An Economic Perspective on the Value of Irish Bank Assets

A Presentation to the Irish Economic Policy Conference January 2014

Gregory Connor Conall MacCoilleNUI Maynooth Davy’s

Outline

1. Four Definitions of Asset Value2. The Economic Loss from Tracker Mortgage

Rate Misalignment3. The Economic Loss from Mortgage Default4. Adding Up the Pieces5. Franchise Value and Equity Valuation6. Conclusions

Four Definitions of Asset Value1. Accounting Value• The value of the asset using inflexible,

conservative accounting rules• Does not impound all currently available

information, by construction• Has proven to be grossly inadequate for banks

during the global banking crisis Example (one of many) using accounting value,

Lehman Brothers had a Tier 1 capital ratio of 11% (almost three times the minimum) in September 2008

Four Definitions of Asset Value

2. Market Value• The realisable value from selling the asset

Not directly relevant if the assets will not be sold

• Theory of banking argues against relying on market values for banking assets

Only useful in limited circumstances (trading book assets)

• If we apply market valuation to all assets on their balance sheets, then Ireland has no solvent domestic banks

Irish mortgage books sell for approximately 50% of their accounting value

Four Definitions of Asset Value, continued

3. Regulatory Value• The accounting value of the asset under regulatory

accounting rules mandated for capital adequacy• More flexibility than under standard accounting rules• Can be stretched or interpreted by the regulator to reach

a desired result• Comment from an October 2013 DEW conference

discussion panel:“The 2014 EU banking sector stress test will be manipulated to produce a bank capital shortfall that does not require too large a capital injection”

Four Definitions of Asset Value, continued

4. Economic Value• The present discounted value of expected cash flows

from the asset Fully current valuation, like market valuation

• Economic value may be higher than market value of the asset:

More efficient utilization of the asset by the bank than by the prospective new owner

An adverse selection discount in bank asset sale prices Market illiquidity or transactions costs

• Requires a model-based valuation

Four Definitions of Asset Value, cont.Does Economic Value Matter?

• Equity value and equity/liability ratio influence bank decision-making and affect medium-term bank stability Managers concerned about maximizing shareholder

wealth will rely on economic values in measuring risk-return tradeoffs

• Economic value and accounting value should be cointegrated time series under clean surplus accounting; see Ohlson (1995) Cointegrated time series are linked in the long run, but can

deviate from each other for considerable periods

The Economic Loss from Tracker-Mortgage Rate Misalignment

Calibration to Newly Issued Assets

• Simplest and clearest valuation of trackers comes from comparison to currently available mortgage products

• Standard variable rate (SVR) mortgages and tracker rate mortgages are both fairly short-rate assets Trackers have an inflexible premium over the ECB rate SVR mortgages change their monthly rate more slowly

than trackers, but the bank has flexibility about the rate

Present Value using Bank’s Cost of Capital

• Asset pricing theory argues that asset cash flows should be valued using the bank’s risk-adjusted cost of capital for that asset type

• Calibrate using the current BoI SVR rate of 4.3% for LTV <75%

• Newly issued SVR economic value = SVR principal value Assumes that new SVR mortgages expected to earn an

economic level of bank profitability, not a monopoly profit level

Some commentators have claimed that SVR mortgages have super-profitability based on bank market power

Cost of Capital for Tracker Mortgage Assets

• Assume the bank’s risk-adjusted cost of capital for mortgage assets has a fixed risk premium over risk-free term structure rates The servicing cost of the mortgage is included in

the cost of capital risk premium• Calculate the fixed risk premium which sets

the economic value of new SVR mortgages equal to their principal

Tracker Mortgage Economic Value: Forecast ECB Rates

• ECB provides an estimated zero-coupon term structure of AAA sovereign government rates Add 12.64 basis points so that the 3-month rate

equals the ECB 0.25% rate (used for first two months)

• Use the unbiased expectations hypothesis to find the expected risk-free short rates from this risk-free term structure of long rates Trackers follow the one-month rate, SVR the two-

year rate

Risk-free Term Structure, Forward Rates and Bank Cost of Capital

0

1

2

3

4

5

6

7

8

9

Risk-Free Long RatesForecast One-month RatesBank Cost of CapitalForecast Standard Variable RatesForecast Tracker RatesForecast Two-year Rates

Time Length of Rate Misalignment

• The tracker rate misalignment may shrink or disappear over time

• Assume that the rate misalignment of tracker mortgages disappears with certainty in X years, and economic value is equal to principal value after that date

• Borrower-side Tracker Mortgage Economic Value = PV(cash payments during misalignment period) + PV(principal value after elimination of rate misalignment)

Accounting Values for Scaling Losses

• Scale to the aggregate assets of the domestic HQ banks excluding IBRC (BoI, AIB, PTSB) Outstanding assets (Q4 2012) of €300 billion Irish mortgage assets (Q4 2012) of €100 billion Approximately 54% of Irish mortgages are tracker

loans (December 2011 Irish Central Bank Report) Assume all trackers have a 125 basis point

premium, 20 year remaining term, standard payment features (interest and principal)

Economic Value Loss From Tracker Mortgage Rate Misalignment

Rate Misalignment Period (Years) 5 10 15 20

% Loss of Principal Value 9.20% 15.27% 18.33% 19.15%

Equity Capital Loss (€ Billions) €4.968 €8.243 €9.899 €10.343

%Loss/Total Assets 1.66% 2.75% 3.30% 3.45%

The Economic Loss from Mortgage Default

• PV(mortgage asset) = PV(promised cash flows) – Prob(default) x LGD LGD = loss given default Mortgage default is conventionally defined as 60 or 90 days

cumulative arrears• A blended default rate of 20.0%

17.4% of principal private residence mortgages and 29.3% of buy-to-let mortgages are in default (90 days + arrears, % by value not number

• New defaults have begun to ease since mid-2013• Treat the default probability as fixed at its current sample

average value – default event has occurred and there will be no new excess defaults

The Economic Loss from Mortgage Default

Loss Given Default 20.00% 30.00% 40.00%

% Loss of Asset Value 4.00% 6.00% 8.00%

Equity Capital Loss

(€ Billions)€4.000 €6.000 €8.000

%Loss/Total Assets 1.85% 2.78% 3.70%

Adding Up the PiecesCombining the Results for Tracker Rate Misalignment and

Mortgage Default (%Loss/Total Assets)

LGD

Years of

Misalignment

20% 30% 40%

5 2.66% 3.32% 3.99%

10 3.53% 4.20% 4.86%

15 3.97% 4.64% 5.31%

20 4.09% 4.76% 5.42%

Adding Up the PiecesCombining the Results for Tracker Rate Misalignment and

Mortgage Default (€ billions, domestic HQ banks, excluding IBRC)

LGD

Years of

Misalignment

20% 30% 40%

5 €7.974 €9.974 €11.974

10 €10.594 €12.594 €14.594

15 €11.919 €13.918 €15.918

20 €12.274 €14.274 €16.274

Adding Up the PiecesSpeculative Property Lending in SME Loans

• Irish regulated banks (including foreign headquartered) have €57.07 billion of small and medium enterprise (SME) loans (12.01% of total assets)

• Many Irish SME loans are effectively property loans rather than conventional business activity loans 43.96% of SME loans are property-related

• Roughly half of SME loans are distressed 12.01%x43.96%x50%x40% = 1.06% Economic Value

Loss/Total Assets• This is another crisis-related drain on Irish bank asset

value

Franchise Value and Equity ValuationFranchise Value or PVGO

• Accounting value balance sheet identity: Asset value = liability value + equity value

• Economic value balance sheet identity: asset value + franchise value = liability value + equity

value• Franchise value is also known as PVGO (present value

of growth opportunities) Captures the value of the bank’s network, proprietary

knowledge, reputation, ECB subsidy, and monopoly power (if any) to overcharge/underpay on new assets/liabilities

Franchise Value and Equity Valuation Franchise Value of Irish Banks

• The shrinkage in the number of domestically active banks serves to increase per-bank franchise value Some of this increase comes from the greater

market power of surviving banks Increased franchise value is partly at the expense

of depositors and savers (higher fees, lower interest rates) and borrowers (more selective lending at higher average rates)

Franchise Value and Equity Valuation Franchise Value of Irish Banks, cont.

• The poor quality of existing Irish bank assets is partly structural rather than temporary: The 2009 Land Reform Act law lacuna accidentally

changed lender property rights Much of the decreased security of loan collateral

has been made permanent by legislation• Realized loan default rate is extremely high;

future probability of default will decline, but could remain high

Franchise Value and Equity ValuationLinking the Economic Value Loss to Accounting Value of Equity

• Accounting valuation rules can spread the loss over many decades, whereas economic valuation imposes present value theory

• Positive net interest margins allows the banks to push the underlying economic value problem into the future, and hope for good news

• The difficulty of measuring franchise value is a limitation in economic valuation of equity

Conclusions• Economic value analysis provides an alternative

to accounting-based or regulatory valuation of bank assets

• This provides a useful alternative perspective on banking sector prospects and policy

• This talk looks at post-Nama shocks to domestic banks’ economic value

• Tracker rate misalignment and the mortgage default explosion have drained considerable economic value from the banks

Conclusions, cont.

• The franchise value of Irish domestic banks has been improved by the withdrawal of foreign banks: Some of this franchise value improvement comes at

the expense of Irish savers and borrowers• The poor credit quality of Irish domestic bank

assets is partly temporary, but also partly reflects a permanent change in the Irish domestic banking environment Debt default rates are extremely high, and could

remain high

Conclusions, cont.

• The Irish economy has several notable strengths predicting above-average performance: English speaking; politically stable; low level of

corruption; international goodwill and political weight Above average PISA scores and fair-to-good education

system Good growth industries: Pharma, technology-related,

medical devices, agribusiness, entertainment/media• The domestic Irish banking sector might add a

drag rather than uplift to comparative national economic performance

Bibliography

• Ohlson, James A., “Earnings, book value and dividends in equity valuation,” Contemporary accounting research, 1995, vol. 11, no.2, pp 661-687.