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PolicyDecember 30 2009

Irish government hopes its bad bank will work

The Irish government has opted for a 'bad bank' to save the nation's finances by buying up bad loans. With some experts unconvinced this was the best solution, only time will tell if the gamble pays off. Writer Philippa MaisterGetting the message: the formation of NAMA has led to protests in Ireland
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Irish government hopes its bad bank will work

The Irish government has embarked on a bold throw of the dice to rescue its nation's banking system and restore its economy to a sound footing. It could be a decade before anyone knows if the venture has succeeded. In the meantime, there are risks aplenty, many of them outside the government's control.

Saddled with billions of euros in bad loans to developers who paid exorbitant prices for speculative real estate and to consumers convinced that a pot of gold awaited them at the end of the property rainbow, and undermined by failures of corporate governance, risk management and regulation, Ireland's banking system is in urgent need of reform and recapitalisation.

Huge losses

"It is not an exaggeration to say we were aghast at the amount of money that has been extended," Michael J Somers, a former head of the National Treasury Management Agency, told a parliamentary committee in May. "We are not talking about tens of millions or hundreds of millions of euros but billions of euros lent to individuals. Much of this money has just been lost."

The solution the government has selected from a range of unattractive options is the National Asset Management Agency (NAMA), a 'bad bank'. Signed into law in November 2009 - despite vociferous opposition - NAMA will buy up bad loans made by Ireland's biggest financial institutions.

The government hopes the cash injection will spur banks to thaw frozen loan channels to businesses and individuals and restart economic growth.

NAMA has been set up as a state agency to acquire from banks and manage €77bn of performing and non-performing loans - then find buyers for them within a seven to 10-year timeframe. The goal is to at least break even and, ideally, make a profit.

Of the assets affected, €15.9bn are in the mainland UK, €4.6bn in Northern Ireland, and €4.9bn in the US and Europe.

The loans, already written down by the banks, will be acquired at a 30% discount or 'haircut' for approximately €54bn - or one third of Ireland's gross domestic product. Banks, with the approval of their shareholders, must apply to take part in NAMA, which may refuse to accept certain assets. The assets NAMA acquires - mostly land and buildings - will be actively managed to achieve their 'best long-term economic value', for example, by making additional investments in the asset itself or in a joint venture.

To keep NAMA off the state's books, a special purpose vehicle (SPV) with an issued share capital of €100m will be created to acquire and manage the assets. Private investors will have a 51% stake in the SPV; NAMA will hold the balance. Purchases will be financed by the issue of government-guaranteed bonds, which banks can use as collateral to raise liquidity from monetary authorities.

If NAMA does not break even when it is wound up, the government has promised to impose a tax surcharge on banks' operating profits until the loss is made up, so the taxpayer is protected.

Pros and cons

Each bank faces a balancing act between the pros and cons of participation. Besides the uncertainties over which loans will be accepted by NAMA and the price it will pay, each bank must consider the effect on its capital base of transferring the loans, as well as potential losses. Ireland's biggest banks, Bank of Ireland (BOI) and Allied Irish Banks (AIB), both anticipate a decline in their key Tier 1 regulatory capital.

On the positive side, banks expect improved stability, reduced capital needs, enhanced liquidity, and increased market and consumer confidence if they participate.

So, will NAMA work? Not surprisingly, there are strong views on both sides.

NAMA's interim director, Brendan McDonagh, a career civil servant, has himself spelled out the biggest risk to success. "For NAMA to succeed within its expected lifespan, economic growth in Ireland must resume at a moderate trend over much of the coming decade," he said in a November presentation he conducted. Mr McDonagh declined an interview with The Banker.

International organisations have generally given the plan a cautiously optimistic reception, and praised the Irish government's forceful actions.

However, the American Nobel Prize-winning economist Joseph Stiglitz has accused the government of "squandering large amounts of money to bail out banks", arguing that failing banks should be allowed to go bankrupt. Others contend the government's solution harms taxpayers.

John Cotter, a financial markets expert at University College Dublin, agrees that instead of being propped up by the government, attrition of banks that are not viable or not of systemic importance should run its course. Furthermore, given that both residential and commercial property markets have frozen, Mr Cotter says the government has had to put a price on something that does not trade - and, in his view, guessed too high. Ireland's finance minister, Brian Lenihan, has even included a premium of €7bn over the estimated current market value of the assets to reflect their long-term economic value. Yet, Mr Cotter says, the banks argue NAMA's valuations are too low.

Uncertain projections

One man with experience in valuing troubled assets is William Isaac, who headed the US Federal Deposit Insurance Corporation during the financial crisis of the 1980s, when 3000 US banks and thrift institutions failed. Now chair of the expert advisory firm LECG's global financial services group, Mr Isaac says assets should be evaluated not on the basis of their current value, but on their anticipated cash flow.

Mr Isaac admits that he is not well informed about the Irish situation. However, he believes no bank would voluntarily sell assets to the government at the current market price - which it could realise on its own - but only at a higher price, thus risking a waste of taxpayer money. Furthermore, he says, the mere fact that an asset is in a bad bank automatically diminishes its value by between 25% and 30%.

"The longer the asset sits with the government, the more the value goes down. And when the government does sell, it will go to a fat-cat investor who will drive a hard bargain and push the price down significantly," says Mr Isaac.

Mr Isaac favours the use of government funds to purchase preferred stock in a troubled bank, while replacing the management and board. Ireland has already adopted this approach on a limited scale with BOI and AIB, which are also expected to participate in NAMA.

Different approaches

Ireland is not the only country that has had to come to the assistance of one or more of its banks in the financial crisis. The US, the UK, Germany, France and Switzerland are among the most prominent other countries to have done so. They have tried a variety of approaches, sometimes in combination, including special liquidity schemes, credit guarantees, recapitalisation, nationalisation, asset protection schemes and asset-backed securities guarantees.

"Everyone is struggling with what the right answer is," says Anna T Pinedo, a partner in the New York office of the Morrison & Foerster law firm who has experience studying the issue. "In the US, we continue to see bank failures, and we have not yet hit upon the right solution."

Ms Pinedo notes that private equity firms, which were expected to seize on the investment opportunities presented by troubled banks, have mostly held back. "Even with regulatory changes in the past year, it is still very difficult for private equity to buy an interest in a regulated entity and avoid itself being regulated," she says.

"Bank regulators in the US are still somewhat sceptical of private equity investors in banks, because they think they have a short time horizon, and ultimately that doesn't contribute to stability."

Ms Pinedo adds that the inclusion of private investors along with NAMA in the SPV is very important, because they are best able to determine pricing and bring market discipline to the process. Investors might include distressed buyer funds, hedge funds and private equity funds. At the same time, she notes, banks which have not fully recognised all the losses associated with their loan portfolio may be reluctant to move them into a NAMA-type institution because they will have to officially write them down.

Common reluctance

Many corporate borrowers share that reluctance, according to John Finn, managing director of Treasury Solutions, an Irish financial management advisory firm and a former president of the Irish Association of Corporate Treasurers. He says that borrowers in default on one loan could find that other assets that are performing well and bringing in enough income to pay off their principal also wind up in NAMA.

Furthermore, there is no certainty that banks will use their NAMA financial infusion to increase business and consumer lending, the chief goal of the agency. "There's no compulsion, no target, no benchmark to see if it is working," says Mr Finn. "It defies logic."

Indeed, AIB's former CEO Eugene Sheehy bluntly stated that banks would focus initially on repairing their balance sheets rather than extending credit.

Still, Mr Finn says Ireland now has an opportunity, to coin a phrase, "to make lemonade from lemons". For example, Ireland can boost tourism to fill overbuilt hotel rooms. Banks that have not been exposed to the Irish property market are becoming attractive targets. He has also observed some non-Irish banks growing more active in the syndication market in Ireland.

"The issue is not whether NAMA is a better solution than TARP in the US or government guarantees in the UK. The issue is which country is going to get out the block the fastest," says Mr Finn. "New Irish companies that are well set up will be looking to make acquisitions now.

"We don't need to have it beaten into us that we got things wrong. People have recognised that and they have started climbing back up the mountain."

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