Historical factors sometimes result in favoring Oil & Gas over the newer renewable energy technologies. Eligibility for MLPs is one such area that can be easily fixed.
Note: This summary presents the key points of the article The Case For Master Limited Partnerships (John Joshi & Malay Bansal, July 20, 2011) published on AOL Energy.
The need for additional capital to flow into renewable energy is clear. The sector has a strong dependence on government incentives while it develops towards price parity with conventional energy sources. Recently, Section 1603 Cash Grant program and the section 1703 and 1705 loan guarantee programs have provided some support. However, many of these programs are scheduled to expire in near future. In the past, the sector depended on tax-equity market for financing of projects. But, with lower profits especially at commercial banks which were active in the tax-equity markets, that market will not be able to play the same role as in the past. The clean energy sector needs more help.
The traditional energy sector has available to it a source of capital in form of MLPs (Master Limited Partnerships) that can invest in Oil and Gas. The MLP structure was created by Congress following the energy crisis of the 1970’s to spur investment in the energy sector for oil and gas exploration, storage, refining, and transportation by providing specific tax advantages to investors. The MLP structure provides the tax benefit of a limited partnership and at the same time provides liquidity of common stock since the PTP (Publicly Traded Partnership) units trade on exchanges just like common stock. Since the MLPs generally hold income producing assets, the resulting high dividend attracts a lot of investors, providing capital to the sector.
Income earned from renewable energy projects, however, is not considered eligible for MLPs. This is because of historical reasons more than anything. When this law was passed in 80s, renewable energy sources were not in the same state as today. This historical factor results in favoring the old energy over the newer renewable sources. Political factors aside, a simple legislation by Congress can correct this to level the playing field. Infrastructure is another sector that is in need of capital, and could also be included.
This, by itself, will not be sufficient, but will be a logical and helpful step in the right direction.
Update 6/8/12: Sens. Chris Coons (D.-Del.) and Jerry Moran (R-Kan.) introduced the Master Limited Partnerships Parity Act (no bill number yet), which would amend the federal tax code to allow investors in renewable energy & bio-fuels projects to form master limited partnerships.
CMBS Hedging Requires a New Approach
July 5, 2011
By Malay Bansal
CMBS loan hedging issues have often tripped even smart real-estate lenders. The current environment requires a careful and different approach than in the past.
Recent spread widening and volatility in CMBS market have drawn attention to hedging issues for loan originators in securitization shops.
An article in this week’s Commercial Mortgage Alert (New Markit Index May Solve Hedging Woes) reported comments from market participants that the recent spread widening, which was equivalent to about 3% decline in value of loans held, hit all lenders, though to different extent depending on their hedging approach. In an increasingly competitive market with declining profit margins in loans, a 3% hit is clearly very significant for any origination business.
Last week, a Bloomberg news story reported that spread volatility was as an important factor in Starwood Property Trust’s decision to back away from originating debt that would be sold entirely into securitizations.
Hedging issues, even when people believed they were hedged, have tripped many very smart real estate lenders in the past. During the previous crisis, after the Russian debt problems in late 90s, the hedges made a huge difference. At the time, many CMBS lenders hedged using only treasuries. Only some used swaps. Those who used only treasuries were hurt doubly as treasury yields declined increasing the prices of treasury hedges they were short, while swap spreads jumped higher decreasing the value of their assets which were valued at a spread over swaps. Those who had hedged using swaps did not suffer that much. Those who did not use swaps had devastating losses. After that painful experience, everyone in the market moved to hedging with swaps.
Hedging with swaps still left the risk of adverse movements in CMBS bond spreads, a smaller risk most of the time. Few years later, as competition increased and profit margins declined, some started using total return swaps on the Lehman CMBS indices (now Barclays Indices) to hedge that risk too. Those legacy indices are not useful now as they contain old deals. Some people have turned to CMBX1 for hedging, as it is closest to the new issue bonds amongst the five CMBX indices. CDS on IG Corp indices have been used at times by some, and I have heard people exploring use of other tools like equity indices. However, all of these approaches need to keep in mind that any hedge used needs to have a very good short-term correlation with new-issue CMBS bond spreads – longer-term relationships do not mean anything. If the hedge can move in the opposite direction of the asset in the short-term, it’s not really a hedge.
Lack of a good hedge was one of the reasons that delayed restarting of CMBS lending. Last year, I suggested to Markit to create a new TRX 2 index based on the few new deals that had been done so far (Restarting CMBS Lending, Feb 9, 2010). The idea did not get much traction then. Julia Tcherkassova, who heads CMBS research at Barclays, articulated the need for a CMBS loan hedging mechanism internally, resulting in Barclays creating a US CMBS 2.0 Index earlier this year. That index provided a mechanism to hedge loans but it was not used much.
An instrument existed to allow hedging of loans but no significant attempt was made to use or develop liquidity in it by the industry. The reason is probably as simple as the fact that new issue spreads were generally in a continuous tightening mode till the recent sudden widening episode, and that made spread hedging seem not that important. Another factor is that the hedging is expensive. In the past, the cost of hedging with Lehman index was around 30 bps (on an annualized basis). With CMBS2 indices, that cost would have been about 110 bps. Given that the loan volumes are lower, giving up profitability becomes tougher. So the new Barclays index came, but was not met with a strong demand and remained unused. The wider bid-ask spreads also make hedging expensive.
Commercial Mortgage Alert reported that Markit is close to rolling out a new TRX index, dubbed TRX.2. Since it is coming out after a widening that was painful for many, it might attract more attention. Hopefully, it will provide a liquid instrument that can be used effectively for hedging loans being aggregated for securitization.
However, another point to think about is that the new TRX index will likely come with or be followed by new CMBX indices. It remains to be seen if the new synthetic CMBX indices will introduce more volatility in cash markets as did the legacy CMBX indices. One thing is sure though – hedging is as important as anything else for loan originators and needs to be given proper attention. All the careful real estate analysis while making loans can come to nothing if sufficient attention is not paid to hedging while loans are being aggregated for securitization. Mechanically following the past methodologies will not be the best approach. The current environment calls for adjustments and creative ideas for hedging to be effective and less costly.
Thoughts on Markets and Economy 