By Malay Bansal
The overlooked reason behind the U.S. Treasury yield’s seemingly irrational behavior.
2014 started with ten year treasury yield at 3% and almost universal expectation that it was going nowhere but up from there (Treasury Yield Forecast for 2014 Climb to Survey High of 3.41%). Yet, confounding everyone, it has done exactly the opposite. Defying everyone’s expectations, it has steadily gone down since the beginning of the year and has been around 2.50% recently!
The underlying logic for expecting yields to go up is sound. As expected, the economy is slowly but surely improving. GDP has been growing. The unemployment rate is coming down. All 8.7 million jobs lost during the recession have been gained back. The unemployment rate is down to 6.2% from 10.1% in 2009. Even underemployment (U6) is coming down and is below 15% now, down from 17.5% during the recession. Inflation numbers are firming. Stock markets are back to previous highs. Real estate prices have recovered a lot of the ground lost during the recession. With the economy improving, and asset prices going up, yields should not be at such low levels.
Also, as expected, the Federal Reserve is tapering its bond buying program (QE3), and is going to end it by October this year. Under QE3, the Federal Reserve was buying $45 billion of treasuries (and $40 bn of mortgage bonds). With QE3 ending, a big source of demand is going away, which is another reason for yields to go up.
All rational logic suggests that yields should have gone up this year, not down! So, does the fact that yields have come down instead indicate an irrational behavior on the part of bond buyers? The behavior clearly has the experts baffled (see U.S. bonds confound experts as yields fall, Street baffled as 10-year bond yields hit lowest in six months, Cramer: Baffled by where interest rates are – CNBC).
Several different explanations have been provided by market experts for this (see Why the World Still Loves U.S. Treasury Debt, Bill Gross says this is what’s really behind the Treasury rally). However, in my opinion, one key reason has not been recognized or understood – the role played by increased availability of information, a concept I refer to as Information Momentum (see Using Information Momentum to Understand Markets & Economy), which has a big impact on behavior of market participants.
To understand the link between the two, consider that the signs of improvement in the economy and job market are clear and evident. Everyone can see that the economy is improving and asset prices have gone up. Though forecasts have come down, yields are still expected to go up from here. Almost everyone believes that rates will be higher in future, although most people also believe that yields are not going up immediately and the start of rate increases is a few months away at the least, as the Federal Reserve has clearly stated that it intends to keep interest rates low for a “considerable time” after ending bond purchases. With the easy availability of information, most people (including, and especially, professional investors and bond buyers) believe that they will know when the rates start moving and will be able to act quickly. The changes at Fed to be transparent in its communications started by Ben Bernanke have had a positive effect generally by reducing uncertainty, but as a result, everyone has higher confidence in their ability to know when the Fed will act to raise rates. It is an obvious and well-recognized fact that when yields go higher, bond values will go down. People will reduce their bond holdings once yields start going up and portfolios start showing losses. However, they do not perceive a need to act now. Compared to the past, a lot more people now, have a lot more confidence in their ability to know quickly and act at the last minute (“Just-in-time decision making”) when yields really start going up. This is an important reason why market participants have not acted on their belief that yields will be higher in future, and that lack of action has resulted in the yields staying lower than they otherwise would be.
If you agree with the above logic, the lower yields are not a result of irrational behavior on the part of market participants, but just a manifestation of change in timing of their actions. Also, there are important implications for future. If everyone believes that they can act at the right moment and do not have to act earlier than that, and most people have the same sources of information, then that means, a lot more people will come to same conclusion at the same time. That will lead to a lot more people acting at the same time. If a lot more people are trying to sell their bonds (or bond funds) at the same time, it will result in a sudden big jump in yields. We saw an example of this in May-June 2013 when 10 year yields jumped up by over 100 bp in a span of two months!
It also has important implications for the Fed. In the past, with somewhat cryptic Fed-speak, which left people guessing on the timing of rate increases, different people had different opinions on timing of rate increase based on their differing interpretations of the Fed pronouncements. That moderated the speed at which the yields moved higher as some people acted earlier than others. This time, Fed’s transparency makes more people more confident they know when rates will start going up, increasing the risk of sudden jump in yields, which can be bad for the economy and markets. Janet Yellen (whose husband, George Akerlof, a University of California, Berkeley, professor, won the Nobel Prize in economics in 2001 and played a role in behavioral economics) and the Fed have their work cut out for them to manage the rate at which yields go up. Actions from the Fed that will raise doubts about timing of rate hike will actually be helpful in this regard. It will not be surprising to see more members of the board dissenting and offering differing opinions, which is one way to introduce some doubt about the timing of the rate increase.
The other thing that the Fed can do to moderate the speed of rise in yields is to adjust their timing to when there is higher demand for U.S. treasuries. Since the US economy is a little ahead of Europe and other developed nations in recovery, the US Dollar is seen to have a positive outlook compared to other currencies. That attracts capital to US treasuries. As other economies recover, the relative attractiveness of the dollar may lessen. This would suggest that Fed will be better off raising rates sooner than later, if the economy continues improving.
Complicating Fed’s decision is the risk of derailing the growth by hiking rates too early, which may cause the Fed to delay action. However, the delay will probably mean a bigger and faster rate rise when they do start raising rates.
The conclusion on the outlook for rates is similar to that in my article (What’s Ahead for US Interest Rates?) last year, though economy has improved measurably since then and is undoubtedly growing. As the economic growth picks up or inflation rises, yields will go higher, and even though it is difficult to predict when yields will start increasing, it is easy to see that when yields do start increasing, the increase could be very rapid and significant. The implications for investors are (i) to not wait till the last minute, but act sooner to adjust positions and portfolios, and (ii) be careful when using strategies that depend on the timing of yield increases to be right.
Note: The views expressed are solely and strictly my own and not of any current or past employers, colleagues, or affiliated organizations.
August 3, 2014
By Malay Bansal
A simple concept that is useful in understanding some counter-intuitive phenomena in markets and economy, and looking ahead to the future.
For over a decade, I have used a concept that I have called Information Momentum in my thinking and discussions to explain phenomena in markets and economy that otherwise do not seem completely intuitive. Understanding why something has been different from expected in the past also helps in understanding and looking ahead to what might happen in future.
At its core, the concept is simple and parallels the similar concept in physics. Every physical object has a mass, and if it is moving, it has a velocity. The product of the two is known as momentum. The higher the momentum, the greater the impact that object will have. The higher the momentum, the higher the force required to stop the object from moving or to change its direction.
A somewhat similar concept can be applied to information. In this case, consider the number of people who receive a new piece of information, and can act on it, as equivalent to the mass, and how fast people get this new information as equivalent to velocity. The more the number of people who receive the new information, or the quicker the new information reaches people, the higher the information momentum for that information.
The concept is simple and so are some observations which help apply the concept to understanding market behavior. Somewhat in jest, and continuing the parallel with physics, I have sometimes referred to them as my laws of information momentum. Four of these observations are mentioned below.
First law of Information momentum is that the information momentum will continue to increase with time. This is obvious today. It started increasing with with internet becoming more easily available to more people, first in US and then around the world. Then, each of the following, as it came on the scene, has contributed to a quantum jump in the information momentum: advent of the web (the world wide web), email, blogs, news sites, internet trading, faster connection technologies like DSL replacing old phone dial-ups, wi-fi connections everywhere, tablets & smartphones with data connection, twitter. This trend will continue and the increase in information momentum will magnify the impact of the other laws.
The second law is that higher information momentum means new information will have bigger impact than in the past. More people acting on a piece of information at the same time means bigger moves in market and possibly more often. A corollary to this law is that higher information momentum can, though will not always, increase volatility and correlation in markets.
The observations by Bespoke Investment Group on “S&P 500 All or Nothing Days” (days where the net daily A/D reading in the S&P 500 exceeds plus or minus 400) as described in the article All or Nothing Days Becoming More Common Than Uncommon, and as shown in the chart below provide a good example of this over a long period.
Source: Bespoke Investment Group.
The third law is that more information momentum means better decisions will be made. Better decisions will logically lead to better outcomes, which in bigger picture, implies higher probability of higher profits for companies and better growth for the overall economy. All else being equal, the future will be better than the past. This applies at every level including at the level of individuals, companies, countries, local markets, and the entire world’s economy. At every level, decision makers will have access to more specific and detailed information and sooner than ever before. In addition to more detailed information about the specific situation, decision makers will have access to more ideas, viewpoints, opinions, suggestions, and criticisms from a wide variety of people through blogs, comments etc. As an example, in 2008 and 2009, when the economy worldwide was facing a huge crisis, with declining values of mortgage backed securities and other bad assets leading the biggest banks towards failure, and the government had to announce extraordinary measures like TARP, even people like me were able to chime in with suggestions directly to people at Treasury and Federal Reserve and via articles in New York Times etc (to toot my own horn, I suggested a plan involving public-private partnership – basically the concept behind TALF and PPIP programs announced and implemented several months later. See Solving The Bad Asset Problem or PDF).
It is easy to see that even with all else being equal, the future will be better than the past. But all else is not equal, if you look at things like what developments like search engines have done to personal and business productivity. You can find answers to almost any question you have just by googling it. Think about how Google Earth has changed the real estate businesses, and other similar examples. All of these are reasons to be optimistic about the future.
The fourth law states that since more information may become available with time, decisions will be made later in time, possibly at the last possible minute when they have to be made. At an earlier time, the Just-in-time concept significantly improved productivity in manufacturing. In a similar vein, decisions to act may be delayed till the last minute so as to take advantage of any additional information that may become available (what I call “Just-in-time decisions”).
Future articles will add more laws and give more specific examples detailing the application of these concepts for understanding various market and economic developments and looking ahead to the future (for the first example of application of these concepts, see Why have U.S. Interest Rates Defied Expectations and What Lies Ahead? ).
Note: The views expressed are solely and strictly my own and not of any current or past employers, colleagues, or affiliated organizations. My writings are simply expressions of my intellectual thought process. I welcome comments, observations, examples and any extensions of the concepts above.
April 27, 2013
By Malay Bansal
Where are US Treasury yields headed and how fast could they move.
Note: A version of this article was also published on Seeking Alpha.
In early February, the U.S. Treasury made a statement that has not received much attention even though what it implies regarding their thoughts on the future demand for treasury securities (and hence yields) is very interesting. The announcement was mainly about the auction of $72 billion of coupon securities, but it also said that it plans to issue a final rule on floating-rate notes in the coming months, with the first FRN auction expected to occur within the next year. The statement probably did not get a lot of attention because the Treasury has spoken about the idea of floating-rate notes earlier too. However, it had never given a specific time frame in the past. This is significant, not just because it will be first new type of treasury security to be issued since 1997 when the U.S. government introduced TIPS or Treasury inflation-protected securities, but also because what the need for the Treasury to issue these at this time implies about their view on interest rates.
The details on the floating rate notes still need to be worked out. Treasury hasn’t chosen the index to use, and is considering the Treasury 13-week bill auction high rate, Treasury general collateral overnight repurchase agreement rate, etc. All of these will make Treasury’s financing cost variable and expose it to the risk of higher costs in future if the index moves higher.
At a time when yields are low, what is the need to introduce a new security that can result in higher costs as rates increase? The only reason to introduce something that may result in higher cost for debt is the worry that there may not be enough buyers for fixed rate Treasury debt once yields start increasing. With trillion dollar budget deficits and need to refinance maturing debt, if there are not enough buyers, the lower demand will naturally result in yields moving higher quickly.
How much will rates move?
There is almost universal expectation that yields are going higher. Numerous reports and articles over the last few months have mentioned expectations of higher yields and concerns about the risks to investors holding fixed rate debt from various market participants (examples: Barron’s, Bank Of America, PIMCO, Financial Times).
In December 2012, when the 10-year treasury yield was 1.71%, the median forecast from all the 21 primary dealer banks of the treasury market was for the 10-year yield to rise to 2.25% at the end of 2013. In Feb 2013, economist Mark Zandi of the widely used Moodys.com offered “Treasury yields are on track to yield as much as 5% in three years,” (though he caveated his forecast with his assumption of Washington taking the right steps). Bloomberg survey puts the current forecast for 10-year treasury yield to rise from 1.66 at present to 2.25 at end of 2013 and 2.73 at the end of 2014. For 30-year bond yield, the survey predicts yields to rise from the current 2.86 to 3.40 by end of 2013 and 3.82 by end of 2014.
The rationale for rising yields is clear. Easy monetary policies and quantitative easing from central banks around the world are meant to inflate asset prices. How could such large scale of printing money to buy bonds not result in inflation at some point? The economy is slowly improving. And yields are at historical low levels.
The 10-year note yields just 1.66%, 5-year note yields a mere 0.68%. Even the 30-year long bond yields just 2.86%. These puny yields expose bond holders to significant risks if yields rise. For the 10-year note, a 50 basis point increase in yield within the next year will result in price decline of about 4.5%, significantly more than the 2% coupon income. The 5-year note will not do that much better – a 50 bp increase in yield would decrease price by 2.5%, far more than the 0.625% coupon. The 30-year long bond will obviously be hurt the most with its longer duration. A 50 bp rise in yield will result in 9.8% decline in price far outweighing the 3% coupon.
If you expected 10-year yields to increase by 100 bps in next 2 years (forecast mentioned above is a rise from current 1.66 to 2.73 or 106 bps by end of 2014), you would lose about 9% in price and earn 4% in coupon. Would you buy at 1.66 yield or wait for yields to rise to 2.73? To buy the notes now, buyers would want a yield closer to 2.73 now, causing an immediate jump in yield. If you expect yields to rise even more, say 5% after another couple of years, would you even buy at 2.73? As expectations of higher yields take hold, the Treasury will have to immediately pay higher yield reflecting future expectations to entice buyers. This will push yields up quickly towards the expected highs. Given how low yields are, the amount and speed of increase could be significantly higher than in the past. Once yields start increasing, the increase will be further exacerbated by selling from holders of pre-payable mortgage backed securities to hedge their increasing durations (convexity hedging which results from the fact that as yields increase, prepayments on mortgages decrease resulting in higher durations which requires selling of treasuries or swaps to hedge the increase in duration).
Floating rate notes do not have the interest rate risk of fixed rate bonds. So investors are not likely to demand the risk premium that they would need for fixed rate bonds. That is the rationale for the Treasury to issue Floating rate notes.
Are Yields the Easiest Shorting Opportunity of a Lifetime?
Yields are near historical lows and are universally expected to go up. With that, are US yields the easiest shorting opportunity in the market? Not really. As with people sometimes, markets say and do different things and it is important to see what they are doing rather than what they are saying. In this case, if everyone is completely convinced that yields will be higher, why would anyone buy treasuries at these low yields at all? Some of the buying could be attributed to some retail investors not being aware of potential for yields to rise or not being mindful of the risk, or their positions being inconsistent with their beliefs. Some of it could be attributed to flight for safety. However, the fact that yields are near the lows is more an indication of a lack of conviction among larger investors about the rates rising quickly and significantly. The expected inflation over 10 years as implied by yields on 10-year notes and TIPs, at about 2.40, is in the middle of the range of 2.10 to 2.60 for the past year. CPI, at 1.5%, is near the lower end of 1% to 4% range of past three years. Gold prices are lowest they have been in two years. Oil price, at 93, is in the middle of the 85 to 105 range over the last three years. These do not show an obvious immediate concern for inflation. The market is doing something different from what people in it are saying and expecting.
What about the polls predicting higher yields? Interest rates are very hard to predict, even for very smart people. Rates have been low for 5 years now. When they dropped initially, almost no one expected them to stay this low for this long. A look at polls and forecasts from past might also be instructive in that regard. In a poll of Primary Dealers in Jan 2011 the median of forecasts from 17 of 18 primary dealers was for the 10-year note yield to climb from 3.33 percent at that time to 3.50 percent by the end of the second quarter of 2011. The average prediction in a Dec 2011 poll was for 10-year yield to rise from 1.85 at the time to 2.74 by end of 2012 (actual 2012 year-end yield was 1.76).
Even if you do see a bubble in yields ready to pop, getting the timing right can be almost impossible. The lower US yields have persisted for 5 years now even though everyone agrees they should be higher. The Japanese Government Bond market has crushed many investors who tried to short it (the widowmaker trade) and provides an example of the difficulty.
Yields could bounce around in the range they have been in recently (1.60 ish to slightly above 2%) for a far longer time than expected, unless the economy improves quickly or inflation picks up.
What to Look Out for?
The direction of interest rates depends most on the economy and what Fed does with QE program and fed funds rate. One of the most important indicators will be any sign that Fed is beginning to pull back on its $85 billion a month bond purchase program. That will happen before Fed actually starts increasing Fed Funds target rate. Federal Reserve’s decision, in turn, will be based on progress in employment situation, which thus becomes one of the most important indicators.
The Federal Reserve has said that it expects to maintain short-term interest rates near zero, even after it stops buying bonds, for as long as the unemployment rate remains above 6.5 percent, provided that medium-term inflation does not exceed 2.5 percent. A good read on this is an article on PIMCO website which also includes a list of 10 employment related indicators the Fed is watching (Telling Tape Time, Tony Crescenzi, April 2013).
The U.S. is not Japan. Our policy makers have learned from the Japanese experience and have not followed the same path. Also, the economy is showing signs of improvement, though more in some sectors than others. As the economic growth picks up or inflation rises, rates will increase. However, exact timing of that increase is difficult to predict with any type of certainty. Yields could bounce around in the range they have been in recently (1.60 ish to slightly above 2%) for a far longer time than expected, unless the economy improves quickly or inflation picks up. Any strategies or positions taken that depend on rates rising within a certain time frame carry a risk even though the view on the direction may be correct. Even though it is difficult to predict when yields will start increasing, it is easy to see that when yields do start increasing, the increase could be very fast and significant.
Note: The views expressed are solely my own and not of any current or past employers or affiliated organizations.
June 1, 2010
These suggestions, sent to the Treasury & FRB in Oct 2008, proposed a plan similar to the TALF and PPIP programs, months before Treasury and others came around to the idea. They were mentioned in the NY Times Executive Suite column by Joe Nocera (complete document is available at nytimes.com here). The Treasury plan was first announced by Treasury Secretary Tim Geithner on Feb 10, 2009. The writeup also included the Turbo concept of limiting interest payments and using excess interest to pay down loan principal, which was included in the TALF announcement on Legacy CMBS on May 19, 2009.
Suggestions for Additional Steps for Tackling the Credit Crisis
By Malay Bansal
Oct 19, 2008
Several steps have been taken by the Treasury and Federal Reserve to address the current economic crisis. These are important and useful first steps, but as everyone knows, the problems are complex and will require additional action, including steps to tackle the root cause of the problem – declining house prices.
Obviously, any step to stabilize house prices will need to focus on decreasing supply by preventing foreclosures as much as possible, and increasing demand by providing incentives to new home buyers. Making mortgage payments more affordable is key to both. Most efficient will be approaches that help people on the margin – people on the verge of defaulting on their mortgage, or those considering buying a house.
Below are outlines of three suggestions I have for consideration along with other steps being contemplated:
1. Better use of part of TARP Funds targeted to buy mortgage assets: Treasury can partner with private buyers instead of buying assets itself.
- Will increase efficiency by tapping private funds. There is a lot of capital waiting to be invested in distressed assets, but has not been invested yet as prices need to be lower to achieve targeted returns without leverage.
- Treasury can lend to or partner with private buyers of distressed mortgage assets with terms like the following:
- Treasury will put up 50% and the private buyer will put up 50%, with Treasury’s interest being the senior interest.
- Funds will be used to buy distressed mortgages and securities at a discount from various large and small banks and financial institutions.
- Mortgage payments from purchased assets will be used in sequential order to (i) pay 5% interest to Treasury, (ii) 5% interest to the Private buyer, (iii) principal to Treasury, (iv) principal to the Private buyer, and finally (v) all residual to the private buyer as its return for the risk. This ensures that Treasury gets its money back first.
- The 5% interest for Treasury will apply for 5 years. After that, it will increase by 0.5% every year till it reaches 9%. Interest for private buyer will stay at 5%.
- Those taking the loan from treasury will need to agree to change mortgage terms to help homeowners including giving borrowers the option to (i) increase loan term by 5 to 10 years, and (ii) prepay loans at any time without penalty (any existing prepay penalties will be waived). Other terms to help homeowners may be included.
- Treasury will offer mortgage assets from banks for bids. The private buyer with the highest bid will get funds from Treasury. Banks will have option of accepting the highest bid or keeping the assets themselves.
- This type of plan will allow participation by numerous large and not-so-large investors. Since there will be multiple buyers competing to buy assets, with their own capital at risk, the plan would help in determination of fair market prices for distressed assets (instead of a situation in which TARP manager is the only buyer).
- This program can run in parallel with direct purchases of assets by treasury, or can be used to sell off assets purchased by Treasury at a future date.
2. Make mortgage principal payments tax-deductible for next 5 to 10 years.
- Mortgage interest is already tax-deductible. Making principal also deductible will make it easier for those who want to but are barely able to make their mortgage payments, and those who are considering buying a house.
- As an example, someone with a $350,000 mortgage and 28% marginal tax rate will save $6,250 over 5 years or $1,250/yr. Over 10 years, savings will be $14,900.
- Better than a single-shot stimulus payment, since (i) it will provide relief over a longer period of time, (ii) it attacks the root cause of the problem by targeting housing, and (iii) it will benefit local governments by preventing loss of property taxes that will otherwise result from foreclosure.
- The deduction may be limited to maximum 15 to 20% of total mortgage payment to focus the benefit more towards newer mortgages (after ten years, principal payment is likely to be more than 20% of total mortgage payment), &/or to mortgages issued in certain years to control total cost.
- The deduction can be phased out above a certain level of AGI to focus the benefit towards those who need it more.
3. Encourage mortgage modifications to lower monthly payments by extending the mortgage term by 5 to 10 years.
- Modify mortgages by increasing the term by 5 to 10 years to lower monthly payment. As an example, monthly payment on a 30 year mortgage with 6.5% rate will decrease by 4.4% (or $1,172/year on a $350,000 mortgage) if term is increased by 5 years. An increase of term by 10 years would reduce monthly payment by 7.4% (or $1,960/year on a $350,000 mortgage).
- Lowering payment without lowering interest rate may be more palatable from fairness perspective, and should be attractive to lenders if it avoids default. Removing any prepayment penalties should also be part of the modification as much as possible.
On Feb 10, 2009, Treasury Secretary Tim Geithner, in a much anticipated speech, announced the long-awaited toxic asset plan, but the market was disappointed by lack of details and sold off.
Extract from Treasury’s 10-Feb-2009 Fact Sheet on the Financial Stability Plan:
FINANCIAL STABILITY PLAN
1. Public-Private Investment Fund: One aspect of a full arsenal approach is the need to provide greater means for financial institutions to cleanse their balance sheets of what are often referred to as “legacy” assets. Many proposals designed to achieve this are complicated both by their sole reliance on public purchasing and the difficulties in pricing assets. Working together in partnership with the FDIC and the Federal Reserve, the Treasury Department will initiate a Public-Private Investment Fund that takes a new approach.
- Public-Private Capital: This new program will be designed with a public-private financing component, which could involve putting public or private capital side-by-side and using public financing to leverage private capital on an initial scale of up to $500 billion, with the potential to expand up to $1 trillion.
- Private Sector Pricing of Assets: Because the new program is designed to bring private sector equity contributions to make large-scale asset purchases, it not only minimizes public capital and maximizes private capital: it allows private sector buyers to determine the price for current troubled and previously illiquid assets.
NY Times Links:
Solving the Bad Asset Pricing Problem
Note: This write-up was published on the Seeking Alpha here. It was a follow-up to the original suggestions, sent to Treasury & FRB in Oct 2008, which proposed a plan similar to the TALF and PPIP programs, months before Treasury and others came around to the idea.
By Malay Bansal
Feb 5, 2009
The Original TARP plan and the Aggregator Bad Bank ideas both have one major flaw: lack of a mechanism to determine appropriate prices for bad assets. Here is an approach to tackle this pricing issue. This approach also gets more bang for the buck for the Treasury by involving private capital in buying of these assets. More clarity in pricing and involvement of private investors are desperately needed for markets to return to normalcy.
There are already a lot of private investors who have raised significant amounts of money to invest in distressed assets. However, a lot of this cash has not been invested yet. Part of the reason is that they desire lower prices to get their returns to higher target levels than what they can get at present. Sellers, on the other hand, are often not ready to sell at even lower than current prices, especially when they believe that prices are already too cheap based on fundamentals. This has led to a stand-off which is leaving these assets on bank balance-sheets. So long as these assets stay on their balance-sheets and uncertainty about their prices continues, banks facing mark-to-market losses can not focus on restarting lending in these markets again.
Lower asset prices is one way private investors can get higher returns. The other method is if they can get financing for buying these distressed assets. If for example, they can get 50% financing on purchase price of assets, they can buy twice the amount of assets they could buy without the financing, thus roughly doubling their returns (minus the cost of financing). This will allow them to pay higher prices for assets and still earn their target returns.
In the current environment, financing is generally not available to investors in these assets. Given that financing can increase returns significantly, it is especially valued by investors at present. And that is what provides the solution to the pricing problem, and can ensure that the banks get the highest prices possible for these assets today, without the risk of any future Mark-To-Market (or actual) losses.
To attract private investors to buy distressed assets, the Treasury can offer to provide financing to private buyers. Prospect of higher returns, especially in an environment where returns on other assets are low, will attract lot of investors to the sector. However, financing will be provided to the buyer who has the highest bid on a given set of assets. That is important. The bidding process creates a mechanism for determining a fair market value for these assets. This plan will allow participation by numerous large and not-so-large investors, not just a few large investors selected by the Treasury. If the bid is too low and the bidder can make an exceptionally high return, another investor is likely to step in with a higher bid, if the bidding process is transparent and open to everyone. Different investors have expertise in different products. Those with the best expertise in the assets being offered will be able to value these assets and bid more aggressively. Since there will be multiple buyers competing to buy assets, with their own capital at risk, the plan would help in determination of fair market prices for distressed assets (instead of a situation in which TARP/Aggregator Bank manager is the only buyer). This bidding process also ensures the banks get the highest price possible for their assets in the current environment. If none of the bids are high enough, the bank is not required to sell, and can retain their assets. This ensures that banks are not forced by the program to sell assets at too low a price. If they choose to sell, their balance-sheet is cleared of these assets, and there is no future claw-back or liability related to these assets for them – the assets will be owned by a third party. They can go on to focus on other things.
Any cash flow received from the assets will be used first to pay interest to the Treasury and the private investors. Then, it will be used to pay principal back to the Treasury. Private investors will not get any of their principal back till Treasury has been paid back completely. The interest paid to private investors will be small (perhaps 4 to 5% range on their invested funds, not the face amount of securities) and will be meant to cover their expenses. Majority of their return will come at the back-end, their higher risk reflecting their higher returns. This priority for paying back Treasury funds first will protect public funds by decreasing the probability and amount of any potential losses on these assets.
Also, for home mortgage backed assets, Treasury can help homeowner mortgage-holders facing difficulty by requiring recipients of financing to agree to certain pre-specified steps to help homeowners in loan workouts.
Providing financing, instead of buying assets itself, provides more bang for the buck for the Treasury. As an example, if the Treasury offered 50% financing on AAA assets, and it has $100 Bn allocated to the program, the program will clear $200 Bn of assets from bank balance sheets. If the treasury used the funds to buy the assets itself, it will be able to remove only $100 Bn of assets from the banks’ balance sheets. Also, it reduces the risk of loss on these assets for public funds, since Treasury will be paid first and private investors will be bear the loss before the Treasury takes any hit.
Since private investors, who will have their own capital at risk before Treasury’s capital, will be buying and managing the assets, the Treasury will not need to build as big an infrastructure as it will need if it were to buy the assets itself. Nor will it need to pay management fees to third-party managers. Also, by using the private sector, this program can be ramped up much more quickly.
To achieve the highest rational prices, the bidding process must allow wide participation by large & small investors (bids should be requested for portfolio sizes that do not discourage small to medium size investors), amount and cost of financing should be known in advance of bidding (will likely be different for different pools and can be announced for each portfolio when it is put up for bid – treasury can even ask for multiple bids for different amounts of financing), and private capital must be at risk while protecting public funds (otherwise plan may face opposition from public).
I had originally included this suggestion among a few I had made to the Federal Reserve and Treasury officials in October after the original TARP plan was announced. I was happy to see the announcement of TALF, which will provide financing for new origination. However, financing for existing distressed assets will help clear the bank balance sheets of these assets, which is needed before banks are likely to increase originating new loans. Also, current Treasury plans do not include the Commercial Real Estate sector. It should be included before the issues in the sector escalate and become much bigger, as it will have significant impact on smaller regional banks that hold a lot of commercial real estate debt.
No single step will solve all the problems. Neither will this one, and it should be one of many approaches. But this approach can be effective since it will start the process for establishing prices for distressed assets, involving private capital in solving the problem, and cleaning up bank balance sheets, which are all prerequisites for eventual return to normalcy in the credit markets.
August 2, 2009
By Malay Bansal
Much has been written about the issues faced by Commercial Real Estate, extent of losses the CMBS bonds will sustain, whether the TALF, PPIP and other government programs will help, and if the commercial real estate market is showing signs of bottoming or is going to keep declining a lot more. There are various views which all seem plausible. If you are not professionally involved in real estate, or if you do not already have a definite view, how do you go about developing your own opinion? This article is an attempt to help with that process.
First step in the process is defining the problem being faced by the CRE market. It is a complex problem and yet the best description of it I have seen is a simple one sentence comment reportedly made by a panelist at a recent industry conference organized by CMSA:
“We have gone from a 6% Cap, 80% LTV world to a 8% Cap, 60% LTV world.”
That is another way of saying the CRE market faces a double-whammy of falling prices and reduced availability of debt, but the use of numbers in this short one sentence elegantly and succinctly captures the essence of the problem. A simple example will help explain.
Let’s take a commercial property, say an office. It is year 2006, property generates $600,000 in rental income per year, and cap rates are 6%. That results in value of $10 mm (600K/6%). In an 80 LTV world, Larry the Landlord buys the building for 10 mm, borrowing 8 mm (80% of 10 mm) for 5 years from a CMBS lender, and using 2 mm of his own money. Now fast forward to a time closer to loan maturity. In the new world, cap rates are 8%, so the new value is lower at 7.5 mm (600K/8%), and the new loan amount is 4.5 mm (60% of 7.5 mm). To refinance, Larry needs to pay off 8 mm, but can only get 4.5 mm in new loan. So, he needs to come up with 3.5 mm. If he has that money or can raise it from somewhere else, he can refinance the old loan and continue to own the property.
If Larry can not raise the additional amount, or if he does not think that it is economically worthwhile to do so, then the loan is foreclosed, and one option for the lender is to sell the property. Ideally, the property can be sold for 7.5 mm, the new value. In the worst case, there should be plenty of buyers at 4.5 mm (since one can buy the property no money down using the 4.5 mm debt available in the new world). The actual price will be somewhere between the two depending on how many buyers are there with cash available to buy, and what is their view of real estate prices in future.
By using the above numbers, we can quantify the range of expected losses in cases of sales:
|Decline or Loss||%Decline or Loss|
|Property Prices||2.5 to 5.5 mm||25% to 55%.|
|Borrower’s Equity||2 mm||100%|
|CMBS debt||500K to 3.5 mm||6.25% to 43.75%|
If you layer in other factors, for example, if you assume that building’s cash flow decreases by 15% due to higher vacancy or lower rental rates (or the actual rent is lower than the assumed rent in aggressive underwriting), the numbers become worse:
New cashflow is 510 K, which results in new value of 6.375 mm, and new loan of 3.825 mm. With a new buyer paying something between 3.825 mm and 6.375 mm in case of a sale, the range of losses is:
|Decline or Loss||%Decline or Loss|
|Property Prices||3.625 to 6.175 mm||36.25% to 61.75%.|
|CMBS debt||1.625 to 4.175 mm||20.31% to 52.19%|
Broad ranges for sure, and you can quibble with the cap rates or LTVs, or the fact that this simple analysis ignores other expenses and complexities, but these are back-of-the-envelope numbers, and give you an idea. For CMBS deals, you also need an estimate on how many loans in a given deal will default. If you assume approximately 40% losses on defaulting loans, then defaults on 20% of loans in the pool will result in 8% losses on CMBS deals, which is somewhere in the middle of the range of losses being predicted by many of the market participants.
Loan extensions can postpone the problem, but not necessarily avoid it, unless the property prices go back to the old levels quickly, which no one expects.
Looking at the example above, one can clearly see the importance and impact of availability of debt. If debt up to 80 LTV were to become available again, that will narrow the ranges above significantly. Clearly, programs like TALF and PPIP that help increase availability of debt are helpful and important. But, they do not solve all problems. They do not help with the decline in value. That pain has to be taken, even though many are trying to ignore it. The current low transaction volume environment reduces confidence in valuations, but eventually volume and clarity on new valuations will both increase. Those who own commercial real estate property with a lot of debt and can not carry it through the downturn will suffer losses they have not recognized yet. But those who have cash and can buy properties at cheap levels in distressed sales will benefit. As always, it will be important to analyze and understand not just the sector, but the individual investments being considered.