FDIC Strategy: Good Bank / Bad Asset Pool

From the WSJ:

The Federal Deposit Insurance Corp is poised to start breaking failed financial institutions into good and bad pieces in an effort to drum up more interest from prospective buyers.

The strategy, which is likely to begin soon, is aimed at selling the most distressed hunks of failed banks to private-equity firms and other types of investors who may be more willing than traditional banks to take a flier on bad assets. The traditional banks could then bid on the deposits, branches and other bits of the failed institution that are appealing.

"We want banks to participate in the resolution process, but we know it's a tough time for banks to participate in the resolution process," said Joseph Jiampietro, a senior adviser to FDIC Chairman Sheila Bair. He made the comments Wednesday during a presentation to a community-banking conference in New York.

The FDIC has found buyers for most of the failed institutions, but many prospective bidders are leery of taking on bad loans from a shuttered bank. That remains the case despite the FDIC's efforts to encourage bidders by providing loss-sharing agreements in about 40 of this year's bank failures.

But those types of deals aren't providing enough comfort to the FDIC, which wants to see a more-vibrant auction process.

"There are certain situations when assets are so distressed and make up a significant percentage of the balance sheet that strategic buyers are hesitant to participate in the process," said Mr. Jiampietro.

Details of the FDIC's latest effort to generate more bidding interest still are being worked out, but "we hope this will have greater appeal to strategic buyers," said James Wigand, deputy director of the FDIC's division of resolutions and receiverships, who also spoke at the conference.

The agency is considering several structures, including transferring the bad assets to a new entity established by the FDIC that will then be sold off. Another option, the FDIC officials said, is to allow traditional bidders to team up with buyers for the distressed assets.

The strategy could provide an opportunity for private-equity firms that complain they are being hamstrung in their efforts to buy failed banks. This month, the FDIC proposed guidelines for private-equity investors that could make it more difficult for them to compete against traditional banks for failed institutions.

Among other things, private-equity investors would be required to hold higher capital reserves than traditional banks. Although the proposals are aimed at deterring private-equity investors from buying and flipping failed banks, the firms contend that they would create an uneven playing field between private equity and traditional banks.

SF Fed President Yellen on Community Banks

From San Francisco Fed President Janet Yellen: Outlook for the U.S. Economy and Community Banks:

"Now let me turn to the business environment facing banks. The industry is going through one of the most difficult periods in modern times. ... Bank profits are down, loan delinquencies are up, and failures are climbing."

"Recessionary effects normally take some time to work their way through loan portfolios. So, even though I expect economic growth to resume in the second half of this year, banking conditions are likely to remain quite weak for another year or two."

"To date, the community banks under greatest financial stress are those with high real estate concentrations in construction and land development lending. Banks that liberally funded speculative housing and condominium construction, and those that funded land acquisition and development, have been hardest hit. Over 20 District financial institutions have failed since last year. The vast majority of them had high concentrations in residential construction and development lending. In fact, these banks had construction loans that averaged about 40 percent of their loan portfolio, well above the District average of 16 percent. Unfortunately, some banks that aggressively pursued these loans had weak appraisal and risk-monitoring systems."

"The next area of significant vulnerability for the banking system, particularly for community and regional banks with real estate concentrations, is income-producing office, warehouse, and retail commercial property. Market fundamentals in most western states are deteriorating. Vacancy rates are rising and rent pressures are hurting property cash flows. Office vacancy rates in both Boise and Portland are expected to reach or exceed 20 percent over the next year or two, the highest rates these cities have seen in many years. Retail shopping centers are struggling with falling occupancy rates and pressures to grant rent concessions. Property values are falling sharply across wide areas of the country, including the Pacific Northwest. Some analysts forecast that commercial property values could experience falls similar to housing of 30 to 40 percent."

"Our biggest concern now is with maturing loans on depreciated commercial properties. In many cases, borrowers seeking to refinance will be expected to provide additional equity and to have underwriting and pricing adjusted to reflect current market conditions. In some cases, borrowers won’t have the resources to refinance loans."

Only 52% of CMBS Loans Maturing in July Have Refinanced

A total of 52% of the $1.8 billion of CMBS loans that matured in July were refinanced, according to analysis by Barclays Capital. That's in line with the 53% refinance rate for the $9.5 billion of loans that have matured so far this year and indicates that borrowers continue to have difficulties lining up take-out financing.

Further evidence of the refinancing difficulties is the increasing volume of loans that remain outstanding even three months after their maturity. According to Barclays analysis, only 51% of the loans that matured in January had been refinanced by the end of February. Three months later, that percentage had grown to 76%. But only 53% of the loans that matured in April had been refinanced three months later.

The lower a loan's debt yield, the more difficult it is to refinance, according to Barclays findings. Debt yield, or exit yield is determined by dividing a property's cash flow by its loan's balloon balance. The higher the number, the better prospects a loan would have of getting refinanced.

Barclays found that only 34% of loans with debt yields of less than 10% have refinanced. And that bodes poorly for the CMBS market, given that the average debt yield for loans in the CMBX series of indices is only 9.7%, according to a Barclays estimate based on most recent available net operating income figures.

Even loans with very high debt yields are having a tough time. Loans with debt yields of 20% or more have an 83% refinance rate. Meanwhile, loans with debt yields of 10% to 15% had a 61% refinance rate, while loans with debt yields of 15% to 20% had a 68% refinance rate.

CRE Crisis Hits U.S. Banks

From the WSJ:

Losses from loans tied to strip malls, office buildings, housing complexes, and the like are hurtling toward record levels not seen since the infamous savings-and-loan crisis.

But at some banks, according to the latest round of earnings reports, the commercial real estate crisis has already arrived. Those companies' worsening conditions could well foreshadow the heavy losses at regional lenders in quarters to come -- and failures or takeovers for some.

"Commercial real estate in the United States of America is going to get worse consistently over the next several quarters," said Jamie Dimon, CEO of J.P. Morgan Chase & Co., earlier this month when he discussed his company's earnings.

At SunTrust Banks Inc., an Atlanta-based bank with 1,700 branches, nearly 20% of the company's $8.2 billion in commercial loans tied to construction projects are nonperforming, or becoming uncollectable, as of June 30. At the same time last year, 6% of SunTrust's construction loans were in late-stage delinquency.

At KeyCorp., a Cleveland-based regional bank with nearly a thousand branch offices, nearly 11% of the company's $6.3 billion in commercial construction loans were classified as nonperforming in the second quarter. During last year's second quarter, 3% of Key's construction loans were nonperforming.

At the height of the S&L crisis, which lasted into the early 1990s, late-stage delinquencies among commercial real estate loans peaked at 6%, while slightly more than 2% of outstanding loan balances became losses, according to data from RBC Capital Markets.

Wells Fargo & Co., for example, said 2.3% of its commercial real estate mortgages were considered nonperforming as of the second quarter, up nearly three-fold from 0.8% a year ago.

The San Francisco bank purchased its large teetering rival Wachovia Corp. at the end of last year, and Wells Fargo now holds $138 billion in commercial real estate loans, more than any other lender. Wachovia expanded aggressively into commercial real estate before falling victim to rising losses from consumer loans.

Nearly a third of Wells Fargo's total commercial real estate loans are tied to properties in California or Florida -- two regions among the hardest hit by the real estate depression.

Remember, a lot of this paper is syndicated, so the losses will be spread over many, many more banks than is obvious. Many of the participating banks will not have the capital to absorb the losses that the large lead banks - who may be recipients of government support - will be willing and able to take.

$165 Billion in CRE Debt Maturing in '09

From Bloomberg: Almost $165 Billion in Commercial Mortgages to Come Due in ’09

Almost $165 billion in U.S. commercial real estate [shops, offices, hotels, apartment buildings and land] loans will mature this year and need to be sold or refinanced as rents and occupancies fall, according to First American CoreLogic.

The U.S. South has the most maturing loans with 60,893 mortgages valued at $96 billion coming due on shops, offices, hotels, apartment buildings and land, Santa Ana, California- based First American said in a report. The West is second with 20,549 mortgages maturing for a value of $35 billion.

REITs will have less trouble with maturing loans held by banks than with debt sold as commercial mortgage-backed securities, said Rich Moore, managing director at RBC Capital Markets in Solon, Ohio.

“If you go to the CMBS market, that’s where the danger comes in, because the CMBS market is a bunch of assets pooled together,” Moore said. “It’s much more difficult to extend those loans -- not impossible, but much more difficult.”

Banks likely will offer extensions to avoid having to manage or sell properties, especially with little buyer demand for commercial real estate during the recession, Moore said. U.S. commercial property prices fell 7.6 percent in May from a month earlier, bringing the total decline to 35 percent since the market’s peak, Moody’s Investors Service said last week. Prices dropped 28.5 percent in May from the year earlier period.

“As long as prices contract, we expect loan performance will worsen and that will make financing difficult,” Sam Khater, senior economist for First American, said in an interview. “Delinquencies and notices of default are rising, and we expect that to continue.”

More than 5,000 properties in the 10 biggest U.S. metropolitan areas got at least one default notice in March, marking the first time that’s happened in First American records going back to January 2003.

Banks Reduce CRE Exposure, Tighten Credit, Demand Remains Flat

From CoStar:

Continued Weakening in Real Estate Markets Increasing Risk, Cutting Demand

As firms continue to downsize, cut costs and reduce inventories, the nation's largest banks are reporting that demand for credit in the commercial real estate market is well below normal levels, according to the U.S. Treasury Department's monthly bank lending survey from the largest 21 recipients of government bailout money through the Capital Purchase Program.

The May survey results released this week found that new loan demand in commercial real estate remains low due to the lack of new construction activity. In addition, developers are reluctant to begin new projects or purchase existing projects under the current deteriorating economic conditions, which include a rising supply of office space as firms downsize and vacancies rise.

Nearly all respondents indicated that they were actively reducing their exposure to commercial real estate loans, as they expect CRE loan delinquencies to increase over the coming year. The outstanding balance of CRE loans of all respondents decreased by 1%, and the median change in outstanding balances was flat.

At the same time, for the month of May, total renewals of existing accounts and total new commitments in commercial real estate increased from April. The changes in renewals and new commitments on the institution level, however, were mixed; 10 of the 17 institutions active in the CRE renewals reported increases in renewals, while seven reported decreases. Nine of the 16 institutions actively making new commitments in the market reported increases in new commitments, while seven reported decreases in new commitments. The median change in renewals of existing accounts was an increase of 2%, and the median change in new commitments was an increase of 11%.

This is an interesting interpretation of the data. With large maturities looming, it seems unlikely there is less 'demand' for credit. It's really that there is less extension of credit due to tightening lending standards.

CRE Wreck Looms For Regional Banks

From CNBC:

"The larger banks that have multiple revenue streams, some of those streams are doing very well," said David Twibell, president of wealth management at Colorado Capital Bank in Denver. "For the smaller banks, the primary revenue generator is going to be the lending side of the business. That's still a real mess out there. Particularly relating to commercial real estate, it's getting worse, not better."

"Banks are writing off commercial real estate loans now at a bigger rate than in the last 20 years," said Kathy Boyle, president of Chapin Hill Advisors in New York. "It's a double-whammy. Banks have another shoe to drop on their balance sheets, and regional banks tend to have a much bigger exposure."

On Shaky Ground: CRE Faces Financial Tremors

From Knowledge@Wharton:

"The shoe has already dropped," says Wharton real estate professor Susan Wachter. "Values are down severely. Vacancy rates are at 20-year highs." The Federal Reserve reports that delinquency rates on commercial real estate loans have doubled in the past year to 7%, as companies pull back on commercial space and retailers go out of business.

Typically, commercial real estate developers help lead the nation from boom into bust by constructing too much space and defaulting on loans, jeopardizing the stability of lending institutions. This time, problems in the financial sector are branching out into commercial property.

"This is entirely a financial crisis, first and foremost. The problem is the seizing up of financial markets, not overbuilding as in the past," Wachter says. "The overall economy is weak and weakening, which is driving down rents. Past real estate crises were centered in real estate without an economy-wide crisis at the same time."

With financing tight, it is difficult or impossible for property owners to rollover short-term financing when it comes due. For example, General Growth Properties, the second-largest shopping mall company, filed for bankruptcy court protection after its lenders refused to refinance $27 billion in debt. The Real Estate Roundtable in Washington, D.C., estimates $400 billion in commercial real estate loans will come due this year. By 2012, the figure will be more than $1.8 trillion.

Wachter sees a bifurcation in the commercial real estate sector. Large, publicly traded real estate investment trusts (REITs), with equity in projects and access to public markets, are best positioned to ride out the downturn, she says. Other real estate firms, particularly those controlled by private equity funds that face short-term debt obligations to financial institutions that are in trouble themselves, will have less flexibility.

An Opportunity?

"This is an opportunity -- or may be an opportunity soon -- for REITs that are positioning themselves to take advantage of other companies and bottom fish to purchase significant properties at bargain basement prices," says Wachter. She cites plans by Vornado Realty Trust to raise $1 billion to create a fund to invest in distressed properties. "It's back to 'cash is everything.'"

Indeed, publicly held REITs reported strong second-quarter results. The Dow Jones Equity All REIT Total Return Index, composed of 114 REIT stocks, rose 28.9% -- the largest increase since the index was created in 1989.

Brian Case, vice president of research for the National Association of Real Estate Investment Trusts, says many REITs have shored up their positions with cash raised in secondary offerings. In the future, he expects to see a new wave of initial public offerings (IPOs) by private real estate investors who are proven managers with strong portfolios, but who are also under pressure from debt that is coming due. In a better credit environment, that debt might have easily rolled over, but in the current climate an IPO may be the only source of new money. They have two choices: sell into a very soft market through 2012 or, if they are strong enough, do an IPO and use that equity to meet debt obligations," according to Case.

Meanwhile, the U.S. government is attempting to ease the crisis by extending its Term-Asset-Backed Securities Loan Facility (TALF) to troubled commercial real estate firms. The program opened for new real estate loans earlier this summer but received little interest. The TALF program was then extended to existing commercial mortgage securities. On July 16, the Federal Reserve Bank of New York said investors sought $668.9 million worth of loans to buy securities backed by commercial real estate loans that were made months or years ago. Two days earlier, Standard & Poor's cut ratings on commercial real estate bonds issued by Goldman Sachs, JPMorgan Chase and other financial institutions, effectively disqualifying billions in bad loans from the government program.

"The government has successfully stopped runs on banks and has stabilized the banking economy, but that doesn't mean it can coerce banks to make loans to entities where the value of their collateral is down as much as in real estate," says Wachter.

Total losses in securities backed by commercial property loans could climb as high as $90 billion in the next few years, according to Deutsche Bank analyst Richard Parkus, who also testified during the recent Joint Economic Committee hearings. In addition, he estimated up to $140 billion in losses from construction loans made by regional and local banks is also in jeopardy. "We believe the bottom is several years away," Parkus told the committee.

Wachter says the use of commercial mortgage-backed securities (CMBS) was not as flawed as mortgage-backed securitization in residential markets, but she predicts the CMBS market will face reforms before it becomes a force in commercial real estate finance again. Ultimately, however, securitization will continue to be an important element in structuring commercial real estate finance. "How it comes back is still in question, but it will come back. There are some clear issues with CMBS."

In the meantime, property owners are scrambling to renegotiate with tenants and reposition properties to make them more likely to receive continued financing. Wharton marketing professor Stephen J. Hoch says retailers are approaching landlords and threatening to close their doors if they don't receive concessions. "The REITs have adapted and tried to be proactive," says Hoch. "It's taken a catastrophe to wake up and smell the coffee."

CRE Loans Failing At Rapid Pace

From the WSJ: Commercial Loans Failing at Rapid Pace

U.S. banks have been charging off soured commercial mortgages at the fastest pace in nearly 20 years ... losses on loans used to finance offices, shopping malls, hotels, apartments and other commercial property could reach about $30 billion by the end of 2009.

Many of the most troubled [regional] banks have heavy exposure to commercial real estate. ...

In contrast to home loans, the majority of which were made by about 10 lenders, thousands of U.S. banks, especially regional and community banks, loaded up on commercial-property debt.

Some analysts, meanwhile, worry that banks aren't sufficiently recognizing losses on their commercial real-estate loans, thereby exposing themselves to bigger losses later. ..."Net charge-offs to date have been highly inadequate," said Richard Parkus, head of commercial mortgage-backed securities research at Deutsche Bank. "This is clearly a problem that is being pushed out into the future."

Sideways Demand

Handling Examinations & MOUs

CMBS Delinquency Rates 5%-6% By Year-End

From Commercial Real Estate Direct: Moody's Sees Delinquency Rate for its CMBS Universe at 5-6% by Year-End

The delinquency rate for securitized commercial mortgages tracked by Moody's Investors Service increased 40 basis points in June to 2.67% and the ratings agency expects it to reach up to 6% by the end of the year.

The rate compares to 0.46% a year ago and the low of 0.22% in July 2007.

Moody's tracks $620.5 billion, or 78% of the total CMBS universe, and counts as delinquent loans that are 60 or more days in payment arrears.

It expects the delinquency rate within its CMBS universe to continue increasing through year-end, noting that the pace of delinquency increase has been intensifying for all property sectors. That pace is being driven by properties unable to generate sufficient cash flow due to tumbling fundamentals.

The hotel sector led the delinquency surge in June as its rate rose 1.24%age points to 3.26%, the second highest rate among all property types. Weak hotel property performance resulting from reduced travel is seen getting worse, as Smith Travel Research has projected that revenue per available room for hotels nationwide will drop 17.1% this year.

Industrial's delinquency rate rose 56 bp to 1.96%, while retail's increased about 50 bp to 2.92% and office's rate increased 26 bp to 1.6%.

The multifamily sector level increased a scant 2 bp to 4.58%, which is still the highest of all sectors. But the delinquency rate's apparent leveling off may not last for long.

Multifamily's June delinquency rate was skewed downward by a $164 million loan against a Phoenix-area portfolio owned by the bankrupt Bethany Group, which became current in June but is likely to return to its former delinquent status. The loan, securitized through LB Commercial Mortgage Trust, 2007-C3, was made current with a payment made by Trigild Inc., which was installed as receiver of the portfolio after Bethany filed for bankruptcy protection.

While Trigild made the payment with reserves it uncovered from its cash sweep of the portfolio's operations, the properties do not appear able to generate the amount of cash flow needed to fully meet their debt-service requirements going forward.

Moody's also said the retail sector's delinquency rate is being complicated by the bankruptcy of the retail REIT, General Growth Properties.

It said that about half of the loans backed by GGP properties are technically 30- to 59-days late, which means that in the coming weeks they will become 60 days past due, which is Moody's threshold for being termed delinquent. The rating agency said it will not count as delinquent loans on GGP properties unless they're past their maturity dates or if lenders have begun foreclosure. The loans continue to pay interest, but have stopped making principal payments, as a result of the bankruptcy.

The rating agency noted that many of the REIT's properties are still generating adequate cash flow to pay off their loans.

S&P CMBS Rating Cuts

On June 4th, S&P put out a report: The Potential Rating Impact Of Proposed Methodology Changes On U.S. CMBS. A few excerpts:

“In our preliminary review of outstanding transactions, there were a number of recent-vintage transactions that required 'AAA' credit enhancement of more than 30% using our 'AAA' stress, which implies that super-senior classes within those deals would be downgraded.”

“Transactions from the 2007 vintage are likely to experience the greatest impact if the criteria are adopted, as most tranches currently rated 'AAA' with 30% credit enhancement ("super dupers") would likely be downgraded. The downgraded classes would have a weighted average rating (WAR) of 'A'.”

“Shorter weighted-average life 'AAA' classes benefit from structural protection and would likely perform better than longer-weighted average life 'AAA' classes. Of the A-2 (five-year) classes from 2005-2007, 25% of the 2005 deals (12 classes, 12 transactions), 10% of the 2006 deals (five classes, four transactions), and 25% of the 2007 deals (15 classes, 13 transactions) are potentially at risk for downgrade based on our analysis.”

“Ten-year super-duper (30% credit-enhanced) classes have a higher potential for downgrades than the shorter weighted-average life classes: 50% (2005), 85% (2006), and 95% (2007) of the super-duper 'AAA' tranches would likely be at risk.”

Rating cuts associated with the new methodology began today with S&P lowering its ratings on 23 classes of CMBS from Credit Suisse Commercial Mortgage Trust Series 2007-C3 and removed them from CreditWatch with negative implications.

"The lowered ratings follow our analysis of the transaction using our recently released U.S. conduit and fusion CMBS criteria, which was the primary driver of the rating actions...."

As an example, GSMS 2007-GG10 A4's (super senior with 30% credit support) were taken from AAA to BBB-. The downgrades mean these bonds are no longer eligible for cheap financing under the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF).

S&P apparently intends to roll out the results of their new methodology over the next “three to six months."

Financial Modeling And Reality

As far as the laws of mathematics refer to reality, they are not certain, as far as they are certain, they do not refer to reality.

-Albert Einstein

Goldman Sachs Fantastic Earnings - Except in CRE

GS earnings jumped 65% last quarter, except in its commercial real estate portfolio where it booked a loss of $499 million from its “real estate principal investments.” This branch of Goldman’s business allows clients to co-invest with Goldman through its Whitehall real estate funds.

As reported in the WSJ, Whitehall funds have been bruised by the economic downturn. In May, one Whitehall fund spent some $3.7 billion between May 2007 and August 2008 to buy a portfolio of casinos, hotels and office buildings and subsequently had to write down those investments by $2.1 billion.

The "real estate principal investment" component of Goldman’s earnings report only reflects its own equity in the Whitehall funds, but beyond that private equity real estate loss, the firm also had some $700 million in commercial real estate mortgage write downs during the last quarter.

Even Goldman is having difficulty in CRE.

FDIC Concentrating Risk Not Resolving Failed Banks

Interesting article from the WSJ "FDIC's Challenge With Busted Banks" illustrates how instead of passing the remains of closed banks to unequivocally strong banks, the FDIC is doing deals with many acquirers who are dealing with their own issues with high exposure to commercial real estate.

Last month, United Community Banks, of Blairsville, Ga., acquired assets and liabilities of Southern Community Bank, including $224 million of loans, from the FDIC, which provided a loss-sharing agreement. Yet United Community has commercial real-estate exposure equivalent to over 850% of its tangible common equity, or TCE. Moreover, its Texas ratio, nonperforming assets as a percentage of TCE plus loan-loss reserves, is 55%. That is more than double the 26% median for smaller U.S. banks.

PrivateBancorp of Chicago acquired all the deposits and just over $900 million of assets of Founders Bank. Adjusted for a recent share issue, PrivateBancorp's commercial real estate is equivalent to 590% of its TCE. Brokered deposits are up over 220% since the end of 2007. They helped fund a 326% increase in corporate loans over the same period.

Great Southern Bancorp, of Springfield, Mo., in March acquired certain deposits and $443 million of loans from TeamBank. Great Southern's commercial real estate, which contains a large share of construction loans, is 536% of TCE. Brokered deposits leaped 44% last year. Last year the bank took a $35 million hit, equivalent to 21% of its TCE at the time, after a single loan to another bank went bad.

This appears to be further aggregation of risk rather than resolution and mitigation of risk. It's the the FDIC's own version of "extend and pretend".

Freddie Mac Comparable Sale Appraisal Clarifications

Freddie Mac has updated their appraisal guidelines and clarified that the appraiser is not required to use distressed sales (REOs, short sales):

The appraiser’s selection of comparable sales is crucial to providing an accurate opinion of value based on market data. With respect to comparable sales, the appraiser must choose appropriate comparable sales, and certify that the comparable sales chosen are those most similar to the subject property. In underwriting the appraisal, the underwriter must consider whether any adjustments are supported and are reasonable. The amount and number of any adjustments must also be considered. Typically, the higher the amount of the adjustments or the number of adjustments the more likely the comparable sales might not be representative of the subject property. Freddie Mac does not have requirements about what comparable sales the appraiser is to use. For example, we do not require appraisers to use Real Estate Owned (REO), foreclosure or short sales. However, if the appraiser determines that these are representative of the properties available to typical purchasers for the market in which the property is located, appraisers must consider their use.

And from under the heading of "Thank You Capitan Obvious":

To determine that a Mortgage is eligible for sale to Freddie Mac, a Seller/Servicer must conclude that the Borrower is creditworthy (acceptable credit reputation and capacity) and the Mortgaged Premises (collateral) are adequate for the transaction. Credit reputation, capacity and collateral are often called the “three Cs” of underwriting; if one of these components is not acceptable or if there is excessive layering of risk across components, the Mortgage is not eligible for sale to Freddie Mac. Sellers must accurately evaluate and determine a Borrower’s ability to repay the Mortgage.

CRE Time Bomb is Ticking

From Dow Jones Newswires:

U.S. lawmakers rang alarm bells about the troubled commercial real estate industry, which has been walloped by the credit crunch and an implosion of property values. "The commercial real estate time bomb is ticking," said Joint Economic Committee Chairman Rep. Carolyn Maloney, D-N.Y.

Banks have yanked back on lending to developers of shopping malls, apartment complexes, hotels and office parks. Meanwhile, the securitization market - a key source of funding for the commercial real estate industry - has been in a deep freeze since last year.

The situation is fueling concerns that property developers won't be able to refinance roughly $400 billion in commercial real estate debt coming due this year. Property values have plunged about 24% since their peak in 2007, further hampering developers' ability to obtain refinancings or loan extensions.

A wave of defaults of commercial real estate loans would deal a blow to the already weakened banking industry. The U.S. commercial real estate market is roughly $6.7 trillion in size and is underpinned by about $3.5 trillion of debt.

The Federal Reserve has taken steps to get lending flowing to the industry. On June 16, it announced it would accept as collateral new issuance of commercial mortgage-backed securities as part of its emergency program to thaw the securitization market. As early as next week, the Fed is expected to extend that to existing, or "legacy", CMBS already held by investors.

The commercial real estate industry believes these steps will help unleash lending to property owners and developers by spurring more investor appetite for CMBS. To the extent that CMBS investors are able to buy and sell the securities again, spreads will tighten, the Fed argues. That will allow financial institutions that make loans backing the CMBS to free up their balance sheets and make new loans to the industry or refinance existing debt.

BANG!

Treasury Works on 'Plan C'

From the Washington Post:

The officials in charge of Plan C -- named to allude to a last line of defense -- face a particular challenge in addressing the breakdown of commercial real estate lending.

Banks and other firms that provided such loans in the past have sharply curtailed lending.

That has left many developers and construction companies out in the cold. Over the next few years, these groups face a tidal wave of commercial real estate debt -- some estimates peg the total at more than $3 trillion -- that they will need to refinance. These loans were issued during this decade's construction boom with the mistaken expectation that they would be refinanced on the same generous terms after a few years.

The credit crisis changed all of that. Now few developers can find anyone to refinance their debt, endangering healthy and distressed properties.

"It's not a degree to which people are willing to lend," she said. "The question is whether a loan can be made at all."

The problem affects not just the recipients of the loans but also the institutions that lend, many of them small community banks and regional firms.

Thousands of these institutions wrote billions of dollars in mortgages on strip malls, doctors offices and drive-through restaurants. These commercial loans required a lot of scrutiny and a leap of faith, and, for much of the decade, the smaller banks that leapt were rewarded with outsize profits.

In doing so, many took on bigger and bigger risks. By the beginning of the recession in December 2007, the median midsize bank held commercial real estate loans worth 3.55 times its capital cushion -- its reserve against unexpected losses -- according to the Federal Deposit Insurance Corp.

Borrower defaults increasingly are draining capital from many of those banks, forcing some to close. Financial analysts said losses on commercial real estate loans are now the single largest cause of bank failures.

The federal government has set up bailout programs to provide relief to the commercial real estate market, but none of these efforts is big enough to address the size of the problem, industry analysts said.

One Fed program to revive lending took aim at the problem. But this effort faltered in June, failing to attract much interest in the issuance of new commercial real estate loans. The central bank said yesterday that the program sparked only $5.4 billion in new loans of any kind last month, less than half the previous month's total.

Another government effort to buy mortgages, including commercial loans, off the books of banks has been shelved because of a lack of interest from industry. A companion plan to buy toxic bank assets, some of which back commercial loans, is being downsized for similar reasons.

Moody's/REAL Commercial Property Price Indices

The Science of Economic Bubbles and Busts

From Scientific American: The Science of Economic Bubbles and Busts

The worst economic crisis since the Great Depression has prompted a reassessment of how financial markets work and how people make decisions about money:

Key Concepts

• The worldwide financial meltdown has caused a new examination of why markets sometimes become overheated and then come crashing down.
• The dot-com blowup and the subsequent housing and credit crises highlight how psychological quirks sometimes trump rationality in investment decision making. Understanding these behaviors elucidates the genesis of booms and busts.
• New models of market dynamics try to protect against financial blowups by mirroring more accurately how markets work. Meanwhile more intelligent regulation may gently steer the home buyer or the retirement saver away from bad decisions.

Consumer Bankruptcy Filings Up 36.5% YoY

U.S. consumers made 675,351 bankruptcy filings in the first half, a 36.5% increase from a year ago, according to the American Bankruptcy Institute. June filings by consumers totaled 116,365, up 40.6% from the same period in 2008. The monthly rate of consumer filings slowed, however, declining by 6.8% from May 2009.

1.4 million new bankruptcy filings expected by by year end.

Profiting From a Bank Failure

Glenn Gray, CEO of Sunwest Bank in Tustin, CA, on his bank's experience in acquiring a failed bank from the FDIC. Interesting comments on how his bank positioned itself to be an acquirer rather than a victim:

Q. What did you avoid?

A. We didn’t touch subprime. We exited speculative construction lending at the end of 2005. And we were very selective about everything but in particular commercial real estate lending.

Q. I understand commercial lending had its own form of stated income lending?

A. We didn’t do any of that, but yes you are right. That’s doing so much on ‘pro forma,’ or projected future revenue (i.e. estimated rent from a property). We underwrote on historical, factual income, not hope. Hope is not a strategy. (Emphasis added)

Zero Down - Not Subprime Loans - Led to Mortgage Meltdown

From the WSJ:

The evidence from a huge national database containing millions of individual loans strongly suggests that the single most important factor is whether the homeowner has negative equity in a house -- that is, the balance of the mortgage is greater than the value of the house. This means that most government policies being discussed to remedy woes in the housing market are misdirected.

....focus on subprimes ignores the widely available industry facts (reported by the Mortgage Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime, and that the foreclosure rate for prime loans grew by 488% compared to a growth rate of 200% for subprime foreclosures. (These percentages are based on the period since the steep ascent in foreclosures began -- the third quarter of 2006 -- during which more than 4.3 million homes went into foreclosure.)

A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

The difference in policy implications is enormous: A significant reduction in foreclosures will happen when and only when housing prices stop falling and unemployment stops rising.

....stronger underwriting standards are needed -- especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can't just walk away.

A Crisis of Politics, Not Economics: Complexity, Ignorance & Policy Failure

Critical Review is publishing a special issue on the financial crisis. Economist Jeffrey Friedman writes in his introduction:

"...if we take seriously the possibility that market participants are making cognitive rather than incentives-based errors, the case for regulation loses considerable force."

"Indeed, what may have saved the world from complete economic chaos in 2008 was the fact that the regulations were loose enough that many investors and many bankers had resisted buying the "safe" securities that most banks seem to have bought. Heterogeneous behavior like that, however, is allowed for, encouraged, and rewarded by capitalism; and is either discouraged or prohibited by regulation, depending on how tight the regulations are."

Economist Arnold Kling interprets Friedman:

"Which is more vulnerable to catastrophic failure: a relatively unregulated system, in which participants pursue diverse strategies; or a strongly regulated system? For Friedman, the latter is more vulnerable, because of the risk of promoting homogeneous behavior, so that one mistake affects everyone."

"All of us have our intellectual hobby horses. Friedman's hobby horse seems to be the existence of cognitive weakness or ignorance. He is constantly asking what happens if leaders have cognitive biases or information gaps. In general, I think when you take that problem seriously, you fear strong government."

Deflation

From the NYT: Krugman on Deflation

Krugman observes that the 3-month rate of change in wages has dropped off precipitously. "Bear in mind that inflation usually runs below the rate of wage change, thanks to productivity growth. So we’re really heading into Japanese-style deflation territory."

See Bureau of Labor Statistics Employment Situation Summary 7-2-09

Private Equity Bank Bidders

From MarketWatch: FDIC Chills Private-Equity Bank Bidders

The Federal Deposit Insurance Corporation on Thursday urged tough capital requirements on private equity firms buying battered banks, and said any firms they buy must be held for at least three years.

"Private-equity investors are probably going to lose their zeal for investing in this undervalued market because the upfront costs will be too much," said Lawrence Kaplan, of counsel in the banking and financial institutions group at law firm Paul Hastings and a former special counsel at the Office of Thrift Supervision.

"The FDIC is saying to private-equity firms that 'while we like your money, we're going to make it too expensive,'" he added.

FDIC Board Approves Proposed Policy Statement on Qualifications for Failed Bank Acquisitions

FDIC Chairman Sheila Bair's Statement:

"I am particularly concerned with new owners’ ability to support depository institutions with adequate capital, management expertise, and a long term commitment to provide banking services in a safe and sound manner. Obviously, we want to maximize investor interest in failed bank resolutions. On the other hand, we don’t want to see these institutions coming back. I remain open minded on many aspects of this proposal, including the categories of investors to whom it should apply, the appropriate level of upfront capital commitments, and the operation of cross guarantee provisions and limits on affiliate transactions. I look forward to receiving comments in these areas."

"I support the transactions we have completed to date which have involved sales to private equity owners. We have imposed some special restrictions on these, including higher capital requirements. However, some have suggested that capital requirements should be even higher, given the difficulties in enforcing source of strength obligations outside the initial capital investment made by the acquirers in so-called “shell” structures. I know that this will be a contentious area, and we are opening high, with a proposed 15% requirement."

"I am also troubled by the opacity of some of the ownership structures that we have seen in our bidding process, though these have not been winning bids. We have seen bids where it has been difficult to determine actual ownership. We have seen bidders who have wanted permission to immediately flip ownership interests. We have seen structures organized in the secrecy law jurisdictions. So based on the experiences we have gathered, I think it is prudent to put some generic policies in place which tell non-traditional investors that we welcome their participation, but only if we have essential safeguards to assure that they will approach banking in a way that is transparent, long term, and prudently managed."

Bank Failure Friday - On Thursday

The FDIC is taking advantage the holiday weekend and has closed a number of banks today:

• John Warner Bank, Clinton, Illinois
• First State Bank of Winchester, Winchester, Illinois
• Rock River Bank, Oregon, Illinois
• Elizabeth State Bank, Elizabeth, Illinois
• First National Bank of Danville, Danville, Illinois
• Millennium State Bank of Texas, Dallas, Texas
• Founders Bank, Worth, Illinois

The FDIC estimates the aggregate cost to the insurance fund to be approximately, $314.3 MM with Founders Bank making up the single largest loss of $188.5 MM. Founders Bank had $962.5 MM in assets, the other banks taken down were all less than $188 MM, and mostly under $100 MM.

We find the failure pattern to date interesting. Failures have primarily been smaller banks not in the 'garden spots' like California, Florida, California, and Georgia where so many of the real estate lending issues appear to reside.