Saturday, March 24 , 2018, 7:20 am | Fair 47º


The Daily Capitalist: State of the Economy, Part II

Real estate sets off a chain reaction of overwhelming debt and bad investments

[Noozhawk’s note: This is the second in a three-part series by Jeff Harding on the state of the economy as we enter 2010. Click here to read Part I. Click here to read Part III.]

The Importance of Debt

The Fed, the Obama administration and a Democratic-controlled Congress are doing everything they can to prevent a recovery by delaying or preventing the liquidation of debt on the books of financial institutions.

In a credit-induced business cycle, such as this one in which the Fed pumped vast amounts of money into the economy (1 percent Fed Funds rates), some asset goes crazy. This time it was real estate, residential first and then commercial. It led to an unprecedented explosion of debt worldwide. This fake money expansion directed capital into bad investments, as we’ve sadly learned.

There’s a reason banks have tightened credit: They are worried about their capital base because they have too much bad debt on their books related to real estate. If they lend the money, they worry they might need it to cover their existing bad debt if things get even worse — so why take the risk and lend, they reason.

The administration is doing everything it can to prevent debt write-downs because it fears the ongoing debacle in commercial real estate and its impact on the banking system. Last year, it approved new FASB Rule 115, a de facto suspension of-mark-to-market accounting for loan portfolios that artificially inflates a bank’s Tier 1 capital base. Banks are undercapitalized; ignore the (not so stressful) stress tests.

The FDIC recently adopted new “extend and pretend” rules that say if the lender believes that the borrower can still pay the loan — regardless of the value of the asset relative to the amount of the loan — it can ignore valuations and not have to reserve for the loan. This gives lenders no incentive to write off loans, so they remain on their books. Ever optimistic real estate investor-borrowers are happy to extend in order to avoid huge income-tax hits as a result of debt relief.

The Big Freeze

The Fed has tried to induce liquidity by buying GSE residential mortgage backed securities, a $1.25 trillion program that will end in April. The net effect was to take about $1.55 trillion of RMBS out of the market. In essence, private debt was off-loaded to the public. A side effect is that they have monetized Treasury debt, yet they haven’t improved the credit markets. At some point, the Fed will have to sell them back to the market in order to tighten credit (a part of the so-called “exit strategy“).

None of these programs has loosened bank credit. The vast majority of small(er) business banking in America is not done by the giants, but by regional banks. And the regional banks are the ones holding most of the bad commercial real estate loans. They are facing massive write-offs and a deteriorating capital base, so they hold their capital close.

The point here is that banks will restrict lending until their loan portfolios and balance sheets are cured. The cure will be to raise more capital in order to improve their Tier 1 capital ratios and write down debt.

This explains why banks are sitting on large “excess” reserves and why we don’t have inflation.

This is the Monetary Base/M1 conundrum: The Fed has opened the monetary sluice gates (Monetary Base) to combat the credit crunch, yet money supply (M1) is declining. Why? Because there is nothing “excess” about these reserves; they are held by banks for business reasons — as a reserve against future problems. The result is that banks aren’t lending, credit isn’t reaching the economy and money supply is declining. This is an international phenomenon.

This won’t change until banks deleverage.


A recent report by McKinsey Global Insight, “Debt and Deleveraging: The Global Credit Bubble and Its Economic Consequences,” concludes that deleveraging will start about now in the United States.

In its study of 32 world financial crises since the Great Depression, the average period of deleveraging lasts six to seven years. The biggest GDP slowdowns are in the first two or three years of develeraging, and the average hit to GDP is 25 percent.

What this means is that without deleveraging, we will catch the “Japanese Disease“: economic stagnation.

Banks are now realizing that commercial real estate is not getting better. I don’t believe lenders will wait too much longer in spite of the government’s effort to prevent it. We need to carefully watch bank balance sheets, credit conditions and money supply.

Commercial Real Estate and Liquidity

Commercial real estate is killing regional banks.

Unpaid loans on malls, hotels, apartments and home developments stood at a 16-year high of 3.4 percent in the third quarter and may reach 5.3 percent in two years, according to Real Estate Econometrics LLC, a property research firm in New York. That’s a bigger threat to regional banks, which are almost four times more concentrated in commercial property loans than the nation’s biggest lenders, according to data compiled by Bloomberg on bailout recipients.

“Community and regional banks basically became real estate banks in the past 25 years, and now real estate is on its back,” said Jeff Davis, an analyst at FTN Equity Capital Markets Corp. in Nashville, Tenn. “The largest banks have other areas where they can make money, be it consumer lending, capital markets and asset management.”

A new report by Standard & Poor’s said: “Even though most highly exposed banks with weaker balance sheets are already rated below investment grade, more downgrades are possible; indeed, approximately 75 percent of the rated banks with the largest exposure to CRE carry negative outlooks. ... We see no reason to believe the impact of this credit cycle in CRE will be less severe in terms of losses banks incur than that of the 1990s. ...

“About 40 percent of rated banks’ CRE loans are made for construction, acquisition and development purposes, of which 22 percent (or 8 percent of total CRE loans) are for residential construction ... nonperforming loans in the homebuilding sector to rise to 18 percent as of Sept. 30, 2009. Homebuilder-related net charge-offs rose steeply to an annualized run rate of 4.8 percent for third-quarter 2009.

“Nonresidential commercial construction loans have gone sour as the fundamentals in those markets deteriorated ... office vacancies reached 17.3 percent as of third-quarter 2009, and C.B. Richard Ellis (CBRE) estimates they will go to 19.5 percent in 2010, higher than the peak of 18.9 percent in 1991. Likewise, retail vacancies, currently at 12.3 percent, are headed to 12.9 percent per CBRE estimates, vs. 11.3 percent in 1991. Multifamily vacancies are at 7.4 percent vs. 7 percent in 1991. Nationally, rents for offices are down substantially more than in 1991 — by 15.7 percent vs. 9.4 percent. This time around, a particular trouble spot is the hotel sector, especially the casino hotel sector, where overbuilding has been a factor. The occupancy rate for this asset class is a low 60.9 percent, a level last seen after Sept. 11, 2001. Nationally, rents for offices are down substantially more than in 1991 — by 15.7 percent vs. 9.4 percent.”

And: “A whopping $585 million of CMBS loans were liquidated in December, the largest monthly volume of liquidations ever. Special servicers, facing growing workloads, have become far more active in disposing of the loans they’re handling. Meanwhile, CMBS delinquencies continued to climb, hitting a rate of 5.22 percent.”

And: “The FDIC recovered $497.3 million, or [only] 29.6 percent of the face value of commercial real estate loans it sold during the third quarter. ... That’s the lowest recovery rate the agency has had since its whole-loan sales program got into high gear late last year ... In contrast, the agency’s recovery rate was 54.7 percent for the 2,487 loans sold in the second quarter, according to FDIC data.”

I don’t mean to beat this issue to death, but from a report prepared by Property and Portfolio Research:

“Due to government intervention, the concept of distressed selling and buying did not materialize anywhere in North America [in 2009],” said Mark Rose, chairman and CEO of Avison Young in Chicago. “The U.S. government put money into the major banks, which in turn extended every loan they could to avoid realizing losses. The Securities & Exchange Commission watched from the sidelines and allowed the impacted lenders to postpone the inevitable.”

PPR predicts that by the second quarter of 2010, lenders will more aggressively write off “distressed” CRE loans. That will attract lots of deal capital waiting on the sidelines. If so, then deleveraging will have begun.

Residential Real Estate

Residential real estate gets the award for “Most Bubbly Asset of the Great Recession!” This is where the river of Fed credit flowed, aided by loose lending standards encouraged and institutionalized by Congress, Fannie, Freddie and the Federal Housing Administration. Wall Street, using faulty risk models, wrapped it up and sold it worldwide. They fooled themselves for years until they realized they couldn’t spin dross into gold.

Rising prices fed the bubble, debt skyrocketed, homeowners pulled out cash and went on a spending spree. This spawned the boom in retail, which spawned the boom in shopping centers. Which has collapsed. The boom was fake; hundreds of thousands of residences built were a huge malinvestment of capital. This is when the damage was done. The bust is the cure.

The residential real estate market is still deleveraging, price deflation goes on and sales are up: “For all of 2009, there were 5.16 million home sales, up 4.9 percent from 4.91 million in 2008. It was the first annual sales gain since 2005.” Much of that increase was due to the first-time buyers’ tax credit, which some say was responsible for 400,000 of sales. Starting in November, sales have tanked (down 16.7 percent in November for previously owned homes).

Regardless of sales, prices keep falling. People may be motivated by tax credits, but mostly I believe they are driven to the market by falling prices. Political reports say the tax credit will not be extended. The most recent Case-Shiller 20 cities report showed prices declining 5.3 percent. Some areas are stabilizing (Dallas, Denver, San Diego and San Francisco), but Las Vegas was down 25 percent, taking the average down.

I believe bargain hunting will continue to occur and sales will continue to rise. Here in California, housing supply has shrunk to a five-year low (3.8 months). The GSEs and the FHA are providing massive amounts of credit to the mortgage market, and I don’t see this stopping anytime soon.

What will prevent a new bubble, and cap prices, for at least this year is the shadow inventory: potential foreclosures. About one in four homeowners are underwater.

“The proportion of U.S. homeowners who owe more on their mortgages than the properties are worth has swelled to about 23 percent, threatening prospects for a sustained housing recover. ... Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American CoreLogic, a real-estate information company based in Santa Ana. Home prices have fallen so far that 5.3 million U.S. households are tied to mortgages that are at least 20 percent higher than their home’s value,” the First American report said.

There could be 3 million foreclosures this year, up from last year’s 2.8 million.

Here are a few more points to consider:

» “U.S. 2009 Foreclosures Shatter Record Despite Aid”

» “More Homeowners Struggling As Option ARMs Reset Higher”

» “‘Shot in the Arm’ or Shot in the ARM?”

» “U.S. Prime Jumbo RMBS Delinquencies Nearly Triple to 9%; CA Drives Trend”

This is threatening the financial integrity of the FHA: “In last year’s third quarter, the FHA insured 25 percent of mortgages, according to Inside Mortgage Finance, a trade publication. ... FHA-insured mortgages made in 2007 and 2008 are largely responsible for the agency’s precarious position, with default rates approaching 24 percent.”

The government’s plans to help beleaguered homeowners is falling flat because it isn’t requiring lenders to write down mortgage principal, or require a renegotiation of secondary home equity mortgages. It takes homeowners about three seconds to figure out that even with lower payments, there is no point paying for a home when the value is less than the amount of the loan.

If there were 5.16 million home sales in 2009, without the boost from a tax credit and with a substantial shadow market, expect prices continue to fall moderately. Sales will continue to increase as people search for bargains. The FHA and the GSEs will provide ample credit for the mortgage market. The government announced in December it was giving Fannie and Freddie unlimited guarantees for the next three years; they have thus nationalized them.

There is one more factor to consider about residential real estate: Homeownership rates are declining (Megatrend No. 5). At the end of 2009, the homeownership rate fell to 67.3 percent from the high of 69 percent. From 2007 to 2009, nearly 4 million homes were lost to foreclosure. And homeownership rates are now moving closer to the level that was common in the 1990s.

A recent study from the New York Fed concluded, “This (negative equity) situation is likely to put downward pressure on future homeownership rates, and has potentially important implications for the maintenance of the housing stock, the stability of neighborhoods and future household saving behavior.”

The residential real estate market is deleveraging, and the government can do nothing to prevent it.

— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.

  • Ask
  • Vote
  • Investigate
  • Answer

Noozhawk Asks: What’s Your Question?

Welcome to Noozhawk Asks, a new feature in which you ask the questions, you help decide what Noozhawk investigates, and you work with us to find the answers.

Here’s how it works: You share your questions with us in the nearby box. In some cases, we may work with you to find the answers. In others, we may ask you to vote on your top choices to help us narrow the scope. And we’ll be regularly asking you for your feedback on a specific issue or topic.

We also expect to work together with the reader who asked the winning questions to find the answer together. Noozhawk’s objective is to come at questions from a place of curiosity and openness, and we believe a transparent collaboration is the key to achieve it.

The results of our investigation will be published here in this Noozhawk Asks section. Once or twice a month, we plan to do a review of what was asked and answered.

Thanks for asking!

Click here to get started >

Support Noozhawk Today

You are an important ally in our mission to deliver clear, objective, high-quality professional news reporting for Santa Barbara, Goleta and the rest of Santa Barbara County. Join the Hawks Club today to help keep Noozhawk soaring.

We offer four membership levels: $5 a month, $10 a month, $25 a month or $1 a week. Payments can be made through PayPal below, or click here for information on recurring credit-card payments.

Thank you for your vital support.

Reader Comments

Noozhawk is no longer accepting reader comments on our articles. Click here for the announcement. Readers are instead invited to submit letters to the editor by emailing them to [email protected]. Please provide your full name and community, as well as contact information for verification purposes only.

Daily Noozhawk

Subscribe to Noozhawk's A.M. Report, our free e-Bulletin sent out every day at 4:15 a.m. with Noozhawk's top stories, hand-picked by the editors.

Sign Up Now >