Asset fire sale must be avoided Sunday, August 16, 2009 By Alan Ahearne Economists worry about bubbles in asset prices because significant damage is invariably done to the economy when bubbles burst. In this country, we face a huge challenge in dealing with the legacy of the property boom. Far too much money was lent out over recent years to buy overvalued property.
Although we are not the first country which has had to pick up the pieces in the aftermath of a boom in credit and asset prices, the task we are facing is especially daunting. We not only have to deal with the bursting of one of the biggest property bubbles on record, we have to do so against a backdrop of the most severe global recession since the Great Depression.
As in other countries, the key to economic recovery is to find an orderly resolution to the problem of legacy loans.
Of course the economy faces other separate challenges that have to be tackled simultaneously -namely, the crisis in the public finances and our loss of international competitiveness. But since the publication of the draft legislation on the National Asset Management Agency (Nama) late last month, the issue of how to deal with legacy loans on the balance sheets of financial institutions has come to the fore in the public debate on economic policy.
Financial markets and international commentators have reacted positively to the Nama bill. Spreads on Irish government bonds over German bonds have narrowed to near their levels prior to the nationalisation of Anglo Irish Bank in January. The Financial Times said this week that ‘‘nine-tenths of the detail of the plan are absolutely right’’, its only concern being that the proposed bank levy in the event of Nama making a loss might be too hard on the banks.
Commentators generally agree that a resolution is urgently needed, because our economy will not recover unless -and until -w e get the banking system back to the business of providing credit to viable businesses and households. Bad lending decisions during the boom are generating uncertainty about the state of the banks’ balance sheets. Legacy loans are clogging up the banking system and dragging down the economy. These problems relate mainly to lending for land and property development.
If banks remain unsure about the losses that will eventually result from these loans, and nervous about the adequacy of their capital, they will not provide the credit necessary to support economic recovery.
More importantly, every euro lent by a bank to a customer must first be borrowed by the bank from somewhere else. Irish banks rely heavily on financial institutions abroad for funding. Uncertainty about the scale of losses on banks’ balance sheets has made this liquidity more difficult and costly to attract. In turn, the availability and cost of credit for viable businesses has been affected.
One approach might be to simply hope that the banks work off these loans over time. But the Japanese experience of zombie banks cautions against this approach. In the 1990s, Japanese banks kept refinancing delinquent borrowers, even though they knew their loans would probably never be repaid. These poor banking practices turned a temporary property downturn into a prolonged economic slump.
It follows that what is needed for economic recovery is a scheme that cleans up the banks’ balance sheets and forces the banks and borrowers to be realistic about their financial positions. This is what Nama is designed to achieve. Schemes to deal with impaired assets have also been introduced in other countries over recent months, including in the US, Britain and Germany.
Nama is also designed to ensure that the resolution to the problem of legacy loans is orderly. Nama can achieve this outcome because it will be patient in disposing of property assets which it has seized from delinquent borrowers.
Outside of Nama, a liquidator appointed to wind up a property company has a duty to sell off seized properties quickly. During an economic crisis, when markets are under severe stress and banks are not functioning properly, these properties may have to be sold at a discount to their underlying economic value.
Economists refer to the discount that the liquidator must pay for a quick sale as ‘the price of immediacy’. By design, Nama will not have to pay this discount because it will sell the properties at its own pace. It is important to note that the outcome for delinquent borrowers is identical, whether liquidation occurs inside or outside of Nama. Property companies are wound up and collateral is seized. The difference is in the speed at which the seized assets are re-sold to the market.
If the amount of distressed properties which may have to be sold over a very short period of time was small relative to the size of the overall market, then there would be little need to worry about the potential for a widespread, destructive fire sale of properties.
Unfortunately, this is not the situation. There are land and development loans worth €60 billion (equivalent to more than 30 per cent of our GDP) on the balance sheets of the state-guaranteed banks, though not all of these loans are nonperforming. Moreover, purchases of land and development projects are usually financed using bank loans. But banks are not making new loans for land and development. That’s the Catch-22.
It would be impossible to dispose of ten of billions of euro worth of distressed properties in a short time under current conditions -and extremely destructive to even try.
No wonder, then, that the IMF, in its recent report on Ireland, describes Nama as ‘‘pivotal to the orderly restructuring of the financial sector and limiting long-term damage to the economy’’.
A key question relates to the value at which the loans will be transferred from the banks to Nama. Some commentators have mistakenly talked about the price which Nama will pay for land and development properties. Nama is not buying properties, but rather buying loans that are secured on properties and other assets -there is a fundamental distinction. The transfer value will be in accordance with EU Commission guidelines on the treatment of impaired assets.
The commission is very clear on this issue: the loans are to be transferred at values based on their so-called ‘real’ -o r long-term - economic value. These are the terms used by the commission. Paragraph 41 of the commission’s communication published in February states that “ . . .the transfer value for asset purchase or asset insurance measures should be based on their real economic value’’. Annex IV of the communication states that ‘‘the objective of the pricing must be based on a transfer value as close to the identified real economic value as possible’’.
Indeed, the fundamental reason for Nama and other impaired asset schemes is to provide a mechanism for assets to be transferred at their long-term economic value and their value realised over that time. This is inherent in the commission analysis of these schemes, and explains why the commission has issued guidelines in the first place, so EU member states do not violate rules on state aid.
A similar approach to valuing impaired assets is being taken in the United States. Federal Reserve chairman Ben Bernanke has discussed the ‘‘substantial benefits’’ of the US government buying assets at a price close to what Americans call the ‘hold-to maturity value’. As he said: ‘‘Banks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down.” Bernanke has also noted the benefits to taxpayers of this approach, since ‘‘taxpayers should own assets at prices close to the hold-to-maturity values, which minimises their risk’’.
Some commentators have claimed that Nama should instead transfer the loans at what they refer to as ‘current market clearing prices’. It is hard to see how this makes sense. The reality is that there is no price at which the market for land and development can clear under current conditions. This is not to say that land has no value, but rather that the market for these assets is not functioning. There seems to be a misapprehension among some commentators that, for Nama to break even, property prices need to revert to the peak levels seen in 2006-07.This is not the case.
Nama is designed to prevent a disorderly resolution involving a widespread fire sale of assets, which would be detrimental to economic recovery.
Insisting that Nama pays prices associated with an outcome that it is designed to prevent is logically inconsistent. The ‘let’s bring on the fire sales and see what happens’ attitude among some commentators cannot form the basis of sensible policy making. The stakes are far too high for that.
Alan Ahearne is an economic adviser to Minister for Finance Brian Lenihan. He was previously a senior economist at the Federal Reserve Board in Washington DC
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