Despite criticising the Comptroller and Auditor General’s (CAG) report on NAMA last week as incoherent and aimless, it does contain some interesting information. And aside from the payments (bizarrely including VAT) made to some third party companies, the detailed worked example of a NAMA valuation of a loan is possibly the most interesting nugget in the entire report. This entry examines the worked example.

Firstly it should be said that despite a NAMA Act, a Long-term economic value (LEV) Regulation, an EU Decision, Tranche 1 and Tranche 2 reports, extensive debate on Irisheconomy.ie (here and here would be the best examples) and indeed an email response from NAMA shown on here, it has never been entirely clear how NAMA value loans and we should be thankful to CAG for at least including the worked example in what is overall a dreadful report.

The worked example looks horrendously complicated when you consider what the objective of the valuation is: to figure out (1) what the property was worth at 30^{th} November, 2009 (2) what it is worth long term and (3) deduct a sum for due diligence and enforcement as these are costs NAMA is incurring. I would have expected the 5.25% due diligence and enforcement to be calculated on the par value of the loan but the worked example shows that it is calculated on another (much lower) figure. I am also confused by the calculation of the current value of the loan and why it makes use of a different discount rate (for which I can find no support in the various legislation and EU Decision). So for the time being I present what the CAG has presented with some better explanation but this is a post to which I expect to return.

The worked example appears at Annex A to CAG’s report from page 49 on and consists of three pages – the worked example, explanatory notes and a graphic illustrating the calculation of the “state aid” element within the NAMA payment for the loan. The “Asset Acquisition Process” in Chapter 2 of the report (pages 29 onwards) provides further explanation as to how some of the rates have been derived. The worked example relates to an investment property loan.

Here’s the worked example.

Here’s the explanatory notes.

Here’s the graphic showing the State aid element of the payment.

The explanatory notes are not very explanatory in my view and I have set out below the components to the valuation.

(1) The **loan balance** is the sum outstanding on the loan – straightforward enough. NAMA of course needed to do a reconciliation between when the valuation was undertaken and when the loan was transferred (additional interest, repayments, additional advances). In this case we assume the loan valued doesn’t change.

**Derivatives** can be confusing creatures. In this case let’s assume the “derivative” of €2,955,704 is an interest rate swap. What’s that I hear you say? Okay, let’s assume the developer took the loan out a couple of years beforehand. At the time the bank was insisting on an interest rate equal to the ECB main rate plus 2%, in other words a variable interest rate as is usual. At the time the main ECB rate was 3%, so the developer would have been paying 5%. The developer though was concerned that interest rates were going to rise and if they did then he might lose his profit on the development. So he wanted to lock in his interest rate, pretty much like a fixed rate mortgage. So he bought a “derivative” from the bank fixing the rate at 6% and that’s what he is supposed to pay. Now of course the ECB rate came down to 1% so it wasn’t a good deal for the developer and now in addition to the outstanding loan, he owes a further €2,955,704 on the derivative. Now if interest rates had shot up to 7% then the bank would owe the developer.

(2) The **Current Market Value** (CMV) of the property on 30^{th} November, 2009. What would the property fetch on the open market at that date.

The **Long term Economic Value** (LEV) of the property is the CMV increased by a subjective % by the valuer to reflect the long term value of the property based on a number of considerations (which are set out in sections 5 and 6 of the LEV Regulation) which are subjectively interpreted by the valuers.

The **Standard Discount Rate** in the example is **5.57%** comes from section 2(2) of the LEV Regulation “the NAMA 5-year discount rate, for bank assets denominated in euro or any other currency, is 5.57 per cent (which includes a risk margin of 1.7 per cent)” **Why 5 years**? That comes from 7(b) of the LEV Regulation “where the bank asset is a bank asset for which the security is land for which the adjustment factor is more than 10 per cent of the land’s value but less than or equal to 15 percent of that value, NAMA shall take into account the projected cash flows of the bank asset over a period of 5 years using the NAMA 5-year discount rate,” **Why is the adjustment factor 15%**? Well that’s going to be a subjective assessment by the valuer based upon the factors set out in sections 5 and 6 of the LEV Regulation but I think it is worth noting that NAMA engaged a British consultancy, London Economics, to report on likely property trends in key NAMA markets and “the report concluded that the range of implied property price changes (in nominal values) for the period 2010 to 2016 for a combination of commercial and residential property was Ireland – 17.7% to 28.8%, UK – 14.7% to 20.3%, US – 10.5% to 23.7% (page 38 of the CAG Report). In addition to a valuer working out the CMV at 30^{th} November, 2009 (what would the property sell for at that date on the open market on the basis of a willing buyer and willing seller, both in possession of perfect market knowledge), the valuer is required to look at cash flows on the property in the **relevant period** (5 years here because of the above)

(3) The **loan collateral valuation **is what NAMA actually pays the bank for the loan and is calculated using three components (it seems derivatives are valued at zero)

(i) the **LEV of the property expressed in current terms** by applying the **Standard Discount Rate** in (2) above of 5.57% and

(ii) then deducting **5.25% representing the costs that NAMA will incur in undertaking due diligence of the loan (0.25%) on acquisition and the predicted average costs that NAMA will incur in enforcing loans (5%** – the standard enforcement fee is supposed to be 15% but NAMA convinced the EU that less than a third of loans would require enforcement) plus the cashflow from the property discounted using the discount rate in (2) above, that is 5.57% in this case.

(iii) and adding the present value of the future cash flows discounted by the **Standard Discount Rate**

(4) The **haircut** (or **discount**) is the difference between the value of the loan (including derivatives) on the bank’s books and what NAMA actually pays. So the difference between (1) and (3) above. The haircut % is the haircut divided by the value of the loan (including derivatives) on the bank’s books. The haircut shown in the example is 30.02%. In reality the haircut on Tranche 1 total was 50% and Tranche 2 total was 56% and the weighted average in Tranches 1 and 2 was 52%. So the example shows a relatively high valued loan.

(5) **State-aid** has not really cropped up in discussions up to now in the context of the detailed valuations but CAG put a number (quantum and %) on it – basically it’s the difference between the Collateral Current Market Value (from (3) above) the **Loan Current Market Value**. And this would be where the CAG lost me. It refers to the CMV of the collateral (€62m), the future rental income (€3.7m in 2010 and 2011 and €5.7m in 2012, 2013 and 2014). And then there is a discount rate applied. This discount rate of 11% is different to the Standard Discount Rate and seems to be a NAMA invention and is shown on page 44 of the CAG report and I reproduce the table here.

I am still lost as to how the CAG arrives at a value of €50,391,460 based on a CMV of the loan collateral of €62,000,000 and future rental income of €3.7-5.7m per annum. Plainly the figure arrived at is less than the CMV of the loan collateral which is partly why I’m confused.

So there you have it. I must declare that I have valued property before so what the CAG presents should not be alien to me, but I must also admit that the calculation of State aid (and in particular the CMV of the loan) is puzzling to me. I expect to return to this entry in future with clarifications.

on November 8, 2010 at 8:25 pmsf ca writerAh, more confusion, just what I neeeded.

I do not understand all the factors invovled in valuation processes in general, but I certainly cannot grasp the — ‘long term economic value’ — idea.

What is the long term economic value of a piece of land in a country that does not even know if it will require IMF intervention or not?

To me, and I doubt if I am alone, the lack of certainty about ‘long term economc value’ invalidates ALL the mathematics.

So what are we left with – fudge.

Given that we have:

-2009 values applied to property in 2010 (and beyond),

-subjective ‘haircuts’,

-fictional long term economic values,

then of the numbers I’ve seen, the only ones that are not tied somehow to a “guess”, are the salaries.

That’s a mathematical fact, not a NAMA bashing criticism, and I hope to be proven wrong.

Guesswork on a 70 billion euro project…to use a California colloquialism….you be trippin’ dude, hella trippin’……

on November 8, 2010 at 8:42 pmsf ca writerre my previous post:

please just tell me I’m wrong….is it really fudgus extrumus to give it the correct latin term?

on November 9, 2010 at 12:06 pmnamawinelakeNAMA apparently commissioned a British consultancy, London Economics at a cost of nearly €100k, to produce long term increases in property in Ireland, the UK and US and they came up with

“2010 to 2016 for a combination of commercial and residential property was

Ireland – 17.7% to 28.8%”

With a sovereign default a probability, intervention from the EU or IMF a probability and 4 tough years ahead for the country with deflation a probability, and remembering both commercial and resi is down 10% from last year so we would need a 35% increase from today to get to a 17.7% increase in 2016 (on a 2009 base) or a 50% increase to get to a 28.8% increase.

Again I would have expected the CAG report to verify the London Economics report was still valid, but …

on November 9, 2010 at 1:06 amwho_shot_the_tigerI think Samuel Beckett may have put it best:

“Make sense who may. I switch off.”

on November 9, 2010 at 1:40 amwho_shot_the_tigerOK, I think I get it, but where did the 11% discount rate come from under the “loan CMV” section and what’s the justification for it?

How does that correlate to 5.57% discount rate applied to the property cash flows?

No…. On second thoughts, I think I’ll stick with Beckett.

on November 9, 2010 at 3:49 amwho_shot_the_tigerCould it be an algorithm of purchasers’ costs (stamp duty etc) on investment properties relative to their ltv ratio?

Cheeese….. this is going to keep me awake all night! These NAMA guys are devilishly cunning.

on November 9, 2010 at 12:01 pmnamawinelakeWhatever the 11% represents and you will see how it is derived in “Chapter 2” of the CAG report but other than it being an investment property with an LTV>100% and NAMA’s grid says 11% I don’t know how it is derived or indeed how it is used – applying it as a discount factor over 5 years on €62m plus the rental income in the example does not give you €50m.

Again I find the CAG a dreadful and unprofessional piece of work. I would have expected a report objective to say (1) Identify the valuation methodology and process from the NAMA Act and Regulation and RICS Red Book (2) Test a sample of NAMA valuations (3) Confirm that the valuation process has been correctly applied and (d) Results/recommedndations.

It doesn’t make sense to me that the due diligence and enforcement % is applied to the LEV and not the nominal value of the loan outstanding today. For example. As I say the valuation of the CMV of the loan also doesn’t make much sense – either the 11% discount rate or how it is applied.

And I will leave you with another gem:- The discount rate to be applied to arrive at the value of the collateral, you know the 5.57% in the example, is supposed to be derived from the Ireland bond rate for lending over a 5 year period (actually it’s the bond rate plus a 1.7% premium so that the bond rate for four years was 3.87% last year). This morning it is 6.8% (http://www.bloomberg.com/apps/quote?ticker=GIGB4YR:IND – this is the 4year bond, there seems to be a problem with the 5 year data this morning) which when you add the risk premium of 1.7% would give you a discount of 8.5% way higher than the 5.57% used in the valuation. If we applied the Nov 2010 bond rates to the valuations then we would be paying a lot less for the loans – in the worked example using a 8.5% discount rate rather than 5.57% rate would mean we paid 65m instead of €72m, a haircut of 38% not 30%. Actually this probably deserves a separate entry.

This is the sort of risk you might expect the CAG report to highlight.

on November 9, 2010 at 12:11 pmSionnachIt may be that the CAG calculation reflects uncertainty regarding the CMV of collateral, 5 years hence.

By applying a risk premium to the future value of the 62,000,000 loan collateral as well as the projected rental income, and discounting both at 11% over 5 years gives you a number close to 50,391,460.

BTW – This blog is wealth of information and a super resource!

on November 9, 2010 at 12:29 pmnamawinelakeThanks for your comment Sionnach, I did start a spreadsheet yesterday which I have put on google docs that tried to validate the numbers. Rather than go through someone else’s work would you care to have a stab at how you get €50m -odd from a “current value” of the loan collateral and the five year’s rental income shown.

(a1) Rent €m Discount (3) Rent (4)

2010 3,700,000 90.1% 3,333,333

2011 3,700,000 81.2% 3,003,003

2012 5,700,000 73.1% 4,167,791

2013 5,700,000 65.9% 3,754,767

2014 5,700,000 59.3% 3,382,673

Total 24,500,000 (c) 17,641,567

€62m at 59.3% (year 5) = €36.8m

Add the two (rent at 17.6 and the CMV at 36.8 and you get 54).

I’m probably missing something but would be grateful to see how you get close to what CAG show.

on November 9, 2010 at 3:53 pmwho_shot_the_tigerBTW, How do they calculate the 15.89% market discount rate on land and development loans for an loan to value ratio of 100% or more?

Is the rational shown anywhere?

on November 9, 2010 at 3:55 pmwho_shot_the_tigerI’ve got to get a copy of the report…. the whole thing is driving me nuts!

on November 9, 2010 at 7:00 pmSionnachApologies namawinelake- I was offline for most of the day. In my haste, I may have hit the number by fluke!

I discounted the cashflows at 13% (11% plus a 1.7% risk premium, which I rounded to 2% given that the cashflows are approximate!). As it turns out, this gives a PV of exactly 50,391,460!

However, as I look more carefully at the document, there is little justification for this approach. I guess, this is how mistakes are made!

on November 10, 2010 at 8:09 amnamawinelakeNo worries Sionnach, I will put a spreadsheet online to see if that helps anyone pull this sword from the stone – maybe there are assumptions about cashflow arising midway through the year, that type of thing but I can’t see anywhere in the legislation justification for 11% & it seems to be a NAMA invention.