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.