Lenihan formula will ensure banks win and taxpayer loses
The Minister for Finance has proved he doesn't actually understand finance and this will likely prove disastrous for the Irish taxpayer who will be left carrying the can, writes Karl Whelan
Published 06/09/2009 | 00:00
ONE of the interesting features of our system of parliamentary democracy is that most of the key decisions are taken by ministers who are politicians without any specialist knowledge of the matters over which they provide.
Normally we muddle through. However, there are times when it is useful to have a Minister for Finance who understands finance.
At this week's Oireachtas Committee meeting on NAMA, Brian Lenihan proved beyond a doubt that he is not such a minister, and that his failure to grasp financial economics could prove to be a disaster for the Irish taxpayer.
A basic principle of financial economics is that a business's share price depends almost entirely on what is expected to happen to the business in the future.
Back in March, the future wasn't looking too good for the shareholders in the main Irish banks. It had become apparent that the property losses of the two Irish banks were likely to leave them insolvent.
The share prices had tumbled because nobody else was willing to re-capitalise these banks -- apart from the Irish Government. Nationalisation seemed inevitable.
That was then. Now, the future for the Irish banks depends on NAMA. Whereas back in March the future for these bad loans involved foreclosure and selling off the underlying assets at market value, now the future involves selling these assets to Nama at the mysterious "long-term economic value" which, by definition, is higher than market value.
Not surprisingly, the share price of the banks has recovered and the current share values are based on a widespread expectation, promoted vigorously by the stockbroking community, that the bad assets will be taken on by Nama with a haircut of only 20 per cent, which will limit the need for state recapitalisation.
When questioned about this stockbroker scenario, Mr Lenihan has repeatedly rejected that this is an inevitable outcome, assuring us that the pricing of these assets will be done independently by Nama. However, he also says that no more banks will be nationalised.
I have been puzzled by this. How could the minister be so sure what prices this independent process would produce and that they wouldn't end up with nationalisation?
Well, this week we got the answer -- and it's not a pretty one.
Firstly, it became clear that the intended pricing process is not in any way independent. With a glum-looking Brendan McDonagh (interim Nama chief) sitting next to him at the Oireachtas committee, the minister asserted: "I can give directions to Nama to have a valuation reconsidered."
Secondly, the minister showed that his thinking about appropriate valuations relies on a tautology that will ensure that the taxpayer transfers huge amounts of wealth to bank shareholders, simply because that is what they expect he should do.
When asked by Richard Bruton how he could be so sure that "long-term economic value" of the bad loans wasn't so low as to render the banks insolvent and requiring nationalisation, the minister responded that he knew this because the current share prices were well above zero. Indeed, Lenihan described to Bruton why he would send Mr McDonagh back to redo his homework if Nama came to him with a long-term economic valuation that wiped out equity in the banks. Here's what the minister said:
"Why would I outline the fact that there may be a residual or substantial shareholder interest left in these institutions if valuations established that their entire shareholder value was wiped out?
"The reason is on the basis of the information that I have at my disposal. This is not information that only I have at my disposal, because markets have assessed that information in the context of their current share price and rating agencies have used it in their assessment of these institutions.
"Were these institutions in the condition which Deputy Bruton suggests, they would not have these positive market ratings and they would not have the degree of shareholder value they do."
That the current share price is based, not on the underlying value of their assets but on what is expected to happen -- the expected 20 per cent discount -- does not appear to have occurred to the minister.
So there we have the key to decoding what long-term economic value means to Mr Lenihan.
The share prices for the banks are now well above zero because the market expects Nama to apply a small haircut.
And if Mr McDonagh has the temerity to come back with a large haircut that would wipe out the equity, the minister will explain to him that the share price shows he must have got his long-term economic value sums wrong.
This is why the minister is so confident the banks won't be nationalised. The markets don't expect them to be nationalised and, based on those expectations, one couldn't possibly justify nationalising.
It is a watertight tautology. The minister is watching the markets who are, in turn, watching the minister. And everyone's agreed the banks won't be nationalised. So they won't be. Meanwhile the taxpayer is left carrying the can.
Karl lWhelan is professor of economics at UCD