Wednesday, October 21, 2009

Shoeless banks.

Long ago, it appeared to me that the commercial real estate bubble was just as big or bigger than the real estate bubble, especially in Bend. I didn't know what it was called, I'd never heard the acronym CRE, but I believed too many commercial buildings were being built, and rents were getting unrealistically high.

So imagine my relief to read this article:

Commercial Real Estate Debt Won't Be the Next Shoe to Drop, Economists Say

Oct 20, 2009 12:55 PM, Elaine Misonzhnik


Yes, that's right. "WON'T" be. It will be a shoeless recovery.


For months, the buzz has been that commercial real estate—with $3.4 trillion in outstanding debt, $1.4 trillion of which is coming due by the end of 2012—would precipitate the next leg in the credit crisis and possibly derail the broader economic recovery. To some, that mountain of debt coming due represents a clear parallel to the trillions of dollars in residential loans that helped destroy more than 100 banks and made the current recession the deepest and longest since the Great Depression.


Um, so far.....so bad?


The situation seems especially ominous given that commercial real estate values are off 40 percent from market peaks and credit markets are barely out of hibernation mode. That means indebted owners can't sell a property and repay their mortgage with deal proceeds. It also makes refinancing difficult. Today, borrowers have to put more of their own equity into a deal and lenders have tighter standards. Loan-to-value (LTV) ratios are not only lower than they were at market peaks, but have to be based on the current value of the property, which is lower than it was a few years back. That means a bank might want to replace an 80 percent LTV mortgage on a property once worth $10 million with a 60 percent LTV mortgage on a property now worth $6 million. To some people, this is sending off warning bells that commercial real estate may do as much damage to our financial system as residential mortgages did in 2007 and 2008.


Still not looking good, but I'm sure they'll get to the point.


Yet according to many real estate economists, this fear is largely misplaced. Commercial real estate debt will likely stall the recovery in the credit markets, they note, but because of a combination of factors, including the limited impact of commercial real estate loans on the overall economy, it won't bring about the same wave of distress as the housing downturn did.

"As far as the impact of commercial real estate on the overall economy, I don't think it's going to be the next shoe to drop," says Robert Bach, senior vice president and chief economist with Grubb & Ellis, a global commercial real estate services firm. "These problems are focused in regional banks and the Federal Deposit Insurance Corp. (FDIC) has a tested method of shutting those down on Friday and opening them on a Monday under the auspices of a bigger bank. These are not too big to fail banks. I don't see [commercial real estate] as an unmitigated disaster—I see it as a repeat of what happened in the 1990s, but the economy can handle it."




Oh, what a relief. Uh.....wait a minute. Your reassurance consists of -- "it won't be an unmitigated disaster" and "the economy can handle it." ??!!

The good news seems to be -- it won't bring down the big banks or require a bail-out; it will only bring down those pesky small regional banks and who cares about those since we have the FDIC? Then follows two paragraphs detailing the problems that the FDIC is having financing this bust, but the tone still seems to be..."What Me Worry?"



The FDIC, however, faces some concerns. A recent analysis by the agency's Office of Inspector General found that during the peak of the real estate market many banks ignored FDIC's 2006 recommendation that they keep commercial real estate holdings at less than 300 percent of total capital. Meanwhile, after dealing with 100 bank bankruptcies last year, today the agency is facing a deficit for the first time since 1933 and might lack the funds to deal with the potential fallout of a commercial real estate crisis.

In 2009, bank failures cost the agency $25 billion on top of the $20 billion it doled out in 2008. To deal with the money shortage, the FDIC is requiring banks to prepay $45 billion of insurance premiums by the end of this year. The premiums would cover the fourth quarter of this year and all of 2010, 2011 and 2012. Overall, the agency is projecting that bank failures between 2009 and 2013 will cost it $70 billion.



Followed by another paragraph about how the CRE market is going to be "battered" for the next few years. "Battered" is their word.



Meanwhile, more than $1.4 trillion in commercial real estate loans are scheduled to mature between 2009 and 2012, including $320 billion next year, according to ING Clarion Real Estate, a real estate investment management firm. That's coming at a time when new sources of refinancing remain scarce and valuations of commercial real estate properties are getting battered by weakening fundamentals. In the first half of 2009, the volume of distressed commercial assets grew 122 percent, ING reports, to $138 billion, including $32 billion in the retail sector.


Still waiting for the good news, guys....Oh, here it is:



The good news is that total volume of commercial real estate debt is about a third of the total amount of outstanding residential mortgage debt, which stands at approximately $10.9 trillion, according to the Federal Reserve Board's figures.

What's more, because the residential mortgage crisis affected almost every homeowner in a country with a homeownership rate of 67 percent, it had a devastating impact on consumer spending, which makes up about 70 percent of U.S. GDP. During the housing boom, Americans would refinance their homes and use the proceeds to shop till they dropped. Once refinancing became impossible, consumer spending dried up. By contrast, troubles in the commercial real estate industry might cause damage to banks and large institutions, but will have a limited effect on Main Street, says Clint Myers, strategist with Property & Portfolio Research, a Boston-based real estate research firm.



So....since it's 'only' a third as big as the residential real estate market and because it doesn't affect the consumer directly, we're golden! As the following paragraph says, it only really impacts on regional banks, and who cares about those?



Any potential damage will also be mitigated by the fact that commercial real estate debt has been largely concentrated on the balance sheets of regional banks, rather than the big national players, and that most of the loans issued before 2005 feature solid underwriting, adds David J. Lynn, managing director with ING Clarion Real Estate.



So, we don't need to worry because "most" of the CRE were issued before the boom, and therefore are more solid. Hmmmm.....well, yeah. Just like most housing loans were issued before the boom and are therefore solid.

But....well, guys, we're ARE talking about the boom and bust, here. I'm sure the loans written 20 years ago are even more solid. I think maybe the real estate agents missed a real handy excuse:

"Well, gee, all the loans we made before we went bat-shit crazy are still solid. What about those, huh? We were pretty good until we were bad!



Today, 54 percent of all commercial real estate loan defaults come from loans sponsored through commercial mortgage-backed securities (CMBS), which were a major source of real estate debt between 2005 and 2007. Loans issued by national and regional banks account for only 12 percent and 11 percent of all defaults, respectively.


The preceding paragraph seems to contradict everything they had said up till now. It appears that the problem is, in fact, a more general national problem -- Commercial Mortgage Backed Securities -- issued between 2005 and 2007.

But again, no worries, because the government won't let the big guys fail:


After the collapse of Lehman Brothers, the government isn't likely to let another big national lending institution go under, so most of the damage from bad commercial real estate loans will be contained in the regional bank sector, Lynn notes. And the financial system could withstand the failure of several hundred regional banks without toppling over, adds Myers.

That's not to say that all those commercial loans won't cause serious problems in the credit markets. As long as banks avoid realizing losses on commercial mortgages, commercial asset values will remain artificially high, Myers says. That, in turn, will likely limit the flow of new credit into the commercial real estate market, leaving some owners cash-strapped.

Myers doubts the possibility of another large bankruptcy in the public REIT sector, since REITs have proven they can raise enough funds to survive through equity offerings. But there will likely be added pressure on privately-held real estate investment firms.



The article rounds up, reassuring us that it's "only" local and regional banks that are going to fail, and who cares about those? I'm sure Umpqua and CACB are totally O.K. with that....



"The real stress in the system [will be on] the banks," he says. "The pace at which regional banks fail will probably accelerate from this year to the next. And what it will mean is that there will be very little new lending activity for commercial real estate and it's going to be very hard to grow."



See? Nothing to worry about.

What's interesting about these types of articles, is that if you just read the headline and the general tone, you'd think things were O.K. But if you read the content, and think about what it's saying, it's anything but O.K.

Especially interesting since this article seems directed to the retail market and you'd think that retailers would be a little more savvy.....you'd think.

The only good news I could see in this article was that the CRE debt was only a third the size of the residential RE debt. Except, I suspect that most of that retail development was concentrated in the boom areas. If a town suddenly becomes 'metro' it's going to be followed by retail. If a town thirty miles away from the city becomes a hot residential area built up from the ground, it's going to be followed by a host of new commercial. Anyplace runaway residential took off, it will be followed by runaway commercial.

Especially towns like Bend.

To me, the most ridiculous part of this article is how it's O.K. if local banks go down because they're covered by the FDIC.

That's a bit like saying, it's O.K. to die, because you've got life insurance.

Thanks a bunch.

2 comments:

Jeff said...

Great evaluation of that article, Duncan.

tim said...

It's code. This is how the paper communicates panic while trying to not piss off advertisers.