Legacy Loan PPIP versus FDIC Note Sales

It’s difficult to work up much enthusiasm for the Legacy Loan segment of PPIP, a program which will reduce losses for banks by goosing returns for private investors with low cost public leverage. Most people (other than the banks themselves) think banks should be punished with big losses, and most people are not keen on helping the investors who will get richer as a result of the mess do even better. I totally get that. However, I think it’s important to point out that the most commonly expressed alternative to PPIP (just let the banks fail and let the FDIC clean up the mess) will be tremendously expensive to taxpayers.

The argument against PPIP is cogently summarized in this Naked Capitalism post. An excerpt:

As readers may recall, we had been skeptical (and critical) of the Public Private Investment Partnership from the outset. It was the third effort at a program that had failed twice under Hank Paulson, namely, to have banks get dud assets off their balance sheets by selling them to a sucker.
That's why this program has never gotten airborne. It requires a bagholder.
The problem isn't, contrary to PR designed to mislead the public, that the assets are hard to value. That holds only for an itty bitty percentage of the total. The real problem is that the banks are carrying them at above market values, and above any reasonable long term value too (their protests to the contrary). The problem is not the saleabilty of said assets, it's that they don't like the prices. Selling them at below the marked value leads to losses, which in turn would reduce their equity at a time when they have been told, in no uncertain terms, to get more.
So the only way the plan works is if someone overpays. The only party that might have reason to is Uncle Sam. The whole point of the "public private investment" part of this is to disguise the overpayment. So the plan is an opaque subsidy to the banks.

Yes this program is a subsidy to banks. It’s not even opaque; it’s transparent to anyone with a spreadsheet. But it’s wrong to say “the only way the plan works is if someone overpays”. The plan works because someone will pay more if an investment can be leveraged with low cost funds. Imagine a housing market with no mortgage debt; fewer houses would sell, and they would sell for much less.

Here is an example I used in my post, Investor Returns on FDIC Discounted Notes. Let’s say this is a subperforming CRE loan which is still making payments:

Here is the same note sale under PPIP:

Note the low cost leverage allows the bank to get a better price (85) and the investor to get a better yield (12% versus 19%). To state the obvious, more banks will sell assets at 85 than 50, and more investors will invest if they can get 19% instead of 12%. Also, assuming a finite amount of investor money, it will go a lot further with the PPIP program (in this example, $5,000,000 without PPIP, $850,000 with the program). If the loan continues to perform and pays off, the investor is the big winner; they get their yield from the payments, and a nice pop when the loan is repaid at par. But, the Treasury wins too, because under PPIP the Treasury is the 50% equity partner.

Of course, the loan may not perform. If after liquidation costs the underlying collateral value is more than the purchase price, the equity investor will still get a return and the FDIC will get its PPIP loan repaid. If the recovery is less than 80% of the discounted purchase price, the equity is wiped out and the FDIC takes the remaining loss on its PPIP loan. The check against this happening is the fact that the private part of the equity does not want to lose its money. It could happen, but absent collusion with the loan sellers there’s no reason why private equity would intentionally overbid. Avoiding collusion is extremely important. Option Armegeddon gives a good explanation of the risk in this post. However, I think this concern is manageable as long as regulators follow the money trail and severely penalize infractions.

Assuming investors don’t overbid, the only “loser” in this scenario is the FDIC, which only collects a 4% interest rate. Is making this loan the best use of FDIC funding capability? Maybe not, but making too small a return is a lot different than characterizing the FDIC as a bagholder. And, consider the alternative; if the bank fails and the FDIC is the note seller at 50 in the first example, that’s a $3,500,000 loss to the taxpayer, versus a 4% return on a PPIP $6,800,000 loan. If you think FDIC loan sales are the best way to maximize value for the taxpayer, this excellent post from REIT Wrecks will open your eyes.

PPIP is not easy to love, but I’ve not seen a better alternative. If you’re not familiar with the PPIP program see a description here.

Why Did Financial Middlemen Do So Well in the Bubble?

Ryan Avent at The Bellows thinks the compensation finance people received during the boom indicates something was drastically wrong:

When you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.

In a similar vein, Baseline Scenario notes the benefits of financial “innovation” did not flow to the customers:

You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.

By contrast, the historical pattern of the financial sector – rising revenues, rising profits, and rising average individual compensation – is what you get if there is increasing demand for your services and, instead of competing to lower costs and prices, you limit supply. Sure, prices fell on some financial products, but financial institutions encouraged substitution away from them into new, more expensive products, with the net effect of increasing profitability (and compensation).

Why didn’t competitive pressure keep a lid on financial sector compensation? In the mortgage world, it’s because everybody was getting what they wanted. Borrowers were getting great rates, in part because loans were underpriced but also because the broader interest rate environment was very favorable. Loan proceeds were high, terms were relaxed, and loans were quick to be approved on the terms applied for (more on that at my post, “Why Did WAMU Abandon Underwriting Standards?”). On the other side, investors were getting what seemed to be an infinite supply of AAA securities to buy, at yields better than treasuries. No one begrudged the money the RMBS and CMBS middlemen were making.

As it turns out, of course, there was a cost associated with giving everybody what they wanted. That great financing inflated the bubble which is now inflicting huge losses on borrowers, and the securities were grossly underpriced for the systemic risk associated with them.

Does Tim Geitner Read My Blog? Are Regulators to Blame for the Housing Crisis?

From a Washington Post interview over the weekend, via Calculated Risk:

Geithner: "For something this big and damaging to happen it takes a lot of mistakes over time. And it is that combination of things. Interest rate here and around the world were kept too low for too long. Investors made - took a bunch of risks without understanding the risks. They were betting on the expectation that house prices would continue to go up - to go up forever. Rating agencies failed to rate these products adequately. Supervisors failed to underwrite loans with sufficiently conservative standards. So those basic checks and balances failed. And people borrowed too much. It took all those things for it to happen."

From my March 21, 2009 post, “Whose Error Was the Housing Crisis?”:

Here are some errors which had to align to get to where we are today:

1) Borrowers took out loans they couldn’t afford

2) Lenders made loans to borrowers which the borrowers couldn’t afford

3) Ratings agencies rated securities comprised of these loans as safe

4) Security purchasers relied on the erroneous ratings and bought the securities

Any of these parties could have averted the crisis had they avoided their respective error.

Calculated Risk takes Geitner to task for not mentioning two other factors:

Although there were many factors in the housing and credit bubble, the two keys were: 1) rapid innovation in the mortgage industry (securitization, automated underwriting, rapidly expanded wholesale lending, etc), and 2) a complete lack of oversight by regulators. As the late William Seidman wrote in his memoir (published in 1993): "Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid."
Geithner failed to mention the rapid changes in lending and the failure of government oversight as the two critical causes of the bubble. Either Geithner misspoke or he still doesn't understand what happened - and that is deeply troubling.

Although “innovation” and the regulators were factors, they were by no means the key factors. I think the innovations CR refers to should be viewed more as tools than culprits (an NRA bumper sticker for bankers - “Automated Underwriting doesn’t Kill Lenders, Lenders Kill Lenders”). More on this topic at “Why Did WAMU Abandon Underwriting Standards?”

The role of regulators is more complex. Certainly if disclosures were improved or some practices were prohibited, some bad loans might not have been made or bought. However, the errors listed above are so basic and so self-destructive I question the ability of outside intervention to control the behavior.

Low End Infill versus the Exurbs

Lansner on Real Estate has a story and podcast on the successful sellout of a new development in Fountain Valley, CA:

Lissoy tells ocregister.com that the quick Fountain Valley sales may have been a bit of an anomaly due in to its rarity — new homes are hard to find in that city…

Also, the podcast interview reveals Lissoy’s thoughts on how some builders are selling simpler, smaller, cheaper homes and that while the lower-priced end of the market in Orange County is doing well, mid-priced and luxury residences are a tough sell.

The success of this in fill development is an interesting contrast to what’s going on in the exurbs like Victorville. For those not familiar with Southern California geography, here’s a map:

The “A” is Fountain Valley. Victorville is the home of the now infamous development demolished by a Texas lender after foreclosure (watch the video here).

Related exurb posts:

Exurbs: How Far Is Too Far?

Underwater Homes, Exurbs, and Income

Foreclosures in the Exurbs

Why Are the Nation’s Worst Housing Markets in the Exurbs?

How Much REO Should A Lender Have?

Bubble Meter notes this story from Business Week:

Buyers looking to purchase foreclosures should still have plenty of opportunities. Only 30% of bank-owned properties are listed on the multiple listing services, says Rick Sharga, senior vice president at foreclosure listing firm RealtyTrac. He figures banks still own as many as 500,000 properties that they want to sell but haven't put on the market.
A home many not be listed because the bank is wrestling with title, repair or owner right of redemption issues. (Several states such as Michigan and Wisconsin give the previous owners the chance to buy back a home that's been foreclosed on). Banks may also be holding houses off the market because selling them now would lower prices even further. Foreclosures typically sell at a 31% discount to similar homes whose owners aren’t in distress. Listing all those homes now, Sharga says, “would have a devastating impact on inventory and pricing." ...

Let’s take the last idea first. No doubt listing a lot of REOs at once does have a negative impact on the market. But, the idea that lenders are holding properties off the market to maintain prices suggests a level of cooperative action for the collective good which I don’t think is occurring.

Having 70% of your REO inventory sitting around unlisted sounds bad, but is it really? There’s always going to be some down time between the foreclosure sale and the listing (evictions, cleaning and painting, etc., say 45 days). Once it’s listed, say it takes 60 days to sell. Then, it takes a while to close (say 60 days). Taking into account these factors, what percent of your inventory at any given time will be listed?

A high percentage in the list stage probably means the properties aren’t moving because the list price is too high. If you’re running an efficient REO shop, having 30% listed at any given time sounds about right.

Given the inventory of homes for sale, is it possible to sell an REO in 60 days? Apparently it is in Phoenix. The NYT, via Calculated Risk:

The low end of the real estate market [in Phoenix] — and in some equally hard-hit places like inland California and coastal Florida — is becoming as wild as anything during the boom.
One real estate agent was showing a foreclosed house to a prospective client when a passer-by saw the open door, came in and snapped up the property. Another agent says she was having the lock changed on a bank-owned home when a man happened by, found out from the locksmith that it was available, and immediately bought it. Bidding wars are routine.

The New Yorker had an interesting story in their April 6, 2009 issue on the experiences of a broker in LA specializing in REO sales (abstract here).

The Problem With Partners

From Luke Johnson’s column in the Financial Times, “Time of Trial Brings Out Our Litigious Side”:

The truly vicious [lawsuits] are those where professional partners have a dispute…Falling out can arise through envy, through desperation, through honour, and a feeling that some are not pulling their weight. Writs are being served all over the place for non-payment of debts, warranty claims over failed acquisitions, unfair dismissal and who knows what. The air is thick with recriminations and resentment, as the Great Recession leaves lots of people broke, unemployed or looking stupid and out for revenge.

Partnerships in various forms (general partnerships, limited partnerships, limited liability companies, tenancy in common) are very common ownership structures in commercial real estate. Sometimes they represent equals pooling resources to acquire and operate properties larger than the individual partners could acquire on their own. More often, the partners bring different things to the table; for example, investors with money but without a lot of real estate expertise invest funds with a general partner that has expertise but not a lot of money.

This all works well until it doesn’t. When a property severely underperforms, few partnerships survive. If additional cash is required, the money investors often balk or expect the general partner to contribute an equal amount or step aside. Even if contributing additional cash to save the investment makes sense, too often partnership differences prevent an economically rational solution.

Lenders often depend on the financial strength of the investor partners, and don’t realize that more often than not the money partners will not support a deal when they’ve lost confidence in the general partner. The greater the number of partners, the greater the difficulty. The sad story of DBSI (see this link) is an extreme case which is being repeated on a smaller scale on a daily basis.

The safest ownership structure is a single experienced, financially strong operator. If you can’t have that, a partnership of equals is your best bet. Partners with unequal resources are their own source of trouble when the going gets tough.

“Legacy” CMBS?

What is a “Legacy”? From Merriam Webster:

Main Entry: ¹leg·a·cy 1 : a gift by will especially of money or other personal property : bequest 2 : something transmitted by or received from an ancestor or predecessor or from the past <the legacy of the ancient philosophers>

Usually a legacy is good, but sometimes you inherit something really screwed up. When WAMU tanked 18 days after Alan Fishman took the CEO job, no one blamed Fishman (although some thought the $7.5M he was paid for the 18 days was a little excessive). The key point here is that it’s only a legacy if you inherited it. It’s not a legacy if the problem was created on your watch.

So, when the Federal Reserve says “Legacy CMBS” is now eligible collateral for the TALF program, I think they’re misapplying the word. These securities would be legacy securities if the management responsible for buying and/or originating them had been replaced, and new management was cleaning up the mess. But, in most cases that management change hadn’t occurred. Perhaps in their own minds management has changed (“That was the old me – the new me would never do those deals”), but I don’t think that counts.

Granted, calling the securities what they are - “wish we were never involved with these CMBS” – is clumsy. We need something short and catchy to describe them. I propose “Whoops CMBS”, in honor of the WPPSS bond default back in 1982. Of course, that was just a $2.25B default; maybe we should call them “Big Whoops CMBS”. Or maybe we could call them “Do-over CMBS.”

Although the misuse of the word ”legacy” in this financial crisis has been irritating me for a while, the impetus for this post actually came from a non-real estate story (yes, I do have other interests). Ian Media Networks filed bankruptcy yesterday, and this quote caught my eye:

“We are pleased with the support from our first lien senior debt holders to resolve the company’s legacy debt issues and fund our television growth plans,” said Brandon Burgess, Ion’s chairman and chief executive officer, in a statement.

Out of curiosity I took a look at Mr. Burgess’s bio, and it turns out he joined ION in November, 2005. Even if the “legacy debt issues” were the result of debt taken on before then, the debt and equity markets were available on pretty favorable terms until last year. Instead of “legacy debt issues”, I think this is more like “didn’t deal with it when I should have debt issues.”

Recommended reading for more on the way people distance themselves from their mistakes: Carol Tavris and Elliot Aronson, Mistakes Were Made (But Not by Me).