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Subprime and PPPs

August 31st, 2007

My column from yesterday’s Fin, comparing the US subprime lending boom with PPPs in Australia, is over the fold.

Beware the PPP pitfalls

AFR 30/8/07

With the very word ‘subprime’ having become toxic, it’s hard to remember the enthusiasm with which the boom in subprime lending in the United States was being viewed only a couple of years ago. It’s even harder to remember, in the light of the dubious practices now being revealed, that some of the benefits being claimed for subprime loans were real.

The US economic system is characterized by high levels of income inequality between households and high levels of income variability over time, and relies heavily on credit markets to allow households to smooth their consumption in periods of low income. Inevitably, such a system entails high rates of default on credit. Until access to bankruptcy was tightened in 2005 well over a million households went bankrupt every year (bankruptcy has now been replaced by foreclosure as the main mode of default).

In such a system, many families were never going to qualify for access to a traditional housing loan, even with a reasonably good income. In a period of rising house prices, this exclusion compounded their economic disadvantage. Subprime loans provided such families with a chance to enter the market.

The risk of default was managed through the innovative device of collateralised debt obligations. Applied correctly, this device permitted risk to be allocated to the market participants best able to bear it. The risky components of mortgages were isolated, allowing what was assumed to be the safe component to be packaged into high-grade securities, often rated AAA by agencies such as Moody’s.

It all seemed too good to be true, and it was. The merits of the idea were lost amid huge fees, deceptive packaging and inherently bad deals. As many as half of all recent subprime borrowers will probably lose their homes.

Australia has not seen much in the way of subprime lending to households. But we have embraced another innovative financial instrument, aimed at borrowers with credit rating concerns, and presented to unwary customers as providing ‘something for nothing’.

The innovative solution is the public-private partnership (PPP) and the customers are governments, unwilling to borrow to finance much-needed infrastructure because they fear losing the AAA rating seen as the hallmark of good financial management.

In ordinary language, there is nothing new about public-private partnerships. Public provision of services always involves some form of partnership with private sector suppliers and contractors. And all governments, even those with positive net financial worth, use private sector finance, in the form of sales of government bonds, to support their investment activities.

The crucial feature of the PPP model that distinguishes it from more general forms of partnership is its focus on the allocation of risk between the public and private sectors. As with mortgage lending, the correct principle, presented in most official PPP policy statements, is that risk should be allocated to the party best able to manage it.

In practice, however, the only risk allocation that is considered acceptable by most proponents of the PPP model is one in which demand risk is transferred to the private sector. This allows ownership of the project, and the associated debt, to be transferred off the books of the public sector. The cosmetic benefits of reducing measured debt do not change the fact that, one way or another, the public must pay both the cost of the project and the high rates of return demanded by equity investors. They do, however, make it possible to present such projects as providing infrastructure at zero cost to the government.

In the absence of this illusory appeal, PPPs may still be the optimal arrangement in some cases. However, the experience of the Queensland government suggests that such cases will be the exception.

Unlike some other states, Queensland has no need for financial cosmetics. And with population growth generating huge requirements for infrastructure investment, it is vital to seek the best value for money. The Queensland government has yet to find any significant project where the benefits of PPP-style private sector risk management offset the higher cost of equity capital.

The one exception, redevelopment of the Southbank TAFE college, was at best a marginal case. The PPP option passed the value-for-money evaluation only after several extensions of time and the withdrawal of a number of bidders.

Queensland has done well to hold the line on demanding value for money despite an enthusiastic push from the finance industry and sections of the bureaucracy, keen to embrace PPPs for their own sake. Other states would do well to follow Queensland’s example.

  1. 2 tanners
    August 31st, 2007 at 09:09 | #1

    Two points in commentary:

    1. You would have to find a project where the willingness of the banker to take on risk exceeded the cost of the capital and the ongoing costs. As this tends to be the reverse of the model of banking (we’ll lend you money so that YOU can take a risk), it comes as little surprise that many PPP proponents want to lend the money, own the project and yet leave the risk with the Government. And to an extent, my poverty stricken understanding of the common and black letter law in Australia makes the ultimate alienation of risk difficult or impossible for the Crown.

    2. Perhaps less on topic, I am waiting for a different class of borrowers to strike difficulty in Australia. It will not be seen for some time, given their high equity, but the consumers of ‘reverse mortgages’ may find themselves in trouble in the next ten years, if their funds have not been used to generate income.

  2. mugwump
    August 31st, 2007 at 09:16 | #2

    For once I agree with you (although the connection with subprime is a bit of a stretch).

    If there is any good use of my tax dollars, it is infrastructure.

  3. conrad
    August 31st, 2007 at 09:31 | #3

    “The US economic system is characterized by high levels of income inequality between households and high levels of income variability over time, and relies heavily on credit markets to allow households to smooth their consumption in periods of low income. Inevitably, such a system entails high rates of default on credit”

    I don’t think that is inevitable at all. Hong Kong has a high level of income inequality, it also has high levels of income variability (one reason why years of deflation didn’t destroy the place). It also has extremely low levels of default on housing loans — and that included a period where housing dropped on average 60%.

  4. August 31st, 2007 at 10:53 | #4

    I read this twice in the AFR but didn’t see any link between the two issues you discuss. I wondered if there had been an editorial slip.

  5. 2 tanners
    August 31st, 2007 at 13:42 | #5

    hc

    The connection I see is the faulty model of risk allocation. In the US case, subprime loans were being partitioned such that part of them were allocated AAA ratings, whihc now appears to be sadly mistaken. In the PPP case, the misrepresentation is made that the investment involves a cost-effective real world transfer of risk away from the government.

  6. Razor
    August 31st, 2007 at 16:37 | #6

    2 tanners – the risk wasn’t allocated improperly. It was priced wrongly.

  7. February 16th, 2008 at 21:38 | #7

    Very nice column John.

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