Affordable Housing Institute : US

“Holmes,” said Watson, turning a five-pound note between his fingers, “I’ve been thinking back to our visit to your brother Mycroft and that extraordinary bank — I should say, investment bank — of which he is a director.”

 

The carriage of a banker: Mycroft Holmes

 

Holmes looked up from the Times, where he had been perusing the foreclosure notices with what seemed to be a perhaps too-cheerful countenance.   “Indeed.  And?”

 

“Aside from my bedazzlement at the array of loan features” — Watson consulted his small notebook — “such a welter of language that Mycroft uses, with self-amortization, accrual, participation, interest rate reset, prepayment options, lockouts, and yield maintenance! — it has occurred to me that loans could also be classified by their principal source of credit.”

 

Watson noted that the broadsheets did not distinguish loans by type

 

“Capital, Watson!” said Holmes.  “You positively scintillate today.  There are, in fact, three principal credit types.  What great motivation unites all lenders?”

 

“They want their money back.”

 

“Precisely so.  And thus, inherent in every decision to lend (as opposed to grant or gift) is a judgment about how and why the borrower will be able to repay it.  For a lender, therefore, the core question in the mortgage credit analysis is:

 

Are we lending because we believe in the value of:

an asset, an entity, or a government?

 

Materializing a whiteboard from the available pixilated space, he drew upon it a small diagram, as the intoxicating smell of dry-erase filled our rooms:

 

 

There are three main types

 

We thus see, Holmes went on, that among the three financial types the underwriting process is quite different:

 

·         Project finance.  The main source of credit is the physical collateral, the property.  Often the loan is non-recourse, so that the borrower entity itself is not liable even if the loan defaults.

 

·         Corporate finance.  The credit source is the enterprise that uses the money.  The individual piece of property forms a source of cash flows, but in the end, the entire enterprise is pledged.

 

·         Sovereign lending.  The credit source is government itself.  As Mycroft discussed, both Bank of England gilts and US Treasuries are backed by no physical assets; rather they have the ‘full faith and credit’ of the sovereign United States behind them.

 

In the US, affordable housing uses almost exclusively project finance; individual loans are individually sized and underwritten on specific properties.  The loans are non-recourse, both as a matter of competitive market practice and because the US tax code has adapted to allow passive investor limited partners to claim their share of tax deductions (depreciation and interest) if the loan is non-recourse, but not if it is recourse (in the latter case, the tax consequences flow to the guarantor).

 

Here’s to project finance!

 

In the UK, Housing Associations use almost exclusively corporate finance.  Like US REITs, they borrow at the entity level, and even though the individual property cash flows may be pledged as part of the collateral, in practice the lender’s credit decision is made on the entity’s balance sheet.  As one might imagine, corporate-finance borrowings tend to be a bit more conservative (lower leverage) than project finance.  Against that, they are much, much more efficient and economical to use — simpler underwriting, more flexibility in raising or lowering the amount borrowed, a much more rapid expansion of debt capacity. 

 

Love live corporate finance!

 

(”That,” Holmes asided, “is part of why massive takeovers like Blackstone’s bid for Equity Office can happen so readily; capital assembly is quick because the underwriting occurs once, at the entity level.  Individual properties need not be examined in detail.  By contrast, Vornado’s offer, which is predicated on disaggregating properties and financing them separately, takes long to put together “)

 

We agree — both methods can work!

 

“Yet these distinctions cannot be pure,” interjected Watson.  “The typical home mortgage is both collateral based — if you do not pay the loan, the lender forecloses on the house — and recourse, with the borrower still obligated even after losing the property.”

 

“As many speculative condo buyers may find out soon” murmured Holmes.  “For that matter, large bond issues of state housing finance agencies mix corporate-finance elements into a project-financed pool, when the agency extends its own credit, implicitly or explicitly, into the issue.”

 

“But what about sovereign lending?  We have barely touched on that.”

 

“And sovereign lending is at one level the simplest, at another the hardest.  You see, when one lends to the sovereign government, as our friend the worldly philosopher has done in Chad, one is exposed not merely to the normal credit risks of an individual venture (project finance) or company (corporate finance), but also to the capriciousness of rulers, sovereigns who may choose not to be bound.  You recall the matter, do you not?” 

 

“Long have I admired your treatises on the hundred and seventeen types of tobacco,” began our guest, twisting the brim of his brushed black silk top hat.  “I have the honor to administer a trust operated by a small philanthropic society,”

 

 

“whose funds, raised by subscription, are deployed throughout the world to aid the suffering and encourage the enterprising.  My predecessor has placed me in a most untenable situation with an African potentate.  Our society, in concert with certain private investors, funded a major pipeline and refinery to extract the potential from a vast oil field that for decades had lain unused while its owners suffered.”

 

The Exxon-led consortium was willing to build the 665-mile pipeline from landlocked Chad to the sea only with the World Bank’s backing, said Rashad Kaldany, director of oil, gas and mining for the bank and its private investment agency, the International Finance Corporation. With Chad’s history of civil war, ethnic strife and corruption, its oil lay untapped for decades because no one was willing to put capital at risk here.

 

“Yes, I do; and as I recall, the matter continues imperfectly unresolved.”

 

It irritated Watson that Holmes thought he would not remember previous blog posts

 

“That is correct.  Unfortunately, this problem will survive us, Watson, for it long antedates us, going back four hundred years.  In the sixteenth century, the richest and most powerful king in Europe, Spain’s Philip II, went bankrupt.”

 

“But first, I shall marry Mary I of England.”

 

“Bankrupt?”  Watson was appalled.  “A monarch unable to pay her bills?  Unthinkable!”

 

“Oh, he did it in a grand style,” laughed Holmes.  “Philip II repudiated his debts.  After all, what could the bankers do?  As a future tyrant will say in a slightly different form, ‘how many divisions do the Fuggers have?’”

 

“No gentleman would do such a thing.  He would be banned from all the clubs.”

 

“Imagine the scandal when he received his expulsion notice!”

 

“Something of the sort happened, at least among the bankers.  The credit markets refused to do business with him, so he was forced to curtail his efforts to lead the Counter-Reformation throughout Europe.”

 

The reign of Philip II of Spain provides a good example to extend our knowledge of sovereign lending. Philip II fought wars through out his reign. To finance fluctuations in military expenditures, he had to borrow extensively. Repeatedly, Philip II’s Genoese lenders had imposed debt ceilings on the Crown. Once after reaching the debt ceiling, the Genoese suspended lending.

 

Portrait of a sixteenth century Genoese banker: Christoph Fugger

 

They further punished Spain by executing a penalty in order to force payment of loans; an embargo on specie delivered to Spain’s armies. The military consequence of the embargo was severe. “Spain was the predominant military power of the age, and Philip II was the last sovereign to credibly threaten to dominate Europe until Napoleon (Kennedy p. 30).” This played a significant role in testing Philip II’s aspirations in Europe and eventually caused Philip II to cede to the lenders.

 

I am not bankrupt; I simply do not choose to pay my debts.

 

“Even so, Philip’s Spain was rich in natural resources, so he had the gold — as, in a future era, Chad will have oil, as will Venezuela, or Iran, which limits the ability of capital markets to discipline fiscal malefactors.”  He sighed.  “And when a sovereign can pay no heed to credit discipline and the interconnected financial markets, he can get up to many other forms of serious mischief.”

 

You have to read the fine print to discover the mischief

 

Watson shook his head.  “In a globally connected world, such as the future will have, no nation can be entirely outside the capital markets.  They take their revenge in depreciating the nation’s currency.  Your brother Mycroft pointed out that paper money is the ultimate form of sovereign lending, and hyperinflation can be seen as the modern form of national bankruptcy.”

 

Watson wanted to know if he should shift his money out of sterling.

 

“Correct.  And in the twentieth century, loss of international banking confidence in a nation’s fiscal policy will manifest itself in hyperinflation and credit collapse, as in Mexico’s Peso Crisis, requiring a complex financial assistance package from the IMF, and the US and Canadian governments, to stabilize it.”

 

“Then why do the multilateral lenders like our worldly friend lend to sovereigns?  Why not lend against individual properties or projects?”

 

“It is more complex, and when you lend in a foreign and sovereign nation, even the best protocols one puts in place can be subverted by a sufficiently unscrupulous monarch.  The World Bank arose at a time when there was no other sustainable credit in developing or recovering nations, so they had little choice.  But how to move global lending into the twenty-first century is indeed quite a three pipe problem.”

 

“If we can crack sovereign lending, the world will become rich.”

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