Sunday, April 25, 2010

"Time, time, on my side..."

I began my business career as a commercial mortgage lender.

Among the issues that had to be negotiated in every deal were the length of the period during which prepayment was not allowed and the size of the penalty that had to be paid when prepayment became possible.

In the mid-70’s we were not very sophisticated in our approach to these issues. We tended to just present a structure that might have been, for example: “closed for five years; open thereafter with a penalty beginning at 3% and decreasing at the rate of ½% each year thereafter”.

We would receive a memo from to time time from the corporate office telling us what the prepayment criteria needed to be and, without much thought, we’d usually just present that to the borrower as an edict from “on high” that was non-negotiable.

After a few years I moved into the equity side of the real estate business and I missed the evolution in thinking about prepayment that occurred in the ‘80s. I heard scraps of conversation in the hallways about the value of the “embedded put” that an open prepayment provision gave a borrower; but I didn’t pay a lot of attention to it.

I just knew that I was mightily annoyed when a lender refused to allow prepayment of a loan on a property purchase I was working on, for instance, or, in one case I remember well, quoted a 36% penalty for the right to prepay.

Why do I bring this up?

First: the more financially sophisticated analysis of the value of prepayment, which evolved during my absence from the lending business, was quite correct.

Second: the fundamental issue involved derives principally from the problem of asymmetrical commitments in the presence of prepayment options.

What’s asymmetrical about the commitments?

The lender might be agreeing to receive a fixed rate of return for 30 years but the prepayment option might allow the borrower to pay back the loan in 5 years. Because the duration of commitment is not symmetrical, neither is the risk.

If rates fall sharply from the level at which the loan is made, the right to prepay: a) allows the borrower to refinance into a lower-cost loan, arguably both decreasing his carrying costs and increasing his equity value, and b) puts the lender in the position of having to reinvest relatively high-yielding funds into instruments with lower returns for a potentially long period of time.

Running the numbers on an option of that sort is what produced the annoyingly high proposed prepayment penalty I quoted above.

The same mathematics apply in essentially all fixed income environments. We all know that time has value in financial terms.

But the ability to CONTROL time, compounds that value. The greater the control the greater the value.

The Receivables Exchange, being a marketplace for INVOICES rather than for receivables portfolios, is, by its nature, a very short-duration investing environment.

The weighted average life of the 91 TRE transactions that we have now closed-out has been about 35 days.

Granted, there’s not much we can do at this point to affect the speed of payment after we’ve bought an auction. But the period during which we are exposed to interest-rate risk is quite short. And the risk we are exposed to attaches only to those transactions that have been purchased and not yet repaid.

We have no obligation to buy or bid on the next auction that appears.

We have no obligation to offer the same terms on auctions after lunch as we did before lunch.

Our pricing can change from one moment to the next as can our willingness to participate either at the level of the Exchange or with respect to any particular Seller.

New information with respect to the economy, an industry or a Seller can be acted upon immediately.

Duration and pricing risks are symmetrical (rather than asymmetrical) as between Buyer and Seller.

In a period of rapidly rising interest rates, a TRE Buyer can respond very quickly; adjusting pricing on new transactions immediately and limiting exposure to potential increased cost of capital for a very short period.

It’s quite true that the knife cuts both ways and that, in a period of rapidly falling rates, the TRE Buyer might face a falling price environment more quickly than he would in some other markets.

But at this point I suspect we face another asymmetry.

What’s the risk of rapidly falling rates in the next couple of years versus rapidly rising rates?

In this environment my guess is that the greater value of the flexibility offered by TRE is on the side of the Buyer rather than the Seller.

There are plenty of points to make in the TRE value proposition for Sellers.

But I think the value of the options related to TIME is currently on the side of the Buyer.

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