So far, in the two posts expanding upon my analytical essay Rethinking and Reengineering the LIHTC Value Chain [.pdf, and worth downloading in full – Ed.], originally published on my for-profit company’s Web site and its email distribution list, we saw that (Part 1) the US’s multifamily rental affordable housing finance ecosystem got disrupted by the capital markets, and that (Part 2) Congress’s solution – a combination of ‘buying back’ previously issued but unsold LIHTC and delivering gap financing for the lost value – will probably help the current pipeline but undermines the value chain’s ability to self-repair.

That’s not going to fix itself, is it?

[Editor's note: for a step-by-step primer on the mechanics of LIHTC allocation, click here.]

Why won’t the system repair itself?

The last six months’ market (in)activity, culminating in the exchange proposal, have conclusively demonstrated that the current LIHTC value chain – the 18-24 month sequence that begins with allocation request and ends only at financial closing – is over-engineered based on the now-false presumption of low-volatility and only rising prices.

Did you really need all those features?

All is not lost, however.

It is fixable, and it needs to be fixed – now.

Now, for our prescription, which is in three parts:

Better get your House in order

1. The goal of value-chain re-engineering

2. What allocators can do

3. What investors can do

It should be no surprise by now that a coevolved system can only return to equilibrium by complementary actions from each of its symbiotic actors, the allocators (those who give out LIHTC awards) and the investors (those who buy the LIHTC futures).

1. The goal: allocation quote matches market price

Let’s start with context, and what we’re after.

The LIHTC system worked perfectly well in 2001 with 77¢ credits. It worked well in 1996 with 65¢ credits. It even worked well in 1989 with 45¢ credits. The market will function, and function efficiently, if we back ourselves out of the over-engineered cul-de-sac that a decade’s benign financial environment led us to create.

Our goal is a value chain in which the allocation quote matches the market price. The ‘allocation quote’ is the net equity price per dollar of credit that is incorporated in the sponsor’s LIHTC application. The market price, of course, is what the awarded LIHTC fetches in the market.

In auction parlance, we want to recreate a world of reliable forward commitments.

Need to know you’ll be there when the time comes

So long as prices are volatile, with quality differentiated pricing still shaking out, the key to minimize the quote-price gap is to shorten cycle time between LIHTC award and LIHTC equity placement.

Shortening allocation-to-close cycle times is a variant of speeding up the marketplace’s OODA loop, or compressing the volatility of a normal yield curve.

To make the vehicle more nimble, get rid of extraneous deadweight:

Keep it nimble, and win!

That in turn requires both allocators and investors to recognize that precision-oriented procedures and requirements they adopted in earlier times now are entanglements that slow them down from the critical goal – matching the allocation quote to the market price.

Today’s 24-month risk cycle from LIHTC application to equity placement is unsustainable. We have to get to a cycle where the time delay from award to closing is no more than six months, and the shorter it is, the better. This includes both trimming procedural requirements and building in shock absorbers, particularly on equity pricing, that allow deals to close at the then-market.

Looks costly, but prevents crackups

2. What allocators can do: improve underwriting viability

Allocators can shorten cycle time by improving underwriting viability and building in adjustable uses of funds that can flex up and down as sources of funds change.

1. Increase the cash development fee.

As I’ve said before, profit is the price you pay for competence. Over the last decade, the LIHTC industry largely forgot this.

Competence, baby!

Allocating agencies have moved from capping permissible total development fee (TDF) to squeezing on the cash portion of development fee, with the balance as DDF. While that’s sensible in a rising-price environment, in a falling-price scenario Cash DF is the shock absorber. States could establish minimum expected Cash DF’s and size these as a percentage of the projected equity raise. That way they could be sure the property could close even in the face of a declining LIHTC price of stated amount.

2. Eliminate ‘minimum bid’ requirements.

LIHTC prices are an auction marketplace of a perishable commodity. It makes no sense to establish a high ‘reserve price’ when you’ll throw out the goods later if nobody meets the minimum.

Some things we just have to sell

Minimum-bid prices are unenforceable and unreliable. They also can act as a barrier to the creation of new demand, risk having some properties fetch no bid at all, and hence can work actually to drive capital away from low-demand states.

When in doubt, simplify. Clear away the clutter.

3. Reduce administrative-minimum requirements; use points. Generally speaking, QAPs are scored on points; highest wins. Some requirements are mandatory, however; they must be fulfilled or the application is disallowed regardless of its other strengths. Over the last half-decade, there has been a trend to more requirements, particularly in areas that do not help the underwriting. Point systems should begin to show wider range of differentiation across applications, in contrast to the “every winning deal scores 100% of available points” that has evolved in some states.

That’s the thinking we like!

4. Create a flexible-source pool of cash.

Generals heading into battle maintain a reserve force, to be committed where circumstances require.

Going where the need is

In financing, bullets are bucks; keep some handy to plug gaps.

Some Exchange funds should be held back as flex cash, in the range of 2-4% of total development cost, to be provided as additional soft debt tied specifically to changes in demonstrable underwriting parameters.

5. Give priority to properties with firm equity commitments.

Which line do you want to be in?

Anyone who’s ever run up to an airline boarding gate knows the key question, and the right answer:

Key question: “Have you checked any luggage?”

Right answer: “No!”

The luggage question is essentially a readiness inquiry; are you ready to go? In stimulus-legislation parlance, it’s ’shovel-ready,’ and in financing parlance, it’s ‘firm quote.’ If you have one, you should move to the priority boarding line.

3. What investors can do: develop more flexible, faster-responding acquisition vehicles

The allocators’ changes above will be sensible on their own; they will work much better, and have much more rapid takeup around the country, if the remaining LIHTC investors who are continuing to buy – and they represent perhaps half of the projected 2009 demand, meaning more are required – re-engineer their acquisition and closing procedures so they can take off faster:

The faster we lift, the better

Investors that want to stay in the business – that want the business to be a business – need to take the lead in innovating capital forms, in directions that were already emerging in 2007 and whose emergence will be accelerated by the demise of antiquated and uncompetitive capital-raising vehicles. They all involve having a faster response to properties offered.

Again the principle, shorten the OODA loop.

1. Develop fast-closing flexible acquisition entities.

In a fluctuating-price market, an investor with an ongoing tax capacity will be interested in dollar-cost-averaging – being able to close properties one by one, as they become available, at customized market prices. Doing so requires an ability to close quickly, so that proposals are not routinely overtaken by market fluctuations.

2. Make investor requirements clear and transparent to sponsors.

That’s clear enough

You don’t always get what you ask for, but if you don’t ask for it, you’ll never get it by making sponsors guess.

As the investor pool has shrunk and sponsors with overhanging-pipeline properties have become ever more desperate for equity, the fewer remaining investors face an even larger pile of proposals to evaluate, straining their capacity and thinning their margins.

Investors need to develop new mechanisms to inform sponsors of what deal features are attractive and unattractive based on tax capacity, yield requirements, CRA interest, underwriting criteria, and investment parameters. This could happen through guidance from individual investors, industry-wide or investor coalition white papers, dissemination of detailed data on closed deals, or use of syndicators as custom-tailoring intermediaries, where particular syndicators are private-label acquirers on behalf of particular investors on particular property tranches.

3. Anticipate the reinvention of CRA. The Community Reinvestment Act, now a venerable thirty years old, is due for an upgrade.

Time to install …

Count me among those who think that the CRA, as it now stands, is smart legislation and effective public-policy. But like anything else that’s gone thirty years without a tuneup, it needs a substantial modernization.

Pretty cool for 1977, eh?

When that happens, LIHTC housing is almost certain to be a preferred and incentivized investment.

CRA’s mania for micro-geographies is a byproduct of its origins in the late 1970’s, when redlining was the geographic proxy for income discrimination. In a world of electronic banking, the geographic fixation is anachronistic. A reinvented CRA will change investors’ spending patterns, and their investment vehicles should be designed with the flexibility to adapt.

Conclusion. Around my neighborhood, it was common in 2008 to see bumper stickers chastising, If you’re not outraged, you’re not paying attention. In 2009’s equity marketplace, the paraphrase should be, If you’re not terrified, you’re not paying attention.

Being terrified is so boring, you know?

Necessity is the mother of invention; fear can concentrate the mind wonderfully. Even with its flaws, the LIHTC value chain is a great invention, one that its stakeholders need to nurture and protect by re-engineering and improving it.

If we start now …

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In yesterday’s post introducing my analytical essay Rethinking and Reengineering the LIHTC Value Chain [.pdf, and worth downloading in full – Ed.], originally published, via my for-profit company’s Web site and its email distribution list, we saw that the US’s multifamily rental affordable housing finance ecosystem got disrupted by the capital markets, and by the end of 2008, was ruptured.

Not your normal wear and tear

During the first quarter, Congress enacted a massive stimulus bill that contained some provisions designed to fix the problem:

Under ARRA (the American Recovery and Reinvestment Act), Congress sought to patch the LIHTC pipeline and sop up the LIHTC glut with two ‘one-time’ actions: $2.25 billion in HOME funding (called the Tax Credit Assistance Program, or TCAP), targeted specifically to LIHTC properties and flowing through state LIHTC allocating agencies, and an exchange of unsold LIHTC for up-front cash at the equivalent of 85¢ per dollar returned.

The amount potentially exchangeable is substantial: 40% of the 2009 allocation (roughly $2.1 billion of new cash), and 100% of the allocated-but-unsold 2007 and 2008 allocations.

[Editor's note: for a step-by-step primer on the mechanics of LIHTC allocation, click here.]

Though this all looked good on paper, a few of us immediately sounded an alarm even before it was enacted, warning of dangers:

The LIHTC industry therefore faces two massive and linked problems:

a. Repricing LIHTC. Pricing dropped discontinuously: from perhaps 85¢ to perhaps 65¢, with greater variation in pricing. A new equilibrium needs to be found at a lower price.

b. Re-underwriting the pipeline. Almost all 2007 and 2008 allocation properties are infeasible at the new pricing and need to be re-underwritten.

Fixing either while making the other worse is no solution at all.

In particular, seeking to create a floor price for LIHTC equity will unfortunately make a temporary pricing drop into a permanent price support, whose distorting effects are all too readily visible in other price-supported programs.

It also creates a two-tier system:

Which lake will you fish in, the upper or the lower?

Patching a subset of properties will leave the rest worse off

By propping up the LIHTC prices—85% is well above the real clearing price today, occasional side transactions notwithstanding—it would salve the underwriting of any pipeline property lucky enough to make the swap.

In doing so, however, a swap-at-85¢ will make all unswapped properties, and the whole delivery system, worse off, for several technical reasons:

1. A swap provides no economic stimulus.

It’s swapping one form of money for another, not increasing total money available.

2. A swap at an above-market price interferes with equilibrium in the LIHTC equity markets.

In inhibits the market clearing – and that’s always a bad thing.

3. A swap removes investors, who provide risk transfer, downside protection, and ‘free’ enforcement of government objectives.

Soft equity has benefits soft debt cannot replicate.

4. A swap does nothing to stimulate investor demand—in fact it undermines the re-emergence of a functioning market.

The Exchange, as it’s come to be known, gives developers an option. They can close their deal now, with outside equity, at (say) 72¢ per $1 of LIHTC, or they can Exchange their LIHTC back to the state, and maybe get a return allocation of 85¢ (minus any state administrative costs, which are going to be material).

When it comes to underwriting, a myth is as good as a mile

Since every penny between 72 and 85 means another penny of either soft debt to be found or developer profit to be made, many developers may choose to hold out – and, like the donkey between two haystacks, may choose nothing.

I’m too smart to fall for that old logical canard

In fact, we have numerous anecdotal reports that this is going on. Of course, it’s been made more challenging by the normal-but-seemingly-interminable process by which legislation turns into action:

Guidance implementing the TCAP and Exchange programs arrived from HUD and Treasury, respectively, some seventy-six days later on May 4, 2009.

Having resisted the natural urge to complain about the slow turning of the gears of government, one should admit that the guidance provides, on balance, a useful way forward. HUD and Treasury provided some useful clarification, some even more useful flexibility, and some discouraging requirements, as is to be expected.

That’s what Congress has done. Will it be enough to self-repair the system in time?

I’m really concerned that system repair will happen too slowly, because it does not repair the evolved soft-equity symbiosis between resource allocators (who care about the public trust and aren’t state-of-the-art on risk assessment) and equity investors (who care about risk but lack the public-purpose gene).

Each of us helps the other in pursuit of our own rational self-interest

LIHTC is allocated annually by public bodies with a mission orientation; each individual transaction is invested in (or not) by private corporations seeking maximum return. Although both roles have their forbears in appropriated programs, as they work in LIHTC each is distinctive – and in the interplay between allocators and investors, the LIHTC value chain creates quality that neither could create on its own.

Allocators hold the public trust. LIHTC allocators are exclusively publicly accountable bodies, limited to a particular state – within its jurisdiction, no allocator competes with any other. Each allocator uses a transparent process to identify statewide public-policy priorities and to convert them into clear and adjudicable scoring rules whereby sponsors can bring proposed properties and compete for LIHTC awards. Because each allocator is geographically bounded, and non-overlapping with any other allocator, allocators collaborate in sharing information, and developing best practices.

As long as each allocator plays in its own backyard, nobody fights

Investors price risk and cull for market feasibility. They have negligible interest in the state’s public priorities; instead they pursue yield, safety, and ongoing viability – all the essential technical and real estate outcomes without which the policy objectives would fail. Because investors’ geographic interests overlap – many are effectively national in scope – they compete for transactions, for sponsors, and for yield. That competition is in turn healthy for the ecosystem, since it has tended to drive yields down, prices up, and efficiency greater.

Each of us is getting something out of this relationship

These roles are distinctive – they do not overlap – and symbiotic. Allocators can give out credits on properties without doing the deepest underwriting, because the LIHTC equity will be much larger, junior to the mortgage debt, and collectibly at risk for fifteen years. Time and again through the investment life cycle, it has been the investors that have taken the decisive action – removing local general partners, changing management agents, injecting capital, forcing the issue on debt restructuring – to assure ongoing property viability, not out of public spirit but out of rational self-interest.

As in nature, the symbiosis evolved out of thousands of individual self-interested decisions by two species each of whom used the other’s outputs as its inputs.

We’ve figured out how to work together

The symbiosis of allocators and investors crept up on us over the course of two decades, starting in 1989 (the first year in which national LIHTC demand exceeded allocation).

Investors drove up pricing.

Allocators sharpened the underwriting.

This symbiosis worked without either side thinking affirmatively about it, because it evolved over a decade-long interval in which prices were stable, pries were rising, and any forward commitment, explicit or implicit, would be money-good when the time came.

If the carousel stops, the symbiosis stops too.

At the Chicago conference of the Affordable Housing Investors Council, a prominent developer commented, in describing the current marketplace, that he typically expends cash before LIHTC allocation equal to perhaps 75% of his expected total net development fee. That’s betting $0.75 to make $1.00 later – a risky proposition. He was wondering whether to exit the business.

I’d love to get out of the business … safely

If aggregate demand falls below new aggregate supply, the unselected properties will be concentrated in the asset types less desirable from investors’ perspectives – and with capital markets being national, that could mean whole states’ worth of LIHTC go begging.

Not all LIHTC is equally attractive to investors. Coastal markets are preferred; so are growing cities. CRA considerations advantage large cities and disadvantage rural and Midwestern America.

What happens politically if LIHTC sells mostly in blue counties, and not in red?

The system has worked incredibly well up to now because there was always enough demand for LIHTC everywhere in America that disadvantaged markets could nevertheless sell their LIHTC, albeit at a slightly lower price. Now demand is down – that’s why we had a 2008 oversupply – and it’s possible to imagine that it will not sufficiently recover by year-end 2009. If so, LIHTC in Massachusetts and Maryland may sell, but Michigan and Montana LIHTC may not.

A national program that goes unsold in a third of the nation is no longer national, and no longer can command national support.

That’s the prognosis – gloomy indeed. But if the stimulus legislation isn’t enough, what then must we do?

A puzzle, isn’t it?

[Continued tomorrow in Part 3.]

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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 US affordable rental housing. 

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.

Enter Congress.

[Continued tomorrow in Part 2.]

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[Continued from yesterday's Part 2 and the previous Part 1.]

“He that is of the opinion money will do everything may well be suspected of doing everything for money.”

– Benjamin Franklin, who was born and raised in Massachusetts

Drive thy business or it will drive thee

So far our review of the white paper (available in .pdf here as Recap Update 72) published by my for-profit Recap Advisors at the request of the Massachusetts Housing Partnership (MHP, www.mhp.net), has hammered home the necessity for clearing LIHTC equity markets by lowering the prices to the point where new buyers come in. 

If we don’t sell it, we lose it

This will take a while:

In a market where CRA equity investment had a measurable monetary value, all non-CRA-motivated buyers—such as profitable Fortune 500 industrials, insurance companies, utilities, and so on—were largely priced out, a concentration by investor type that only now is revealed to have been dangerous for the industry as a whole.

New buyers likely to emerge in 2009 will be precisely those Fortune 500 entities with reliable earnings, of which, recession notwithstanding, there are plenty.  However, the emergence of such buyers will provide little short-term relief, because of:

·         Time delay.  It takes a fair interval of time to educate a corporation to LIHTC and to move that education through to an actual equity investment check.  If past experience (the early 1990’s) is any guide, 6-9 months is a typical decision interval.  Given the recent correction and overall reevaluation of financial risk, the interval may be longer this time.

New market entrants take many months to develop

·         Pricing at lower levels.  Entities that are not financial institutions will place no premium on CRA consideration, so they will enter the space only at prices competitive with other CFO earnings management tools, such as other tax credits.

In this, unfortunately, the LIHTC will suffer in competition with other tax credits.  When LIHTC was enacted in 1986, it was virtually the only such tax credit.  In the 22+ years since then, other tax credits have emerged as investment vehicles: historic, New Markets, energy, and so on. Compared to these new credits, LIHTC has a long delivery period (10 years), a longer risk period (recapture, 15 years), and greater relative complexity (it is the longest section of the Internal Revenue Code).

The market clearing price for new LIHTC, therefore, must be at levels well below the 2007 equilibrium, and probably below the 2008 asks of $0.85 or so.  (Section 3A)

In the paper, I was cautious; in reality, I think this market clears at $0.65.  Which leads to our next important point:

6.  Provide an underwriting cushion to handle equity price drops.  The industry faces two problems:

No dead deals, please

a.  LIHTC equity prices are much lower than they were before.

Prices that in some desirable coastal markets were above $1 per dollar of LIHTC (observed by Recap to be “hyperactivity” back in 2006) are now below $0.80 in some cases.  Observable prices now are legacy deals—properties in the pipeline from before the disruption.  Much lower price are not registering yet because fewer pipeline properties are feasible at those prices and markets have yet to accept the few that will.  Section 2E.

There went my feasibility

b.  Pipeline properties that relied on old prices will need to be re-underwritten. 

The first problem is solved by getting to a new price quickly, so that markets can clear. 

Based on pricing adjustment alone, Massachusetts’ allotment of credits will go only 77% as far as it did last year.  Fewer pipeline properties will get done in the new reality. 

Once you know that prices don’t work, the next step is apparent:

Stress-test applications at lower-than-average equity prices, at least until the market settles at an equilibrium price.  That will avoid having pipeline properties come back for additional credits because markets have moved during the allocation process

7.  Have resources available to assist pipeline properties to close.  They represent a sunk cost (by somebody) and an affordability opportunity. 

Part of that flexibility can come from recognition that simpler financing will help pipeline properties get done.  Currently, political incentives are such that funding providers are encouraged to provide a little help to many pipeline properties—that shows they are supposedly leveraging contributions from others and allows claims to large numbers of units funded.  The result, however, is complex, multi-source financing subject to many different timetables, and leading to rickety, vulnerable deal structures.  Section 4D

You think your bridge financing structure is sound?

New resources are essential because the development pipeline is long, and complex:

In an LIHTC underwriting of allocated credits, the LIHTC equity is normally the largest chunk of the capital stack, typically 45-60% of total sources.  However, it becomes a firm commitment last in the development sequence, specifically:

Make sure you do them in the right order!

1. Sponsor secures site control.  This requires expenditure of funds.

2. Sponsor sizes debt and/or secures permanent debt commitment.

3. Sponsor secures preliminary commitment for soft gap-filling funding.

4. Sponsor applies for LIHTC, stating an expected LIHTC equity price.

5. Sponsor wins LIHTC competition.

6. Sponsor places LIHTC at an actual LIHTC equity price.

7. If the actual equity price is ‘too far’ below projections, then sponsor returns to Step 2 and iterates until success.

8. Sponsor closes the property transaction.

The development sequence is also financially bass-ackwards:

The significance here is that Steps 1 through 4 involve expenditure of non-recoverable costs, and that the transaction does not work—in the sense of sources matching uses—until Step 6. 

LIHTC development is thus a poker game where you make escalating bets and increasing risk, and now the game’s rules have been entirely changed.

If the actual equity price is below the level needed to align sources and uses and the transaction lacks the necessary cash cushions, then the sponsor returns to an earlier stage and repeats the entire process, with no guarantee that prices will not further erode in the next cycle.  Section 3D

8.  Maximize flexibility with gap-filler resources.  Allocators should increase and concentrate any other LIHTC-compatible resources available to them.

We can divide LIHTC properties into three cohorts, each of which will need additional resources:

·       Past – Properties with pre-2007 allocations should all be closed (though there are always exceptions), but they will be under stress as resident incomes fall.  Properties expecting to refinance to address capital needs or with maturing debt to repay may turn to public sources if private capital markets remain frozen.

·       Present – Properties with 2007-2008 allocations but no equity investor may need intervention with additional credits or gap fillers to stay alive.  Some will fail to attract investment and will turn back their allocation.

You may need a little present assistance

·       Future – Properties with 2009 allocations will need more credits, given the slump in pricing.  They will also likely require more gap-fillers in the form of soft loans or grants.

All of this implies a greater concentration of affordability resources per unit of housing.  In other words, triage.  Section 4A

Some of you aren’t coming out

9.  Collect and disseminate reliable data on LIHTC markets: allocations, awards, pricing.

For an eight-billion-a-year industry, every step of which is in the public domain, we have surprisingly little good information.  We put some into the report, using the specific to imply the general:

For example, of 39 Massachusetts pipeline properties allocated in 2007 and 2008, only 8—barely over 20%—have closed with firm equity.  That means roughly 80% of pipeline properties are still lacking in solid equity, with a whole new round of allocations coming up in 2009.  For the first time in the LIHTC’s history, not only will there be a substantial pool of unused credits to be redistributed nationally, but there will be $2-4 billion of 2008 LIHTC without an equity investor, even as another $8 billion or so of new LIHTC will be allocated to states.  Section 1B

Can’t play the game if you can’t see the cards

10.  Keep the competitive process.  It harnesses market forces, even in weaker markets.  As the report put it:

We have heard calls for handing out credits on a first-come, first-served basis on the theory that competition among developers is a thing of the past.  Such calls miss the central role competition has in the success of the LIHTC program.  Competitive allocation harnesses market forces to the efficient allocation of scarce resources.  What Massachusetts must do, however, is focus the competition on the aspects critical to the success of pipeline properties—provision of equity.

Competition for resources – by developers to a state, and by states with each other – has been among the principal reasons why housing tax credits work. 

Who wants tax credits?

As I wrote two years ago:

There are investment tax credits and investment tax credits, and yet in political and programmatic terms, the LIHTC stands head and shoulders above the others.

“One of these things is not like the others, one of these things is just not the same.”

What makes the LIHTC so nifty?  A remarkable, one might almost say prescient, confabulation of features, some of which are intrinsic to fiscal tax expenditures rather than appropriated programs.

[Snip]

4.             Capped and competed.  The amount of credit is fixed, so sponsors have to compete with one another.  This leads to a virtuous-circle feedback cycle as each year’s competition is a bit fiercer than the preceding one’s.

Each time I cycle, I get better.

5.             Allocated on a use-it-or-steal-it basis.  Each state has a specified amount to spend, with uncommitted amounts returned to a national pool where other states can claim it.  As a result, each state is highly motivated to spend all of its credits.

Wanna try to steal those tax credits?

Competition is also healthy among states, because some will heed the warnings (like ours) and react faster and better. 

When there are more properties chasing less capital, the easiest to close have an advantage.  Allocating agencies should see themselves as a critical link in an aggregate value chain that works only if the awards are funded and closed.  The private sector—syndicators, developers, investors—in Massachusetts will certainly invest their efforts in crafting a revised operating protocol if they have reason to believe the public sector will approach in the same spirit.

Such leadership by Massachusetts government officials will not only help the state’s stock and stakeholders, it can help lead LIHTC allocators in other states to rethink their own procedures and policies.  There is no time to lose, else national players will perform their own unsympathetic triage and cross off their lists states whose agencies are hidebound by a delivery paradigm that is two years out of date.

Those that demonstrate syndication-friendliness will be the winners:

Whether they realize it or not, states are now competing with each other on their ‘equity syndication friendliness.’  

I’m competing to be friendly

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