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 understoodthe 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.

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.

S&P500 All or Nothing Days Graph

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.

By Malay Bansal

A Simple and easy to implement idea for reforming the issuer-paid model for credit ratings that accomplishes the goal of the Franken Amendment.

Note: A version of this article was also published on Seeking Alpha.

Five years since the credit crisis, debates on how to reform the ratings process continue with no good solution or consensus in sight, even though there is general agreement about the conflict of interest inherent in the issuer-paid model which allows ratings-shopping by issuers, and the need for reform, especially for Structured Finance securities. The Franken Amendment to the Dodd-Frank Act  specifies a solution to be used if the SEC cannot find a better alternative, which proposes creating a board, overseen by the SEC, which will assign rating agencies to provide initial ratings for structured debt securities.  Even though the goal of eliminating the conflicts arising from issuers selecting the agencies is desirable, the proposal has not garnered support from many industry participants as a practical solution. This article suggests an alternative reform which is simpler and easier to implement, and achieves the same basic goal.

The basic problem, especially in structured finance (and especially in securitization of mortgage and other debt), is that the issuers or their underwriters select the agencies that will rate a structured debt issuance. They obtain preliminary ratings from all agencies, and then the agencies providing the highest ratings are selected to rate that transaction. Since agencies get paid only if they are selected to rate the deal, they have an incentive to provide the highest rating possible, which creates the conflict of interest.

The Franken amendment solution seems to address this conflict. However, it addresses the wrong part of the problem. The real problem is not that the issuers want to get the best ratings possible. It is rational behavior for any issuer to want to know what the economics of a deal will look like before proceeding, and want to get the best economic result from a debt issuance. Having a board to assign rating agencies could result in issuers not knowing till too late which agencies might rate their deal and what the economics of the issuance might look like. This will introduce unnecessary uncertainty for the issuers. The same outcome could also be achieved by simply prohibiting issuers from obtaining preliminary ratings. This will avoid having to create the bureaucracy of a new board, but will have the same undesirable consequence of uncertainty for the issuers.

The real problem is that the rating agencies depend on issuers to select them to rate specific transaction for all of their revenues. Usually two agencies are selected to rate the transaction. They get paid, others do not. Keeping too high a standard means not being selected and not having any revenue. The higher ratings they can give, the more transactions they will rate and the more money they will make. That is the perverse incentive and the conflict of interest in the current system, that needs to be resolved. The problem is in the system which leads to undesirable outcome with people trying to be economically rational in behavior. In some ways, this issue may become worse this time as there are many more rating agencies now competing than the three dominant ones in the past, and the overall structured finance issuance volume is much smaller.

As one solution, SEC tried to promote unsolicited ratings from agencies that were not selected by the issuer to rate the deal. However, the due-diligence for rating asset-backed deals is expensive. Also, the rating agencies do not want to alienate issuers for fear of not being selected for future deals. So, unsolicited ratings have not been given. Another alternative idea talked about is to have the users of the rating pay for it. That approach faces criticism that all investors should have access to the same information, not just those who can pay for it. Also, investors generally do not like the idea of paying for ratings. Neither the Franken Amendment solution, nor the above two seem like a viable solution. One key problem, especially in structured finance transactions, is that it is expensive to perform the right amount of due diligence to rate a deal, and some amount of upfront payment may be necessary, which as a practical matter, will have to come from the issuers, leading us back to the existing business model.

In an earlier article (Three Misconceptions about Issuer-Paid Ratings), I argued that this problem seems intractable because of three widely held misconceptions about the issuer-paid nature of the ratings. The biggest block is perhaps the third one – the belief that the “Ratings have to be either Issuer-Paid or Investor-Paid.” Almost everyone seems to think that ratings have to be either paid by issuers or investors.  However, it does not have to be one or the other. Just a sufficient portion of the fee has to come from, or be driven by, investors to provide the right incentives.

If we do not want the status quo, the solution has to accomplish the following goals:

  • Should not add uncertainty for issuers.
  • Should not require new bureaucracy of an SEC board specifying agencies to use for each issuance.
  • Reduce dependency of rating agencies on being selected by issuers for all of their revenue.
  • Give investors control of part of revenue.
  • Allow rating agencies to provide ratings without having to worry about if they will be selected.

Here is one solution that accomplishes all of these: Require an additional rating agency for each transaction. This agency will be paid from the proceeds of the issuance, just like the other two agencies picked by the issuer to rate the deal. However, this agency will provide the ratings after the transaction has settled. This will effectively achieve the same objective as attempts to get unsolicited opinions or ratings, but an agency will be hired and paid to do it to ensure the right amount of due diligence and quality. Also, to avoid the conflict of interest issue, the additional agency will not be selected by the issuers, but by investors. This can be easily achieved by letting the investors vote for the additional agency on a website maintained by the issuer’s underwriters. Websites are already used for transactions to share transaction information with investors, and it will be easy to add a page to let them vote on the additional rating agency. It will be important to include all investors in the voting process, not just those who purchased bonds in the deal, to avoid the conflict that may arise from investors wanting the best ratings once they have purchased the bonds.

This solution does require the issuer to pay for one more rating agency. However, the cost is easily manageable and worth the benefit, and better than having an SEC board assign rating agencies. More important, it means that at least one third of the rating agency revenues will be controlled by investors, and the agencies are not completely dependent on selection by issuers. It gives them an incentive to do better work for investors, both in the initial ratings, and in the on-going monitoring of the deals.

As I have suggested earlier (Rating Agency Reform: The Real Problem That Has Not Been Recognized), over time, everyone will be better off if rating agencies can move towards a subscription based model for at least part of their revenues. If investors have control over a significant enough portion of the total revenues of the rating agencies, investors, rating agencies (including their investors), and the entire financial system will benefit from the proper alignment of incentives that would be created.

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. The intent is not to promote any particular view point or agenda, and the writings are not influenced by any other groups or individuals.

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).

Conclusions

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.

 

By Malay Bansal

Investments in clean energy and infrastructure projects can help address the unemployment problem and make American business more competitive. The challenge is financing these investments in the current environment. There is a creative solution available that does not require new taxes, printing more money, or increasing the deficit.

The President is set to propose investments in infrastructure and clean energy in his jobs speech next week. There are several reasons that make spending on infrastructure and clean energy a good idea at this time: the jobs created are local and cannot be exported, the jobs created are in sectors like construction that are facing higher unemployment, it generates demand for products and services from a variety of industries creating more jobs, deteriorating US infrastructure is sorely in need of maintenance, and now is a good time to make these investments as raw materials and labor are cheap (maintenance is necessary and overdue – not doing it now just means that it will have to be done at a later time when it will likely cost more).

Even though infrastructure investment is a good idea, it faces two big problems.

First is the need to finance these investments. With the focus on reducing deficit, it will be difficult to get everyone to agree on spending money on these projects. The President has made similar proposals in the past. Republicans are almost certain to oppose more spending and any taxes to pay for it this time too. The bankruptcy filing this week by the solar power panel maker Solyndra, which had $527 million in loans from Federal government, and had been praised by the President, will be held up as an example by many of a poor government investment that put public money at risk, and a reason why government should not get involved.

The second problem is picking projects that are productive and not just a waste of money. Government may not be the best judge for picking the best projects.

The solution to both problems is increased involvement of private sector.

However, to get the private sector to invest in infrastructure projects, the government has to provide incentives, but in a way that does not increase deficit or taxes. One creative possibility for doing this may be by using the estimated $1 trillion of unrepatriated profits US companies hold in foreign subsidiaries.

American companies can generally defer paying taxes on foreign profits as long as they keep the money outside US. When they bring the money back to US, they have to pay the top corporate tax rate of 35%. To defer taxes, US companies generally have left large sums of profits in their foreign subsidiaries. These untaxed profits are part of the reason large multinationals have lower overall tax rates for which they have been criticized at times.

The administration has proposed taxing worldwide income of US companies, but faced strong opposition since that would put the US companies at a competitive disadvantage.

On the other end, US companies are arguing that they could bring back the earnings in their foreign operations if the US government offered a tax amnesty and permitted them to repatriate foreign earnings at a low rate of around 5% instead of the 35% federal tax they face at present. They argue that 5% tax could bring $1 trillion back to US for increased economic activity and could generate additional $50 billion in federal tax revenue.

The tax amnesty will not result in an increase in deficit or taxes, as government is giving up what it is not getting anyway – without it, these funds will not come back into the US economy, and the Treasury will not get the additional tax revenue.

However, the tax holiday idea has been opposed by many as the funds brought back will not necessarily be used to generate jobs. The companies could use the money for M&A activity, stock buybacks, and paying out dividends. A similar tax-amnesty program was implemented in 2004. However, of the $362 billion that was repatriated, very little was used for actual investments to create jobs.

A better idea, one that addresses this concern, will be to offer the tax amnesty only to the funds brought back that are actually invested in infrastructure and clean energy projects in the US. However, money is fungible, and it can be easily moved from one bucket to another. To ensure that the tax break really results in investments that create jobs, the repatriated money has to be separated from the other funds of the repatriating company. Hence, for this idea to be effective, the funds brought back must be invested with third-party private fund managers for a minimum number of years to qualify for the tax break.

A limited time tax amnesty will encourage US companies to repatriate earnings back to US quickly. A requirement to invest in infrastructure projects for a minimum fixed number of years (say something between 3 to 5 years) will ensure that the funds brought back create jobs. Companies will be allowed to invest in either debt or equity depending on their risk-reward preferences. Government will not be involved in making investment decisions. All investments will be chosen and managed by private fund managers, who will pick projects and investments based on sound economic calculations of cost-benefit and expected returns. The companies will be free to pick any fund manager based on their judgment of manager’s capabilities and investment strategy.

This basic framework could be enhanced in several ways. Companies could be encouraged to invest for a longer period by offering to reduce any taxes on the earnings from the infrastructure investments, if the investments are held for say 7 to 10 years or more. Also, companies could be allowed to use part of funds brought back to build new plants for their own use, or setup funds that finance purchases of company’s products.

This proposal is a middle of the road approach which addresses the problems the US economy is facing in a productive way and should be acceptable to both sides. Even if there are plans to change rules to tax worldwide earnings of US companies in future, it still makes sense to address the past earnings that are held outside US.

Longer term, the US needs to develop regulations that clarify and encourage private sector investment and involvement in the clean-energy and infrastructure sectors, both of which are essential for the growth and competitiveness of the US economy in the longer term. The areas that need attention from lawmakers and regulators include Public-Private Partnerships, securitization of infrastructure financing, and eligibility rules for MLPs and REITs.

Note: I originally wrote about this idea in November 2010 and shared it with several policy-makers, elected officials, industry chieftains, think-tanks, and members of the media. Given the state of the economy, the idea is more timely and urgent now. The original, more detailed, article is at https://marketsandeconomy.wordpress.com/2010/11/23/tackling-the-us-unemployment-problem/.

By Malay Bansal & John Joshi

The issuer-paid model for ratings is widely seen as one of the most significant aspects of the process that needs to be reformed. Yet, no good solution to reform this process has emerged. Part of the reason for that are three widely held misconceptions.

Issuers select which NRSROs will rate their deal, and they pay the rating agencies rating their deals. Many blame this dynamic for causing a conflict for the agencies, and enabling ratings-shopping by issuers. This is perhaps seen as the biggest problem in the current ratings system. Dodd-Frank and other rules in the US and Europe are trying to reform the process. Some proposals suggest removing references to rating agencies from rules, while others suggest regulating them more heavily. The former leaves a hole; the latter increases the perception that the ratings have official approval. No good solutions have emerged.

A previous article in this blog and in Structured Credit Investor (The Unrecognised and Unaddressed Ratings Issue, Malay Bansal, 7 July 2010) made the point that the ratings reform is proving to be intractable because the real issue is not being recognized or addressed in any of the reform proposals. The real problem is that the rating agencies are combining two roles into one. The first role is to provide a rating based on statistical analysis of historical performance of the assets (remember that the ‘SR’ in NRSROs stands for Statistical Ratings). The second role is that of a research analyst to provide an opinion on what might happen in the future. Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future. This allows rating agencies to downgrade companies or countries even while they are in the process of attempting to improve their financial condition. The official NRSRO status gives their subjective opinions extraordinary power and can actually have an impact on the outcome, making the ratings more pro-cyclical.

The logical solution is to separate the two roles. NRSROs should be doing Statistical Ratings – based on past performance of assets, known facts, events that have already taken place, and statistical models and methods that are well disclosed. They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade till the event actually happens. So they will not be precipitating events.

The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role, and should be open to any research provider, including NRSROs. These credit ratings could be designated as ‘Informational Ratings’, without any legal or official role impacting investor charters, debt covenants, and so on, which will only use the ratings designated as NRSRO Ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started – as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.

The conflict of issuer-paid ratings could be avoided if issuers paid the fee for NRSRO ratings, which will be freely available to everyone, but investors paid the fee for research and informational rating available to subscribers only. Availability of the second will serve as the important function of checks and balances on the NRSRO ratings paid for by the issuers. However, neither issuers, nor the rating agencies seem to find that suggestion appealing. This is partly because of three widely held misconceptions about issuer-paid ratings.

Misconception 1: Issuers Pay for Ratings

Investors, naturally, don’t like the idea of having to pay for ratings, especially since they get it for free in the current system. However, the reality is that they are really the ones paying for it even now. The bankers for the issuer select, engage, and pay the rating agencies, but the payment comes from the money paid by investors for purchasing the bonds. By letting the bankers pick the agencies, investors tilt the balance of power to the issuer. Since they are paying for it anyway, investors should be open to paying for ratings more directly. This will reduce their concerns about the conflict of interest.

Some have criticized the high fees charged by the raters. However, there is another factor investors need to consider in this regard.  If they want good quality output from the agencies, they need to be paid sufficiently to be able to attract and retain talented people. Lowering the fee is not the solution. Any scheme which involves investors selecting and paying for research from the agencies that provide better information and analysis will increase competition and provide the right incentives.

Another point in this regard is that only investors who purchase the bonds at initial issuance pay for ratings at present. Cost for investors will be lower if it was spread over all the investors. Subscription fees could be partly based on AUM, making it easier for smaller investors to subscribe.

Misconception 2: Investor-Paid Rating System will be Bad for Rating Agencies

Many, though not all, on the rating agency side, do not like the idea of having to rely on investors for their earnings. It is much better to get all the fees upfront, which sometimes includes the fee for surveillance of the deal throughout its life. However, the preference for upfront payment misses some important considerations.

First, there are a lot more investors than issuers. Even smaller payments from investors could provide the same or more revenue. Also, a smaller charge will cause more investors to sign on for the service.

Second, if the revenue is coming from investors, it is not dependent on the volume of deals, and will not fluctuate dramatically based on volume of issuance. This will provide more stability to those organizations, and allow them to focus on the quality of their work.

Third, more stable revenue would mean a higher multiple for the valuation of their businesses, which will be a positive for their owners and investors.

Fourth, if payment for rating is at the time of issuance, the agencies have to be picked to rate it. This does not align the interests of rating agencies with those of investors, creates a credibility problem, and leaves them open to criticism. By reducing the incentive to be picked to rate the deals at issuance, agencies will be better off, as will be the overall financial system, including the issuers.

Misconception 3: Ratings have to be either Issuer-Paid or Investor-Paid

Almost everyone seems to think that ratings have to be either paid by issuers or investors.  However, it does not have to be one or the other. Just a sufficient portion of fee has to come from investors to provide the right incentives. Especially in structured finance transactions, where it is expensive to perform the right amount of due diligence to rate the deal, some amount of upfront payment may be necessary. However, if payment from investors is a significant portion of total revenue of rating agencies, investors and the financial system will benefit from the proper alignment of incentives that would create.

Clearly, splitting the rating agency role into two is a significant change. However, if done thoughtfully, it can be a significant improvement to the current system, and work for the benefit of everyone.

Notes:  Views expressed are personal views only, and not of any affiliated organization or group. This article was originally published in Structured Credit Investor.

By Malay Bansal

High unemployment is one of the most important issues the US economy is facing, and one of the most effective ways to tackle this problem is investments in productive infrastructure. Here is an idea that will encourage private investment in infrastructure without requiring increases in deficit or taxes, along with steps needed to ensure that the program will be effective.

High level of unemployment at 10%, or 17% if you also count the under-employed, is one of the biggest challenges the US economy faces today. Consumers are about 70% of the economy. People without jobs can’t spend as much on goods and services, and can’t buy houses, which does not help housing situation, another significant issue.  US companies have managed to increase profits but partly by reducing costs and spending, which also does not help the economy grow. The QE2 program just started by the Federal Reserve is meant to help unemployment indirectly by driving interest rates lower, but its effectiveness is far from certain, and is being questioned by many.

Why Infrastructure Investments?

One generally agreed approach to increasing employment is investment in infrastructure projects. The jobs created are local and cannot be exported, and the jobs will be created in sectors like construction that are facing higher unemployment (about 21% of the eight million jobs lost in 2008 & 2009 were in the construction sector, which still has unemployment at 17% level). Also, spending on infrastructure generates demand for products and services from a variety of industries, creating more jobs.1

Another consideration in favor of infrastructure investments is that deteriorating US infrastructure is sorely in need of maintenance. American Society of Civil engineers estimates that US needs $2.2 trillion in infrastructure spending over next five years2. The collapse of the I-35W bridge over Mississippi River in Minneapolis in Aug 2007 was a vivid example of this need. Increased spending also makes sense comparatively – US spends 2% of GDP on infrastructure, while China and Europe spend 9% and 5% respectively.

Also, several factors make this a good time to make investments in infrastructure – raw materials and labor are cheap, as is cost of financing. The maintenance is necessary and overdue. Not doing it now just means that it will have to be done at a later time when it will likely cost more.

Issues in Investing in Infrastructure

The biggest issue is finding funds without increasing deficit or taxes. US National debt for the $14.5 trillion economy has already ballooned to more than $13 Trillion. In Sep 2010, the Obama administration proposed a plan to spend $50 billion on infrastructure investments. However, the congress has not approved the plan, and the increased focus on reducing deficit and spending in the newly elected congress will constrain spending by the federal government. The state and local governments have lower tax revenues due to weaker economy and lower real estate values, and are constrained in their ability to spend.

Need for funds is one problem. Another problem is picking projects that are productive and not just a waste of money. Government may not be the best judge for picking the best projects. Solution to both problems is increased involvement of private sector.

Investment in Infrastructure without Increasing Deficits or Taxes

To get the private sector to invest in infrastructure projects, the government has to provide incentives, but in a way that does not increase deficit or taxes. One possibility for doing this may be by using the estimated $1 trillion of unrepatriated profits US companies hold in foreign subsidiaries. American companies can generally defer paying taxes on foreign profits as long as they keep the money outside US. When they bring the money back to US, they have to pay the top corporate tax rate of 35%. To defer taxes, US companies generally have left large sums of profits in their foreign subsidiaries.

These untaxed profits are part of the reason large multinationals have lower overall tax rates for which they have been criticized at times. Earlier this year, the administration proposed restricting companies from deferring taxes on profits earned oversees (estimated to raise $210 billion in revenues over next 10 years), but faced strong opposition since that would put the US companies at a competitive disadvantage.

On the other end, US companies are arguing that they could bring back the earnings in their foreign operations if the US government offered a tax amnesty and permitted them to repatriate foreign earnings at a low rate of around 5% instead of the 35% federal tax they face at present (see editorial in Wall Street Journal on Oct 20, 2010 by John Chambers, the CEO of Cisco, and Safra Catz, the President of Oracle). They argue that 5% tax could bring $1 trillion back to US for increased economic activity and could generate $50 billion in federal tax revenue.

The tax amnesty does not cause an increase in deficit or taxes, as government is giving up what it is not getting anyway – without it, these funds will not come back into the US economy, and the Treasury will not get the additional tax revenue. However, the funds brought back will not necessarily generate jobs. The companies could use the money for M&A activity, stock buybacks, and paying out dividends. A better idea will be to offer the tax amnesty only to the funds brought back that are invested in infrastructure projects in the US. A limited time tax amnesty will encourage US companies to repatriate earnings back to US. A requirement to invest in infrastructure projects for a minimum fixed number of years (say something between 3 to 5 years) will ensure that the funds brought back create jobs. Companies will be allowed to invest in either debt or equity depending on their risk-reward preferences. All investments will be chosen and managed by private fund managers, who will pick projects and investments based on sound economic calculations of cost-benefit and expected returns. The companies will be able to pick any fund manager based on their judgment of manager’s capabilities.

This basic framework could be enhanced in several ways. Companies could be encouraged to invest for a longer period by offering to reduce any taxes on the earnings from the infrastructure investments, if the investments are held for say 7 to 10 years or more. Also, companies could be allowed to use part of funds brought back to build new plants for their own use.

Will Private Investors Invest In Infrastructure?

If the government did allow repatriation at low tax rates for money to be invested in infrastructure, would there be demand for it? Can these projects generate returns that investors will find attractive? The answer to both is affirmative. Prequin reports that currently 28 US Infrastructure debt funds are on the road trying to raise $26.4 billion. Europe, smaller in size, but with better developed Public Private Partnership programs in the sector, has 38 funds trying to raise $29.3 billion. Large investors have expressed willingness to invest in these projects. Zhou Yuan, head of asset allocation at China Investment Corporation (CIC), said earlier this month that CIC would be willing to invest in large projects like high speed links between US cities, and super high-voltage transmission lines that provide a good risk-return profile, and suggested US should invest $1 trillion over next 5 years in form of public and private equity partnerships to create jobs (instead of QE2) and improve competitiveness.

Ensuring the Program is Effective

An editorial in New York Times on Oct 23 opposes the idea of tax holiday for repatriating foreign investments citing the experience of 2004. In 2004, after strong lobbying by the US multinationals, the Congress passed the American Jobs Creation Act in which the Homeland Reinvestment provision gave US companies a one-time break to pay 5.25 percent rather than 35 percent in taxes on the repatriated foreign profits, with the intention that the repatriated money would prompt investment in the United States economy and spur job growth. To qualify for the one-time tax break, companies had to promise to use the money to invest in their domestic operations. They could not use it to pay dividends, or compensate executives.

The program was heavily used by large corporations – many in the pharmaceutical and technology industries. For example, Pfizer brought back $37 billion, and Hewlett-Packard repatriated $14.5 billion. The amount of repatriation exceeded expectations. In all, 843 corporations took advantage of the offer, bringing back $362 billion in foreign profits. Of that amount, $312 billion qualified for the tax break, giving those companies total tax deductions of $265 billion claimed from 2004 through 2006.

According to analysis later, of the $299 billion companies brought back from foreign subsidiaries, between 60 and 92 percent of it went to shareholders, through increased share buybacks or increased dividends. Repatriations did not lead to an increase in domestic investment, employment or R&D, even for the firms that lobbied for the tax holiday stating these intentions. For example, Dell, which repatriated $4 billion, spent $100 million on a plant in Winston-Salem, N.C, which they said they would have built anyway, and used $2 billion two months later for a share buyback. Also $100 billion was estimated to go right back to foreign subsidiaries.

The provision requiring domestic investment had wide definitions of the term investment and allowed corporations to use repatriated profits to shore up their domestic finances, pay legal bills and even bankroll advertising. While companies did make investments in their domestic operations, the repatriated money also freed up a corresponding amount of cash to pay out to shareholders or buy back stock.

Money is fungible. It can be easily moved from one bucket to another. Hence, to ensure that the tax break really results in investments that create jobs, that money has to be separated. Hence, for this idea to be effective, the funds brought back must be invested with third-party private fund managers for a minimum number of years to qualify for the tax break.

Longer term, the US needs to develop regulations that clarify and encourage private sector investment and involvement in the infrastructure sector. Public-Private Partnerships and securitization of infrastructure financing can play a very useful role in developing this sector which is essential for the growth and competitiveness of the US economy in the longer term.

 

1An Oct 2010 report from the Council of Economic Advisors & the US Treasury (An Economic Analysis of Infrastructure Investment) discusses the benefits of infrastructure investments in detail. Also, see Jan 2009 article How Infrastructure Investments Support the U.S. Economy: Employment, Productivity and Growth from PERI & AAM.

2Also see CBO Testimony on Current and Future Investment in Infrastructure.

 

 

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.

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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.

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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:

FACT SHEET

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:

http://graphics8.nytimes.com/images/blogs/executivesuite/posts/MalayBansalPlan.pdf

http://executivesuite.blogs.nytimes.com/2008/11/07/where-is-fdr-when-we-need-him/?scp=2&sq=Malay%20Bansal&st=cse

 

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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.

 

By Malay Bansal

Note: This write-up was published on Seeking Alpha website and was selected as an Editor’s Pick article.

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%.
Borrower’s Equity 2mm 100%
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.

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