NNO: Recipe for financial jambalaya
[New New Orleans posting archive here, with updates here, here, here, here, here, and here.]
Last Friday I skewered the Wall Street Journal’s half-Bakered critique of House Financial Services Committee Chairman Richard Baker’s well-thought-out proposal to extend Federal credit toward the rebuilding of New Orleans. I finished with a list of the real things to worry about, and rashly promised to lay out a rebuilding plan addressing them in the context of Mr. Baker’s fine legislation.
What challenges New New Orleans right now is not the physical rebuilding but the financial infrastructure. In the affordable housing ecosystem, money is blood, the aerating circulator that brings financial nutrients to build, maintain, and rebuild the body, and even to decompose dead matter.
“For a frank or a pfennig or a buck or a pound …”
As I’ve discussed at length you can rejuvenate a complex economic ecosystem if and only if you can make the money flow.
Now that we’ve got the underwriting lined up …
This means a structured finance solution to flow recapitalize property, especially affordable housing.
(By the way, I do this for a living, in the US and overseas.)
Making the money flow: the golden rules. If you want to coax money out of wallets and into transactions, you have to observe the golden rules:
Financial structuring fundamental principles: the golden rules
1. Make Stone Soup. A proper financing structure satisfies every constituency and uses all the resources we have from every source. “We only win if everybody wins” is a marvelous mantra for structuring collaboration.
2. Nobody’s in it just for ‘goodwill’. Everyone’s participation has to make economic sense for that participant. Goodwill is a wonderful thing, but finance is business, and business flourishes only when it harnesses the law of economic gravity.
3. Align the incentives. I’ll invest my money with you only if (a) I win when you win, and (b) when I lose, you lose too. An extension of this principle is: continuously share everything, ups and downs; no cliff-effect incentives.
4. Closest decides. Whoever is closest to the asset or decision sees it best and should have control over operational decisions. The Charge of the Light Brigade was ordered by an officer who wasn’t looking at the territory. This means that those on the ground tend to be smaller-scale, those farther away larger-scale, and as a result aggregation is an essential further function.
5. Control means risk assumption. Those who want control buy it at a price: assumption of risk. You want to drive, you sit in the crumple zone. An extension of this in a lending context is that the originator must take first loss.
6. Either a lender or an investor be. Not both. Debt and equity are always in fundamental tension, and a capital source should never — repeat, never, never – hold both debt and equity on the same transaction. More generally, a capital source is usually wisest when it integrates all its business lines around one of three roles – lender, investor, or sponsor — and forsakes the other two.
Will the mayor and governor step up?
The necessity for a Federal role. The scale of disaster (estimated at over $67 billion in residential property loss, according to a U. S. Bureau of Economic Analysis study cited in National Mortgage News Daily) overwhelms the total resources of the State of Louisiana, much less those of the City of New Orleans. We must therefore bring in the Federal government. But how can we square a major Federal role with the golden rules (above)? As I wrote a while back:
The corollary to thinking big is not acting small. It is up to the Federal government:
· To provide the strategic vision
· To make the big, fundamental decisions that are preconditions of advancement but must inevitably inflame a quarter of the populace
· To establish the major initiatives
· To fund the last loss
· To get out of the way once this is done
All too often, a national government — any national government — has a tendency to advise smaller levels of government, “You have an entirely free choice, now pick my recommendation and do it exactly as I tell you to.“
“I’m from the Federal government and I know what’s best for you.”
We can apply this to
· Loan guarantees (subject to risk sharing as above)
· First mortgages or preferred equity recovery positions
· Credit enhancement for LRC Bonds, provided that the State of
Observe that this approach — Federal government takes last loss — is consistent with the wholesale-not-retail posture we recommended above.
“How to do it”: Rebuilding
Rebuilding
Involving the City, State, and Federal Governments
1. Loan origination. City of
2. Loan aggregation. State of
3. Loan placement. The City sells these loans at par to LHLT. City conducts loan servicing, asset management, and property inspection, all through designated private mortgage services.
4. Bond issuance. LHLT, as “Bond Issuer,” issues CMBS bonds (call them “Rebuilding New Orleans Bonds”) secured by (a) the city’s Rebuilding New Orleans Loans, and (b) LHLT Collateral Pledge. Bonds are issued in two groups: Class A for the bottom [90]% (paid first), Class B for the top [10]% (paid only after the Class A’s are fully paid).
5. Credit enhancement. Louisiana Recovery Corporation (proposed Baker-bill Federal agency) insures the Class A Rebuild New Orleans Bonds.
6. Top-loss repurchase. City of
Items in green and orange are underwriting variables, subject to negotiation, to be tested in the capital markets.
Does it address the risks? Last Friday’s post finished up with:
Here are the real things to worry about in Mr. Baker’s bill:
1. Markets must clear; if they don’t, all activity is distorted, artificial, and unhealthy.
2. Adverse-selection risk: those whose property was damaged less than 40% [Baker-bill LRC buyout price. — Ed.] will not sell to the LRC, whereas those damaged more than 40% will.
3. Agency risk in economically untrustworthy adjudicators.
4. Perverse incentives for
5. Bureaucratic paralysis brought on by direct government ‘retail’ involvement.
Let’s test it.
“Looks like we’ve got a winner.”
1. Markets will clear. The first step is a financing to a current owner, or a property purchase or sale. The government is thus not in the buy-and-hold business, it’s in the lend-and-get-repaid business. The government stimulates market participants, it doesn’t become a market participant.
2. Adverse-selection risk. Yes, the Federal government has got some. (None financing structure is perfect; there’s always elements of risk.) We’ve mitigated it by (a) being a lender throughout, and (b) putting the State and City in the crumple zone. The State and City are contributing hard equity to the Bond pool, and buying the top-loss bond piece.
3. Agency risk. This we’ve dealt with. In the above financing structure, the City and State are at risk for the top 10% of the loss. If the bonds perform, the City and State make money. If they don’t, it will be the State and City — the issuers — that bear the economic brunt.
4. Perverse incentives. These still exist at the level of individuals within State and City government — we have not eliminated the public-choice problem. We’ve just, in classical investment-banking strategy, transferred it to someone else.
5. Bureaucratic paralysis. All the property activity is done privately: by owners, buyers, sellers, private mortgage originators, and private mortgage servicers. Government is in its essential role in public-private partnership.
There are still risks, but we must weigh them against the economic gangrene that is steadily settling in to what was one of
What about the knobs? I have deliberately omitted from this financing structure all the knobs:
It goes to eleven
These market variables that calibrate the economics:
1. Cost of funds. Interest rate on the Bonds.
2. Collateral ratio. How much of the State and City’s resources must be ring-fence pledged in as additional collateral.
3. Senior-junior ratio. The appropriate split between Class A and Class B (I showed 90-10, but that should be tested in the marketplace).
They’re interdependent, but these ratios are the dimensions of a universe within which it will be possible to find equilibrium point that make the capital flow.
Cooking up New New Orleans. Just as solutions to complex interdependent problems are always unique and complex, so too does every culture have an anything-goes dish, whether bouillabaisse, cioppino, paella. Here’s hoping the Cajuns can quickly whip up a financial jambalaya.
“Anyone want some jambalaya bonds?”
I’ve brought the recipe 
.