Highlighted Articles (Click on Home above to see all articles):

Analysis & Comments on Markets & Economy:

Creative Solutions/Ideas:

Tutorials:

 

Appeal: Consider supporting our troops and their families – they have given so much: Special Operations Warrior Foundation, Wounded Warrior Project, and others

Note: Views expressed in my writings are solely my own.

See Also: Media Quotes, Market Comments, Some Useful Information

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.

These suggestions, sent to the Treasury & FRB in Oct 2008, proposed a plan similar to the TALF and PPIP programs, months before Treasury and others came around to the idea. They were mentioned in the NY Times Executive Suite column by Joe Nocera (complete document is available at nytimes.com here). The Treasury plan was first announced by Treasury Secretary Tim Geithner on Feb 10, 2009. The writeup also included the Turbo concept of limiting interest payments and using  excess interest to pay down loan principal, which was included in the TALF announcement on Legacy CMBS on May 19, 2009.

______________________________________________________________________________

Suggestions for Additional Steps for Tackling the Credit Crisis

By Malay Bansal

Oct 19, 2008

Several steps have been taken by the Treasury and Federal Reserve to address the current economic crisis. These are important and useful first steps, but as everyone knows, the problems are complex and will require additional action, including steps to tackle the root cause of the problem – declining house prices.

Obviously, any step to stabilize house prices will need to focus on decreasing supply by preventing foreclosures as much as possible, and increasing demand by providing incentives to new home buyers. Making mortgage payments more affordable is key to both. Most efficient will be approaches that help people on the margin – people on the verge of defaulting on their mortgage, or those considering buying a house.

Below are outlines of three suggestions I have for consideration along with other steps being contemplated:

1. Better use of part of TARP Funds targeted to buy mortgage assets: Treasury can partner with private buyers instead of buying assets itself.

  • Will increase efficiency by tapping private funds. There is a lot of capital waiting to be invested in distressed assets, but has not been invested yet as prices need to be lower to achieve targeted returns without leverage.
  • Treasury can lend to or partner with private buyers of distressed mortgage assets with terms like the following:
    • Treasury will put up 50% and the private buyer will put up 50%, with Treasury’s interest being the senior interest.
    • Funds will be used to buy distressed mortgages and securities at a discount from various large and small banks and financial institutions.
    • Mortgage payments from purchased assets will be used in sequential order to (i) pay 5% interest to Treasury, (ii) 5% interest to the Private buyer, (iii) principal to Treasury, (iv) principal to the Private buyer, and finally (v) all residual to the private buyer as its return for the risk. This ensures that Treasury gets its money back first.
  • The 5% interest for Treasury will apply for 5 years. After that, it will increase by 0.5% every year till it reaches 9%. Interest for private buyer will stay at 5%.
  • Those taking the loan from treasury will need to agree to change mortgage terms to help homeowners including giving borrowers the option to (i) increase loan term by 5 to 10 years, and (ii) prepay loans at any time without penalty (any existing prepay penalties will be waived). Other terms to help homeowners may be included.
  • Treasury will offer mortgage assets from banks for bids. The private buyer with the highest bid will get funds from Treasury. Banks will have option of accepting the highest bid or keeping the assets themselves.
  • This type of plan will allow participation by numerous large and not-so-large investors. Since there will be multiple buyers competing to buy assets, with their own capital at risk, the plan would help in determination of fair market prices for distressed assets (instead of a situation in which TARP manager is the only buyer).
  • This program can run in parallel with direct purchases of assets by treasury, or can be used to sell off assets purchased by Treasury at a future date.

2. Make mortgage principal payments tax-deductible for next 5 to 10 years.

  • Mortgage interest is already tax-deductible. Making principal also deductible will make it easier for those who want to but are barely able to make their mortgage payments, and those who are considering buying a house.
  • As an example, someone with a $350,000 mortgage and 28% marginal tax rate will save $6,250 over 5 years or $1,250/yr. Over 10 years, savings will be $14,900.
  • Better than a single-shot stimulus payment, since (i) it will provide relief over a longer period of time, (ii) it attacks the root cause of the problem by targeting housing, and (iii) it will benefit local governments by preventing loss of property taxes that will otherwise result from foreclosure.
  • The deduction may be limited to maximum 15 to 20% of total mortgage payment to focus the benefit more towards newer mortgages (after ten years, principal payment is likely to be more than 20% of total mortgage payment), &/or to mortgages issued in certain years to control total cost.
  • The deduction can be phased out above a certain level of AGI to focus the benefit towards those who need it more.

3. Encourage mortgage modifications to lower monthly payments by extending the mortgage term by 5 to 10 years.

  • Modify mortgages by increasing the term by 5 to 10 years to lower monthly payment. As an example, monthly payment on a 30 year mortgage with 6.5% rate will decrease by 4.4% (or $1,172/year on a $350,000 mortgage) if term is increased by 5 years. An increase of term by 10 years would reduce monthly payment by 7.4% (or $1,960/year on a $350,000 mortgage).
  • Lowering payment without lowering interest rate may be more palatable from fairness perspective, and should be attractive to lenders if it avoids default. Removing any prepayment penalties should also be part of the modification as much as possible.

____________________________________________________

 

On Feb 10, 2009, Treasury Secretary Tim Geithner, in a much anticipated speech, announced the long-awaited toxic asset plan, but the market was disappointed by lack of details and sold off.

Extract from Treasury’s 10-Feb-2009 Fact Sheet on the Financial Stability Plan:

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

 

____________________________________________________

 

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

Originators want to originate new loans, investors want to buy bonds with new conservatively underwritten loans, Treasury & Federal Reserve want the new issue CMBS market to start, borrowers certainly want to take out new loans to refinance maturing loans, and yet, four months after the Treasury launched the program, not one new issue CMBS deal has come to the market.

This highlights the chicken-and-egg type problem that the CMBS market faces. Everyone knows that the new origination will be of higher quality and so should have tighter spreads than the legacy bonds. Yet, lacking an efficient hedge, all that the originators have for indication of spreads are the legacy bonds, which are still too wide for new issue deals. In other words, originators are looking for tighter and stable bond spreads to originate, and market is looking for new collateral for tighter spreads – sort of a chicken-and-egg type problem.

One solution is to wait till legacy bond spreads tighten and stabilize, giving loan originators more confidence, but that might mean new issue TALF program may not get much traction before it ends. Another approach is to accelerate the legacy TALF program by removing some of the uncertainty that borrowers in that program face today. There are two easy to implement steps that will be helpful and allow investors to buy bonds throughout the month, rather than waiting till just before the TALF subscription date. First, the price used for calculating loan amount can be adjusted for interest rate movement from purchase date to the subscription date, and second, Federal reserve can allow potential borrowers to submit a list of potential bonds for purchase before actually buying the bonds, with approvals announced two or three weeks before the subscription date. Pre-approval of bonds will be almost as effective as disclosure by the Fed of their bond approval (or rejection) methodology, which more and more market participants are asking  the Fed to do, and which Fed has been reluctant to do, probably because doing so might reduce their flexibility.

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

By Malay Bansal

Note: This write-up was published on the Seeking Alpha website here.

On Feb 10, when the Treasury secretary Tim Geithner announced the Financial Stability Plan, which included a Public-Private Partnership Fund to remove bad assets from banks’ balance sheets, the markets reacted very negatively because of disappointment with lack of details on the plan. According to news items, the announcement of details is imminent now. Given the magnitude of reaction to the original announcement, many in the market await the plan details with interest.

That Fed should provide financing to private investors, instead of buying toxic assets itself (to help remove these troubled assets from banks balance sheets), is accepted by a lot more people now. By involving private capital, the government can minimize use of public funds and provide a mechanism for determination of fair prices for these toxic assets based on competitive bids by multiple private investors (my follow-up and original articles describe the reasoning).

Although no details have been announced, and the details are likely to change till the program is finalized, recent news articles have suggested that the administration is considering setting up multiple Investment Funds, with a Private Investment Manager running each fund. The Investment Managers will put up some equity, and government will provide financing to the funds. The private investment managers would run the funds, deciding which assets to buy and what prices to pay. Since there would be a limited number of funds, they would most likely target all types of assets rather than focusing on one specific type of distressed security. In addition to providing financing, government will also add equity to the fund alongside the private manager and would share in any gain or loss with the manager.

Even this simple description has couple of factors that are significant and bear watching.

First, if the government sets up a limited number of Investment Funds, it will reduce the competition for assets. One of the major results desired is for the selling banks to get the highest rational price possible for these assets to avoid further losses to them. With just five to ten investment funds bidding, the banks will be less likely to get the highest possible price. Instead of setting up just a few Investment Funds, the financing should be available to all investors – whoever has the highest bid on the legacy assets being sold should get it. Let various people and companies who have expertise in different types of assets assess and bid on them. Greater expertise and competition will result in higher sale prices.

Second, the idea of government putting in equity in these Investment Funds is less than ideal. The logic for doing this, of course, is that the private investors will benefit from the plan, and so the public should benefit too by investing alongside them. However, the goal of government in this endeavor is not to take investment risk for any potential gain, and Treasury should not be risking public money in this manner.

Also, saying that public should benefit alongside the private investors implies that the private investors are getting a sweet deal from the government and would make outsized returns by using government’s help. Suggesting this would only generate opposition to the plan from the public. Reality is, and should be, that the private investor should be taking the first loss risk. No public money should be at risk of loss till the private investor has been fully wiped out. This risk is what justifies the higher returns the private investors will get, if the asset performance does not turn out to be worse than pricing assumptions. Their returns will be less than expected if the asset performance is worse than assumed at the time of pricing. It will be very important to explain this aspect to lawmakers and general public to promote understanding and to avoid criticism and opposition of the plan. Private investors should not be asking the government for additional guarantees, and should clarify the risks they are taking to avoid backlash from general public and lawmakers.

Another justification offered for Treasury to put in equity in these funds may be to increase the total amount of funds used to buy toxic assets. Using simple numbers of let’s say 50% equity and 50% financing, the argument may be that, if the private investor puts $100 million, then government will put in another $100 mm resulting in total $200 mm of capital. If however, the government also put in $100 mm of equity alongside the $100 mm of private investor’s capital, then the total of $400 mm will be available to purchase assets. However, this logic is flawed. In this example, the government will be putting in $300 mm of capital and private investor $100 mm. If the government only provided financing, using the same 50% equity and 50% financing, it will be able to get total of $600 mm to purchase assets.

The TALF program has undergone significant changes since it was originally announced. In fact, the Public-Private Program could even be modeled along somewhat similar lines.

The Public-Private Partnership program will play an important role in the cleanup of bank balance sheets, which is one of the prerequisites for eventual return to normalcy for credit markets. We watch with interest what it would look like when the Treasury announces the details.

By Malay Bansal

Treasury Secretary Tim Geithner announced the long-awaited toxic asset plan, but the market is disappointed by lack of details.

The plan is headed in the right direction but  implementation details will be important.

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

Note: This write-up was published on the Seeking Alpha website 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

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.

_______________________________________________________________

Extract from my original Suggestions sent in Oct 2008 to the Treasury & the FRB (the write-up was mentioned in the NY Times Executive Suite column by Joe Nocera and the complete document is available at nytimes.com here). My writeup included the Turbo concept of using part of excess interest to pay down loan principal, which was included in the TALF announcement on Legacy CMBS on May 19, 2009).

——————————————

Suggestions for Additional Steps for Tackling the Credit Crisis

By Malay Bansal (malay.bansal@gmail.com)

Oct 19, 2008

2. 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.

My Suggestions on TARP

October 19, 2008

Note:  These suggestions, sent to Treasury & FRB in Oct 2008, after the Treasury announced the original TARP plan to buy distressed assets,  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 and the complete document is available at nytimes.com here. The new Treasury plan was first announced by Treasury Secretary Tim Geithner on Feb 10, 2009. My writeup also included the Turbo concept of limiting interest payments and using  excess interest to pay down loan principal, which was included in the later TALF announcement on Legacy CMBS on May 19, 2009. Another suggestion was to use tax incentives to increase housing demand.

By Malay Bansal

After TARP plan came out, I made some suggestions for improving it  to the Treasury & Federal Reserve for their consideration.

My Suggestions included the following points:

  • Treasury should provide financing to private buyers rather than buying distressed assets itself. Financing will help private buyers reach their target returns, and get them started on buying distressed assets clogging the system. Also, by providing financing to highest bidder on distressed assets, treasury will create a mechanism for pricing these assets based on competition from private buyers. Treasury can protect public funds by getting paid first and ensuring the private buyers get no more than 4 or 5% coupon (to cover expenses) on their invested money before the treasury gets its money back. Also, by requiring recipients to agree to certain steps to help homeowners, the plan can help homeowners who may be facing difficulty.
  • Treasury will get the biggest bang for the buck by helping those on the cusp of defaulting, or those who may be considering buying a new home. Increasing home buying demand is as important as steps to decrease supply by reducing foreclosures. One step that will help more than a one-shot stimulus payment, will be to make the mortgage principal payments tax-deductible for next 5 to 10 or more years.
  • One of the easiest steps to lower monthly mortgage payments will be to extend the mortgage term by 5 or 10 years for those facing potential problems. This should be least controversial of the modifications being discussed, and will not encourage those who do not need it to ask for it.

 

—————————————————————————————–

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. 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.

2. 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.

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.
%d bloggers like this: