Commercial Real Estate is in a Slow-Motion Car Crash

Analysis and Discussion with Harrison LeFrak of LeFrak Organization:

FDIC to Allow Private Equity to Buy Failed Banks

The FDIC eased the way today for private-equity firms to buy failed banks through the FDIC.

The board of the FDIC voted 4-1 Wednesday to require private-equity firms with no history of bank management to maintain a 10% capital-asset ratio and to submit to strong restrictions on lending to their affiliates. The rules also require private-equity firms that bid on banks to commit to owning and operating them for three years.

New banks are required to have an 8% capital commitment.

The new FDIC policy strongly encourages private-equity firms to form partnerships with existing bank holding companies when bidding on failed banks to avoid the capital requirements.

FDIC Chairman Sheila Bair said the new rules would expand the pool of capital bidding on failed banks, and she said it was appropriate to put in stronger capital requirements for bidders with no history of running a bank.

Expect banks to be hit with major fees for deposit insurance

From MarketWatch:

FDIC Considers Another $5.6B Fee on Banks

The bank collapses and the FDIC's depleted deposit insurance fund -- $13 billion on hand as of May -- are leading observers to speculate that the agency will hit banks with two large special fees it said it would consider in September and December that could each roughly match a $5.6 billion one-time fee it charged banks in May. That fee is payable by Sept. 30.

In addition to the assessment, banks are charged periodic fees -- totaling $15 billion a year-- to fill the fund, which used to pay depositors of failed institutions.

Congress in May also gave FDIC the authority to borrow as much as $500 billion from the Treasury Department until the end of 2010 to fill the depleted funds, and increased its permanent borrowing limit to $100 billion from $30 billion.

The FDIC may borrow capital from Treasury's federal financing bank, not only in a situation where its deposit insurance fund has run out, but because it needs liquid working capital to finance additional bank closures.

In good times, the fund has been made up of liquid Treasury bonds. However as the economy declined, a larger amount of the fund has become illiquid receivership assets made up of problematic loans that can't be used -- at least not in the short term -- to resolve the next failed institution. An injection of capital from Treasury may be necessary so that the FDIC can resolve the next failing institution.

CRE Prices Off 36% From Peak - Off 1% In June

Moodys/REAL Commercial Property Price Index

Inflated Loan Values

From Bloomberg.com:

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”

While Regions may be an extreme example of inflated loan values, it’s not unique. Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said. The difference represented 58 percent of the company’s Tier 1 common equity, a measure of capital used by regulators that excludes preferred stock and many intangible assets, such as goodwill accumulated through acquisitions of other companies.

Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bank’s Tier 1 common equity, by comparison, was $47.1 billion.

The disparities in those banks’ loan values grew as the year progressed. Bank of America said the fair-value gap in its loans was $44.6 billion as of Dec. 31. Wells Fargo’s was just $14.2 billion at the end of 2008, less than half what it was six months later. At Regions, it had been $13.2 billion.

Other lenders with large divergences in their loan values included SunTrust Banks Inc. It showed a $13.6 billion gap as of June 30, which exceeded its $11.1 billion of Tier 1 common equity. KeyCorp said its loans were worth $8.6 billion less than their book value; its Tier 1 common was just $7.1 billion.

When a loan’s market value falls, it might be that the lender would charge higher borrowing costs for the same loan today. It also could be that outsiders perceive a greater chance of default than management is assuming. Perhaps the underlying collateral has collapsed in value, even if the borrower hasn’t missed a payment.

If nothing else, today’s fair-value gaps highlight the arbitrariness of book values and regulatory capital. Banks already have the option to carry loans at fair value under the accounting rules. For the vast majority of loans, most banks elect not to, on the grounds that they intend to keep them until maturity and hope the cash rolls in.

Consequently, the difference between being well capitalized and woefully undercapitalized may come down to nothing more than some highly paid chief executive’s state of mind.

Fair-value estimates in the short-term can be a poor indicator of an asset’s eventual worth, especially when markets aren’t functioning smoothly. The problem with relying on management’s intentions is that they may be even less reliable.

All the more reason to have a through and carefully reasoned analysis of collateral values.

Congressional Oversight Panel: Losses Pose Threat to Small Banks

From MarketWatch: Small Banks May Need to Raise $21 Billion

According to a report from the Congressional Oversight Panel, which is charged with overseeing the $700 billion Troubled Asset Relief Program, or TARP, the 18 largest financial institutions with over $600 million in assets would "be able to deal with" whole-loan portfolio losses projected in an analysis the group completed.

However, the report's analysis of troubled whole loans suggests they pose a threat to smaller public banks, those with $600 million to $100 billion in assets.

"Using the same assumptions, it looks as if banks in the $600 million to $100 billion group will need to raise significantly more capital, as the estimated losses will outstrip the projected revenue and reserves," according to the report. "The capital shortfall for those relatively smaller banks is primarily due to the lack of reserves, which on average account for only 25% of the expected loan losses."

The report said that, based on a less pessimistic scenario, smaller public banks would need to raise between $12 billion to $14 billion in capital to offset their losses. However, it added that based on a more stressful scenario, these institutions would need to raise $21 billion in capital to offset their losses.

The model employed assumptions that were 20% more negative than stress-test assumptions employed by the Federal Reserve Board in an analysis it made earlier this year to examine how large financial institutions would handle a potential downturn in the economy.

Rep. Jeb Hensarling, the lone Republican member sitting on the COP, said he dissented on the August report, arguing that it employed assumptions that are excessively pessimistic. This was particularly so, he said, when it came to a model it employed examining the capitalization of smaller banks.

"As with any econometric model, input assumptions drive the output results and it is far from clear that future economic conditions will be 20% more negative than the 'more adverse' standard adopted by the Fed for the stress-tests," said Hensarling, R-Texas.

The panel took issue with a Public Private Investment Partnership program being rolled by the Treasury Department. The PPIP program is preparing to buy toxic mortgage securities from financial institutions, but the Treasury has delayed indefinitely a program to buy whole loans from financial institutions.

That has COP members expressing concern about a failure to address the issues of smaller banks.

"The problem of troubled assets is especially serious for the balance sheets of small banks," the report said. "Small banks' troubled assets are generally whole loans, but Treasury's main program for removing troubled assets from bank' balance sheets, the PPIP, will at present address only troubled mortgage securities and not whole loans."

The COP panel's analysis is based, in part, on stress tests conducted by bank regulators in May that evaluated the health of the 19 largest U.S. financial institutions. However, the COP report examined potential whole-loan losses at 719 banks, large and small.

The COP report argued that problems for small banks are compounded by the fact that they hold "greater concentrations of commercial real-estate loans," which pose a potential threat of high defaults.

"Small banks have more difficulty accessing the capital markets than larger banks," the report wrote. "Despite these difficulties, the adequacy of small banks' capital buffers has not been evaluated under the stress tests."

The report recommended having bank regulators repeat stress tests if conditions exceed those in the worst case scenario envisioned by the evaluations in May.

It added that Treasury and bank regulators should take steps to improve disclosure of the terms and volume of troubled assets on institutions' books, which would help "markets function more effectively."

Emphasis added

MIT CRE Index Sets Record Decline

From Reuters:

Despite a pick up in sales, commercial real estate prices posted a record drop in the second quarter, according to an index developed by the Massachusetts Institute of Technology Center for Real Estate.

With an 18.1% drop, the index, which tracks commercial property sold by major institutional investors, is now down 22% year-to-date, 32% from a year ago and down 39% from its mid-2007 peak, according to the report released on Monday.

"The big news this quarter is not just the magnitude of the drop, but the fact that transaction volume actually increased in the presence of this decline, the first volume increase since last summer," David Geltner, director of research at MIT/CRE, said in a statement. "Perhaps most important, the supply-side index of the prices property owners are willing to sell at plunged a record 18.5%, suggesting a degree of 'capitulation' that may help to finally bring market prices to a bottom.

The decline in nominal terms is far greater than the 27% drop the in the previous major commercial property downturn in the late 1980s and early 1990s. Adjusting for inflation, both periods are now tied at a 41% decline.

The downturn in commercial real estate, as marked by the index, also is greater than the collapse in U.S. housing prices, which are off 30%, the report said.

The 18.1% decline was the steepest in the index's 25 year history, far greater than the former record -- a 10.6% decline in the fourth quarter of 2008.

FDIC Guidance on SFR Junior Lien ALLL

When estimating credit losses on each group of loans with similar risk characteristics, an institution should consider its historical loss experience on the group, adjusted for changes in trends, conditions, and other relevant factors in the current economic environment that affect repayment of the loans in the group as of the allowance evaluation date. The need to consider all significant factors that affect collectibility is especially important for loans secured by junior liens on 1-4 family residential properties (junior lien loans) in areas where there have been declines in the value of such properties.

See "Allowances for Loan and Lease Losses in the Current Economic Environment: Loans Secured by Junior Liens on 1-4 Family Residential Properties."
http://www.fdic.gov/news/news/financial/2009/fil09043a.html

At least quarterly, each institution must analyze the collectibility of its loans held for investment and maintain an allowance for loan and lease losses (ALLL) at a level that is appropriate and determined in accordance with generally accepted accounting principles.
An appropriate ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired and on groups of loans with similar risk characteristics that are collectively evaluated for impairment.

After determining the appropriate historical loss rate for each group of junior lien loans with similar risk characteristics, management should consider those current qualitative or environmental factors that are likely to cause the estimated credit losses on these loans as of the ALLL evaluation date to differ from the group's historical loss experience.

Failure to timely recognize estimated credit losses could delay appropriate loss mitigation activity, such as restructuring junior lien loans to more affordable payments or reducing principal on such loans to facilitate refinancings.

Examiners will continue to evaluate the effectiveness of an institution's loss mitigation strategies for loans as part of their assessment of the institution's overall financial condition.