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.

 

 

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By Malay Bansal

I recently attended the Dow Jones Private Equity Analyst Conference, which was the 17th annual event hosted by top editors from Dow Jones & the Wall Street Journal. It was a well organized event with a lot of people in attendance and provided an opportunity to listen to and exchange ideas with significant participants in the industry. Below are some thoughts and ideas that I heard more than once, or which stuck with me for some reason.

Opportunities in Emerging Markets

It was one of the themes that I heard most often in different conversations – both on-stage and off-stage. Facts are known – emerging markets are now equal in size to the US, bigger than Europe and growing faster. Consumers there have very little debt, as opposed to US, where 70% of GDP is consumer spending, and the consumer is over-leveraged. This presents all sorts of opportunities to financial and non-financial firms. Not surprisingly, China, India, and Brazil were mentioned as the places with the most opportunities. However, there was one cautionary note that was heard often too – an investment in an emerging country requires local presence and cannot be done remotely from US. A local partner may be helpful, with or without a local office there.

Opportunities in US

Many of the opportunities mentioned in US were in Energy & Infrastructure areas. And one hurdle or negative most often mentioned was the upcoming changes to accounting and regulatory policies, including changes to treatment of carried interest.

Energy was a major topic of conversation – both the current forms, and the newer clean-energy technologies and companies. Participants saw opportunities in many areas. One interesting viewpoint favored investment in natural gas assets, with the thought process that natural gas assets may be purchased at cheap prices based on lower natural gas prices, providing a bigger return when prices rise.

Infrastructure was another major area talked about with opportunities in US. PPP (Public-Private Partnership) volume has been low in US, which is lagging far behind Europe & Canada in this space. Issues in the Chicago Parking Meter program, Midway Airport, and others have slowed other similar efforts. However, need for infrastructure spending in US is huge, and deals are happening. 80% of these are estimated to be private-to-private deals and provide opportunities. Public-private opportunities will also develop with time. One view was that the second wave of Public-Private initiatives will come from cities and municipalities rather than states, which may mean that approval the process will be quicker.

In my opinion, with its ability to create jobs locally, we can expect to see more focus from politicians on the infrastructure sector. Also, with lower yield in other investments, private equity firms and other investors will find investments in infrastructure, which usually provide a built-in hedge for inflation, attractive. In some ways infrastructure investments are similar to investments in commercial real estate properties, and some of the money targeted towards distressed commercial real estate may be able to find a way to achieve desired returns by changing the focus to infrastructure investments, especially if the government provides appropriate incentives.

 

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.

 

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