Affordable Housing Institute : US

By:David A. Smith

 

Though he may not know it, in commercial real estate, dentist Ky Nguyen has just become a keystone species, for reasons illustrated by the opening of this Wall Street Journal article from a while back:

 

Ky Nguyen, a dentist, inside the shopping plaza in Manteca, Calif., that he purchased at a discount in July. Max Whittaker for The Wall Street Journal

 

Four months ago, Ky Nguyen was paying about $6,000 a month in rent for his small, 1,600 square-foot dental office, part of a mostly vacant strip mall in Manteca, Calif.

 

South of Stockton in the San Joaquin Valley

 

In July, he bought the entire 25,000 square-foot mall for $1.9 million, purchasing it from a loan servicer that had foreclosed on the property.

 

And why did Mr. Nguyen become an unlikely landlord?

 

[He paid] one-fifth of what the prior owner paid.

 

The mall was an empty burrow, Dr. Nguyen its sole inhabitant.  To the loan servicer, the mall was on its way to being a negative asset.  Not so for Dr. Nguyen, to whom it represented an occupancy opportunity:

 

“We jumped on the opportunity,” said Mr. Nguyen, a 36-year-old Vietnamese immigrant.

 

To Dr. Nguyen, purchase gave him economic security, and plenty of motivation to get a return on investment – by becoming an amateur but local landlord:

 

Now, with an affordable mortgage and some rental revenue, his debt service comes to about $2,000 a month less than he used to pay in rent for his office.

 

Dr. Nguyen’s mall (1333 Historical Way, Manteca, CA)

 

If empty structures are not  to be demolished (either by euthanasia or by dilapidation), they must be reoccupied, preferably by residents who will protect their castle.  Owned homes, where jobs go to sleep at night, are defended by their owners, one of many reasons their prices hold up better than many other asset classes, whose diurnal workers empty it every evening.

 

Around $400 billion of commercial real-estate loans made by all lenders mature in 2012, up from $375 billion this year and $250 billion in 2010, according to Deutsche Bank.

 

With hundreds of billions of dollars’ worth of overlevered commercial real estate sitting on financial institutions’ books, changes have to be coming. 

 

Special servicers, the troubled loan specialists that oversee hundreds of billions in commercial mortgages on behalf of bond investors, have sold $11.6 billion in distressed loans and foreclosed property in the past 12 months, according to analysts at Deutsche Bank AG.

 

That’s up from $7 billion over the prior 12-month period and from $1.2 billion in the 12 months prior to that, according to Deutsche Bank.

 

 

The properties will never recover their current debt in any short time interval, so there are only two choices: Cut the debt (usually through bargain-basement resale), and raise the NOI (through new occupancy).

 

Anyone want to be some non-performing loans?

 

By and large, these assets are being shed at big losses. Of the loans sold by the special servicers, bond investors suffered an average 38% loss on loans or property sold this year, according to Deutsche Bank.

 

For the NOI boost, the properties need new occupants, and who more motivated than the potential investor?

 

Three years after the economy’s turn sent commercial property prices tumbling, opportunities for investors are on the rise as lenders and servicers are disposing of a growing volume of distressed loans and foreclosed properties.

 

On the market: Loan and property sales by special servicers on US commercial property. Source Deutsche Bank.

 

The increased flow brings in new owners to ‘zombie’ buildings that have for years been struggling with high vacancy and a lack of investment by owners overwhelmed by debt.

 

Not zombies, which are animated corpses devoid of thinking.  Rather, these malls and similar commercial real estate properties are emptied burrows, built by one species and now left hollow, to be reoccupied by newer, smaller species.  The original developers are like gopher tortoises, which dig extensive burrows that they eventually abandon, only to provide a haven for other species that move in when the gopher tortoises are gone:

 

Need to work on the curb appeal and signage, don’t you think?

 

The burrows, which are dug by the tortoises, also provide homes for other animals, such as indigo snakes, gopher frogs, mice, foxes, skunks, opossums, rabbits, quail, armadillos, burrowing owls, snakes, lizards, frogs, toads and other invertebrates. Some species share the burrows with the tortoises and others utilize abandoned burrows.

 

Choose from many spaces and locations

 

Digging reusable burrows makes gopher tortoises a keystone species, one whose presence has a disproportionately large effect on the environment.  A burrow adaptively reused by other animals creates a new pricing point, and the catalyst for market revival by market clearing:

 

At the same time, though, the new owners pose a threat to existing landlords who are still struggling to get by on boom-year debt levels. Today’s investors are able to charge lower rents and still make a profit.

 

That’s neither Dr. Nguyen’s problem, nor the market’s.  Competition at lower price points will force realization of the embedded losses being deferred by owners whose tenants are laboring under above-market leases that will gradually expire. 

 

Existing landlords are “between a rock and a hard place,” says William Robert, a Scottsdale, Ariz.-based former banker who now invests in distressed property with his sons. “They can’t make their debt service on the lower rental rates that are available.”

 

Then their lenders had better reset it.

 

To be sure, many property owners who are unable to pay off mortgages amid a sluggish economic recovery are cutting deals with lenders and servicers to modify and extend the terms of these loans.

 

As Margaret Thatcher was fond of saying, there is no alternative.

 

Cut the debt now or cut it later

 

“For the first year or two of the crisis, stuff was coming in faster than it would go out,” said Tad Philipp, a [former] managing director at Moody’s Investor Service who tracks commercial mortgages. Now, he said, “a whole lot of stuff that got into trouble in ’09 has now gone through the process.”

 

Tad’s getting a fillip out of the flipping

 

Vintage by vintage, the industry will work through the Great Global Deleveraging of income-producing assets.

 

“They’re finally starting to dump these assets at prices that make sense,” said Nate Paul, chief executive of World Class Capital Group, an Austin, Texas-based private-equity firm [Which I suspect adheres to Smith's Law of Organizational Scale – Ed.] that has spent about $150 million on 25 acquisitions this year.

 

Bit by bit, the assets will come up for sale.

 

Buyers are welcoming the increased volume of distressed assets being put on the block.

 

Many of them raised money in the early years of the downturn in hopes of buying discounted properties but until recently there hasn’t been much for sale.

 

The buyers are one half of the necessary ecosystem, because they bring money to renovate and refurbish the empty burrows.  Dr. Nguyen and those like him are the other half – and in many ways, the more important half – because they find the new animals to reinhabit the burrow.

 

Opportunities are increasing in particular for small investors like Mr. Nguyen. Most of the loans and properties being sold by special servicers are small, with an average size in 2011 of $8.4 million, according to Deutsche Bank.

 

Empty burrows are key to a healthy ecosystem because they create low-cost ready-to-move-in spaces for smaller species to live in the burrow.  Snakes reuse meerkat burrows.  Woodpeckers live in gum trees hollowed out by termites.

 

See any snakes?

 

Well located empty malls invite new business formation:

 

He plans to fill much of the vacant space with a restaurant run by his in-laws and a chiropractor’s office run by his wife.

 

That puts capital back to work, puts people back to work, and little by little puts our economy back to work.

 

Auction.com, a commercial loan-sale website that has sold more than $5 billion in commercial loans and foreclosed properties this year, says 80% to 90% of its buyers are smaller local investors.

 

Plenty of good real estate and businesses in the bargain basement

 

 

 

Continued from yesterday’s Part 1.]

 

By:David A. Smith

 

In yesterday’s Part 1, we met the Don Quixote of rent control, lifelong New Yorker James Harmon, whose case challenging the statute lost on appeal to the U. S. Second Circuit Court of Appeals, but may be heard by the Supreme Court granting certiorari.  To fill in the legal arguments, I’ve used Richard Epstein’s Wall Street Journal op-ed (Palatino brown) and Cato’s description of its amicus brief (Georgia gray), because the New York Times’s (December 19, 2011) story, though sympathetic, glides over them, preferring to focus on the long-suffering plaintiff:

 

A couple’s home is its castle … unless it’s rent stabilized, that is

 

The Harmon family’s ties to the house go back to 1949, when his grandfather, the waiter, and his grandmother, a Belgian governess, bought it.

 

Throughout history, real estate ownership, especially of urban residential property, has been one of the very few ways that the unlettered and untitled could become self-sufficient – and it’s heartwarming to see the family pooling its money to buy a piece of the American dream. 

 

Newly constructed public housing – Jacob Riis Houses and Lillian Wald Houses – along the East River

Before the construction of FDR Drive

 

In 1949, Manhattan was no enclave of the rich, but a working-class industrial city that was rapidly building public housing.

 

On the Town, 1949

 

The Upper West Side was a pleasant but by no means exclusive residential area.

 

Still the archetypal Holmes to many of us: Basil Rathbone

 

Mr. Harmon grew up there, delivering newspapers to Basil Rathbone and other neighbors, until he went on to West Point, where he was in the class of 1965. He was awarded a Silver Star in Vietnam.  Mr. Harmon and his wife returned to live there in 2002, and three years later he took out a $1.5 million mortgage to buy his brother’s share of the house.

 

Mr. Harmon and his wife live on the parlor floor, behind the bay windows sheathed in decorative copper. With the appraising eye of an owner, he points out a ragged hole in the window glass left by a bullet in the 1970s.

 

The floors above are divided into six one-bedroom apartments.

 

Multi-household housing would have been natural enough in the 1930s or 1940s, with the brownstone being subdivided into a rooming house, presumably with the landlord on the parlor floor for maintenance, community, and security.

 

Three are market rate rentals.  

 

And you know that Mr. Harmon will never let those apartments go back into being rent-stabilized.

 

The other three are occupied by rent-stabilized tenants, inherited from his parents, who have been there for what Mr. Harmon calculates as 90 tenant-years,

 

In other words, an average of thirty years apiece.

 

and it is not necessarily, he says, by virtue of their neediness.

 

“It is all about luck — a racket in which property owners and market rate tenants always lose,” Mr. Harmon says in his petition –

 

As we’ve seen, he is right about that.  Some get lucky, some have friends, some are politically connected.  As Richard Epstein noted:

 

People who don’t live in New York City … may recall their outrage in 2008 upon reading that New York Rep. Charles Rangel worked the system by paying a total of $3,894 a month for four rent-stabilized luxury apartments in Harlem, about half the market price.

 

Aside from the sweetheart deal – $975 per month – that Mr. Rangel was able to secure, and felt no qualms about using, four apartments is itself a travesty.  More broadly, few if any rent-stabilization residents are deserving.

 

–  borrowing a term he often encountered when he was chief counsel to the President’s Commission on Organized Crime in the Reagan administration.

 

Over the years, small things have galled him, like on a morning 12 years ago, when he opened the Sunday newspaper to find a subtenant bragging that he lived in a spacious one-bedroom apartment with a terrace in an exciting neighborhood near Central Park for “practically free,” or $1,190 a month.

 

Such braggadocio would gall a person with much less at stake than Mr. Harmon.

 

The writer called it ‘real estate karma,’ and the building was, yes, the Harmon family ‘maison.’

 

Karma is a bitch, isn’t it?

 

Not my handwriting

 

Mr. Harmon has an affinity for uphill causes.

 

In his previous foray to the Supreme Court, he got the court to reverse a finding of contempt for two Yonkers City Council members who refused to pass a housing and school desegregation ordinance.

 

Finding contempt for not voting the ‘right way’ would be taking political correctness a bit too far, wouldn’t it?

 

He also secured a pardon for Sgt. Osvaldo Hernandez, a veteran of the war in Afghanistan, from a youthful gun conviction so he could become a New York City police officer, but he has not gotten the job because the Police Department says only people “who have never been convicted of a felony” can become officers.

 

Sorry son, you’re a felon – except you’ve been pardoned

 

Evidently Mr. Harmon picks out individuals wronged by ‘the system’ and seeks to get justice for them.  One such, he realized, was himself:

 

Mr. Harmon said he had appealed to his assemblywoman, Linda B. Rosenthal, a strong supporter of rent regulations. Ms. Rosenthal said Mr. Harmon had asked for an exception to rent regulations for his building, which she found untenable because it would, she said, extend to thousands of other people in “the vanishing middle class.”

 

For real estate development, except when rent-stabilized

 

 “I understand he thinks he could make more money, that he is being deprived,” she said. “But I have so many constituents who would willingly trade his problems for theirs.”

 

Evidently for Ms. Rosenthal it’s all about votes, not property rights.

 

She said her views had nothing to do with the fact that she lives in a rent-regulated apartment, though she added, “If I didn’t, I probably wouldn’t be representing tenants in this district because I couldn’t afford to live in the city.”

 

As the old parliamentarians used to say, Where you stand depends on where you sit.

 

Mr. Harmon said he had nothing against his tenants, whom he greets and mingles with at the mailboxes and in the floral-carpeted foyer.

 

He is certainly tolerant, given facts like these:

 

[One of Mr. Harmon's] rent-stabilized tenants, David Mlotok, moved into 2-R with his then-girlfriend in 1976, he said recently, as he stopped to talk while bringing his dry-cleaning home. Mr. Mlotok was paying $1,298.24, according to the papers.

 

Times Square, 1976, when Mr. Mlotok moved in to West 76th Street

 

Now a youthful-looking 73 with a full head of white hair, he said he had worked in video production, as a freelance photographer and doing stage work at Lincoln Center, and now works in publishing.

 

So he’s lived in the apartment for 35 years, with someone else doing all the maintenance, upkeep, and paying the heat. A sweet, sweet deal.

 

Sweet, dude

 

Mr. Mlotok said that whether he could pay market rent was “a personal issue.”

 

Unquestionably so, Mr. Mlotok, as the City of New York in its infinite wisdom has declined to make rent stabilization means-tested, age or personal situation qualified, or in any way something other than a lottery for the fortunate.

 

But in the final analysis, he said, it was just an apartment, and it was not irreplaceable.

 

“The apartment doesn’t keep me in the city; New York keeps me in the city,” he said. He mused about moving to a small town in Colorado. How about Brooklyn or the Bronx?

 

“To me, to live in New York is to live in Manhattan,” Mr. Mlotok said. “To live in Manhattan is to live just north of the park and down into the Village.”

 

Is that a sense of entitlement speaking?

 

According to his original lawsuit, filed in 2008, the tenant in Apartment 3-F was paying $951.22 a month –

 

Earlier in the article, the Times referenced Mr. Harmon’s citation of a 59% discount from market; if so, market for that apartment would be $2,375 a month, implying that the Apartment 3-F resident is saving $1,425 per month, every month.

 

–  and owns a home on Long Island, which the Harmons contend that they are effectively subsidizing.

 

I’d say the implied subsidy was very effective, wouldn’t you?  Indeed, it’s a beautiful example of what Peter Senge would call ‘seeing the system’.  At one end is a huge input from Mr. Harmon – namely the $1,425 legally mandated in-kind discount – and at the other is 3-F’s Long Island house.  In between lies a boatload of money.  At (say) 5.0% interest rate, 30-year amortization, the money 3-F is not paying Mr. Harmon will support a mortgage of $265,000.  Add to that (say) five years of savings and you have a down payment of $85,000.  In short, Mr. Harmon’s enforced largesse has bought 3-F a house worth $350,000.

 

The tenant in 4F was paying even less — $908.72.

 

Both of those tenants did not return telephone calls.

 

With any luck, the Supreme Court will return Mr. Harmon’s call, and overturn rent control nationwide.

 

 

 

 

By:David A. Smith

 

Is rent control’s penny dropping? 

 

 

Even dropped from the Empire State Building, it can’t kill anyone

 

Though ’tis a consummation devoutly to be wished, I had given up believing that rent control would ever be ruled an economic taking without due process or just compensation (even though it is both), because the procedural and administrative defenses mounted by a determined confiscatory local government are so tortuous to besiege and scale that for nearly forty years no one has. 

 

Destined to have his name in the law books? James Harmon

 

Now there’s a plaintiff, James Harmon, who’s within hailing distance of the Supreme Court, and if the Supreme Court takes up the case, this could be bigger than Kelo v. New London, the landmark decision in eminent domain, whose prosecution and judgment tracked the rise in housing prices, and whose 2005 decision (which affirmed its Constitutionality) triggered a massive blowback that coincided with the market’s top, and the beginning of our long, long fall in housing prices.

 

The telegenic plaintiff: Suzette Kelo posing before her house

(Which was later moved and which she later quietly sold.)

 

Wonder of wonders, even the New York Times’s (December 19, 2011) article profiling him declines to demonize; indeed, it starts sympathetically.

 

James D. Harmon Jr. learned the value of a house as a child, shoveling coal into the furnace of one of two Upper West Side buildings owned by his grandfather, a French immigrant who worked as a waiter. “Jimmy, you take care of your building and your building will take care of you,” his grandfather told him.

 

Being a landlord is a job; property residual value is not merely luck or inflation, but he residue of diligent stewardship.

 

“But the word he used in French wasn’t building,” Mr. Harmon recalled the other day. “The word he used in French was ‘maison,’ which means home.”

 

As I’ve previously posted, you are what you live in, and what the Messrs. Harmon handed down, father to son to grandson, was a respect for property rights.

 

Now Mr. Harmon, 68, who grew up in one of those buildings — a bow-fronted town house on West 76th Street near Central Park — has gone to the United States Supreme Court contending that New York City’s rent laws constitute a taking of his property without just compensation, a violation of his constitutional rights.

 

Those of us in the real estate business have known this for decades, yet now is the first time we have a fair shot at actually hearing the case heard.

 

The regulations are meant to support the government’s goal of maintaining affordable housing for its citizens.

 

‘Meant to support’ is probably a fair summary of the policy logic behind rent control, but as law professor Richard A. Epstein notes in a Wall Street Journal op-ed, those goals are basically never achieved:

 

Epstein wants to bar rent control

 

All versions of rent-control laws share a single dominant characteristic: They allow a tenant to remain in possession of property after the expiration of a lease at below-market rents.

 

Back when Cambridge had rent control, my pro-rent-control friends used to argue vehemently that the bargain element was not an intended outcome, just a side-effect of its anti-gouging provisions.  Yet rent control has so many pro-tenant and anti-landlord biases built into its structure and administration that invariably it becomes a rent bargain, a progressively greater rent bargain:

 

New York even gives the tenant a statutory right to pass on the right to occupy the premises at a controlled rent to family members who have lived with them for two or more years. The tenants in Mr. Harmon’s complaint pay rent equal to about 60% of market value.

 

Cato’s description of its amicus brief urging the Supreme Court to take up certiorari is even more blunt:

 

Rent control is literally a textbook example of bad economic policy.

 

Economics textbooks often use it as an example of how price ceilings create shortages, poor quality goods, and under-the-table dealings. A 1992 survey revealed that 93% of economists believe that rent control laws reduce both the quality and quantity of housing.

 

 

 

Doctors recommend counting on your fingers

For patients who have fingers

 

That level of agreement among usually contentious dentists is akin to a moral certainty, one which Mr. Harmon certainly shares:

 

Instead, he says, the laws have forced him and his family:

 

1. To shoulder the government’s burden.

2. To extend what is essentially “privatized welfare” to rent-stabilized tenants who are paying rent 59% below market rates and who have rights of succession to their lodgings in his house.

 

While the second claim is the more striking figure, as the late great Max Kargman taught me, when we were suing the Federal government over the Constitutionality of ELIHPA, it’s the first of these two challenges that should have the most traction. 

 

For whatever set of reasons, previous Supreme Courts have given localities wide discretion to establish ‘temporary, emergency’ rights to intervene in private contractual bargains, and the principle of stare decisis (Latin for “to stand by what is decided”) makes it hard for one Supreme Court simply to reverse a previous Supreme Court.  Cato again:

 

In their lawsuit, however, the Harmons face many unfriendly precedents that have given states free reign to regulate property, to the point that it is occupied on an essentially permanent basis while surviving Fifth Amendment scrutiny.

 

When the pressure is enough, however, the Court can often find a way, as Brown v. Board of Education effectively overturned Plessy v. Ferguson. 

 

One way to challenge some laws is to argue they are so arbitrary and poorly justified that they violate the Fourteenth Amendment’s Due Process Clause. Because this is an especially difficult type of challenge to bring, Cato joined the Pacific Legal Foundation and the Small Property Owners of San Francisco Institute on a brief supporting the Harmons’ request that the Supreme Court review lower-court rulings against them.

 

As we’ve previously seen in San Francisco, the right of adverse possession gained by rent control can be so extreme as to constitute a permanent judicial squat – and as we saw in Cairo, it can lead to physical seizure of the property, to the point where the tenant is building or demolishing walls and the landlord is helpless.

 

Demise of some great Cairo neighborhoods: sixty years in one slide

 

Following the Supreme Court decision in Yee v. City of Escondido (1993), the court insisted that “government regulation of the rental relationship does not constitute a physical taking.”  

 

Yee v. Escondido involved San Diego’s ordinance regulating the rent of mobile home pads, and was essentially a homeowner-protection law, mobile homes actually being immobile and in my view the Court overreached in its finding – but there it is, stare decisis, and if the Court is going to overturn rent control, then the plaintiffs need a new avenue, such as the government’s self-interest: making them pay for a benefit that society as a whole should fund.  Moreover, the policy if self-defeating, heroin for urban neighborhoods.  As Cato puts it:

 

As expected, therefore, New York City’s Rent Stabilization Law — the most (in)famous in the country — has led to precisely these effects:

 

Housing is scarce [The same is true in rent c0ntrol domains Cairo and Mumbai. – Ed.]

Apartment buildings are dilapidated because owners can’t charge enough to fix them

Housing costs have only increased (in part because costs are transferred to non-rent mechanisms such as “non-refundable deposits”).

 

This last point is a classic example of the Law of Economic Pressure.  When the cost of occupancy is driven down below market, then the market finds a way to monetize some of that, for benefit not of the property owners but for someone else in the value chain – in this case, the resident who can ‘resell’ a supposedly non-transferable occupancy right.

 

Yet the RSL persists, benefiting those grandfathered individuals who rent at lower rates but hurting the city as a whole.

 

Mr. Harmon understands the slow expropriation of property, because he has experienced it:

 

“Put yourself in our position,” Mr. Harmon, a former federal prosecutor, said of himself and his wife, Jeanne. “Suppose somebody told you, you’ve got an extra bedroom, we’d like to put someone in there for as long as they want to stay, and you have to take care of them for the rest of their lives and the rest of your life. That’s really what this is like.”

 

We’ve got the right plaintiff – the one who can express rent control’s inequity, and who can live it every day.  Hallelujah!

 

 

The Second Circuit recognized that the Harmons would be entitled to just compensation when their property is subject to a “permanent physical occupation.”

 

If that is so, then the Harmons are likely to win, because it is self-evident that rental under rent stabilization is as permanent as ownership – in fact, it’s more permanent, because the tenancy is inheritable and hence could last in perpetuity, where ownership could not.  [And it requires no financing, either, so you can't be foreclosed! – Ed.]

 

In Yee v. City of Escondido (1993), the court insisted that “government regulation of the rental relationship does not constitute a physical taking.” That comes as a real surprise to the Harmons when they hear footsteps each night above their bedroom.

 

As we saw in Cairo, a long enough rental can become a permanent adverse possession.

 

Supreme Court decisions dating back to Block v. Hirsh (1921) hold that once a landlord has let a tenant onto the premises for a year, the legislature can extend that lease indefinitely.

 

And in Mr. Harmon’s case, the protracted occupancy is reaching Methuselah proportions.

 

 

I know all of you are my children, but you can’t have the apartment until I die, okay?

 

[Three of Mr. Harmon's apartments] are occupied by rent-stabilized tenants inherited from his parents.

 

There’s proof, if proof were needed, that the tenant has more durable property rights than does the owner.  The owner inherits negative-value assets.

 

The city’s rent regulations have been challenged many times going back decades, making this case an uphill battle. Mr. Harmon has lost twice in lower courts, most recently in September, when the United States Court of Appeals for the Second Circuit, in Manhattan, ruled that the rent-stabilization law did not constitute a taking because (a) it did not stop him from using the building as a rental property and (b) it did not stop him from living there himself.

 

Both arguments are fig leafs of tissue paper – is Mr. Harmon to be granted the right to live in whatever sliver of the house has not been taken for the people’s uses?

 

“Courts usually pay scant attention to these well-settled claims and routinely reject them,” said Jarred Kassenoff, a lawyer for landlords and tenants.

 

Generally they do, which is why the Supreme Court has a wide purview.  Otherwise we’d still be living in the demesnes of separate-but-equal.

 

Once upon a time, the Supreme Court said this was acceptable

 

But Mr. Harmon appears to have caught the attention of the high court, which has asked the city and state to file answers by Jan. 4 to his petition to be heard. [The City got a filing extension – Ed.]  The case could have wide repercussions for the almost one million rent-stabilized apartments in the city.

 

“We are confident that once the U.S. Supreme Court receives our brief, the lower courts’ decision will stand,” said Leonard Koerner, chief of appeals for the city’s Law Department.

 

They always say that.

 

Step 1: Say you’re confident even when you’re not

 

[Continued tomorrow in Part 2.] 

 

 

 

[Continued from yesterday's Part 1.]

 

By:David A. Smith

 

Yesterday we saw that Greece’s puppet masters appear to be compel private bondholders to take a severe loss but to exempt the European Central Bank from that selfsame loss, on the theory (though that’s not how the New York Times put it) of protecting one’s lifeline and stealing from one’s contractual counterparties. 

 

How long until we default, again?

 

While both sides have tried to adopt a conciliatory tone –

 

The conciliatory public postures are born of different necessities.  In the manner of bullies everywhere, the shadowy officials want the banks to knuckle under without a confrontation, so they can preserve their ability to intimidate.  Meanwhile, the bankers hope to secure a climbdown from the government side, and know that embarrassing them in public, while personally satisfying, is likely if anything to make the officials less likely to be rational.

 

– the threat of a disorderly default and the spread of contagion to other vulnerable countries like Portugal remains pronounced.

 

Default is not some abstract that one catches like a virus, it is as inevitable a future consequence of profligate overspending as liver failure is of binge drinking. 

 

“The private sector has come a long way” [said Hans Humes, CEO of Greylock Capital]. “We hope that the other parties agree that it is more constructive to reach a voluntary agreement than the alternative.”

 

Blaming the bartender who refuses to sell you any more hooch that you cannot pay for is a classic inebriate’s misdirection of anger.

 

“In my opinion, it is unlikely that this is the last restructuring we go through in Europe,” said Hans Humes, a veteran of numerous debt restructurings and the president and chief executive of Greylock Capital, the only hedge fund on the private sector steering committee, which is taking the lead in the Greek negotiations.

 

Humes in happier times

 

Obviously this is not the last fight, it is only the first.  And that, as much as anything, is why the banks must refuse to agree, and must compel litigation.  If they knuckle in Greece, they will be forced to knuckle in Italy.  And Portugal. 

 

I can do this again and again

 

And on the next Greek bailout, when the previous haircut proves not to be enough, and the government demands yet another haircut. 

 

Meanwhile, the public-debtor side seems bound and determined to leak into the press ever-more-blatant confiscatory threats:

 

To increase Greece’s leverage, the country’s negotiators have said they could attach collective action clauses to the outstanding bonds, a step that would give them the legal right to saddle all bondholders with a loss.

 

O to be a sovereign, who can just add words to a signed contract and expect them to be validated.

 

This would particularly be aimed at the so-called free riders —

 

These holders are people who bought the bonds, most likely at substantial discounts, from their original holders who needed to sell them.  Calling them free riders overlooks that for every buyer, there was a seller, and the sellers were people who trusted Greece originally.  Without these new buyers, the market in Greek bonds would have collapsed entirely a long time ago and the country would be in default now.  This fact too has escaped the Times’s notice.

 

– speculators who have said they will not agree to a haircut [Or at least, not this scalping – Ed.] –

 

He volunteered to let me do it

 

– and are betting that when Greece receives its aid bundle in March, their bonds will be repaid in full.

 

Not necessarily in full, but in any event at a higher rate than the unilateral

 

If the collective action clause is used — and Greek officials say it could become law next week — these investors, who bought their bonds at around 40 cents on the dollar, are likely to suffer a loss.

 

In politics, perception is reality, and in markets, future risks have present cost.  Every time a debtor government proposes confiscating creditors’ property through the guise of a forced discount or other mandatory restructuring, it worse than chills the market, it destroys capital’s confidence.  However this fiasco comes out, I cannot imagine these banks returning to the European debt markets voluntarily for a decade, and if that’s the case, where will the money come from?

 

Unless the Euro fractures, pretty soon the only Euro lender will be the European Central bank.  And then they might as well start inflating the currency willy-nilly, since printing money that they can sell only to each other will do that anyway.

 

That, in turn, could prompt suits from investors claiming in the Court of Human Rights that their property rights had been violated.

 

They have.

 

“Because Greece is changing the bond contract retroactively, this can become an issue in a human rights court,” said Mathias Audit, a professor of international law at the University of Paris Ouest.

 

When Audit (rear) speaks, will the court listen?

 

When a sub-sovereign entity breaks the law, aggrieved citizens need a non-sovereign venue where they can take their complaint.  Either that is a supra-sovereign body (as in America, where breaches by states can be pursued in Federal court), or by an independent co-sovereign body (as in a supreme court, which many nations have) acting as arbiter of a supra-sovereign agreement called a Constitution.

 

Now all we have to do is get it ratified

 

The European Court of Human Rights has issued thousands of rulings with limited force because those ruled against have been beyond the court’s power to reach. 

 

That’s 2,395 in 2009 alone!

 

A ruling on this issue, however, would be enormously consequential.

 

Such a case would take years and would have to run its course in Greece before being heard by human rights judges in Strasbourg, France.

 

Meanwhile Greece would be a pariah in the capital markets – as would many other European states.

 

But with their considerable financial resources, some funds may be willing to pursue such a route –

 

Forget the financial resources – at issue are principles momentous for the future of global finance, to say nothing of the ruling 100x to 1 ratio of stakes versus legal costs.

 

– and they point to similar cases won by hedge funds in Latin America.

 

Curious thing about law, that; if there are sound principles, then the results are foreseeable and reliable.  Unlike political consequences. 

 

While the prospect of Greece paying an investor any time soon is slim, the country wants to avoid a parade of lawsuits across Europe, which would restrict its ability to raise money in international markets.

 

Some of the Latin American countries were completely shut out of international capital markets for a decade or longer.

 

Argentina, which defaulted on its debts in 2002, still faces legal claims from investors that have made it nearly impossible for the country to tap global debt markets.

 

Capital remembers, and adjusts its behavior.  That is capital’s only defense against sovereign abuse.

 

“It cannot be Angela Merkel that decides who suffers losses,” said one aggrieved investor who was considering legal action and did not want to be identified for that reason.

 

If not me, then how about Michel?

 

“What Europe is forgetting is that there needs to be respect for contract rights.”

 

Forgetting, or hoping to wish away?

 

It is not just the legal cudgel that investors are threatening to use. Some hedge funds have discussed among themselves the possibility of demanding a side payment, as they describe it, as a price Europe and Greece must pay if the two want the funds to participate in the agreement.

 

That will fail too, if only because its further unfairness will exasperate some who might otherwise have gone along.

 

Beyond all the byzantine wrangling, a crucial question is how this would benefit Greece.

 

And we care about helping Greece

 

Even with the deal, Greece’s debt would be no less than 120% of G.D.P. in 2020 — which seems to be slight progress given the austerity and pain its citizens must endure during this period.

 

“The real issue is not who participates in the deal,” said Jeromin Zettelmeyer, the deputy chief economist at the European Bank for Reconstruction and Development and an authority on sovereign debt.

 

Zettelmeyer’s praying for enough debt relief

 

“The question is whether there is enough debt relief for Greece, and there may not be, because the fiscal and growth situation in Greece is quite dire.”

 

Greece is going bankrupt.  The sooner the better.  Sooner default is better default.

 

 

 

 

By:David A. Smith

 

 

In the two months since I pronounced sentence on it (“The euro is over.  Either that, or European democracy is“), the Eurozone has postponed disorderly default only through a series of progressively more contorted, dubious, and anti-democratic measures, of which the most recent was reported backwards by the New York Times, which led with the response, not the stimulus, so I’ve rearranged the text:

 

Greece [is] considering passing legislation to force all private bondholders to take losses, while exempting the European Central Bank, which is the largest institutional holder of Greek bonds with 50 billion euros or so.

 

In other words, the government of Greece, which we all know is insolvent if not fully bankrupt, proposes to choose which creditors it will pay and which it will stiff – and it is choosing to pay its fellow governments instead of private citizens.

 

Whom shall I pick today?

 

The bond restructuring is a critical element for Greece to receive its latest bailout from the international community. As part of that 130 billion euro ($165.5 billion) rescue, Greece is looking to cut its debt by 100 billion euros through 2014 by forcing its bankers to accept a 50% loss on new bonds that they receive in a debt exchange.

 

Previously the Greek government camouflaged its intention by calling the cramdown ‘voluntary,’ and attempting to use that to claim the cramdown was not a credit event. That betrayal of core principles can now be seen to have been wholly wasted as the ‘voluntary’ mask has slipped aside, making it clear that this is intended to be an abrogation of agreement, backed by the force of government.

 

In America, such cancellation of contractual rights would clearly be Unconstitutional and compensable under the Fifth Amendment’s Takings Clause, but Europe has no similar protections, leaving the creditors high and dry.

 

 

You effed up.  You trusted us.

 

The Times betrays its biases by inverting the story:

 

Hedge funds have been known to use hardball tactics to make money. Now they have come up with a new one: suing Greece in court to make good on its bond payments –

 

Where is it written that suing to enforce a contract is ‘hardball tactics’? 

 

– though that could be a multiyear project with no guarantee of a payoff.

 

The alternative is to do nothing and have a full guarantee of no payoff (other than the partial payment that the bad debtor decides magnanimously to allow).

 

So magnanimous it’s in my Titian portrait

 

And it would not be likely to produce sympathy for these funds –

 

I missed the part where plaintiffs who have unquestionably been wronged have the burden of proving themselves sympathetic to bystanders, rather than the bourgeois standard of merely being right.

 

– which many blame for the lack of progress so far in the negotiations over restructuring Greece’s debts.

 

To the Times author, unwillingness to have one’s contract

 

I wonder how he would feel if the newspaper itself arbitrarily cut his salary in half or summarily laid him off?

 

Cut my allowance, will you?

 

Evidently all animals are equal, but government animals are more equal than others

 

Legal experts suggest that the investors may have a case because if Greece changes the terms of its bonds so that investors receive less than they are owed, that could be viewed as a property rights violation — and in Europe, property rights are human rights.

 

Property rights are human rights, and when the property rights are trampled, the human rights are assaulted shortly thereafter.  Already many semblances of democracy have been browbeaten or suspended outright, as the Eurozone’s creditor nations (France and Germany) are doing everything they can to whip the smaller nations into line, elections be damned.

 

According to one senior government official involved in the negotiations, Greece will present an offer to creditors this week that includes an interest rate or coupon on new bonds received in exchange for the old bonds that is less than the 4% private creditors have been pushing for — and they will be forced to accept it whether they like it or not.

 

Not only will the face amount be cut in half, the resulting interest rate will be below market, so the true discount will be even bigger.

 

That is a tough pill for investors to swallow, given the already steep losses they face, and one that would be likely to increase the cumulative haircut to between 60% and 70%.

 

I’ve been cut in half … but don’t worry about me

 

As I posted before, rescheduling debts at a below-market rate is an old insolvent-sovereign face-saving trick that goes back at least as far as George IV when he was Prince of Wales.  Creditors go along only at bayonet point – literally or figuratively.

 

The lower interest rate would help Greece by reducing the punitive amounts of interest it pays on its debt, making it easier to cut its budget deficit.

 

‘Punitive’?  Once again the Times author reveals biases not supported by the facts.  Punishment implies that the creditors are being vindictive for no business purpose.  The creditors would like nothing better than not to have to hold Greek debt.  They would certainly take being paid cash in Euros, to which they are entitled under their signed contracts, and so if forced by circumstances to roll over their indebtedness, in what is obviously an extremely risky security, they would naturally price in compensation for the risk.

 

Indeed, to all the business risks must now be added political risk.  Every time the European leaders open their mouths about how they will re-trade, compromise or flat-out ignore contractual provisions, they scare away more potential buyers of Greek debt, which makes those who remain ever more fearful.

 

You’re going to feed me more Greek bonds, aren’t you?

 

This cycle of coerced extension must end in default.  It is appalling that those who are arm-twisting the creditors cannot see this – or equally appalling that they see it but feel compelled, out of public choice theory of mere selfish embarrassment, to pretend it isn’t happening.

 

I don’t see any defaults, Angela, do you?

 

At the root of the dispute is a growing insistence on the part of Germany and the International Monetary Fund –

 

Anti-democracy comes in many guides.  Neither the IMF nor Germany ought to be in any position to order the sovereign nation of Greece to do anything.  The IMF can quite rightly condition further assistance on anything it wants, and presumably it is.

 

The surprise collapse last week of the talks in Athens raised the prospect that Greece might not receive a crucial 30 billion euro payment and might miss a make-or-break 14.5 billion euro bond payment on March 20 — throwing the country into default and jeopardizing its membership in the euro zone.

 

If Greece were truly sovereign, then the Greek government would have the alternative of defaulting on its debt, or of printing drachmas to repay the debts. 

 

The inscription reads, Greek democracy, 100 drachmas

What quaint antiquarian notions: Greece, democracy, and drachmas

 

Neither avenue is currently available, the drachma having gone the way of all flesh, and Greece’s Eurozone partners having threatened every form of dire consequence imaginable. 

 

You have been warned

 

The Greeks, like the Italians and the Irish before them, have woken up to lost sovereignty as the price of default avoidance, without ever having voted to cede their independence.

 

– that as Greece’s economy continues to collapse, its debt (now about 140% of its gross domestic product) needs to be reduced as rapidly as possible.

 

No one sensible argues that point.  At issue is who takes the pain.

 

Ain’t that a kick in the punt?

 

Inflating the currency, or printing money to pay debts (which is basically the same thing), would distribute the pain equally across (x) all of Greece’s creditors (all of whom would be denominated in the same drachmas), and (y) all of Greece’s citizens, whose drachmas would buy less of everything else the world has to sell.

 

Trying to force the creditors to take haircuts spares the Greek citizens the bill for their own overspending, which is inequitable, and penalizes the private investors who trusted the Greek government’s integrity, which is disgraceful. 

 

Even more infuriating, if one were a creditor, is that the puppet strings are held by utterly unaccountable foreigners, in the form of German politicians and unelected IMF executives. 

 

And in the clouds, there is laughter

 

Who are they to order anybody to do anything?

 

Those two powerful actors — which control the purse strings for current and future Greek bailouts — have pressured Greece to adopt a more aggressive tone toward its creditors.

 

As a personal matter, I hate indirection in human communication, because it always breeds unaccountability.  Either the Greek officials have the right to make decisions on their own, or they should be sidelined and the faceless ‘senior government officials’ should be speaking in public.  Intimidation via indirection is the mark of organized crime.

 

 “This is crunch time for us. The time for niceties has expired,” said [one senior government official involved in the negotiations], who was not authorized to talk publicly. “These guys will have to accept everything.”

 

Translation: All your property rights are belong to us.

 

 

As Liam Neeson eloquently said in Taken, Your arrogance offends me, and for that the rate just went up.

 

I will look for you.

I will find you.

And I will kill you.

 

Talks between the two sides picked back up on Wednesday evening in Athens when Charles Dallara of the Institute of International Finance, who represents private sector bondholders, met with Prime Minister Lucas Papademos of Greece and his deputies.

 

Pay me in Dallaras or I’ll sue you?

 

If the talks to not reach agreement, just how much of a case do the bondholders have?

 

[Continued tomorrow in Part 2.]