Re-engineering the LIHTC value chain: Part 1, it’s broken
Nothing to worry about?
Here’s how it opens:
1. Executive Summary
In 2008, after more than two decades of uninterrupted and rising success, the LIHTC value chain – the sequence by which annual LIHTC awards turned into successful properties – broke. In 2009, it needs fixing.
There goes the added value
In classic business-school terms, a value chain is the linkage of steps, activities, and actors by which components are assembled into a product whose value is greater than the aggregate cost of the components and their assembly. It can be presented abstractly, which isn’t much help to anybody:
A value chain more comprehensible to most readers is that for originating a home-purchase loan, with materials taken from a housing-finance module I taught last summer at the Boulder Instituted of Microfinance. The home loan origination chain has seven roles –
– who work together in a multi-step sequence (for a step-by-step description, click here):
Development of LIHTC properties follows a different sequence:
Like some other value chains, this one must be completed to have any value. Because interim products have minimal value and significant carrying costs, the LIHTC value chain is uniquely vulnerable to disruptions along the way.
Evolving within and engineered for a benign and stable financial environment, the LIHTC value chain we knew was volatility-fragile. This was not an intrinsic condition, but an indulgence to which we succumbed over a period of a decade and a half.
Like, say, a global financial crisis?
What happens if we push the button?
The pipeline rupture was a casualty of the dramatic fall in prices of income-producing assets, and the global deleveraging that followed in its wake. Congress reacted by passing, in early February, the American Recovery and Reinvestment Act (“ARRA”), more commonly known as the stimulus bill, which includes some LIHTC recovery provisions (described below) designed to sop up excess supply and patch funding gaps in the pipeline of busted deals.
Two months later, we can see that ARRA’s LIHTC recovery provisions are no panacea (see §2 below). The LIHTC value chain is still in jeopardy, and with it, the future of American affordable rental housing production. Yet, as demonstrated in §3 below, if we lose the LIHTC delivery system, we as a nation will have lost something of great value to
In writing all this, I’m completely serious. Nothing less than the future of American affordable rental production is at stake.
If LIHTC is to remain the dominant resource for such production – and we think it should, as the system has remarkable benefits not replicable with any appropriated program – then we need to rethink the LIHTC chain, recognizing the essential and symbiotic roles of LIHTC allocators and LIHTC investors, as presented in §4, and their complementary roles and added value within the value chain.
Ever since I started studying the LIHTC systematically, both in the US and abroad, I’ve become convinced that it is a terrific delivery vehicle, because as soft equity it buys governments benefits not obtainable elsewhere.
As I put it in the Policy Update:
The LIHTC is an affordable housing delivery system that has proven remarkably cost-effective over more than two decades with the unique benefits of soft equity. Each deserves a brief explanation, particularly to demonstrate that they cannot be replicated with appropriated programs.
1. Risk transfer. In any appropriated program, the government takes initial performance risk. In LIHTC it does not.
Who’s taking the risk?
When government (or a lender) gives the developer money before completion, the funder takes the completion risk. If the property is not completed, the lender loses.
Tax credits eliminate this risk because the government pays only when the property is completed. All the development risk is borne by the developer(s).
That’s visibly true now. Two-plus years’ worth of LIHTC pipeline is in jeopardy – many properties are stalled — and how much has the government actually spent on them? Zero.
My kind of investment
2. Post-audit compliance. In an appropriated program, oversight is normally based on administrative criteria (“Did you follow the recipe?”) with a pre-approval element (“May I please raise rents now?”). In soft-equity programs like LIHTC, oversight is normally based on outcomes (“Does the food taste good?”) with an ex-post-facto observation (“Were your rents too high?”)
Just be scrumptious, no matter how you do it
I’ve written about process-oriented regulatory kudzu and how it endlessly grows. Post-audit, outcome-oriented compliance doesn’t grow – and the costs can be imposed on the users. How much does the government pay to get audited financial statements on public companies? Zero, because the companies hire independent auditors to compile them, because they are mandated to do so.
3. Collectibility of recapture. In an appropriated program, financial penalties may be levied but are hard to collect in practice. In soft-equity programs like LIHTC, collection is easy because everyone does business with the IRS.
We can always fine somebody, but are they collectible?
Appropriated compliance penalties – interest, late fees, civil money penalties – must be collected in cash from the delinquent. This is hard because there is always credit risk. The sponsor may be bankrupt, or nominally-capitalized (such as a small community non-profit), or politically untouchable. Enforcement against the property is equally problematic; it makes the administrator into the villain, and even if the money is present, removing it from the property weakens property operations. Often the property is taken ‘economic hostage,’ where the regulator hesitates to enforce because doing so will throw the property into default, imperiling the residents. Many a disreputable HUD sponsor has hidden behind the property’s viability, using the residents as an economic human shield.
In a soft equity program like LIHTC, collectibility is trivial because it uses the IRS collection system, and because the investors are large financial institutions that do business with Treasury in a dozen ways. As a result, non-collectible LIHTC recapture is unheard-of, whereas it’s all too common in HUD programs.
If it’s of such value, how did the LIHTC value chain break? That’s visibly true now. Two-plus years’ worth of LIHTC pipeline is in jeopardy – many properties are stalled — and how much has the government actually spent on them? Not a penny.
What we’ve lost so far on uncompleted LIHTC properties
The price of that risk transfer is a complex and curiously sequenced value chain:
While there are always variations, the typical pre-2008 LIHTC transaction was assembled in seven essential steps, as follows:
You get the biggest source of capital at the end
In its pre-crunch equilibrium state, a typical LIHTC property would be compromised of 15% hard debt, 55% soft equity from LIHTC, and the balance, say 30% although anywhere from 10% to 50%, from soft debt sources.
Of these seven steps, two were particularly challenging, expensive, and uncertain of success:
Step 5: Winning the LIHTC allocation. To win the allocation, sponsors had to project high prices, and then achieve those high prices. In a benign environment, of stable or rising LIHTC prices, they could do this, and the system worked.
Step 3: Securing soft debt commitments. So competitive was the pre-2008 LIHTC environment that sponsors would have anywhere from two to nine sources of soft debt, each with its own technical requirements.
[We put Step 5 before Step 3 deliberately, because we wish to show that the more essential step happens later – out of sequence – and that this inverted sequentiality is a problem.]
Everybody develops LIHTC deals this way
The LIHTC equity was and is essential – the biggest source of funds, and the one that all other providers would scrutinize before they contributed their modest soft debt amounts. But the value chain has this backwards time sequence. Logically, you’d want to lock an equity price first, and hence define your funding gap precisely, and only then get the soft debt, as shown below:
An early stage in the process: seeking soft debt based on an estimated funding gap
But the allocation/ award sequence, as administered by agencies, made you get all that soft money first, before you got the LIHTC allocation. (Agencies did this because they were in the catbird’s seat, and they wanted to make sure nobody got an allocation who couldn’t actually use it. This natural complacency borne of economic clout created a gigantic value-chain vulnerability that was poorly understood at the time.) Further, soft debt being hard to come by, people would scramble around for multiple sources in a patchwork financing quilt, as housing finance consultant Sherlock Holmes explicated at scintillating length.
An early stage in the process: seeking soft debt based on an estimated funding gap
Getting the soft debt before the soft equity is like cutting the patch before you’ve seen how big the hole is:
Because the critical step (LIHTC pricing) occurs after the gap-filling step (securing soft debt), we have a cart-before-the-horse challenge.
It was engineered for a market of rising prices:
In the pre-2008 environment, sponsors made optimistic projections of LIHTC equity raise, then scurried about stitching together a quilt of soft debt until their sources balanced their uses, then hoped to win an allocation, then placed the equity afterwards.
And a market of shrinking appropriated resources:
There was and is no intrinsic reason why the soft debt has to come from multiple disparate sources. That’s an entropic feature of the old way of doing business, a consequence of the varying cost-value gaps arising in different local markets, coupled with the extremely slender underwriting coverage ratios to which the market had evolved.
When prices started falling, the system broke.
As we first documented a year ago in State of the Market 6: What Price a LIHTC Ticket?, the equity syndication marketplace stalled last spring, when it became clear that the CRA-motivated financial institutions whose pricing had led and defined the market, no longer had meaningful tax appetites. Weakening demand and tax-appetite uncertainty led to a shortage in bid quotes, and caused the LIHTC equity market to stall during summer.
Not good …
Protracted failure-to-quote broke the LIHTC pipeline. Sponsors who secured allocations based on (say) 85¢ LIHTC pricing simply could not close at 74¢ — even moving to 100% deferred development fee (meaning no sponsor cash in the development phase) would not be enough to close the funding gap. So the sponsors facing non-viable price quotes then proceeded either to pursue more soft debt financing, or to wait and hope for better pricing. This stasis persisted through summer and into fall, when many of us expected the demand to return, only to be disappointed by the stream of bad news emanating from the capital markets, as one by one major institutions that had been LIHTC buyers – Fannie Mae, Freddie Mac, Citi, Wells Fargo, WaMu, Wachovia – withdrew from the buying marketplace.
By the end of 2008, we had a situation utterly without precedent in the LIHTC era: substantial overhanging unsold LIHTC, and an empty marketplace with only a handful of bid prices.
The system was broken.
[Continued tomorrow in Part 2.]