After two long posts focusing on outgoing Treasury Secretary Hank Paulson’s Remarks on the Role of GSEs in Supporting the Housing Recovery, we’ve seen that the Secretary:

1. Has concluded, with audible reluctance, that privately-run GSEs are likely essential.

2. Correctly restates the inescapable dynamic tension between social and economic goals.

Tell me something I don’t already know

He offers a menu of four possible futures:

The future’s up in the air

Depending on the degree of subsidy policymakers choose, there are a variety of options for structures to replace the GSEs, including:

(1) Expanded FHA/ Ginnie Mae. Some advocate that beyond the current credit crisis the U.S. government’s long-term policy should make the implicit, explicit. Explicitly guaranteeing Fannie and Freddie’s obligations would essentially nationalize this significant portion of the U.S. housing finance market.  Under this model, the GSEs could become a government entity, or their functions could be absorbed by FHA/Ginnie Mae.

Along with RHS, the oldest Federal housing agency, established 1934

FHA is an arm of the Federal government; Ginnie Mae is a private corporation wholly-owned by the Federal government.

Once upon a time, the peer of Fannie Mae

In either case, the GSEs would no longer have private shareholders. The size of the eligible population of homebuyers would determine how large a share of mortgage credit exposure the government would own.

I view the permanent nationalization of the GSEs, essentially expanding the role of FHA and Ginnie Mae, as a less-than optimal model.  

Me too.

The blogger agrees with me?

While it offers the perceived advantage of explicit government support, it eliminates the necessary private sector evaluations of credit risk and the private market stimulus to innovation.

That’s the big defect of a purely governmental model.  FHA’s last innovative product was over a decade ago, and its ability to grow its business is constantly at the whim of Congress, which doles out credit subsidy.  A banker shouldn’t be politically controlled, and a banker should have financial incentive to innovate.

Next victim!

(2) Partial Guarantee. A hybrid of this would be to create a Ginnie Mae-like entity for non-FHA mortgages, structured as a partial guarantee mechanism. The new entity could operate on a similar basis as Ginnie Mae, but provide only partial guarantees for MBS.  Investors would then have a floor under potential MBS losses, but would still evaluate the credit risk associated with individual issuers.

In effect, this model would make the GSEs into a last-loss insurer, taking risk greater than some negotiated levels.

That be us

The devil, of course, is in the details; if you’re taking some of the losses, then you have to negotiate how much loss you take in each issue or asset class.  Pre-conservatorship Fannie Mae solved this problem very effectively with its massively successful and clever Delegated Underwriting and Servicing (DUS, rhymes with ‘muss’) program – a program, we should note, whereby Fannie Mae acquired and resold huge volumes of loan pools, without experiencing the systemic risk or balance-sheet turbocharging that got the GSEs, Fannie in particular, in their current impasse.

While such a hybrid program would clearly define the extent of the government’s guarantee, developing risk sharing parameters compatible with profit incentives would be as problematic, and potentially as inefficient, as in the current GSE structure.

The Secretary’s arguing that if the GSEs are going to have to balance the tensions between risk/ profit and subsidy/ affordability, they might as well own all of it, not just some of it, and they might as well be in the program space themselves, rather than adding a layer of principal-agent risk in working with and through independent mortgage originators, who sometimes go bad and make bad loans.

I don’t care what a blogger says, I still don’t like it

(3) Privatization. A third alternative would be to remove all direct or indirect government support, completely privatizing these companies while breaking them up to minimize systemic risk.

What we might call the AEI solution, because solons like Alex Pollack have long advocated this, and claimed it can be done at the stroke of a pen.  It could, if we had an autocracy, but in a democracy, the government OODA loop of creating legislation is so slow the forces of incumbency would likely rally.

Curiously, with the conservatorship, we theoretically could completely privatize the GSEs – but we need the eggs:

As appealing as this alternative sounds, it is difficult to envision a sound, practical, private sector mortgage insurance business of any significant size that does not require large amounts of capital, and consequently generates only a modest return on capital.

“If it were privatized, it would need tons of capital that it hasn’t got.”

The recent problems encountered by monoline insurers, which ventured into guaranteeing mortgage product, as well as the experience of the GSEs, underscores this point.

Good point.

Moreover, a break up scenario does not look particularly promising, as reverse economies of scale would take hold.

Having built it, don’t unbuild it.

It is also worth noting that a regional mortgage insurer would lack diversity as a risk mitigant.

Right.  Capital is national if not global.

Perhaps a consortium of banks would find it advantageous to own a national mortgage insurer to wrap their product, or some other good private sector business model may emerge.

Perhaps they wouldn’t.

Anybody out there want to own a national mortgage insurer?  No?

But I am skeptical that the “break it up and privatize it” option will prove to be a robust or even viable model of any substantial scale, without some sort of government support or protection.

And I’m not the only skeptic

However, should policymakers choose to scale back public policy bias toward homeownership, we will eventually find out what business model the free market would support.

Elsewhere in this speech the Secretary makes a long philosophic discursion into the economically rational but politically incendiary territory of suggesting we should get rid of the mortgage interest deduction – but that third rail of politics is best left for another post or posts.

Wanna not get re-elected?  Touch the mortgage interest deduction

Finally, in the manner of good salesmen everywhere, the Secretary finishes with the option he favors:

(4) Housing Utility. Finally, given traditional U.S. public policy support for marshalling private capital to expand homeownership, establishing a public utility-like mortgage credit guarantor could be the best way to resolve the inherent conflict between public purpose and private gain.

Turning on and off the spigot of liquidity?

Under a utility model, Congress would replace Fannie Mae and Freddie Mac with one or two private sector entities. The entities would purchase and securitize mortgages with a credit guarantee backed by the federal government, and would not have investment portfolios.

These are the GSEs pre-Jim-Johnson era, with no balance-sheet turbocharging.  But the Secretary wants a further shackle:

Where did those pesky GSEs go?

These entities would be privately-owned, but governed by a rate setting commission that would establish a targeted rate of return, thereby addressing the inherent conflicts between private ownership and public purpose that are unresolved in the current GSE structure.

Alternatively, the ‘rate commission’ could instead set ongoing capital requirements, and periodically require capital to be redeployed into new products.  State HFA’s operate something along these lines.

This commission would also approve mortgage product and underwriting innovations to continually improve the availability of mortgage finance for a population to be defined by the Congress.

A noble ambition.  Much harder than it sounds.  If the rates of return are set, where’s the pressure to innovate?

In this model, continued safety and soundness regulation would be essential.

Actually, in any model they’re essential.

So Secretary Paulson plumps for a public-utility concept – which is by no means nonsensical – but just at the point the hard questions would need answering, he punts.

Next Administration!

Maybe that’s right – the decisions will belong to his successors – but it’s disappointing.

Not boldly going anywhere

In all the Secretary’s many words, there are some whose absence was deafening:

He didn’t say we needed two.

Didn’t I?

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Yesterday we saw from outgoing Treasury Secretary Hank Paulson’s Remarks on the Role of GSEs in Supporting the Housing Recovery, that no matter how much he worries about their existence, he has (correctly, I think) concluded the GSEs play an essential role in creating omnipresent secondary-market liquidity, and in allowing targeted rate cuts to particular asset holders – namely, owners of homes.

Policymakers must decide if the GSE subsidy is a public policy priority.

Although the Secretary is properly cautious, it’s clear, I think, that he grudgingly accepts their value.

“We need the eggs”

If the GSEs are to play a role, then, the debate is clearly framed:

Which side do you come down on?

Government support needs to be either explicit or non-existent –

Yes.  We’ve learned, to our sorrow, that the peekaboo Federal guarantee – now you see it, now you don’t – combined the worst of both worlds: massive agency risk (management could just pump up the volume of balance sheet) with minimal Federal supervision. 

– and structured to resolve the conflict between public and private purposes.

Any middle ground is a recipe for another crisis.

Please, lord, not another crisis

Although there are strong differences of opinion over the government’s role in supporting housing, under any course policymakers choose, there are structures and choices that can resolve the long-term conflict of purposes issues.

Sounds like a man reconciled to the GSEs’ continued existence in some form:

And it is clear that to protect against systemic risk in the future, the GSEs should be constituted with a portfolio no larger than what is minimally necessary for warehousing purposes.

Here is Secretary Paulson’s core, critical message – leash them lest they overrun you.

This won’t hurt a bit

Why?  As I wrote back in June, 2006 when the OFHEO report came out:

Starting in the late 1980’s, GSE securitization of mortgage loans created systemic liquidity never before seen in the world. It fueled an expansion of credit, and a compression of interest rate spreads, that coincided with a long-wave rise in national homeownership rates.

[Snip]

In fact, in one sense it was too successful — the entities ran out of worlds to conquer. Their market share was so large, they so dominated their main market, that Fannie Mae needed to do something else.

In fact, three something elses:

Fannie Mae management believed that, to double EPS by 2003, the Enterprise would have to achieve three business objectives. Page 45.

We need to go through these slowly, because each one is very important.

1. First, in the credit guarantee business Fannie Mae would have to securitize a greater share of the single-family mortgage market, in part by (a) penetrating the subprime market …

Subprime lending — that is, financing those who fall below conventional credit standards — is a hotly contentious area.  Some see it as bringing needed capital to those redlined by prejudice.  Others see it as exploiting the financially undereducated. It’s too big to address here.  [June, 2006 – Ed.]

The next one’s easier:

2. Second, in the portfolio investment business, management would have to increase rapidly the size of Fannie Mae’s retained mortgage portfolio, while avoiding significant compression of the portfolio’s net interest margin — the spread between the average interest rate earned on assets and the average rate paid on liabilities. The portfolio investment business had generated the majority of the Enterprise’s net income in 1998 (and continued to do so in subsequent years), so that expanding business offered the best prospect for growing earnings. Page 45.

If I am interpreting correctly OFHEO’s statement [and we now know they did – Ed.], more than half of what the Fannie Mae made in this interval, they made by turbocharging the balance sheet, the thing that GSEs should not do. That is extraordinary.

3. Third, senior management believed that it would have to achieve steady, rather than irregular, EPS growth.

Now we know those smooth earnings were a manufactured illusion.

Everything was on the up and up at headquarters

Secretary Paulson is in no doubt that even a tightly constricted GSE would serve its essential function:

Without portfolios of significant size, the enterprises’ management of interest rate risk would remain a vital function for the safety and soundness of the enterprises, but would no longer present the same potential systemic risk.

This is essentially the same point made by Fed Chairman Alan Greenspan (that is, before conventional wisdom decided this whole mess was his fault):

That was Fannie and Freddie’s original purpose, because it’s essential for a healthy housing finance ecosystem:

The first line of business provides substantial benefits for affordable housing through the process of using credit guarantees to turn mortgages into marketable securities that trade in public debt markets.  This process creates a wide variety of liquidity benefits, some of which flow to homeowners and mortgage originators. 

“A rising tide makes the pie higher.”

Making loans more liquid frees up originators to go back to work, and the competition also lowers the rate spread (between safe rate and what the borrower pays), so customers get cheaper money.  (”When lenders compete, you win.”)

Moreover, creating securities from the mortgages extended to nontraditional homeowners is an important step to making mortgage credit more widely available. 

Newly liberated originators go find new borrowers, and move gradually down the bankability pyramid.  That’s good for everybody:

Focusing Fannie and Freddie on this type of securitization activity can promote affordable housing without creating significant risks to the [nation’s] financial system [and by extension, the taxpayers].

The financial system is not at risk because the securities are issued only when the loan pools are sold, so there is a perfect match in asset maturity (when the loans come due, so do the bonds).  Private parties are taking the risk, not the Federal government.

Thus the GSEs, even in the minds of libertarian-oriented marketers like Greenspan and Paulson, serve the essential role of providing continuous permanently-available secondary-market liquidity.  We need the eggs …

Two elderly women are at a Catskill mountain resort, and one of ‘em says, “Boy, the food at this place is really terrible.”

The other one says, “Yeah, I know; and such small portions.”

Even as we need the GSEs, the Secretary would really like to create alternatives to them:

If we are to maintain a private-sector secondary mortgage market – which I believe serves the taxpayer and the homebuyer equally well – then we must enhance the ability of depository institutions to fund mortgages, either as competitors to a newly-established government structure or as a substitute for government funding.

As I previously posted in the Adventure of the Money Store, deposit-taking is for a bank the lowest-cost source of capital yet it exposes banks to maturity-risk mismatches.  Depositors can pull their money out at any time – such as panic – in which case the bank would have a liquidity crisis. The deposit-taking system thus relies on the Federal deposit insurance, making the government the liquidity source of last resort (as with big banks under TARP).  The Secretary doesn’t like having to make the Hobson’s choice between the TARP risk or deposit-insurance risk, so he’s wishing for powers to push deposit-taking institutions more into the capital markets.  Yet still, in part because of what I’ve labeled Jefferson’s Curse (to match John Steele Gordon’s Hamilton’s Blessing), we in the United States have over 10,000 banks, a commendable locality in banking service that nevertheless has a very large cost: inefficient anti-scaling in complex capital finance.

Securitization was supposed to solve that.

Didn’t work so well

Every new technology experiences a honeymoon interval where it is seen a panacea – creating new benefits with no risks.  The longer it takes for the risks to appear, the worse they seem to be when they show up, perhaps because they encouraged such risky behavior.  Securitization will return, probably with boring old high-hard-equity requirements. 

One way to do this is for the government to receive some compensation for its guarantee. The current GSE Preferred Stock Purchase Agreements take a small step in this direction, in that as of 2010 the GSEs must pay the government a fee for the taxpayer backstop on their guarantees.  

This is promising, but there’s an inherent tension:

Of course, if this rate perfectly reflected the risk versus the cost of the guarantee, there would be no subsidy to mortgage availability.

I perfectly balance the dynamic tension

As I posted over four years ago, in Fannie Mae’s awfully big advantages, the GSEs’ existence is predicated on the expectation that they are a more efficient deliverer of government advantages, and hence more efficiently convert government resources into ongoing affordability.  This is challenging:

I don’t

It is obviously inherently difficult to reach an exactly correct price, yet a long-term fee-like structure in exchange for explicit government backing would help to reduce advantages over private institutions.  

Once that decision is made, the GSEs should be restructured to meet that public policy choice and satisfy three objectives:

How many objectives?

[1] There must be no ambiguity as to government backing. It must be explicit or non-existent.

“Guarantee or guarantee not.  There is no try.”

[2] There must be a clear means of managing the conflict between public support and private profit.

Conflict means tension.  Sometimes it can be balanced.

But sometimes it can’t …

[3] There must be strong regulatory oversight of the resulting institutions.

Those are entirely sound precepts.

Ah, but how to do it?

Sorry, out of time today, answer tomorrow.

 [Continued tomorrow in Part 3.]

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“I would, but I need the loans”

Guy goes to a psychiatrist and says, “Doc, uh, my brother’s crazy; he thinks he’s a chicken.”

And the doctor says, “Well, why don’t you turn him in?”

“I would, but I need the eggs.”

Woody Allen, Annie Hall

That, in a nutshell, represents the views of outgoing Treasury Secretary Hank Paulson, as presented in an important testamentary bequest he has written, romantically entitled by Treasury, Paulson Remarks on the Role of GSEs in Supporting the Housing Recovery:

Who you calling ‘romantic’?

After a cogent recapitulation of how we got here, unnecessary for faithful readers of this blog, the Secretary dives into the GSE conundrum:

Today, Fannie Mae and Freddie Mac are in a temporary form that, while stable, cannot efficiently serve their Congressionally-chartered mission and protect the taxpayers’ investment over the long-term.  

About to become a butterfly or an alien?

The GSEs are critical to getting us through this current period, and this is our first priority. More may need to be done to clarify and simplify their structure and to increase their effectiveness in curbing further housing price correction. But we cannot look only at this short-term need; policymakers must resolve the question of long-term structure because the pre-conservatorship model has been disproven.

As we’ve previously explored, in their pre-conservatorship phase (what ordinary folk might call ‘life’), the GSEs were able to turbocharge their balance sheets, surf the risk curve, generate massive profits, and squelch criticism.

Over time, the GSEs’ advantages enabled them to grow at a phenomenal pace, so that today they have $5.4 trillion in obligations outstanding, held by investors in the U.S. and around the world.

Just for reference, that’s:

            $5,

     400,

                        000,

                               000,

                                     000.

Feed my balance sheet!  Feed me!

As a comparison, that is almost 40% the size of the entire $14 trillion U.S. economy. The systemic risk posed by such size was heightened by the fact that investors assumed that GSE securities were backed by the U.S. government and therefore virtually risk-free, despite repeated statements by consecutive U.S. administrations to the contrary. These debt-holders would be the largest, but not the only, conduits of systemic impact should either GSE fail.

Massive systemic impact?  Pig pile!

Derivative counterparties, for example, would also be overwhelmed by a default of either GSE.

As we’ve seen, the uncontrolled growth of unlicensed insurance – credit default swaps – posed a unique new systemic risk to the global financial system.

With that as background, you’d expect Secretary Paulson to use his conservatorship powers to shut down the GSEs. 

Why should I do what you expect?

As we progressed through the current housing market downturn, investors fled mortgages that carried any credit risk. But because the GSEs take the credit risk on the mortgages they guarantee and because investors believed there was implicit government backing, the conforming loan market continued to function relatively well.

But we needed the eggs …

As a result, the GSE share of new mortgage business rose from 46% in the second quarter of 2007 to 84% in the second quarter of 2008.

Within that innocent small statistic lies a powerful and perhaps painful admission for the Treasury Secretary to make:

“I’d have shut down the GSEs, but I needed the liquidity.”

In 2008, we desperately needed the GSEs. 

Without the GSEs to finance mortgages, it was very clear that mortgage finance would essentially dry up.

That is, the US housing finance system would have seized up, with incalculable consequences for the world economy.

This is what happens when your engine seizes up

So, in the manner of the Breaker Morant court martial, which let the Australians out of prison to help beat off a Boer attack, only to convict them later for having killed other Boers, Secretary Paulson green-lit a massive expansion in GSE lending even while wanting their balance sheets to shrink.

[After helping repel a Boer attack on the prison where he and Morant are being held]

Well, that broke the monotony.

Leaving the GSEs, who are now providing backstop liquidity on five out of every six new mortgages, each of them directly backed by Treasury, actively growing the marketplace even as their ultimate fate is unresolved.

Secretary Paulson thus tries, in the face of this contradictory behavior, to assert a consensus:

The public debate over the long-term structure of the GSEs is dramatically changed today – no one any longer doubts the systemic risk these entities posed.

That’s right, I think – but such consensus is rapidly forgotten in the hurly-burly of Washington politics and budget expediency.  Fortunately – or is it? – during the conservatorship the GSEs are statutorily prohibited from any form of lobbying.

It is clear to all conservatorship is a temporary form, and that returning the GSEs to their pre-conservatorship form is not an option.

All right, even accepting this, should the GSEs, now on trial for reckless financial endangerment, be hanged, sentenced, pardoned, or commended?

How can you condemn me, Your Honor, when I’m so winsome?

Lower mortgage rates enable more potential homebuyers to return to the market and help put a floor under home prices.

A reason to keep the GSEs.

Initially, following our September actions, mortgage rates did fall.

This was after the conservatorship, remember.  Meaning that the Treasury guarantee initially calmed the debt markets.

Market turmoil subsequently increased and mortgage rates rose, but not nearly as much as the cost of other forms of credit. Still, neither the taxpayers nor the economy were getting the full benefit of the agreements put in place to effectively guarantee GSE debt.

Translation: The markets were so spooked they couldn’t see the nose on their face.

Who has time to think?

We could have gone back to Congress to ask for authority to directly guarantee GSE debt, however this would have been difficult to achieve.

The Secretary declines to state the more likely reasons: (a) such a step would probably have been politically irreversible, in effect mooting the deliberations by granting financial amnesty, and (b) the Secretary already had too many powers, and the markets feared he would exercise them – which in turn made their exercise inevitable.

We immediately noted that, given the effective government guarantee and the spread between Treasury rates and those of the GSEs, the taxpayers would profit if the government simply issued Treasuries to buy GSE securities.

Those of us who saw this as it happened were – and are still – astonished. 

“The market can stay irrational longer than you can stay solvent.“

– John Maynard Keynes

Imagine you can buy either of two IOU’s.  One is signed by your friend’s father.  The other is signed by your friend, and co-signed by her father.

Whose IOU is better?

Your friend’s IOU pays 6.5% interest; her father’s pays 5.0%.  You have 150 basis points of favorable risk-curve spread for taking the same risk. 

You buy the 6.5%, don’t you?  The markets didn’t; in fact, there was an avalanche away from GSE securities to Treasuries.

This baffled me then.  It baffles me now.

Run away!  Run away!

On November 25, the Federal Reserve announced a new program to purchase up to $100 billion in GSE debt securities and $500 billion in GSE MBS. This Federal Reserve program had a significant impact. The 30-year fixed rate has fallen from an average of 6.04% the week before the policy was announced to a record low 5.10% last week –

Ah – rate relief

–  accomplishing a vitally important step in addressing this housing correction – lower mortgage rates that may bring additional credit-worthy buyers into the housing market.

And keep other people from defaulting:

[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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