provide an updated business plan when the loans have been transferred and assigned values. Given that the intention appears to be to transfer the remaining  tranches by the end of this year, and given that NAMA has up to 12 months to assign precise values to loans whose values might have been estimated, then that means we might have to wait until 2012 for a new business plan.

However, it is contended by NAMA that its prospects have improved as a result of last Thursday’s announcements. Not only are the haircuts more severe but removing €6.6bn of €5-20m loan exposures at AIB and BoI will also improve prospects because these loans are widely believed to be severely impaired. Laura tells us that the €800m negative Net Present Value (the adverse scenario in the June 2010 Business Plan) is likely to be pared back.

Laura has also learned that there will be brief statements when future tranches are transferred (remember that there will be five further tranches, one for each of the NAMA Participating Institutions – PIs, AIB, Anglo, BoI, EBS and INBS). These brief statements will contain less detail than the previous tranches. That said, NAMA remind us that they will still produce quarterly reports and accounts (by the bye, where’s the one that was due at the end of September 2010?). The one previous quarterly report contained a lot of detail on the tranches but it is produced publicly up to 3.5 months after the event, ie transfers in Oct-Dec 2010 will be contained in the March 31st quarterly report which will be made available presumably in April 2010.

NAMA’s statements about the disclosure of information in terms of future tranches and a new business plan are depressing. Last Thursday, NAMA’s scope fell from €81bn to €74bn and indeed if you take out the UK AIB sale, Anglo’s UK and US loans, EBS’s €232m of “missing loans” and possibly Paddy McKillen’s loans then that reduces to €68bn with an anticipated consideration of €28bn. These are major changes, and although some of the changes might serve to reduce NAMA’s risk, others such as the loss of what are assumed to be performing loans increase risk.

It would be nice to know how NAMA is getting on with its €2.5bn State-backed euro commercial paper programme. Will NAMA be able to repay the Exchequer €250m borrowed in May 2010 as a working capital advance (we learn from Laura that €40m was spent by NAMA in Q2 – what about Q3?). Without this €2.5bn and given the estimate of NAMA non-interest generating loans it seems unlikely that NAMA can repay that advance.

And whilst appreciating the role that journalists have in seeking out the facts, it would have been helpful if NAMA had issued a statement last week in response to the changes to its scope and operations.

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Reminds me of reporting from Wimbledon, and indeed it looks like the hearing might go the full two weeks. It’s Paddy’s application and so opening for him yesterday was senior counsel Michael Cush who outlined what Paddy was (and just as importantly wasn’t) setting out to achieve.  Paddy is arguing

(1) That the procedures adopted by NAMA in its interpretation of the NAMA Act (particularly in relation to eligible assets) were a denial of a Constitutional right to fair procedures

(2) NAMA failed to exercise relevant considerations when judging the inclusion of Paddy’s loans in NAMA

(3) The decision to acquire Paddy’s loans was taken on December 11th/14th before NAMA was established (21st December 2009)

(4) Under a correct interpretation of the EC approval to the NAMA scheme, at least some of a borrower’s loans must be impaired

(5) The NAMA legislation relating to the definition of eligible loans is so broad as to be unconstitutional

Reasons 1-2 are textbook reasons for launching judicial reviews in Ireland. Reason 3 is new to me in the context of this case. Reason 4 is the cause of the hullabaloo a couple of weeks ago when Paddy sought to include some recent correspondence and to expand his application.

Paddy wasn’t questioning

(1)  If NAMA was a good or bad idea or a good or efficient model to deal with the State’s difficulties

(2) The merits of NAMA acquiring Paddy’s loans

(3) The merits of NAMA acquiring unimpaired loans generally

(4) NAMA’s valuation procedures

(5) Whether Paddy’s €2bn-odd of loans were a systemic risk to the banking system

Other detail to emerge was that Paddy had 62 properties (shopping centres, hotels and offices) valued at €1.7bn-€2.28bn (Simon Carswell says €2.8bn) and there are loans totalling about €2.1bn secured against those properties with banks participating in NAMA, all of the loan repayments are being met and that the €150m income being generated on the properties amount to 1.7 times the required interest to be paid. They are 96 per cent let on 25-year leases to blue-chip tenants. It was conceded that the interest cover might have fallen below the permitted ratios on some loans as agreed with the banks but overall it was well above the typical level of 1.2 times interest cover. 26% of the property portfolio is in Ireland, with most of the remainder in the UK (with “many” in Northern Ireland), France and the US. Just 2.5% of his portfolio was land and development. Yesterday it emerged that the offending loan was for a reported GBP £35m on a property adjacent to Paddy’s Berkeley Hotel in London’s Knightsbridge. Of course it would depend on the LTV of the loan and what the property is now worth but 2.5% would seem to relate more to €1.7bn of property (a barrister being tendentious, no!)

There is a dedicated TAB for the Paddy McKillen case where you will find the background to the case and all the latest news. Henceforth these daily updates on the hearing will be posted there only.

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