Delay and Pray

“Delay and Pray”, also known as “Extend and Pretend”, probably best sums up exactly where Irish banks and indeed NAMA are right now.

No, I’m not joking. There are oft used phrases across the Atlantic – specifically in relation to the type of loans that have made our banking system insolvent – commercial real estate (CRE).

The US itself is facing a commercial real estate crisis, particularly over the next four years, as this excellent FT analysis outlined last week. $1.4 trillion worth of CRE loans will reach the end of their terms over the next four years. The problem is that nearly half of these loans are already in negative equity. As the FT says:

More shocking is that banks and their auditors are typically well aware of the problem, but have not written down the value of property as prices have fallen. Instead they are “extending and pretending” – or “delaying and praying”: holding property values steady and assisting the borrowers where possible. They need to. If banks were accurately to record property values, they would write down assets on their own balance sheets and jeopardise their business.

This actually sums up how the Irish banks, especially Anglo, have been dealing with our property developers. Rolling over interest, not writing down the loans, not crystalising the losses, doing repayment deals with developers – to drag it out – extending and pretending.

The US government has examined this situation throughout a Congressional Oversight Panel. Their report was issued two weeks ago. You can read it here. The panel concluded that it expects many banks to go under, and the pretence to come to an end, as the FT quotes:

“There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public.”

Equally so for Ireland. Brian Lucey, writing in today’s Irish Times, makes a point along similar lines. He is worth quoting here at length:

Eighteen months into the crisis in the Irish banking sector, and astonishing as it may seem, no real effective repair action has yet taken place. Not a single impaired loan has been taken off the books of the banks. Instead, Government handling of the banking system has been marked by an unwillingness to face up to this fundamental problem – the banks are effectively bankrupted by the losses that they face on speculative lending.

The National Asset Management Agency (Nama), as structured, is designed to buy time for the market, somehow, to sort it out, as there is an ideological obsession at the heart of Government against the notion of the State as the majority shareholder in the banks, even if required and even if temporary. But events may force their hand.

Recall that Nama will in essence take off the banks the loans secured on now deflated bubble assets. The idea is that, in extremis, Nama can sell the assets for their “long-term economic” value and recoup some of its outlay. Nama is proposing to take over some €33 billion of land and development loans in Ireland alone.

Here it is in a nutshell: NAMA is one massive “Delay and Pray”.

Given that our banks are insolvent, that they are facing massive liquidity issues with the imminent closure of the ECB discount window, they cannot keep the pretence of extending and pretending up forever – and NAMA is, or was supposed to be, the answer to their prayers. You could also argue that Bank of Ireland recently changing its fiscal year was part of this tactic.

The Government would take the crappy loans from the banks (rather a lot), and through some financial voodoo, the losses would still not be crystalised, and rather ingeniously – the debt would not appear as sovereign debt for Ireland, or as debt for the banks, but would instead be dumped into this NAMA bad bank.

And NAMA has one sole purpose – keep the pretence going that someday, somehow, the value of the underlying assets will return to peak prices. Delay and pray. Do not write down the loans. Do not accept the reality of the losses. Do not pass go.

Not only is it unlikely that this will happen, it is almost impossible. Morgan Kelly wrote in December that it could take 50 years for the underlying assets to return to 2006 prices. Last week, in the High Court, we saw development lands being written down by 60% to 98% (in terms of valuation, not borrowing). These figures are the reality of the lands that NAMA is taking charge of. And we are overpaying already. How long do you think it will take rezoned agricultural land bought for €13m at peak, revalued at €600,000 in 2010, to return to €13m? The answer is: it won’t. So much land was rezoned that there is no necessity for rezoning for a further 70 years in many counties. Add to that the 300,000 vacant properties. Add to that little demand. Add to that zombie banks unable or unwilling to lend.

This is the reality of NAMA. Delay and pray.

And as if to add salt to the wound, Lucey further explains:

“…in many cases of development land the title was not actually transferred to the developer; rather, they took out a licence to develop. This was, it seems, a scheme to minimise tax, but it leaves open the incredible scenario that rather than being secured on an asset, these loans were secured on what is technically a derivative whose value has now collapsed to zero. If the underlying assets are worth zero, the hole in the banking system is that much larger.”

Lucey is referring sideways to the famous Section 110 of the 2007 Finance Act. This was a part of the Act that was never activated through a commencement order, which would have effectively closed the loophole that allowed developers to avoid paying stamp duty when buying landbanks. Brian Cowen, as Finance Minister, and Brian Lenihan after him, failed to commence the section due to concerns that it would further undermine the property market.

At the time, the Government commissioned AIB/Goodbody to write this report on the Section. It was published in November 2007, and is available here. The report concluded that if the Section were to be commenced:

It is recommended that Section 110 provisions should not be commenced at this time. To do so, would run the risk of exacerbating the down turn in the property
market.

Of course, the market was already beginning its freefall by this time, as the market had peaked some 11 months previous. The Goodbody report hedges its bets, in some places saying things could get bad, and in others saying they might not – as any good report does. But was is critical here is who owns the land.

A developer wishes to buy rezoned land from a farmer. Instead of paying money directly to the farmer (and incur stamp duty), the two instead enter a deal in order to avoid it. They enter a resting on contract or a type of lease. The developer essentially takes out a 100% mortgage to buy the right to build on the land, with no collateral to back the loan since he essentially does not own the land in question. Stamp duty is payable by the buyers of the houses that are to be built on the land, but the developer has avoided paying it.

As Lucey says it is essentially derived, and with little or nothing backing the loan, the losses are far steeper for the lender in a situation where few or no houses were built or sold. Those ghost estates are ‘worth’ far less than many might have assumed. Joan Burton pointed again to this last week. As late as April 2008, the Government was still considering commencing the section, but never did so.

It logically follows that where the banks lent money with no obvious collateral to back the loan, and where the supposed value of derivative is now zero, the bank sustains a massive capital loss.

However the banks are simply delaying and praying until NAMA takes over the loans, and then NAMA continues the praying.

We are in for one hell of a fiscal mess.