Ever seen a Great Divide? (http://en.wikipedia.org/wiki/Continental_Divide)
In real estate, there is a lot of talk about a Great Divide that exists between buyers and sellers these days. Also referred to as the bid/ask spread, we are in a situation where buyers have one set of demands and sellers have a different set of expectations, often the two do not meet. But, given time and a hard push off the plank by lenders, this disconnect will resolve itself.
There is a very different Great Divide occurring in commercial real estate that is generally unrecognized - that between investors and lenders. Lenders want exceptionally safe deals, low loan to values, high rate spreads, built-in floors, etc. Investors want the deals with lots of distress, big potential for upside and growth, some current income, etc. Find a deal that looks like those two descriptions simultaneously and you have a pot of gold at the end of the rainbow.
This is the big secret that is underlying the current freeze occurring in commercial real estate markets - it isn't just that buyers and sellers can't agree, it is is that lenders and investors are at odds. Great Divides are difficult places, they are hard to cross and unforgiving. The good news is that the commercial real estate market will unthaw much sooner than a Great Divide will level out, the bad news is that neither is likely to occur soon.
Thursday, January 29, 2009
Sunday, January 25, 2009
Community Reinvestment Act
The Community Reinvestment Act (CRA) is a driving force in the housing and community development field. For more info/background on CRA, see www.ffiec.gov.
Once the economic stimulus bill is passed, CRA is expected to come back to the forefront of the legislative agenda in the House. In part this is because it is important to housing and community development investment, in part it is because the banks want it changed, in part it is because the federal government now has a financial stake in institutions through more than just deposit insurance, in part it is because Rep. Barney Frank chairs the House Financial Services Committee, etc.
Here are 4 suggestions for regulatory change to make the program better:
1. greater transparancy of what geographic areas/customers qualify for CRA activities, how banks are evaluated, etc. Talk to most loan officers and they have no idea how/why/where their bank is evaluated, let alone members of the community. If loan officers don't know, it is a given that most members of the community don't understand it either. With today's technology, there is no reason this type of information can't be provided on-line using maps, images, charts, etc.
2. evaluations based on customer (i.e. both depositors and borrowers) addresses rather than based on deposit dollars. As it is, deposits can be skewed by all types of things but the current subprime debacle shows us that both the deposit base and the customer base matter to a bank's involvement in communities.
3. use some sort of peer-based relative measure of performance for ratings/evaluations rather than an absolute measure. This change will introduce market forces and competition to the process.
4. consider the requirements that should come with federal aid and whether CRA should be expanded to other consumer-oriented companies that use financial assistance. Taxpayer money isn't without strings - to avoid a free-for-all, takers should feel as though they are facing either the gallows or the taxpayer's requirements with the gallows looking like a viable choice.
Once the economic stimulus bill is passed, CRA is expected to come back to the forefront of the legislative agenda in the House. In part this is because it is important to housing and community development investment, in part it is because the banks want it changed, in part it is because the federal government now has a financial stake in institutions through more than just deposit insurance, in part it is because Rep. Barney Frank chairs the House Financial Services Committee, etc.
Here are 4 suggestions for regulatory change to make the program better:
1. greater transparancy of what geographic areas/customers qualify for CRA activities, how banks are evaluated, etc. Talk to most loan officers and they have no idea how/why/where their bank is evaluated, let alone members of the community. If loan officers don't know, it is a given that most members of the community don't understand it either. With today's technology, there is no reason this type of information can't be provided on-line using maps, images, charts, etc.
2. evaluations based on customer (i.e. both depositors and borrowers) addresses rather than based on deposit dollars. As it is, deposits can be skewed by all types of things but the current subprime debacle shows us that both the deposit base and the customer base matter to a bank's involvement in communities.
3. use some sort of peer-based relative measure of performance for ratings/evaluations rather than an absolute measure. This change will introduce market forces and competition to the process.
4. consider the requirements that should come with federal aid and whether CRA should be expanded to other consumer-oriented companies that use financial assistance. Taxpayer money isn't without strings - to avoid a free-for-all, takers should feel as though they are facing either the gallows or the taxpayer's requirements with the gallows looking like a viable choice.
Monday, January 12, 2009
The Future of the GSEs
Paulson recently spoke on the subject of his actions regarding GSEs and the his recommendations for their future. Given that he covered two of my favorite subjects (housing and P3s), it got my attention.
Paulson makes 3 broad claims in this article that I disagree with, one of which is worth emphasizing:
1) it is the GSEs' mixed-incentive structure that allowed them to become so big. This is an odd place for Paulson to stake his claim given that he turned the TARP into a mixed-incentive structure...
2) the GSEs can help the economy return to normalcy by keeping mortgage rates low and by mitigating foreclosures. Artifically low rates were part of what got us where we are, but addicts will be addicts...
3) the question re: the GSEs' future is how much we want the government to reduce mortgage interest rates by taking on mortgage credit risks. It is this issue (i.e. the role of GSEs in housing policy) that I want to address.
Yes, one way GSEs can affect housing policy is by taking on mortgage credit risk. Whether or not this credit risk is appropriately priced and/or the benefits of government-sponsored funding are passed through to borrowers is a question that has been long debated. Yes, it is important to ask whether the private sector couldn't address most issues of credit risk adequately without GSEs. But no, I don't think credit risk is the only, or even primary, role for the GSEs.
The GSEs' primary role is actually contained in Paulson's reference to covered bonds as a potential solution to the current situation. Without government involvement, most mortgage rates and mortgage terms would be variable (rather than fixed) and short-term (less than 30 years). Why? Because this would match the rate and term obtained on funds used by financial institutions and mortgage market participants to create mortgages.
Are variable rates and short maturities good public policy? For households that can bear financial risk, those kinds of terms are fine and perhaps even preferable. But for households on fixed incomes, limited incomes, or purchasing their first home and needing stability in their housing cost, short-term variable rate debt can be deadly. And it is here, in the world of creating more long-term fixed rate mortgages than would otherwise be generated by the market, that GSEs and housing policy can come together.
It is generally misunderstood that GSEs borrow on variable rates with relatively short maturities and use it to fund fixed rate long maturity mortgages (they also used it to fund a lot of short-term variable rate mortgages as well but that is a different issue). That's why we all care that debt holders might no longer want to buy GSE debt - if the GSEs financed all debt with rates and terms matching the mortgages that were purchased, no one would care that the demand for GSE debt might decline. But, when the GSE debt has a short maturity that is due and subject today's rates and the mortgage asset has a long maturity at a fixed rate, well, Houston...we have a problem and it looks a lot like the last one (S&Ls in the 1980s).
Why would any entity create a mismatch? Because it generally is financially profitable to do so as long as short-term rates remain relatively low, long-term rates are relatively high, and there is not a liquidity problem with rolling the short-term debt over each period (i.e. the achilles heal in the current environment).
This is the real question for the next administration and financial markets to resolve - does changing who creates and uses mismatched funding (i.e. S&Ls, investment banks, commercial banks, the private sector, or GSEs) make a difference in who carries the risk, how well it is handled, and the impact it has on the market place? I am going to suggest that it possibly does, but in a sort of indirect way. What are long-term rates comprised of: inflation expectations, risk premiums (i.e. stability of returns), overall level of rates, etc. No one entity controls those factors, but who has the most influence on them? Monetary and fiscal policymakers. So, to the extent that mismatched funding is best influenced by monetary and fiscal policymakers, it seems that is also best used by monetary and fiscal policymakers. In other words, why should the GSEs or the government take on mortgage credit risk or issue adjustable rate loans that are less than fully amortizing? The private sector can do that just fine. But, it is also very unlikely the private market will address the power and stability of a fully amortizing 30-year fixed rate loan to the level desired by public policy.
Underneath the surface of Paulson's political argument (i.e. this problem started before I came, I tried to fix it early on, I couldn't get it done because of politics, that's why I took the extraordinary steps that I did) lies the political-economy argument that should be addressed by this Congress and this administration - mismatched funding is a powerful but dangerous game that thrives on imbalances in the financial markets. Understanding that point is critical for determining the best way forward for the future of the GSEs and housing policy.
Paulson makes 3 broad claims in this article that I disagree with, one of which is worth emphasizing:
1) it is the GSEs' mixed-incentive structure that allowed them to become so big. This is an odd place for Paulson to stake his claim given that he turned the TARP into a mixed-incentive structure...
2) the GSEs can help the economy return to normalcy by keeping mortgage rates low and by mitigating foreclosures. Artifically low rates were part of what got us where we are, but addicts will be addicts...
3) the question re: the GSEs' future is how much we want the government to reduce mortgage interest rates by taking on mortgage credit risks. It is this issue (i.e. the role of GSEs in housing policy) that I want to address.
Yes, one way GSEs can affect housing policy is by taking on mortgage credit risk. Whether or not this credit risk is appropriately priced and/or the benefits of government-sponsored funding are passed through to borrowers is a question that has been long debated. Yes, it is important to ask whether the private sector couldn't address most issues of credit risk adequately without GSEs. But no, I don't think credit risk is the only, or even primary, role for the GSEs.
The GSEs' primary role is actually contained in Paulson's reference to covered bonds as a potential solution to the current situation. Without government involvement, most mortgage rates and mortgage terms would be variable (rather than fixed) and short-term (less than 30 years). Why? Because this would match the rate and term obtained on funds used by financial institutions and mortgage market participants to create mortgages.
Are variable rates and short maturities good public policy? For households that can bear financial risk, those kinds of terms are fine and perhaps even preferable. But for households on fixed incomes, limited incomes, or purchasing their first home and needing stability in their housing cost, short-term variable rate debt can be deadly. And it is here, in the world of creating more long-term fixed rate mortgages than would otherwise be generated by the market, that GSEs and housing policy can come together.
It is generally misunderstood that GSEs borrow on variable rates with relatively short maturities and use it to fund fixed rate long maturity mortgages (they also used it to fund a lot of short-term variable rate mortgages as well but that is a different issue). That's why we all care that debt holders might no longer want to buy GSE debt - if the GSEs financed all debt with rates and terms matching the mortgages that were purchased, no one would care that the demand for GSE debt might decline. But, when the GSE debt has a short maturity that is due and subject today's rates and the mortgage asset has a long maturity at a fixed rate, well, Houston...we have a problem and it looks a lot like the last one (S&Ls in the 1980s).
Why would any entity create a mismatch? Because it generally is financially profitable to do so as long as short-term rates remain relatively low, long-term rates are relatively high, and there is not a liquidity problem with rolling the short-term debt over each period (i.e. the achilles heal in the current environment).
This is the real question for the next administration and financial markets to resolve - does changing who creates and uses mismatched funding (i.e. S&Ls, investment banks, commercial banks, the private sector, or GSEs) make a difference in who carries the risk, how well it is handled, and the impact it has on the market place? I am going to suggest that it possibly does, but in a sort of indirect way. What are long-term rates comprised of: inflation expectations, risk premiums (i.e. stability of returns), overall level of rates, etc. No one entity controls those factors, but who has the most influence on them? Monetary and fiscal policymakers. So, to the extent that mismatched funding is best influenced by monetary and fiscal policymakers, it seems that is also best used by monetary and fiscal policymakers. In other words, why should the GSEs or the government take on mortgage credit risk or issue adjustable rate loans that are less than fully amortizing? The private sector can do that just fine. But, it is also very unlikely the private market will address the power and stability of a fully amortizing 30-year fixed rate loan to the level desired by public policy.
Underneath the surface of Paulson's political argument (i.e. this problem started before I came, I tried to fix it early on, I couldn't get it done because of politics, that's why I took the extraordinary steps that I did) lies the political-economy argument that should be addressed by this Congress and this administration - mismatched funding is a powerful but dangerous game that thrives on imbalances in the financial markets. Understanding that point is critical for determining the best way forward for the future of the GSEs and housing policy.
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