joestiglitz1

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T HE HI GH C OU R TC OM M E R C I A L2010 No. 909 JR

B E T W E E N :D E L L W A Y I N V E S T M E N T S L I M IT E D , M E T R OS PA L I M IT E D , B E R KL E Y

PROPERTIES LIMITED, MAGINOTGRANGE LIMITED, MAY PROPERTYHOLDINGS LIMITED, SCI 20 PLACE VENDOME, DIRECTDIVTDE TRADING

LIMITED, SUBMITQ EST LIMITED, BELFAST O FFICE PROPERTIESLIMITED, THE FORGE LIMITED PARTNE RSHIP, FINBROOK

INVESTMENTS LIMITED, CONNIS PROPERTY SER VICES LIMITED,FORMCREST CONSTRUCTION LIMITED, CHESTERFIELD (THE

PAVEMEN TS) SUBSIDIARY LIMITED, ABBEY DEVELO PMEN TS LIMITEDAND PATRICK McKTLLEN

APPLICANTSA N D

N A T I ON A L A S S E T M A N A GE M E N T A GE N C Y , I R E L A N D A N D T HE ^A T T OR N E Y GE N E R A L

RESPONDEN

AFFIDAVIT OF DR. JOSEPH E. STIGLITZ

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I, Professor Joseph Stiglitz, residing a1258 Riverside Drive Apt 12 CD New York, NY 10025,United States of America aged eighteen years and upwards M ake O ath and say as follows:I . I N T R O D U C T I O N

1. I make this affidav it at the request of the Applicants in the above entitledproceedings, for the purpose of providing an expert opinion to the Court. Iunderstand that the duty and the role of an expert witness are to assist the court andthat experts have a duty to be impartial. I have abided to this duty and m ake thisaffidavit from facts within my knowledge, save where otherwise appearing and whereso appearing I believe the same to b e true.

A. QUALIFICATIONS2. I am one of ten University Professors at Colum bia University. I currently hold joint

appointments in the Department of Economics in the Faculty of Arts and Sciences,the Department of Finance in the Gradate School of Business, and in the School ofInternational and Public Affairs. Prior to assuming this position, I held pro fessorshipsat Stanford, Yale, Princeton, and Oxford where I taught a wide variety of gradateand undergraduate courses in economics and finance.

3. From 1993 to 1997, I served as a mem ber of the President Clinton 's Council ofEconomic Advisers, and from 1995-1997, as Chairman of the Council and a memberof the Presiden t's Cabinet. As Chairman and Cabinet Mem ber, I was the principieperson within the White House responsible for formulating fiscal policy, financialsector regulation and banking policy, and coo rdinating policy with the U.S. Treasury.

4. From 1997 to 2000, I served as Chief Econom ist and Snior Vice President of theWorld Bank, in which capacity I had the responsibility of advising countries aroundthe world on the design of fiscal and monetary policies.

5. Relevant to the topics I discuss in this affidavit, I have published leadingundergraduate and gradate textbooks, authored over 500 scholarly articles, writtennumerous academic books and a variety of popular books.


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6. In 2001, I was awarded the Nobel Prize in economics for work which is directlyrelevant to this case. This work includes the study of how Information asymm etriesaffect economic behavior, the determination of the conditions under which effcientsharing of risk occur, and the economics of fnancial markets.

7. Additional qualifications can be found in my Curriculum Vitae attached and labeled"JES1."

B . O V E R V I E W A ND S M M A R Y O F C O N C L U S I O N S8. In preparing this affidavit, I have reviewed the witness statements regarding the role

and operations of the National Asset Management Agency ("AMA") within theIrish banking crisis, including its purported role in improving bank balance sheets andenhancing econom ic perform ance. My rev iew of these material s indi cates that thereis considerable confusion regarding how the banking sector works, the economicallyappropriate process fo r addressing bank insolvency, and the role that AM A can playin addressing bank insolvency. I have also reviewed data and a ffidavits pertaining tothe performance of McKillen's portfolio and the extent to which his loans pose asystemic risk to the Irish economy. Based on this review, the economic benefits tomoving the McKillen loans to AMA are questionable at best. To the contrary,McK illen, the banks and the taxpayer are likely to be injured by such a m ove.

9. I am aware, having been so advised by the legal advisors to Mr. Mc Killen, that thisHonourable Court is unlikely to rule upon the question as to whether the McKillen-related loans are or are not suitable for transfer to A MA . Rather, I understand it tobe the case that the Court is more likely to be concerned w ith the manner in which thedecisin to take a transfer of the McKillen-related loans was m ade. That being so, Iwish to note at the outset that from the perspective of Mr. McKillen there arecompelling arguments as to why his loans ought not to have been transferred toAMA, and it is my understanding that he was never given an opportunity to makethose argum ents. Furthermo re, from the perspective of the Irish economy and thebanking sector - including in particular the banks lending to Mr. McK illen - there areseveral factors which strongly indicate strongly that there should not have been a


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transfer to AM A. Based upon both w hat I have revewed to date and also what Ihave been told, I see no evidence that any consideration was given to these factors inthe taking of the relevant decisin. It is my ow n strong opinion that there should no tbe a transfer of the McKillen loans to AM A. Furthermore, in light of the incentivesassociated with AMA and its structure and powers, it is particularly important tohave procedural safeguards and due process, neither of which would be undulyburdensome.

10. My affida vit proceeds as follow s. First, I outline the role of long-term relationshipsin the banking sector in addressing the asymmetric information problems that arepervasive in this industry. Second, I discuss best practices for addressing bankinsolvency, highlighting economic considerations relevant to choosing which assetsshould be purchased by A MA . Third, I provide analysis of the Irish banking crisisand the creation of AMA, incuding an economic analysis of NAMA's structure andits statements to shareholders and taxpayers with respect to its perform ance. Fourth, Iexplain why N AM A's structure and incentives - in particular its incentive and abilityto seize performing loans in the absence of due process - do not reflect best practicesfor addressing bank insolvency. Fifth, I explain from an information econom icsperspective why a transfer of the M cKillen loans will likely h ave a negative impact onMcK illen. Sixth, I review evidence indicating that McK illen's loans are not impairedand that his portfolio does not impose systemic risk on its lenders. Seve nth, I discusshow allowing for due process would improve NAMA's efficiency and reduce thepotential for injury to the banks, taxpayers, borrowers, and the Irish economy morebroadly. Eighth, I review the testimony of A MA w itnesses, Ms. Anne Nolan, Mr.Brendan McDonagh, Ms. Aideen O'Reilly, and Professors McAleese and Lae.

11. I will use several words hrougho ut this affidavit with precise meaning:a. Impaired loan - M eans a loan where there is an explicit expectation by the bank

and its accountants that a loan loss will occur.1

See discussion of def init ions in International Accounting Standards in aff idavits of John Trench andMichae l Cragg.

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b. Technical default - Means that a loan covenant is breached but the loans are beingftilly serviced.

c. Payment default - Means that the borrow er's cash paym ent obligations to thelender are not being m et.d. Performing loan - M eans that the cash flow requirements of the loan (scheduled

interest and capital payments) are being met (see Affidavit of John Trenchparagraph 32).

12. The conclusions of my anaysis can be summarized as follows:a. There is a standard process for addressing bank insolvency that creates

appropriate incentives for borrow ers and lenders. The Irish go ve rnm en fsresponse to the banking crisis implements parts of this standard toolkit, thoughsome of the distinctive aspects of its response do represent deviations from bestpractice and raise concerns that require particular attention with respect to theacquisition of assets. In order for the gov ern m en fs process to work well, it iscrucial that the government focus on identifying and acquiring those loans forwhich: (i) principal and interest is not being repaid or (ii) there is a significant riskof nonpayment.

b. Although NA M A's role should be confm ed to paying for bad loans at fair marketvalu, it has both the incentive and the ability to underpay banks for good assets.AM A has an incentive to seize bank assets that are performing well because thisstrategy allows it to create short-term gains for shareholders and demnstrateprofitability to the public. A MA is able to act in accordance with thisinappropriate incentive largely because of the extraordinary powers that it hasbeen granted to rewrite contracts and seize bank assets without consultation withborrowers.

c. NA M A's incentive and ability to seize good loans is highly problematic. IfAMA is allowed to underpay for performing loans, the banks will be le weakerand the taxpayer will be le no better off - in fact, they may be worse off, bothbecause of the likely increase in public costs of bank recapitalization and because


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of the adverse effects on the economy. Further, NA M A's acquisition of goodloans (which it has an incentive to do) will hurt the banks, the econom y, and -most relevant to this case - good borrowers such as McKillen.2 This is becauseAMA does not have a bank's reputation, incentives, or information, or does ithave a ba nk 's ability to issue or roll over credit. In the absence of these resources,AMA cannot recreate the valu generated in normal long-term bankingrelationships.

d. In sum, the structure of A M A (includ ing its short time horizon and its inabilityto issue credit) create the possibility of value-destroying loan transfers. NA M A 'sincentives exacerbate this risk, making what would otherwise be a theoreticalpossibility into a matter of serious matter of concern. Such value-destroyingtransfers hurt the banks, the economy, and, most relevant to this case, goodborrow ers such as McK illen. AM A has disrupted and may well continu todsrupt Mc Killen's core long-term real estte business and it will have an adverseeffec t on the valu of his assets and his ability to refinance loans. This is becauseMcKillen's business - long-term investment in income-generating real estte - isa business that relies on predictable sources of credit and predictable tenantbehavior. Unlike speculative developmen t, in which a developer builds to sell atprices that he hopes are higher than the costs of acquiring the land and buildingstructures, businesses grounded in long-term real estte investment areparticularly harmed by a transfer to AM A. In more normal times, given enoughtime, McKillen could presumably transfer his banking relationship to anotherwilling, long-term lender. But these are not normal times, and AM A proceduresand timetables may not provide McKillen with the time that would normally berequired for a transfer of this scale.

e. Consistent with my discussion above, the affidavits provided by A MA do notprovide any explanation of why moving McKillen's loans to AMA is good forthe Bank of Ireland or Anglo Irish Bank. They also provide no explanation of

While many of these problems are inherent in any good bank-bad bank restructur ing, I re land's structure ,with par tia l pr vate ownership of AMA, represents par ticular r isks, and is a structure not 1ike1y to befo l lowed e lsewhere in the wor ld .

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why such a move is good for taxpayers, save fo r the nebulous claim that M cKillenposes a systemic risk because he is a large borrower. In fact, the evidence showsthat McK illen loans are not impaired and p ose no systemic risk.f. Based on the foregoing analysis, it is my opinion that the Irish economy wouldbeneft most from leaving the McKillen loans with the banks in which theycurrently reside. Given the breadth of M cKillen 's assets, the extent ofdiversification in his portfolio, and the fact that McK illen's assets were assembledand fmanced over a three decade period - a period in which McKillendemonstrated himself to be a reliable, long-term borrower - it is in the country's,the banks' and McKillen's best interests for his loan portfolio to remain with thebanks that originated the loans. A MA w ould need to conduct an extensivedialogue with McKillen in order to understand the economic support for this.Instead of engaging in such conversations, however, AMA has exercised itsbroad powers to purchase assets it considers eligible, even in the face ofobjections by banks or borrowers.

g. As a general matter, it is good policy fo r AM A to gather information fromborrow ers who wish to make a case for staying out of A MA . If AM A neglectsto gather such information, it will almost surely m ake econo mic m istakes that hurtthe state, the borrowers, and the banks. Thus, providing borrowers with theopportunity to ob ject to their loan transfer to AM A is good econom ic policy thatgenerally makes borrowers, lenders and the state better off. Failing to providethis opportun ity creates the risk of a taking , as well as a situation in wh ich thestate and the economy is made w orse off.

II. THE ROLE OF LONG-TERM RELATIONSHIPS IN THE BANKING SECTOR13. Financial institutions are primarily vehicles for facilitating transac tions betwee n those

who have capital and those who wish to borrow either: (i) to fmance investments or(ii) to consum e now at the expense of future consumption. While conceptuallystraightforward, the complex real-world structure of financial institutions and m arkets

3 A taking is when the government acquires pr vate property and fails to compnsate an owner fa ir ly. Ataking can occur even without the actual physical seizure of property.

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is to a large extent a response to issues arising from differences in informationavailable to borrowers and lenders. These information difference s - or asymm etries ~give rise to problems of m oral hazard and adverse selection.14. Moral hazard in banking arises because key aspects of borrower behavior often cannotbe observed by the lender. As a result, once a borrower is insulated from the risks ofits actions, it can change its behavior in a way that is adverse to the interests of theender. For example, real estte developers may have an incentive to undertakeexcessively risky investments when they have a limited downside and an unlimitedupside when gambles pay off. The Irish real estte frenzy increased the problems ofmoral hazard, as developers raced to build and flip properties in the absence ofadequate bank supervisin. Similarly, in the aftermath of the Irish banking crisis,banks themselves m ay have the incentive to take excessive risks. This is because theymay perceive themselves as insulated from the full cost of their decisions by the beliefthat the Irish go vernmen t will not let them fail.

15. Adverse selection in banking arises both because borrow ers differ in the prohabilitywith which they will be able to repay their loans and because lenders are unable toperfectly identify reliable borrowers. As a result, the pool of loan applicants maychange once the terms of provisin of credit change. For example, when a lenderincreases the interest rate that it charges, borrowers with a high probability ofrepayment may drop out of the pool, leaving only those borrowers with a lowprobability of repayment. With these changes in the pool of lenders, it is difficult forlenders to ensure that the terms they offe r - e.g., the interest rates that they charge -appropriately reflect the risks that they face.

16. Many practices have developed to address the moral hazard and adverse selectionproblems discussed above. For example, banks typically require collateral fromborrowers. Because of concerns of moral hazard, banks making construction loansoften require borrowers to meet specifc milestones befo re providing additional fund s.Banks also use consumer credit scoring to help differentiate potential customers whoare likely to repay their loans from those who are not. Banks can then offe r betterinterest rates to those customers who appear to be relatively credit-worthy.


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17. One of the most important ways in which adverse selection and moral hazardproblems are addressed in the banking sector is through long-term relationshipsbetween bankers and borrowers. Long-term comm ercial banking relationships, suchas those that McK illen has with Ang lo-Irish Bank and Bank of I re and, help banksdifferentiate borrowers w ho are good risks from those who are bad risks. As thecommercial borrower builds an ever-longer track record with a particular bank, theunderwriters gain confidence in the borrower and the bank is able to offer lowerinterest rates. reduced collateral requirements, reduced information reportingrequirements, and greater loan amounts, al! at greater and safer profts to the bank.4Long-term relationships also help address the moral hazard problem. Given theprospect of ongoing benefts from the relationship, both the borrower and the lenderhave strong incentives to behave well even under adverse, and often complex,circumstances.5 Long-term "incentive compatible" relationships enable more flexiblecontracting, based on trust. These relationships are an important part of the reasonthat parties can agree to short or medium-term loans (such as those McKillen has)even when financing a long-lived asset.6 Institutional practices and understandingsbetween the parties can substitute for explicit contract provisions, reducingcontracting costs and enhancing fexibility and effciency.

18. With no long-term relationship in place to mitgate concerns with respect to moralhazard and adverse selection, organizations like AMA are severely constrained intheir ability to recognize and supp ort successful borrowers. Mo reo ver, N AM A'sincentive to develop such a mutually beneficial relationship with its borrowers islimited, for two reasons. First, unlike traditional lenders that derive their pro fits froma long-term relationship with a credit-worthy borrower, NAMA's goal is to discharge

See the aff dav it of Joe Belang er fo r greater detail5 This is because each par ty perceives the valu of i ts future reward to be greater than ar ty immediate valuganed from engaging in opportunistic behavior today.6 See the aff dav it of Joe Bela nger fo r greater detail7 No con tract is ever "com plete " in the sense that i could antic pate every conting ency. t would beprohibit iv ely expensiv e even to a ttemp t to do so. Econ om ists refer to the und erstand ings that serve aspartia l substi tutes as "imp licit contrais." The y not only provide for greater eff c ie ncy and f exibil i ty, theyalso reduce l i t igation costs.

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its portfolio in a relatively short span of time.8 Second, AMA lacks one of theprmary means for effecting a long-term mutually beneficial reationship withperform ing borrowers, the ability to meaning fully extend credit. In a long-termbanking reationship, credit facilities are rolled over upon expiration of a loan if boththe bank and the borrower have behaved well, thus providing profit incentives forfuture good (non-opportunistic) behavior. How ever, AMA is not a bank9 and doesnot have the same ability to provide rollover credit on a long-term basis. W ithout thepromise of future rewards from a mutually benefcial long-term reationship, bothAMA and good borrowers such as McKillen have an increased incentive to behaveopportunistically. The response by AM A seems to be rule-based procedures thatrisk the destruction of valu by requiring relatively rapid sales of assets, even inunfavorable markets. Potential buy ers' knowledge that sellers may be undercompulsin to dispose of their assets would adversely affect sellers' bargainingposition even in more favorable market conditions. This concern is even morepertinent in the current climate of high uncertainty and liquidity constraints.

19. Clearly, NA M A's structure and incentives present significant problems for McK illenand other borrowers who run successful businesses that rely on loan refinancing.10Given these considerations, AMA should not be allowed to acquire and administerloans that are currently perform ing well, without the full benefts of due process.

See the aff idavit of Joe Belanger for detail .At some points, i t seems to make a great deal of this, saying that i t should therefore not be called a "badban k," and therefo re canno t have the adverse reputation effects associated with a bad bank. Th e generalnomenclature in bank restructur ing is to refer to asset management vehicles l ike AMA as a bad bank,even thoug h they are really wo rk-o ut vehicles. Bu t this re info rces the point I am makin g: wo rk outvehicles are designed to work out bad loans, and the fact that they don' t have the tools or long-termhorizon of a bank means that they are not suitable for managing performing assets.In the language of economis ts , NAMA's purchase of McKil len wi l l e l imna te the economic benef t s tha thav e accrued to the ban ks and McKille n as a result of their par tic ipation in a repeated gam e. Thro ugh thisrepeated game, McKillen and i ts banks have each buil t up the reputation for non-opportunistic behaviortha t i s needed to e f fec t mutua l ly benef c ia l t r ansac tions . N A M A 's purchase of McKil len would replacethis repeated game with a one shot game that could well preven! such benefc ia l transactions from takingplace and thereby destroy market valu.

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III. BEST PRACTICES FOR DEALING WITH LOAN INSOLVENCY ALLOWGOOD LOA NS TO CONTINUE TO BENEFIT FROM THEIR EXISTING LONG-TERMRELATIONSHIPS20. Lending is risky, even when banks do a good job of assessing creditworthiness and

mon itoring loans. Bank regulations are designed to ensure that the bank has adequatecapital to meet its liabilities, i.e. money that it has "borrowed" from depositors. Thegreater the amount of bank capital held by these shareholders, the less susceptible thebank is to becoming insolvent, i.e. to have insufficient assets to meet its obligations.

21. Bank regulators are concerned about capital adequacy for a second reason: if bankshave insufficient capital, they have an incentive to undertake excessive risk (makingbad loans), and this is especially so if they are likely to be bailed out by thegovernmen t (if they are too big to fail). While bank supervisors are supposed tomitigate this risk, they can do so only imperfectly.

22. In periods of turbulence, assessing whether banks are adequately capitalized may beespecially difficult. There may be problems of information asymm etries betweenregulators/supervisors and banks. Banks often claim that they are illiquid meaningthat no one is willing to provide the banks the funds they need (at least at reasonableterms) when in fact they are insolvent - i.e., they are unable to raise additional capitalbecause the valu of their liabilities exceed their assets. In the case of Ireland, theoffer of a very broad go vernmen t guarantee of all bank liabilities meant that the bankswere neither illiquid or insolvent since they were effectively backed by thegov ernm ent's fu l capacity to tax. If the guarantee is removed , the twin problems andilliquidity and insolvency will immediately emerge.11

This has one fur ther impo rtant imp cation: Th ere are two rationales put forward for str ipping out the badloans. On e is to reduc e the uncerta inty associated with the ban ks' balance she et The second ismanagerialto allow one insti tution ( the good bank) to focus on good loans, the other on working out badloans. But if the bank is essentia lly insolven t, the f irst objec tive beco mes largely ir re levan t Thegov ernm ent will , in any case, hav e to bear the r isks. The go vernm ent is currently d oing so through theguarantees i t provides to those providing capita l to the banks, and given the effective insolvency, i t w11have to continu to do so. Mo ving the r isk from one public body to another does not change the overallr i sk to the econom y or the publ ic somethin g which the marke ts have a l ready recognized . Theconsequences depend only on the improved manag ement of the asse ts tha t migh t r e su l t My ana lys issuggests that , to the contrary, a move of a performing loan is l ikely to result in a worse management of theasset .

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23. Standard rules of capitalism dctate who will bear the losses associated with a banksolvency problem. These rules require that shareholders lose all valu and thatbondholders become ne w shareholders. Only after bondholders have lost their capitalshould government inject new capital, through deposit insurance and governmentbailout funds. The bank, in such circumstances, will need to receive an infusin ofnew funds (i.e., be recapitalized), typically first firom the government (to make itviable), and then from the prvate sector through a pub lic offering. In either case, thebank can co ntinu to exist and to provide funds.

24. Bank insolvency , if hand led in accorda nce with these standard rules, will not entail aserious interruption of the flow of credit to borrowers. This approach to addressingbank insolvency has worked in very large banks, such as Continental Illinois, and in avariety of countries, including Sweden and Norw ay. Indeed, as with bankruptcies inother sectors, bankruptcies among banks can lead to better performance, asuncertainty about the status of creditors is resolved and as the Corporation imdertakeschanges in managemen t. In contrast, deviations from these standard rules result ininequities, and going forwa rd, can lead to large adverse incentive effects.

25. To prevent banks under prvate control from throwing good money after bad in thepresence of a governm ent guarantee and to reduce uncertainty about insolvency itself,it may be desirable to take the bad loans away from the bank. In that case, it isobviously appropriate for a government entity to pay the bank the expected valu ofthe bad loans. Such payment forces recognition of the (expected) loss, and therebyma king clear the shortfall in capital. Howev er, it is impo rtant to realize that thegovernmenfs payment to the bank of fair market valu for its bad loans does notcause the bank to become insolvent. It only makes apparent the insolvency thataccounting standards have allowed to be hidden - the bank was already insolvent. Ifthe bank is insolvent, such stripping out of the risky loans will not enable the bank toretum to lending. It will not resolve the bank s' financial position. It can only be seenas a first step in the recapitalization process, which, as described above, should entailfirst converting bondholders into new shareholders, and then, if necessary, furtherinjections of capital.

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26. Wh ile, in the "bad bank " approach to addressing banking crises, it may be necessaryor desirable fo r the government to p urchase bad loans from banks in order to facilitaterecovery, economic logic clearly indicates that it is poor public policy for thegovernment to purchase good loans from the banks. This destroys the valu of long-term banking relationships that facilitate profitable transactions in a sector pervadedby asymmetric information problems and incentives for opportunistic behavior. Withthe severance of such relationships, bank risks may actually be increased and accessto additional funds reduced, all with adverse effects on new potential borrowers andother good borrow ers. Further, and as discussed in detail below, there may be followon effects: risks to the taxpayer may increase, the interest rate government pays mayincrease, and this m ay lead to further increases in the cost o f capital to the b anks, andto borrowers.

IV. BANK INSOLVENCY IN IRELAND AND THE CREATION OF AMA27. Below, I describe the banking crisis in Ireland and discuss the Irish gov ernm ent' s

response to this crisis, including its creation of AMA. I also explain that the roleaccorded to AMA by the EU is to forc banks to realize their losses by purchasingbad loans at an amount approximately equal to long run fair market valu. As notedabove, NAMA's role need not conflict with an economically consistent process foraddressing bank insolvency, though in the best of circumstances, the "bad bankapproach" reflected by AMA is one fraught with challenges (see section V below).However, NAMA's current structure provides it with incentives to underpay thebanks, seize good assets in order to offset losses from riskier loans on their boo ks, andcreate short term gains for the AMA shareholders.12 Further, AM A has the abilityto act on these incentives due to the extraordinary powers it has been granted torewrite contracts. NA M A's authority in this regard is well in excess of that affordedto ordinary com mercial lenders.

As I explain la ter , AMA created a SPV for acquir ing loans from banks, and i t is more accurate to saythat the sharehold ers are shareho lders in the SPV . Thro ugh out this report I simp lify by referr ing to theshareholde rs in the SPV as "A MA shareholde rs . "

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A . DESCRIPTION OF THE IRISH BANKING CR ISIS28. As discussed in detail in Dr. Cra gg's affidavit, Ireland 's economy was hit especially

hard during the fnancial crisis of 2008, and those doldrums have continued untiltoday. Unlike the crisis in the United States, Irelan d's econom ic problems were notdriven primarily by exotic fnancial instruments. Rathe r, they represented a "plainvanilla property bubble"13 fueled by large concentrations of lending for property-related purposes.

29. Irelan d's economy was hugely dependent on building and construction; those sectorsmade up 20% of the coun try's GD P in 2007. This figure was more than 5% higherthan in any other Western European country and more than double the share thatbuilding and construction represented in the United States' GDP for 2007. 14Construction also employed over 13% of the workforce at its peak in the third quarterof 2006, which amounted to nearly a doubling of the economy-wide employmentshare before the property run -up.15

30. Furthermore, construction accounted for an ever-increasing proportion of Irelan d'sGNP as the bubble became mo re inflated. As discussed in Dr. Crag g's affid avit,' 6 4%to 6% of Ireland's national income in the 1990s carne from homebuilding, the usuallevel for a developed econom y. By the peak of the boom in 2006-07, how ever, thispercentage had increased to 15%, and other construction endeavors representedanother 6% of GNP (163 billion in 2007 17). This distortion in the economiccontribution from housing and other construction projects was driven by theovervaluation of Irish real estte and the excessive availability of credit to fnancehousing and comm ercial real estte developm ent.

13 Regl ing , Klaus and Max Watson, "A Pre l iminary Repor t on the Sources of I re l and ' s Banking Cr i s i s , "2010, p . 6 a t tached and l abe led " JES2 ." Al te rna t ive ly desc r ibed as an "old- fash ioned proper ty b ubb le" inHonohan, Pa t r i ck , "What Went Wrong in I re land" May 2009, P repared for the Wor ld Bank a t t ached andl a be l e d " J E S 3 . "M Cragg Affidavi t 1J27.15 C r a gg A f f i da v i t 127 .16 C r a gg A f f i da v i t ^ 2817 Cent ra l S ta t i st i c s Of f i ce , "Nat iona l In com e and Expend i ture : Annua l Re sul t s for 200 9," June 30 , 2010 , p .3 a t t ached and l abe led " JES4."

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31. In the third quarter of 2006, the number and average size of approved m ortgagespeaked. By the raiddle of 2007, unsold units were beginning to accumulate. Thisproperty slowdown spelled bad news for the Irish banking system, which had "lentheavily to builders and developers to fmance projects and to make speculative landpurchases."19

32. The collapse of the building boom left Irish banks facing large losses from buildersand developers, and as a result, the major Irish banks' share prices started to slidesteadily after March 200 7.20 The crisis carne to a head on September 29, 2008, w itha run in wholesale markets on one of the largest banks, Anglo Irish. In light of theglobal fmancial crisis and international concerns about Ireland's fmancial sector,pressure mounted for the government to respond.21 The fear was that, withoutgovernment intervention, banks w ould co ntinu to hoard capital, erasing all liquidity.At tihte extreme*

they would become "zombie banks" , representing risks to theeconomy and the public fiscal sector.33. In September 30, 2008, in response to the run on Anglo Irish, the government

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guaranteed all the depo sits and the snior debt of Irish banks. In January 2009, thegovernment nationalized An glo Irish. On February 11, 2009, the Irish governm entinvested 3.5 billion in preference shares in two large retail banks: Allied Irish Banksand Bank of Ireland.24

18 C r a gg A f f ida v i t f 2 9 .19 Kel ly , Morgan, "The I r i sh Credi t Bubble , " December 21 , 2009, UCD Centre for Economic Resea rchWo rking Paper Se r ies 2009, Work ing Paper WP 09/32, p . 3 a t tached and labeled " JES 5."2 0 Kel ly , Morgan, "The I r i sh Credi t Bubble , " December 21 , 2009, UCD Centre for Economic Resea rchW orkin g Paper Series 2009 , W orkin g Paper W P09 /32, p. 15 attached and labeled "JES5 .". See also CraggA f f ida v i t 1fl32-33 and Figure 6.21 Second Aff idavi t of Ann Nolan , Ju ly 30 ,20 10 , - 7 .2 2 Zombie banks are banks that should be dead ( i .e . have inadequate capita l) but remain among the l iving.Such ba nks pose a r isk to the public f in anees, becaus e they hav e an incentive to eng age in reckless (andworse) forms of lending and other behavior , even with negative expected social re turns, typically imposinghigh future expected bailout costs.2 3 Second Affida vit of Ann No lan, July 30, 2010, - 7. See also "Go vern men t Decisi n to Safeg uard Ir ishBanking Sys tem," Depar tment of F inance of I re land, September 30 , 2008 a t tached and labe led "JES 6" and"Credi t Ins t i tu tos (F inanc ia l Suppor t ) Scheme 2008 ( the "Scheme") : Marke t Not ice ~ Conf i rmat ion ofStatutory Guarantee," Department of Finance of I re land, October 22, 2008 attached and labeled "JES7."24 " AM A Busin ess P lan , " June 30 , 2010, AM A, p . 10 a t tached and labe led "JES8 ." Af f idavi t of BrendanMcDonagh, July 30, 2010, ^jlO.

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34. Dr. Cragg has esimated that, when fm ally realized, Irish bank losses will be ll cxccssof 30 billion. For at least the three ma jor banks participating in A MA , the realized

* 25 *

losses will be well in excess of existing bank capital. Without a governmentguarantee (which allows banks to boixow at the Irish sovereign rate), and the resultantaccess to the European Central Bank (ECB) and other sources of credit, the Irishbank s would be illiquid. This is because the ban ks' wh olesale borrow ing costs (athigh interest rates representing their junk rating), would b e well in cxccss of proceedsfrom their retail and commercial lending (at lower interest rates reflecting borrowercredit quality). Under these circumstances, bank insolvency would immediatelyemerge. The only reason that the Irish banks remain func tioning is the presence of theblanket government gu arantee of bank liabilities. But providing liquidity to banks inthis way does not resolve the underlying p roblems of bank insolvency. M oreover, anyvalue-destroying transfers and/or transfers to AMA at prices that reflect a paymentless than the valu of the asset - including the valu of the banks' long-termrelationships with borrowers that might be severed or impaired by any involuntarytrans fer - increase the eventual cost to taxpayers. The market appea rs increasinglysensitive to such costs, and there may accordingly be a large indirect cost throughincreased borrowing costs.

B . T H E R O L E O F A M A35. As discussed in detail in Dr. Crag g's Affida vit,26 The National Asset Management

Agency ("AMA") Act of 2009 (the "Act") provided for the creation of AMA bythe Irish government in order to remove bad or impaired assets from the balancesheets of participating Irish banks. This logic behind the decisin was to remov euncertainty about the soundness of the banks' balance sheets and make it easier forthem to access fund s in the fnancial markets. The Irish governmen t, through AM A,would acquire the loans from the banks for a discount, paying for them withgovernmen t-guaranteed bonds. AM A is expected to have a finite lifespan and

2 5 Cragg Affidavi t


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requires that 25% of its loans be repaid or refnanced w ithin three years.27 As I shalldiscuss below, and as I have noted above, this rationale for creating AMA has beenvitiated by events. It is now clear that the banks are undercap italized; there is littleuncertainty associated with this. And henee m oving the risky assets off the ban ks'balance sheets will not allow these banks to access fmancial markets. It is only thegovernment guarantee that allows access; and only a substantial recapitalizationwould allow a return to access without a governmen t g uarantee.

36. AM A was given broad powers to complete this mission: "A MA m ay acquire aneligible bank asset of a participating institution if AMA considers it necessary ordesirable to do so having regard t the purposes of this Act and in particular theresources available to the Minister [of Finance]...NAMA may acquire, from aparticipating institution, performing or non-performing eligible bank assets."Significantly, the Act gave AMA the power to acquire eligible bank assets even ifthe participating institution did not consider the loan to be eligible, and even if theparticipating institution objec ted to its acqu isition. AM A had no obligation toconsult with the borrower.

37. With bank losses of over 30 billion and governm ent capital injections into the banksof over 25 billion,29 at least according to some observers, AMA, as originalyenvisaged, would h ave allowed the Irish governm ent to cover the enormous additionallosses through a hidden recapitalization. In particular, the original plan for AM Awould have required it to overpay for failing bank loans arising from credit extendedto developers.30 However, the EU balked at this original plan (as a form of state aidthat was not allowed) and has only allowed AMA to exchange government backedsecurities for development and associated loans, at long-term economic valu. Theextent of the state aid was limited to the difference between what AMA pays to the

27 "A MA Business P lan , " June 30 , 2010, A MA , p . 10 a t tached and labe led "JES8 " Af f davi t of BrendanMcD onagh, Ju ly 30 , 2010, f l 0 .2 8 Nat iona l Asse t Managem ent A gency Ac t of 2009 a t tached and labe led "J ES9 ."2 9 Cragg a f f davi t30 Morgan Ke l ly , "The I r i sh Credi t Bubble , " UCD Centre for Economic Resea rch , WP09/32, p . 16 a t tachedand labe led "JES5."

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banks for assets transferred to AMA (at most the long-term economic valu) andcurrent liquidating vales (current market valu, or CM V).

38. In its final design, AM A merely increases certainty about the state of the Irishban ks' b alance sheets by replacing illiquid and harder to valu assets with assets thatare, for the most part, easier to valu (government pap er). The realized bank lossesdue to the transfer of assets to the A MA portfolio will be on the order of 40 billion,as discussed by Dr. Cragg.32 Thus, AMA will effectively make apparent the currentbank insolven cy, in wha t should be seen only as a first step towa rds recapital ization.But, AMA itself cannot recapitalize the banks. Henee, AMA is not and cannot bethe primary policy that saves the Irish banks ~ this role will belong to whatever policyis chosen to replace the bank gu arantees which are currently supporting the bank s.

39. In fact, when AM A acquires a good asset, it may increase uncertainty because 5%of the payments are with a bond whose valu depends on NAMA's performance.For reasons that will be clear, this bond could have little or no valu, so that even withan accurate valuation, there would be a 5% haircut, increasing the risk and m agnitudeof bank insolvency.

C . A M A P R O J E C T I O N S O F P R O F IT A B I LI T Y H A V E B E E N D E CL IN T NG40. AM A has established a Special Purpose Vehicle (SPV) for the purposes of

acquiring loans from the banks. This SPV is 49% ow ned by the public and 51%owned by prvate investors. The prvate investors in AM A are restricted in theamount of return they can receive on their investment 34 These limitations include anannual dividend of no mo re than the Irish Go vernment 10 year bond yield at the time

Aff id avi t of John M ulcah y, Ju ly 30 , 201 0, 1 and Euro sys tem , "Op inin of the Euro pean Cent ra l Bankon the es tabl i shment of the Nat iona l Asse t Management Agency," Augus t 31 , 2009, p . 6 a t t ached andlabe led " JES 10."32 Cragg Aff id avi t H68.3 3 " A M A B us i ne s s P l a n , " J une 30 , 2010 , A M A , pp . 4 , 25 a t t ac he d a nd l abe l e d " J E S 8 . " " D r a f t A M ABus iness P lan ," Oc tober 13 , 2009, AMA, p . 6 a t t ached and l abe led " JES1134 " AM A Bus ine ss P lan ," June 30 , 2010 , A M A , pp. 15-16 a t t ached and l abe led " JES 8." The fac t tha tcur rent pro jec t ions imply tha t prof i t s wi l l be be low the cap impl ies tha t , a t the margin , pr va te inves torswi l l be ge t t ing 51% of any inc rementa l prof i t .

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of dividend declaration35 and when AMA meets its objectives and is wound up, nomore than 10% of the total capital invested in AMA can be paid out as a profit. 36The bulk of the fmancing for purchasing loans from the banks is derived fromgovernment guaranteed bonds.

41. In its October 13, 2009 business plan, AM A projected a total profit of 4.8 billion.373 8In its June 30, 2010 business plan, projected profit had fallen to 1 billion. The

decline in N AM A's projected profits was much noted in the Irish press. IndeedAM A has been subject to serious criticism. For example. the Labour party financespokeswoman said that clearly the first AMA draft plan had been "a fantasy."Further, the public appears to be growing increasingly disenchanted with AMAitself.40 Given the decline in expected p rofits, tax payers and prvate investors are farmore likely to be equally spliting profits from AM A. Thus, AM A appears to beunder serious political pressure to provide an improved return for its shareholders -both public and prvate.41

42. These results should not be seen as a surprise. If A MA d oes in fact pay ful! long-term market valu, then it can only make a profit if: (a) it is superior to the bank in themanagement of the assets; and/or (b) the market performs better than appraisersgenerally believed to be the case when the valuations occurred. But given the

For reference, the current 10 year bond yield, as of 201 0, is 5%. National T reasury Man age men t Agen cy,"Ireland: 5.00% Treasury Bond 2020," January 14, 2010 attached and labeled "JES 12."36 "A MA Business P lan , " June 30 2010, A MA , p 15 - 16 a t tached and labe led "JE S8."37 "Dra f t AM A Business P lan , " Oc tober 13 , 2009, AM A, p . 10 a t tached and labe led "JE S 11" and"A MA Business P lan , " June 30 , 2010, AM A, p . 4 a ttached and labe led "JE S8."3 8 "A MA Business P lan , " June 30 , 2010, AM A, pp . 4 , 25 a t tached and labe led "J ES8 ."3 9 See, for example, I r ish Times Reporters in The Irish Times, "ama ' to make prof i t of lbn , ' " Ju ly 6 , 2010attached and labeled "JES 13."40 For example: "ama is a macroeconomic three-card tr ick. . . . " in Sean Barrett , "ama will distor t marketand i s economic nonsense , " The Irish Times, September 2 , 2009 a t tached and labe led "JE S 14;" " AM Awil l r ecover 16bn for the taxpayer on the 40bn i t in tends to spend. . . . " in Emmet Ol ive r , "AMA to' r ecover jus t 16bm out of 40 bn spend on loans , " ' The Irish Times, August 26, 2010 attached andlabeled "JE S 15;" "I t appears man y of the worr ies over A M A . . . are coming to frui ion alread y." inGregory White , "Massive Commercial Real Estate Loans Now Blowing Up Tn Treland," Business lnsider,Aug ust 24, 2010 attached and labeled "JES 16;" Geof f Percival, "A M A b oard set to forecas t modestprof i t , " Irish Examiner, July 6, 2010 attached an d labeled "JES 17;" " AM A is unlik ely to ever get backthe fu l l amount i t i s owed. . . . " in Thomas Mol loy , "AMA won ' t r ecoup fu l l amount owed for landloans , " Independent , Au gus t 4, 2010 attached and labeled "JES 18."41 See, for example, I r ish Times Reporters in The Irish Times, "ama ' to make prof i t of 1bn, ' " Ju ly 6 , 2010attached and labeled "JES 13."

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deficiency in experience, the inherent disadvantages of being a short temorganization (where valu is maximized with long-term relationships), and theconstraints imposed by public sector rules, it would be a surprise if AMA were ab leto squeeze additional valu out of these assets. Some of those advocating "bad b ank"strategies believed that the market was temporarily depressed, and that government -with a longer time horizon than markets - could hold the assets until the marketrecovered. How ever, AMA has a relatively short time horizon, and within this shorttime horizon, global fmancial markets have performed far more poorly than manyexpected earlier on in the crisis. Indeed , increases in interest rates facing Ireland, iftranslated into increased lending rates more generally (as is often the case) will act tofurther depress real estte prices, making losses (in the relevant time horizon) evenmore likely.

43. N AM A 's one effective strategy for increasing profits is to underpay fo r the loans, butshould AMA be successful in doing so, it increases the costs to the public throughm ltiple channels. Mo st importantly, if the banks are in fact insolvent, for every 1of profits for AMA, the public loses half, as half of the gain goes to privateinvestors, and all of the bank losses are likely to be borne by the government. 42

44. There is another way of thinking about what is going on. This is cise to a "zerosum " outcome; assets are just being moved aroun d. Gains by one party (say, as aresult of mispricing) are a loss to another. If private investors are to be com pensated,it has to be negative sum for government and the bank together, but if the public ispicking up the shortfall of banks at the margin (and it appears that it will be, since thebanks are likely insolvent) then any gains to the private investor mean a loss to thepublic. I have also delineated a num ber of reasons why w hat is going on is likely todiverge from "zero sum." Reasons that we might observe a negative sum outcomeinclude the fact that: (a) AMA is less experienced than the banks from which it isacquiring the loans; (b) AMA is a short-term organization, which has adverseeffects on hiring, implicit contracts, etc. and which means that the benefits whichaccrue from a long-term relationship cannot be reaped; (c) AMA has adverse

4 2 This is , of course, only true if prof its are belo w the cap ped level, which appears to be the l ikely c ase.

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incentives (given both its prvate o wnership and short term focus), exacerbated by itspolitical positioning, and claims that it will be profitable; (d) the large haircuts,including partial payment in the form of an asset of uncertain valu, combined withthe failure to solve the insolvency issues, may increase opportunistic incentives; (e)incentives for borrowers are similarly adversely affected; and (f) the ability of thebank to recruit good borrowers in the future is also likely to be adversely affected.43Offsetting these negative effects is the possibility of some "positive" gains: (a)preventing opportunistic behavior by banks and borrowers with respect to bad loans;and (b) diseconomies of scope - allowing bank s to focus on good lending. In the caseof any particular asset, one has to ask whether the overall adverse e ffec t on the p ublicand the negative sum im pacts are greater or less than the positive sum im pacts. In thecase of performing assets, such as Mr. McK illen's, there is an overwhelm ing case thatthe adverse effects dominate. Indeed, with such assets the problem of oppo rtunisticbehavior is limited, and the transfer of such assets vitiates the purported benefits ofNAMA's specialization in bad assets.44

V. NAM A'S INCENTIVES AND ABILITY TO SEIZE PERFORMING LOANS AREINCONSISTENT WITH GOOD PUBLIC POLICY45. As discussed above, it is bad public policy for a quasi-governmental agency such as

AMA to purchase performing loans from the banks in which they reside because theseverance of long-term relationships between performing borrowers and their lendersneedlessy destroys valu. There may also be long-term adverse reputation effects toIrish banks and com merce, for reasons explained b elow.

46. How ever, even if - contrary to economic logic and evidence - there were no valu inthese existing long-term relationships, purchases of performing loans by AMA

While AMA only has the power to acquire loans made be fore December 31 , 2008, bor rowers a re l ike lyaware that the banks' problems have not been f i i l ly resolved, and that there is therefore considerable r iskof fur th er actions, e .g. a A MA II . The comp ulsory tran sfer of perfo rmin g assets to A M A co uld wellhave a chil l ing effect on any good borrower seeking to establish a long-term banking rela tionship with anIr ish bank.In fact , internal correspondence that I have reviewed from AMA would appear to ref lect the potentia ltha t the adverse e f fec ts domina te . E-mai l f rom Michae l Co nnol ly , "Coroin /M aybou rne , " March 11 , 2010,20:59, p. 105 in produced mater ia ls and e-mail f rom Eilish Finan, "Coroin/Maybourne," March 12, 2010,00:37, p. 122 in produced mater ia ls a ttached and labeled "JES 19."

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would provide no benefit to the public, even though they could provide benefts toA M A. To see this, it is helpful to consider the impact of such purchases on the bank,on AM A and on society as a whole.47, As previously discussed, EU requirements prevent AM A from overpaying for theloans that it purchases.45 Henee, when AMA seeks to purchase a loan, it can eitherpay an amount cise to fair market valu46 or it can confscate the loan for a valubelow that amount. If AMA pays fair market valu for a good loan, the bank iscomp ensated for its loss and AM A has a good loan on its books. Thus, neither thebank or AMA is materially better off and AMA has no incentive to undertakesuch a transaction. On the other hand, if AMA seizes a performing asset, payingless than that asset is worth, it transfers money from the banks to itself Underpay ingbanks for their assets exacerbates the banks' insolvency problem. Indeed, thecondition under which a bank would not voluntarily transfer a risky loan at long-termfair market valu - a transaction that would provide liquidity without diminution ofasset valu - is if it planned to engage in some risky activity that would expose thegovernm ent to further losses without comm ensurate benefts. Unless AM Abelieved that the bank's supervisors could not monitor/circumscribe such behavior,there should be a presumption that the unwlingness of a bank to relinquish a loanarises because the bank believes it is not being paid fair market valu for the asset.

48. There is no societal beneft to NA M A 's confiscation of perform ing loans. (Recall therationale for confiscation of loans: reducing risk and reducing the scope for moralhazard; both are problems only with risky loans.) Indeed, for reasons I have alreadystated and discuss further below, there may be large societal costs. Given these

45 If AMA were to overpay banks for bad assets, i ts payments would represent a hidden recapita lization ofthe ban king system. A gov ernm ent mig ht conceiv ably wan t to eng age in such a hidden subsidy ,recapita liz ing the bankin g system in a wa y that taxpay ers wou ld not see as a direct approp riation. Wh ilethis is bad public policy and contrary to EU rules against subsidies, i t is a course that has been taken orpropo sed in several countr ies. For the E U 's opinion on subsidies and the desire for the mini mum level ofsta te a id see, for example, Eurosystem, "Opinion of the European Central Bank on the establishment of theNat iona l Asse t Management Agency, " August 31 , 2009, p . 6 and "Informat ion f rom European UnionInsti tutions and Bodies," Commission, Off ic ia l Journal of the European Union, C 72/1, Annex IV, pp. 20-21 a ttached and labe led " JES 20. "4 6 As noted above, the extent of the sta te a id was l imited to the difference between what AMA pays to thebanks for assets transferred to AMA (at most the long-term economic valu) and current l iquidatingva les (cur rent marke t va lu , or CM V) .

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concerns, why migh t AM A want to seize perform ing assets? Coniscation ofperforming loans is the most certain way for AMA to make money and therebyfiilfill its previously m entioned prom ises to shareholde rs and tax payers. But it shouldbe clear that giving AMA the right to confscate performing assets providesincentives and opportunities that are adverse to the interests of the overall fmancialsystem and the economy. Moreov er, because there is signifcant prvate ownership inAMA, transfers that take place between AMA and the banks are not just transfersbetween the taxp aye rs' pock ets. Instead, they constitute, at least to some extent,transfers from taxpayers to private shareholders in AM A.

49. I have seen certain documentation provided by the Respondents on discovery whichindicates that AMA is in fact approaching the McKillen loan portfolio on the basisof an incentive to m ake a profit for itself.47

50. Ironically, those confiscations that make NA M A's perform ance look good (Le. yield apositive return, as a result of underpay ing) weaken banks. Mo reover, the performingassets that are most attractive to AMA - i.e., the assets for which eventual disposalis likely to be easiest, because uncertainty is the least ~ are likely to result in thegreatest loss of social valu as a result of their confiscation, precisely because theseare loans with the highest long-term valu. Further, these seizures do not justrepresent an unjustified transfer of wealth; their adverse effects run counter to thestated objectives of AMA.

51. In summ ary, stated taxpayer and shareholder gains on AMA are unlikely to berealized unless the banks are underpaid for their assets. Gains to taxpayers andshareholders that would result if AMA paid banks less than bank assets were worthwould be off set by losses to the government, which would simply have to pay more inbank recapitalization. One should be skeptical about the more sweeping claims aboutthe ability of AMA to generate profits - they are not only unproven, but, given itsstructure, unlikely.

4 7 E-mail f rom Michael Connolly, "Coroin/Maybourne," March 11, 2010, 20:59, p. 105 in producedmater ia ls and e-mail f rom Eilish Finan, "Coroin/Maybourne," March 12, 2010, 00:37, p. 122 in producedmater ia ls a ttached and labeled "JES 19."

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52. AM A has limited resources, and it is important that it use those resources carefully.Given these considerations, economic logic indicates that AMA should focus itsattention of nonperforming loans, development properties that are not income-generating and that are not likely to become so, and generally borrowers that areilliquid and insolvent, and where the transfer would arguably increase the valu thatcould be extracted from the asset and not decrease it (because of moral hazard issuesarising from "throwing good money after bad" due to bank guarantees and bankinsolvency). This specificaly mean s that AMA should focus its purchases on loansfor property development and not for income-generating assets like housing andIRtenant-occupied com mercial real estte.

53. A MA could also play a particular role in helping stabilize the real estte market inIreland, by avoiding a rash of liquidity induced fire sales, which are often part of thepropagation mechanism of fmancial crises. This suggests that, other things beingequal, AMA should foc us on loans for development in Ireland, and plan to retain theassets for a long period of time given the leve! of overbuilding in Ireland.

VI. MCKILLEN WILL LIKELY BE INJURED FURTHER THRO UGH A TRANSFER54. NA M A's incentives for dealing with performing assets Hke the McKillen loans are

fundam entally different than those of a commercial bank. Thus, while it may be inthe interest of AMA, the banks and the government to transfer poor quality realestte development loans to AMA,49 there is no good economic reason to transfergood assets to AM A, especially in light of the likely harm . As discussed above,there are several sources of harm that arise from the basic informa tion economics andtheories of incomplete contracting outlined at the beginning of my affdavit.a. First, AMA does not have the resources, knowledge, or relationships to service

and negotiate with borrowers like M cKillen.48 There may be cases of income generating assets that are "developmental ," in the sense that , for instance,they are currently loss making, but with suff ic ient increased investment, they might be made profitable .4 9 1 emp hasize " m ay " because this conclusin req uires ( i) inabil i ty of supervisors to preven t bad len dngdecisions; ( i i) an assumption that AMA has a superior abil i ty to manage the resolution of bad loans; and(ti i) the benefits of the long-term credit re la tionship associated with a bank loan are more than offset bythe losses associated with opportunit ist ic behavior by bad borrowers that cannot be constrained byadequ ate supervis in. The second hypo thesis is par ticular ly questionab le .

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b. Second, unlike traditional lenders that derive their profits from a long-termreationship with a credit-worthy borrower, NAMA's business model has arelatively short time horizon and accelerated workout objectives,

c. Third, NAMA's stated business model - reducing total loans outstanding by 25%within three years - exacerbates the problem because of the need for asset sales,n normal times, if an isolated asset were for sale, one would find several willingbuyers vying for the purchase, and the buyer would be able to find a source offinance, Indeed, that is what one means by "long-term econom ic valu," the pricethat an asset could achieve in the long-term, and the long-term economic valu ofa loan is related to the underlying assets. But these are not norm al times, and themarket is not likely to return to anywhere near normal in 3 years, especially giventhe scale of the property bubble and the weaknesses in the banking system. Thus,if large numbers of assets are simultaneously put in the market in the ncxt tiuroGyears, the market price of these assets would, even in more normal times, likelybe depressed; but that is especially so now.

d. Fourth , reworking the terms for performing loans whereby total debt repaymentis accelerated by 25 percent is even more problematic. When financing incomegenerating properties with long lives, as an economic matter it is simply notpossible to generate sufficient income to pay down such loans by 25 percentwithin 3 years. Com petition in the long run will only allow landlords to chargerental income that will cover principal payments, interest payments and normalprofits associated with the typically very long lifespan of the asset.

e. Fifth, under the AMA plan, McKillen will be required to submit a BusinessPlan within 30 days outlining how he will radically reduce his debt within a 3-5year cycle. This is a very short time period for reducing debt exposure on a long-lived perform ing asset. This is a radical restructuring requirem ent and likely to beunobtainable, given the severing of McKillen's long-term lending reationship, amo ve that other potential lenders will interpret negatively. Therefore, given thatthere is no evidence of McKillen's not being able to service his debt, such areduction in his debt would not make economic sense. Mo reover, rapidly


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disposing of assets in the midst of a fmancial crisis is more than likely to result ina capital loss.50

f Sixth, without the promise of future rewards f rom a mutually beneficial long-termrelationship, both AMA and the once-performing borrower have an increasedincentive to behave opportunistically. For example, A MA would have anincreased incentive to make onerous demands on McKillen, even going so far asto unilaterally rewrite his loan con tract Similarly, without the promise of profitsfrom a long-term relationship, it could become economically rational for theAMA borrower to walk away from property in which it no longer had an equityinterest 51 Further, both p arties have the incentive to engage in a game of chicken.If a borrower sees his equity being wiped out, he could simply stop managing hisassets, which would have a devastating a ffect on their valu to A MA .

g. Seventh, with McKillen's loans transferred to AMA, it could become rationalfor McKillen's tenants - especially those in fnancial trouble - to stop paying rentsince AM A may have a limited ability to find replacement tenants.

h. Eighthy given NAMA's purpose, if AMA acquires good loans, the reputation ofgood borrowers would suffer. For instance, parties who might considerrefnancing the McKillen loans could rationally infer that, like other AMAborrowers, M cKillen is a bad credit risk.

i. Ninth , because AMA increases the uncertainty about the net worth of anyAMA borrower (and rationally would be expected to decrease the expectedvalu of that borrower), good AMA borrowers - which may entail some of the

In some countr ies, forced disposit ion of assets has played a central role in corrupton, as the assets weresubsequently acquired at greatly discounted pr ices by those with access to funds or who were qualif ed inr igged auctions, where re la tively few buyers were qualif ied.Even a f irm with posit ive equity might undertake r iskier actions, given the reduced l ikelihood of access tocredit in the future; in a sense, the valu of the on-going f tr rn has been reduced. The perverse structure ofAMA (its short term horizon, the large role played by pr ivate equity investors) and the associatedincentives to which i t gives r ise , as well as NAMA's capacity l imitations, exacerbate these problems. Andthese problems are fur ther exacerbated by the global f nancial cr isis , which presents great diff icult ies ingett ing access to a lternative sources of f inance.

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better entrepreneurs and property managers - will fnd it more difficult to getaccess to credit.

j. Tenth, the diversin of attention to dealing with AMA and its short-sighteddemand s would rationally lead lenders to curtail fu nds to such borrowers.k. Eleventh, when performing assets are being transferred to AMA, they are being

transferred to a less competent party than a bank. In discussing global bankingcrises, I often ask, "Do w e really believe that the governm ent has an advantage ingarbage disposal?"52 The main rationale for the creation of a bad bank (AMA)is that it might develop competence in the disposition of bad assets. However,given the constraints, it would be naive to expect that a bad bank could developcompetence in managing performing assets.53

55. In sum, the only way that one could be confident that AMA w ould not injureMcKillen is if it had superior capacities at managing bank relationships, which bynecessity requires the ability to extend credit. But AM A is a new institution,without experience. Moreover, without a bank charter, it cannot mea ningfully extendcredit for long periods of time in an incentive compatible lending relationship. Thestructure of AM A thus creates the incentive for AM A to underpay the banks, seizegood assets in order to offset losses from riskier loans on their books, and create shortterm gains for the AMA shareholders. This potential problem is compounded by thepowers granted to AMA to rewrite contracts, well in excess of those afforded toordinary commercial lenders.

52 Joseph Stigli tz , Free Fall : America, Free Markets, and the Snking of the World Economy (New York:W.W. Norton and Company, Inc. , 2010) , 122.53 The bes t th ing for A MA to manage i s nonper forming loans and only nonper form ing loans . Indeed, tha tis one of the key rationales for creating a specialized insti tution l ike A M A in the f irst place. (Given th elikely insolvency of the banks, the other ra tionale , moving r isk off the banks" balance sheets, is of l imitedvalu, as 1 have already explained .) I t is stra ightforw ard for A M A to culi the nonpe rform ing loans fromthe bank balance sheets, especially if i t a l lows for bank and borrower input in the event of a dispute abouthow the loan i s pe r forming.

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V I I . T H E M C K I L L E N L O A N S A R E N O T C U R R E N T L Y I M P A I R E D O R D O T H E YP O S E S Y S T E M I C R I S K56. The key questions which AMA should consider in determining whether or not to

acquire a loan portfolio are: (i) is the loan portfolio impaired? And, (ii) does the loanportfolio pose a systemic risk i.e., could the failure of this loan po rtfolio cause a chainof subsequent failures that could potentially bankrup t the entire system? My reviewof the evidence in this matter indicates that for McKillen's loans, the answer to bothquestions is no.

A . T H E M C K I L L E N L O A N S A R E N O T CI JR R E N TL Y IM P A I R E D57. That the McKillen loans are not impaired is demonstrated by evidence presented in

the affidavits of Mr. John Trench and Mr. Patrick McK illen. These affidavits showthat the McKillen properties are meeting all of the loan servicing requirements andthat the po rtfolio is generating income in excess of its fnancing costs with an averageinterest cover of 1.7 which in my experience is well in excess of typical interestcoverage for well performing loans.

58. In contrast, NA M A's measure of M cKillen's impairment and payment default risk isfar less reliable. To assess M cKillen's portfolio, AM A com pares the amount ofMcKillen's loans to a valuation of the commercial real estte financed by those loan.The reason that NAMA's measure is unreliable is that commercial real esttevaluations obtained during a period of extreme illiquidity in the real estte market canfluctuate dram atically.

59. Indeed, that is the reason that most countries do not forc mark to market accountingon commercial banks that have a practice of retaining (and rolling over) mortgages.In the United States, even impaired assets - where the borrower may be delinquent inpaymen ts - do not have to be written down in the midst of the crisis.

60. In order to obtain a reasonable approximation of long-term property valuation for usein NAMA's loan to valu ratios, AMA would need to undertake extensiveconsultation with the property owners and managers. I understand that A MAappraisers did not pursue such consultations with respect to McKillen's portfolio.

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However, I further understand that appraisals in which such consultations werepursued showed that the valu of McK illen's properties is well in excess of his loans.

B . T H E M C K I L L E N L O A N S D O N O T P O S E SY S T EM I C R I S K1. The Size of the McK illen Loan Portfolio does not Imply that it Poses aSystemic Risk

61. According to Ms. O'R eilly, AMA decided to acquire M cK illen's loans "...bec auseof our belief that the extent of aggregate exposure of relevant participating institutionsto Mr. McKillen and his companies ... under credit facilities granted by thoseinstitutions being the sum of approximately 2 billion was such as to create asystemic risk....The risk to the banking system of any potential impairment in anexposure of 2 billion and the potential losses hat would be suffered by theparticipating institutions, which were already in receipt of substantial State supportdue to their individual systemic importance was such that AMA considered theacquisition of Mr. M cK illen's credit facilities was necessary to furth er the purposes ofthe Act."54

62. In fact, however, AM A is mistaken in its basic assumption that the size ofMcKillen's loan portfolio provides a good measure of the degree of systemic risk thatit imposes. To see this, conside r an owner of several, separately incorporated assetswho faces a series of value-impairing events (shocks). As long as these shocks areuncorrelated with common ownership, there is no reason to believe that the singleowner would be more likely to go into default than individual owners of similarassets. In order for the large single owner to face greater defau lt risk, it wou ld have tobe the case that common ownership causes correlation in shocks.

63. Comm on ownership could produce some increase in correlation among the shocksthat a business experiences - e.g., correlated judgment errors and/or correlatedliquidity problems, with the "owners" being unable to provide additional capital asrequired. But, with a macro-econo mic shock, and a well capitalized owner, thatcorrelation could actually be less than the average correlation.

5 4 Aff idavi t of Aideen O 'Re i l ly , Ju ly 30 , 2010 %43.

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64. Moreov er, one owner who se loans contain cross default clauses (i.e. contractualclauses that, in the event of a defau lt on one loan, preciptate defau lt on all loans) mayeven lower systemic risk. This is because the strong incentives that the borrowerfaces not to d efault are viewed as outweighing the risks impo sed.55

65. In any case, an econom ic analysis of systemic risk needs to take into accoun t themagnitude of the losses that might be incurred, if loans were not repaid. Given thelower loan to valu ratios and the high income generation of the McKillen assets,there is in fact little risk, let alone systemic risk. In fact, there is little risk that bankswould not be able to generate enough income from the assets to pay interestobligations to depositors, or even less risk still that the bank would breach (because ofa non-payment) capital adequacy standards.

66. On the contrary, acquiring the assets at too low a price could increase systemic riskfor the bank ing system, and rapid d isposition of the underlying assets could contributeto capital losses to be experienced by AM A. In fact, was AM A to systematicallypursue this policy of acquiring good loans, it could lead to broader systemic risk forthe country as AM A und erpays for the loans and destroys valu. Pursuit of such apolicy would raise the amou nt required fo r recapitalizing the banks, increase the costsassociated with the guarantees to the banks and increase the cost of the AMA debt,all three of which place additional costs on the state at a time when sovereign risksassociated with the Irish governm ent are rising.

2. Review of Evidence on Systemic Risk Posed By McK illen Portfolio67. Mr. John Tren ch's affidavit pro vides further evidence reftiting the notion that the

McK illen loans impose systemic risk just because they are large. A review of theMcKillen loans quickly fmds that the McKillen loans are diversifed across manycountries, with approximately one half in the UK, one quarter in Ireland and theremainder throughou t Europe and North Am erica. Further, the McKillen loans arediversifed across the various Irish bank s and M cKillen has ex tensive holdings at eachof Bank of Ireland, Anglo Irish and Allied Irish.

Of course, if lenders worr ied about the systemic effects of the simultaneous operation of such cross defaultc lauses, the different assets could be separated, and cross default c lauses e liminated.

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68. W hile the majority of M cKillen 's loans are with Anglo Irish, in terms of systemic riskthis is hardly a problem since Anglo Irish has already been nationalized. Indeed, oncewe take this fact into account, McKillen's loans make up far less than even onepercent any one bank's total loans.56 Therefore, the argument that any bank isoverexposed to risk via the McK illen loans is incorrect.

69. Dr. Cragg ' s affidavit also shows that the banks in which the McKillen loans reside arealready suffering massive amounts of impaired loans relative to their Tier 1 capitaland are effectively insolvent,57 How ever, even if one were to cali all of the McKillenloans impaired it would not appreciably worsen the situation at any of these banks.To illustrate, 1 refer to the following figure from D r. Cragg 's affidavit.Figure 1: Impaired Loans as a Percentage of Tier 1 Capital, by Bank58

800%7 0 0 %6 0 0 % -U

S 5 0 0 %w 4 0 0 %reS4> 300%


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70. As Figure 1 shows, the difference in impaired loans relative to bank capital with andwithout the McKillen loans is hardly noticeable in the case of AIB and Bank ofIreland. The refore, there Is no question that M cK illen's BOI and AIB loans do notreprese nt a furthe r systemic risk to the banks. Further it is irrelevant if the Ang lo Irishloans are impaired since, as the figure shows, this bank h as already failed.

V I I I. A L L O W I N G F O R D U E P R O C E S S W I L L E N H A N C E N A M A ' S E C O N O M I CE F F I C I E N C YA. ECONOMIC STANDARDS FOR DETERMINING COMPENSATION N A TAKING BVTHE STATE

71. Econo mists have recognized that it may be important that the State seize privateassets for public use. However, two due p rocess safeguards are typically put in placein recognition of the importance of the rule of law and private property. These twodue process safeguards are as follows:a. First, it must be possible to show that the acquisition is for public ben efit (and

implicitly, that there are reasons that the acquisition cannot be effected throughvoluntary transactions). For example, when land is acquired for a road, there is awell-defined public purpose, where the refusal of a single party to sell couldimpose large costs. In such case, it is clear why socially benef cial voluntarytransactions may not be possible. How ever, there are many other cases in whichthe justifcation for a taking may not be as apparent. The main ben efits mayaccrue to other private parties. Wh en there are private beneficiaries (likedevelopers abutting the new roads), one needs to be especially sensitive toprospects for abuse, and one has to look particularly closely at the putative publicbenefits.

b. Second, the private owner must receive fair compensation for his property. Thiscompensation should be based on the valu of the existing valu of the asset, notthe valu of the asset after, say, the pu blic investment. Further, valuation of theexisting asset must take into account reasonable future prospects. For exam ple,the comp ensation fo r a vacant lot should not be based on its current use (zero), buton the fact that on that lot a building could be built. If there is a high valu public

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use of the asset, then the valu after acquisition should be greater than the valubefore acquisition, and the owner should receive compensation based on theasset's p re-acquisition valu.

72. Given the principies outlined above, it is clear that the valu to be paid for M cK illen'sportfolio should be based on the portfolio's pre-acquisition valu; and this valushould include the benefts associated with an ongoing bank reationship (which thetransfer of the assets to AMA w ould terminate). In contrast, the asset's post-acquisition valu is likely to be less than the pre-transfer valu, since the valu of theongoing bank reationship will be lost upon ac quisition. Thus, if the price to be paidfor the McKillen loans is justifed, it must be justifed by external benefts, such asincreased econ omic stability. Such benefts will o ffset the fact that the asset is wo rthless in NA M A's hands than it is in the hands of M cK illen's long-term bankers. It goeswithout saying that to justify the involuntary acquisition the social benefts of theacquisition m ust exceed the prvate co sts.

73. In M cK illen's case, I have shown that the transfer is more likely to be associated withno social be nefts , possibly even social costs. If that is the case, it is unlikely that thesocial be nefts su ffce to o ffset the prvate costs experienced in the transfer.

74. Further, the transfer of the loan to A MA invo lves no compensation to the borrowerfor his lost long-term relationships with his lenders, and resulting collateral damage.Indeed, no provision was made for such compensation, perhaps because it was nevercontemplated that good assets (where there was a positive valu to thelender/borrower reationship) w ould be transferred.

B . T H E I M P O R T A N C E O F D U E P R O C E S S75. I have long argued over the course of my career that there are grounds for

circumscribing unfettered property rights. Firms should n ot, for instance, be allowedto engage in anti-competitive behavior, and compulsory licenses have an importantrole to play in access to medicines. How ever, my co ncern in the current matter is thatAMA has not made a compelling case for a breach of McKillen's basic propertyrights.

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76. A closer exam ination of A MA sho ws that it is structured with incentives that goagainst the purported public interest of helping the econom y revive in this mom ent ofcrisis. Worse still, while some private entities (including possibly the fma ncialsystem itself) may bear substantial costs, other private entities (including NAMA'sprivate shareholders) may be the benefciaries of the powers granted to AMA.

77. Pub lic policy structures that allow - or even worse, prov ide incentives - for this kindof transfer of wealth should be particularly suspect. The fact that N AM A's conduct intransferring performing assets to itself is consistent with its incentives should be evenmore troubing.

78. Governm ents always have an incentive to underpay for assets, and even more sowhen there are private benefciaries (e.g. when the assets are sold to privatedevelopers). This is why systems of checks and balances, judicial scrutiny and thelike, are im po rtan ! These longstanding legal doctrines are grounded in concerns ofequity; but they also are motivated by economics; security of property righ ts and the"sanctity" of contracts - both explicit and implicit - are foundational to a marketeconomy. Involuntary transfers of assets represent a "taking " which should beundertaken only wh en there is a compelling public interest. Even then, it is importantthat there be full and adequate com pensation. So too for the breaching of long-termrelationships.

79. If these basic principies are not followed , there is a serious risk to Ireland 's reputationas a country respecting the rule of law, with consequent adverse short-term and long-term e ffects on its economy. It is striking that NA M A 's only defenses are theargument regarding systemic risks and the more troubling argument that transparencyand due process in a democratic society can be ignored because they may complcatethe implementation of the policy objectives embodied in AMA.59

80. A relatively straightforward and expeditious model of due process that includesborrowers can be easily designed for AMA and applied broadly on a voluntarybasis, or, more narrowly just to borrowers that are deemed to be potential systemic

59 Affidavit of Brendan McDonagh, July 30, 2010, T|17.

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risks. Recall that the magnitude of risk is a inction of the potential size of a loss, thelikelihood this loss will occur, and the correlation with other risks faced by the bank.If systemic risk is a consideration, it is crucial to understand that the magnitude of riskis a function of the poten tial size of a loss and the likelihood th is loss will occur. Forsystemic risk, the magnitude of risk is further extended to not only include thepotential size of the losses from an individual owner, but the potential losses mustthen be suffciently large and interconnected that it will lead a cascade of effects thatthreatens the entire fmancial system. (A further element of systemic risk is presentedwhen a quick sel-off of large numbers of assets exacerbates further asset pricedeclines, especially in the presence of more widespread lxquidity problems, leadingagain to cascade effects. The appropriate response to such problems is to keep themoff the market until there can be time for an orderly disposal and/or until the liquiditycrisis has been resolved. As I have noted, however, NA M A's bu siness model risksexace rbating this form of systemic risk. And this aspect of systemic risk is likely tobe m ost relevant to properties within Ireland and not the McK illen properties.)

81. The refore, the due process I imagine must allow for borrowers to present, nter alia:(1) the strengths and sources of their credit-worthiness; (2) the quality of the income-generating capacity of the financed property; (3) the valu of any collateral and otherproperties; (4) the nature and likelihood of potential threats to servicing the loans; (5)any factors that mitgate these risks including, the geographic and industrydiversifcation, the centrality and importance of the properties, and the experience andtrack record of the borrowers; and, (6) likely correlation with other losses that mightbe experienced by the bank in the aftermath of the breaking of the Irish propertybubble. Without consideration of these factors it is simply not possible to assess thesystemic risk. In addition, recall that one of the basic rationales for AM A takingover the assets and their management is to enhance the valu that can be extractedfrom those assets, given the moral hazard risks that have been identifed. But I havealso raised a concern that, at least in some instances, there is a substantial risk thatsuch a transfer will actually reduce the valu of the assets. There fore, both economicfairness and economic effcien cy require that both the lender and the borrower be ableto present evidence relating to the magnitude and nature of the moral hazard risks and

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the extent to which those risks have been, or could be, mitigated, and the risks that atransfer be valu decreasing rather than valu enhancing. In designing a process, thefollowing points might be borne in mind: (1) the number of borrowers that mightconceivably present systemic risk is very limited, and therefore the resources and timerequired to implement an appropriate procedure would be limited; (2) even if therewas an opportunity for all borrowers to make representations the overwhelmingprobability is that many, perhaps most, borrowers will not avail of the opportunitybecause as a matter of fact relatively few borrowe rs are likely to have a real incentiveto make represen tations because their loans are chronically imp aired. If there wereconcerns of excess burden be posed by such a process, it might be permissible froma policy objective to limit the entitlement to representation depending upon the levelof impairment of borrowers' loans and incorprate strict but nonarbitrary time limitsthat do not negatively impair the borrower.

I X . R E B U T T A LA . REBTJTTAL OF ATDEEN O'R EL LY

82. In 1 11 of her affidavit, Aideen O 'Relly suggests that McK illen's statements ofchoosing the Bank of Ireland based on trust and a strong relationship are fallaciousdue to the fact that there exists covenants in the loans at issue that would have enabledthe loans to be transferred to another fnancial institution or a third party withoutM cK illen's consent. This completely ignores the well estabished principies ofrelationship b anking, as detailed in M r. Belang er's affida vit. Further, her claim that atransfer of the M cKillen loans to A MA is not inconsistent with the original contractis completely baseless since before AMA was created, no one could havereasonab ly foresee n that such an entity wou ld exist. Further still, M s. O'Re illyattempts to portray AMA as a lender, even though AMA freely admits it is aworkou t vehicle and not a bank. This last point is evident since AM A is not evenlicensed as a bank in Ireland.

83. In % 17 Ms. O 'Reilly describes how AM A may not seize an eligible bank asset whenthe "land or development exposure is incidental to the main business." Ms. O 'Reillyprovides no standard for determining whether or not a particular degree of exposure

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meets here definition of the incidental. How ever, in f 30 and % 32 Ms. O'Reilly statesthat the Maybourne Loan is a development loan due to some GBP 30 million of theGBP 472 m illion total loan being developm ent-related. It would seem that such asmall fraction, just over 6% , would be considered incidental by most.

84. In % 35 I note that Ms. O'Reilly suggests that AMA was always intended to acquireloans secured on investment properties and not just land and development loans.However, it would seem clear that AMA never intended to acquire investmentproperties unless they were tied to some larger problem. Certainly, this is what wascontemplated by the EU when it stated that "assets that cannot presently beconsidered impaired should not be covered by a relief programme. Asset reliefshould not provide an open-ended insurance against future consequences of

60recession.85. As noted above, in f 43 of her affidavit, Ms. O'Reilly gives the sheer size of the

McKillen asset portfolio as the rationale for NAMA's decisin to acquire the assetssince the 2 billion total posed a systemic risk is com pared to a total of 50 billion fo rthe 100 largest borrowers. Such a comparison has no meaning in determiningsystemic risk because it takes no account of the likelihood of loss and the potentialmagnitude of losses regarding either the 2 billion or the 50 billion. What Ms.O'Reilly apparently fails to realize is that the McKillen loans are small relative to thetotal Irish banking sector, and in particular are diver

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