Showing posts with label mortgages. Show all posts
Showing posts with label mortgages. Show all posts

Saturday, December 29, 2018

29/12/18: Vultures, Prime Ministers and the Mud of 'Values' in Newtonian Finance


In a recent conversation with the Irish Times (https://www.irishtimes.com/news/politics/leo-varadkar-defends-vulture-funds-and-criticises-practices-of-irish-banks-1.3742477), Ireland’s Taoiseach (Prime Minister), Leo Varadkar, “has defended so-called vulture funds”, primarily U.S-originating buyers of distressed performing and non-performing mortgages, “stating that they are more effective at writing down debts than banks which “extend and pretend” rather than reaching settlements with homeowners.”

Mr Varadkar alleged that:

  • “…homeowners whose mortgages were sold off to such funds would be “no worse off” than those whose loans were owned by the banks.”
  • And, “he disagreed with the use of the term “vulture fund” and criticised the practices of our own banks.”

A direct quote: “I’m always reluctant to use the term vulture funds because it is a political term. What we’re talking about here is investment banks, investment funds, finance houses, there are lots of different things and lots of different financial entities there and the term is used, vulture funds. But you’ll know from the numbers that they’re often better at write-downs of loans than our own banks. Our own banks tend to ‘extend and pretend’ rather than coming to settlements with people.”

Let’s deal with Mr. Varadkar’s claims and statements:


1) Is ‘vulture fund’ or VF a political term? 

The answer is no.

As a professor of finance, I use this term without any political context or value judgement. As do Investopedia, and the Corporate Finance Institute (CFI), along with a myriad of text books in finance and investment, as do the Wall Street, Bloomberg, Reuters, Wall Street Journal… In fact, all of the financial sector. For example, CFI defines VFs as “a subset of hedge funds that invest in distressed securities that have a high chance of default”. So, Mr. Toaiseach, the term ‘vulture fund’ is a precisely defined concept in traditional, mainstream finance. It is not a political term and it is not a term of ethical value assigned to a specific undertaking. In fact, as a finance practitioner and academic, I see both positive and negative functions of the VFs in the markets and society at large. Just as a biologist would identify positive aspects of the vulture species in natural environment.

Vulture Funds are invested in and often operated by ‘different financial entities’, including ‘investment banks’. They are a form of ‘investment funds’ when they are stand-alone undertakings. Which covers the entirety of the Taoiseach’s argument on this.

As an aside, a term ‘financial house’ used by the Taoiseach is not a definable concept in finance in relation to mortgages or other assets lending. Instead, FT defines a financial house as “A financial institution that lends to people or businesses, so that they can buy things such as cars or machinery. Finance companies are often part of commercial banks, but operate independently.” 

In other words, financial organisations and entities purchasing distressed and insolvent Irish mortgages cannot be classified as ‘financial houses’, and any other classification of them allows for the use of the term Vulture Fund.


2) Can VFs be regulated into compliance with the practices other lenders are forced to adhere to?

The answer is no. 

They simply cannot, because VFs always, by their own definition, pursue a strategy of recovery of asset value, not the recovery of debtor solvency. Regulating them as any other undertaking, e.g. banks, will remove their ability to exercise their specific strategies. It will de facto make them non-VFs.

Here is CFI on the subject: ““Vulture” is a metaphor that compares vulture funds to the behavior of vulture birds that prey on carcasses to extract whatever they can find in their defenseless victims.” Note the qualifier: defenceless victims: CFI is not a softy-lefty entity that promotes ‘victims rights’, but even corporate finance professionals recognise the functional aspects of the vulture funds. VFs cannot trade/exist on the same terms of traditional lenders, because: (1) they are not lenders (they do not pursue transformation of short term funding into long term assets, as banks do), (2) they have zero (repeat zero) social responsibility (no legislation can induce them to have any such a mandate in terms of social responsibility in funding assets as banks have, because such a mandate would invalidate the VFs investment model), and (3) unlike lenders, VFs deal with specific types of assets and specific areas of risk-pricing that cannot be covered by the lending markets precisely because of the implied conflict between the lenders’ longer-term market strategies, and the need to recover and capture asset values. In other words, you can’t make vultures be vegans. And I place zero political or social value in these arguments. It’s pure finance, Taoiseach.

“Vulture funds deal with distressed securities, which have a high level of default and are in or near bankruptcy. The funds purchase securities from struggling debtors with the aim of making substantial monetary gains by bringing recovery actions against the owners. In the past, vulture funds have had success in bringing recovery actions against sovereign governments and making profits from an already struggling economy.”

What this tells us is (a) VFs pursue legal seizures of assets from debtors as a norm (in the case of mortgage holders - this amounts to evictions of renters and forced sales of owner occupied properties); and (b) VFs are good enough at that job to force sovereign nations into repayments (which puts into question even the theory of efficacy of any consumer protections the Government can put forward to restrict their practices).


3) Are debtors better off or as well off under the vulture fund management of their debts as under other banks’ management?

The answer is: it depends. 

If a debtor genuinely cannot recover from insolvency, then forcing earlier insolvency onto them actually provides a benefit of offering an earlier restart to a ‘normal’ financial functioning of the debtor. This is the ‘clean slate’ argument for insolvency, not for VFs. In order to achieve this benefit, the insolvency must be done with a pass-through of losses write-downs to the debtor (avoiding perpetual debt jail for the defaulting debtor). The VFs simply do not do this on any appreciable scale, and are even less likely to do so in the tail end of the insolvency markets (later into insolvency cycle).

Why? Because they have no financial capacity to do so. Do a simple math: suppose a VF purchases an asset for EUR60 on EUR100 of debt face value (40% discount on par). Costs of managing the asset can be as high as 5%. Cost of capital (and/or expected market returns) for VFs is ca 15%-18% due to high risk involved. The asset is assumed to return nothing - it is severely impaired, like a mortgage that is not being re-paid. To foreclose the asset, the VF has to pay another cost of, say, 10% (legal costs, eviction-related and enforcement costs, etc including costs involved in disposing of underlying property against which the mortgage is written). And the process can take 1-2 years. Suppose we take the mid-point of this at 1.5 years. There is uncertainty about the legal costs and timings involved. Suppose it involves 10% of the total mortgages pool purchased by the fund. The cost or recovering funds for the VF, accounting for compounded interest on VF’s own funding, is now EUR22.99-25.91. Take the lower number of this range, at EUR22.99 per EUR60 asset purchased. Suppose the VF forecloses on the house and sells it. Suppose the house is an ‘average’ one, aka, consistent with the current residential property price index metrics, and the mortgage was written around 2005-2007 period. This means the house is roughly 20 percent under the valuation of the mortgage at the mortgage origination. So the VF will get EUR80 selling price on EUR100 loan. If the mortgage was 90% LTV, roughly EUR90. Take the latter, more favourable number to the VF. and allow for 1.5 years cumulative asset growth of 20% (property values inflation). VF’s cumulative returns over 1.5 years are 25.06% or 16.04% annualised. The VF has barely performed to its market returns expectations. There is zero room for the fund to commit any write downs to homeowners in this case. None in theory, none in practice.

In contrast, the banks do not face market expectation of returns in excess of 15% pa on their assets, nor do they face the cost of funding at 15-18%, which means they can afford passing discounts to the homeowners.

The situation is entirely different, when a debtor can recover from insolvency, e.g. via pass-through to the debtor of market value discounts on their debt (30-40% that VFs would get in the sale by the bank), or via restructuring of the loans, a VF will never - repeat, never - allow for such a restructuring, because it results in extending the holding period of the asset required for recovery. VFs are not in business of extending, and, yes, Taoiseach is correct on this, they are also not in business of pretending.

Now, the logic of selling non-recoverable (via normal routes of working out) assets to VFs can accelerate the speed of insolvency. But the logic of selling recoverable assets to VFs only forces insolvency onto borrowers where they do not require such for the recovery. Any restructured, but performing mortgages sold to VFs will be inevitably foreclosed (insolvency created), even though they are recoverable (insolvency is not optimal). And there is nothing the Government can do, short of forcing VFs to become non-VFs, to avoid this.

I append zero, repeat zero, social impact costs to this analysis. These are, however, material in the case of mortgages and foreclosures, especially due to the adverse impact of such actions on demand for social housing, and in light of ongoing housing crisis in Ireland.


4) Are VFs subject to “the the same regulations and the same consumer protections as the banks,” as the Taoiseach claimed?

Answer is no. 

VFs do not adhere to the same regulations and the same oversight as the banks. The proof of this is the fact that Government is currently supporting legislative attempts to bring VFs into the regulatory net, aka the Michael McGrath’s bill that FG support. If the Government is supporting a new legislation, the Government is admitting that current regime of regulation for the VFs is not sufficiently close to that of the banks. If the current regime is sufficient to cover consumer protection to the extent that the banks regulations are, then why would there be a need for a new legislation?


In a summary: the Taoiseach is simply out of his depth when it comes to dealing with the simple, well-established in mainstream finance, concept, such as the VFs. This is doubly-worrying, because the Taoiseach is leading the charge to provide a new regulatory regime, to cover the areas that he appears to have little understanding of.

Per Taoiseach: “We support that and we are going to make sure that anyone who has a mortgage, who is repaying their mortgage, making a reasonable effort to pay it, continues to have the exact same protections, the exact same consumer protections as they would if the loan was still owned by the banks.”

This is a wonderfully touchy statement of the objective. Alas, Mr. Taoiseach, you can’t have asset ownership by the VFs combined with the regulatory protection measures that invalidate VFs’ actual business model. And you can’t scold the banks for ‘extending and pretending’ on borrowers, while at the same time codifying these ‘extensions’ for all investment funds, including the VFs. The cake vanishes once you eat it. Finance is Newtonian, in the end.

Friday, November 20, 2015

20/11/15: U.S. Households' Deleveraging: Painful & Long


An interesting set of charts plotting trends in U.S. household credit arrears over time, courtesy of the @SoberLook


Three things stand out in the above. 

Per first chart, credit cards debt is the only form of credit that saw arrears drop below pre-crisis levels. It also happens to be the form of debt that is easiest to resolve - largely unsecured and easily written down. Mortgages debt arrears - while declining significantly from crisis peak - still remain at levels above pre-crisis averages. Ditto for all other forms of household debt. 

Also per first chart, improving labour markets conditions are doing zilch for student loans arrears. These remain on an upward trend and close to historical highs.

Thirdly, from the second chart, new volumes household credit in arrears in 3Q 2015 are broadly consistent with the situation in the same quarter in 2014, with new arrears falling to 4Q 2007 levels, but still running at levels well above 2003-2006 levels.

This, in an economy characterised by more robust labour markets than those of Europe and by personal insolvency regimes and debt resolution systems more benign than those in Europe. In simple terms: deleveraging out of bad debt is a painful, long-term process. Good luck to anyone thinking that raising rates will do anything but delay it even longer and make the pain of it even greater.

Wednesday, March 13, 2013

13/3/2013: IMHO press release on CBofI Mortgages Plan

Here is the IMHO press release on today's Central Bank announcement relating to mortgages arrears resolution. This sums up my views and views I agree with.


Press release

March 13th, 2013

Government and Central Bank mortgage plan throws borrowers to the wolves, says Irish Mortgage Holders Organisation


Todays announcement that the Central Bank of Ireland will set targets for six major banks in relation to restructuring of mortgages in arrears is a sad extension of the failed policies of the past that have allowed Irish mortgages crisis to spin out of control and have resulted in total mortgages arrears of unprecedented proportions.

The latest plan lacks any prescriptive solutions and allows banks to determine the nature, the extent and the application of all solutions while setting the terms and conditions with out any supervision. The plan delivers no improvement in transparency of solutions to be offered to borrowers by the lenders and provides no protection for borrowers against potential abuses by the lenders of their powers.

While the review of the code of conduct is to be welcomed the review fails to deliver a meaningful improvement to the previous practices and does not allow for an effective protections for borrowers.

Mr Elderfield's statement claiming that the regulator intends to remove the current cap on number of times a bank is allowed to contact or call or visit a borrower ahead of the review of the code of conduct is very concerning. In our view, the central bank is underestimating the extent to which the banks are willing to go to pressure borrowers. It also pre-empts the actual review of the code of conduct for mortgage arrears..

The borrower is exposed and has been afforded no protection in this plan. The lenders are incentivized to maximize the rate of extraction of savings and income from the already distressed borrowers prior to completion of any long-term forbearance or restructuring agreements, thus reducing the effective relief that can be accorded the borrower in the end.

The net effect of this plan will be additional stress on mortgage holders and more power to banks without an appropriate safety net or independent arbitration for mortgage holders.

The Irish mortgages crisis, now into its sixth year, is still raging beyond any control of the authorities. Per latest figures from the Central Bank of Ireland, 186,785 mortgages (including BTL) in Ireland are at risk (in arrears, restructured or in repossession), accounting for an unprecedented 25.3% of all mortgage accounts still outstanding. The balance of mortgages at risk,  relative to the total balance of all mortgages outstanding has reached a catastrophic figure of 31.9%. With some 650,000-750,000 estimated people residing in the households with the principal residence in mortgages difficulties, we are witnessing a wholesale destruction of savings, pensions and wealth of several generations of Irish people.

State response to this crisis to-date has been woefully inadequate and erring on the side of the financial institutions. Todays announcement offers no hope for any meaningful change in the ways Irish authorities treat ordinary borrowers in distress.

For further information contact:

David Hall


or

Constantin Gurdgiev

IMHO

Friday, January 2, 2009

Can lower interest rates spur housing market growth?

In an earlier post I wrote:
Elsewhere in Europe and the US, similar [to the Irish banks] capitalization schemes have failed to reduce the cost of corporate borrowing or to restart lending to the households. In the UK, a £43 billion capital injection scheme has been in place for almost two months and the supply of consumer and business credit continues to fall - whether due to demand slowdown, lenders withdrawal from the market or both. In the US, massive banks’ capital supports have lowered the mortgage rates, but there is no meaningful increase in new mortgages uptake.

Here is more evidence that lower rates and re-capitalizations of banks are not driving new mortgages applications up:
"British interest rates have already been slashed to 2%, their lowest level since 1951. ...Amit Kara, an economist at UBS ...expects rates to be cut to just 1% next week and to 0.5% by March. British interest rates have never gone below 2% since the central bank was created in 1694,"
but
"Mortgage approvals for house purchase ...fell to just 27,000 in November, the lowest level since the series began in January 1999 and a third of its level a year ago."

Ditto in the US, where (Marketwatch): "The average rate on 30-year fixed-rate mortgages fell for the ninth week in a row this week, setting another record low". The 5.1% mortgage rate recorded last week is the lowest since the data started in 1971.

Another report by the Mortgage Bankers Association (see details here) showed that the resurgence in the US mortgages issuance (155% year-on-year) on the foot of dramatic interest rates declines is accounted for by re-financing applications (83%). Of the remainder, some 2/3 of mortgages growth was due to the Federal Government purchases.

In short, the answer to the question in the title is NO.

Lower interest rates are only a part of the solution, but the paramount condition for rekindling the markets is that households must de-leverage significantly enough to bring their debt in line with their after-tax incomes. This is a lengthy and painful process that can be aided only by
  • income tax cuts or rebates (US);
  • consumption tax cuts (UK); and
  • liberal personal bankruptcy laws (US).
Even with these in place it has taken US households 6 months of straight contraction in indebtedness to start (cautiously) testing the re-mortgage market waters again.

None of these policies are even being tried in Ireland!