Soft debt: the kindhearted banker
The curious case of the kindhearted banker
“Soft debt, Holmes? What on earth do you mean?”
The great detective smiled. “Debt that is not hard,” he said cryptically.
Watson chafed at the straight lines he was being given
“Very well then,” answered Watson, throwing down his Times and recognizing the inevitability of a Holmes exposition, “what is hard debt?”
“Hard debt was good enough for the Bank of England!”
Money is a commodity, began Holmes with fingertips pressed aristocratically together, that comes in four kinds.
Hard debt in the upper left quadrant …
A lender is someone who rents money to a borrower. In a typical loan, such as that provided by the Bank of England, the lender makes a hard-headed decision and demands a loan with hard — mandatory — repayment terms:
What is hard debt?
One of the fundamental four kinds of money, with these characteristics:
1. Fixed amount. A sum is provided up front from lender to borrower.
2. Interest rate. Fixed or floating, a rate is stated.
3. Term. The loan comes due after a finite time.
4. Payment sequence/ regularity. The debtor makes regular payments, most commonly in equal amounts.
5. Collateral. Often, beyond the debtor’s pledge to repay, the lender may claim against a piece of property (real estate) to satisfy the debt.
6. Security. The debtor has a legal instrument (mortgage, bond) that protects its preferred access to the collateral.
In making a loan, the banker has only one motivation: financial gain. Given market dynamics of supply and demand, lenders provide capital to high-paying borrowers, and those borrowers are able to pay the debt back only by seeking maximum income — which, in the affordable housing context, means market rents. In equilibrium markets, therefore:
Money at market cost produces market rate housing
Given equilibrium markets, housing affordability means a cost-value gap:
The cost-value gap
By definition, efficient markets produce market housing: market quality, at market price (sales price or rental). Affordable housing is intended to provide market quality at below-market price. There is thus always a cost-value gap:
+ Cost of providing market-quality housing (plus affordability rules)
– Value of housing as affordable (affordability restrictions reduce value)
= Cost-value gap (what government must cover)
The cost-value gap represents the amount government must deliver to induce markets to create the desired housing.
Solving the cost-value gap, Holmes continued inexorably, means solving the affordable housing lemma:
Affordable housing: the funding lemma
Affordable housing
=
+
Government contribution
Watson was severely nettled to discover that ‘lemma’ was indeed a word.
Now the government may choose not to put its contribution in up front, as a grant or direct capital subsidy. Indeed, there are strong reasons not to do so:
1. The pinch point for underwriting viability arises, therefore, at inception/ development.
2. Inflation helps property viability. Cash flow may be zero or small at initial occupancy, and rise over time, even within the same affordability levels.
Given these, government has found it effective to create social lending by providing soft debt:
What is soft debt?
Soft debt is capital that typically has the following features:
a. Loan. Expectation of repayment/ recovery. Distinguished from equity (ownership participation of indefinite duration), and from grant (capital provided with no expectation of economic repayment/ recovery).
b. Deferred repayment. Unlike a normal loan, repayment is deferred so that the borrower’s payments required are less than the interest accrued.
c. Compliance/ recapture. Compliance is maintained via a covenant whose enforceability is normally tied to the financing instrument/ security. Recapture is achieved by accelerating the soft debt.
d. Affordability covenant. The borrower or recipient pledges to provide affordability in one of several ways: price, rent, eligibility.
e. Favorable interest rate. Not mandatory but common as a further element in affordability.
When then
use soft debt?
Soft debt in the upper right quadrant …
Several reasons:
1. Close the cost-value gap without using high leverage on hard debt.
2. Capture economics as inflation improves cash flow.
3. Act as a check on market conversion by providing acceleration in full if the property goes market.
4. Provide an economic enforcement mechanism for affordability compliance.
Who provides soft debt? Either:
· Government directly (HOME, CDBG, HoDAG, UDAG, M2M soft seconds).
· Private lenders (”social lenders”) who have program-related investments (PRIs) that mix grant-type capital with economic investments and pursue a ‘double bottom line.’
When does it arise in the affordable housing ecosystem? Typically, in the third phase of evolving ecosystemic complexity:
Phase 1: Pure private model (economic slums). [US, everything up through 1937]
Phase 2: Pure public model (public housing, derived by a grant). [1937 through 1966]
Phase 3: Public-private partnership (using private ownership and development, subject to government regulation). [1968 to present]
(An abbreviated US affordable housing history may be found here.)
“And that brings us to the modern age?” Watson asked hopefully.
“No skipping ahead, Watson.”
“Not quite,” said Holmes with a twinkle in his eye. “There is also Phase 4, the introduction of soft equity.”
Housing finance:
Evolving sophistication and ecosystemic complexity
Grant >>>> Soft debt >>>> Soft equity
“You might call soft equity The
