The Government is nationalising the riskiest part of the bank sector, writes SIMON CARSWELL, Finance Correspondent

THE AIM of the Government’s decision to transfer €80 billion to €90 billion in bad property loans from the banks to a Government-run agency might be to free up lending, but it moves the riskiest loans on to the State’s books.

As anticipated, Minister for Finance Brian Lenihan announced in the Budget that the Government will set up a National Asset Management Agency (Nama) to assume the riskiest loans from the guaranteed Irish banks and building societies.

Lenihan said the aim was to ensure that the banks had “a clean bill of health, their balance sheets are strengthened and uncertainty over bad debts is reduced”.

The Government has identified loans with book values totalling between €80 billion and €90 billion to be transferred, saying the “principal uncertainties” within the banks relate to these loans.

But just why is the Government forcing the taxpayer to take ownership of the banks’ most toxic assets and effectively nationalising the riskiest part of the banking sector?

The Government’s belief is that the banks cannot provide new loans until their risky old loans are taken off their balance sheets.

By doing so, the Government believes it can draw a line under their capital needs, remove uncertainty over future loan losses and allow them to start lending again.

Otherwise, the fear is, the lenders would turn into so-called “zombie banks” focused on just running down their riskiest loans.

The scheme will start with the State buying the loans from the banks by selling them a Government bond or a Government-guaranteed bond issued by Nama.

The Government says it will pay the banks substantially less than the book values of the loans – in other words, well below €80 billion to €90 billion – for the assets. The State will recover its money by selling off the property assets over time and winding down Nama. If there is a shortfall, the Government will levy the banks.

Lenihan said the cost of servicing the bond debt “will be offset, as far as practical, from income accruing from the assets”.

Crucially, the Government has not declared the discount to be applied in transferring the assets. The department said Nama would buy the loans “at an appropriate discount” and the banks would “have to recognise a loss at the time of being transferred”. It said Nama’s loan-to-value ratio would be “considerably lower” than the banks, reflecting the discount.

The discount will be vital both to assessing the risk to the taxpayer and the losses in the banks. If the discount is too high, the banks must absorb much larger losses upfront and ultimately could be forced to turn to the taxpayer for further capital to stave off insolvency. This could force the Government further down the road of bank nationalisations.

“If the crystallisation of losses at any institution requires additional capital, the State will insist on participation by way of ordinary shares in the relevant institution,” Lenihan said yesterday.

If the discount is too low, the taxpayer will shoulder losses on the sale of the transferred property assets which the State will not be able to recoup until the property market recovers over time.

The decision to create what is essentially a bad bank in all but name – in addition to guaranteeing and recapitalising the banks – is seen as a way of avoiding outright nationalisation of the entire system, a scenario the Government wishes to avoid at all costs. However, the State is effectively heading in that direction.

Lenihan acknowledged the plan would lead to “a very significant increase in gross national debt”. Even assuming that the State will acquire up to €90 billion in bank loans for €54 billion – a discount of 40 per cent on the book value of the loans – this will double the national debt to €108 billion.

By assuming bank loans currently worth up to €90 billion, the Government is taking ownership of a fifth of all Irish bank loans.

In terms of risk-weighted assets – the gauge used by regulators to assess the capital needs by banks to protect them from risky loans – the State is assuming almost a quarter of all risk-weighted assets across the Irish banking industry.

The Government says that not all these loans are bad, but it is taking control of the worst of them, all in the hope that it will free up lending to cash-starved businesses battling the recession.