An Economic Perspective on the
Value of Irish Bank Assets
A Presentation to the Irish Economic Policy
Conference
January 2014
Gregory Connor
NUI Maynooth
Conall MacCoille
Davy’s
Outline
1. Four Definitions of Asset Value
2. The Economic Loss from Tracker Mortgage
Rate Misalignment
3. The Economic Loss from Mortgage Default
4. Adding Up the Pieces
5. Franchise Value and Equity Valuation
6. Conclusions
Four Definitions of Asset Value
1. 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

•
Theory of banking argues against relying on market
values for banking assets

•
Not directly relevant if the assets will not be sold
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

•
Economic value may be higher than market value of
the asset:



•
Fully current valuation, like market valuation
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 riskreturn 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 TrackerMortgage 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 twoyear rate
Risk-free Term Structure, Forward
Rates and Bank Cost of Capital
9
8
7
6
Risk-Free Long Rates
5
Forecast One-month Rates
Bank Cost of Capital
Forecast Standard Variable Rates
4
Forecast Tracker Rates
Forecast Two-year Rates
3
2
1
0
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
€4.968
(€ Billions)
€8.243
€9.899
€10.343
%Loss/Total Assets
2.75%
3.30%
3.45%
1.66%
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
% Loss of Asset
Value
Equity Capital
Loss
(€ Billions)
%Loss/Total
Assets
20.00%
30.00%
40.00%
4.00%
6.00%
8.00%
€4.000
€6.000
€8.000
1.85%
2.78%
3.70%
Adding Up the Pieces
Combining 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 Pieces
Combining 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 Pieces
Speculative 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 Valuation
Franchise 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 Valuation
Linking 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.