Tuesday, March 30, 2010

COMMERCIAL REAL ESTATE - the next shoe to drop

The American meltdown continues.  The first financial crisis of 2008 was brought about largely by the use of derivatives based on inflated land values with insufficient income to serve the mortgages. These derivatives were essentially without real value and their collapse led to a massive taxpayer bailout of financial corporations deemed “too big to fail” That was the crisis of 2008/9. Well, Elizabeth Warren, the Harvard law professor who heads the congressional oversight panel designed to monitor the bailout is issuing yet another warning. The panel warns that “Over the next few years, a wave of commercial real estate loan failures could threaten America‘s already-weakened financial system.”

Of course, congress and the media are ignoring this warning as usual. The current Goldman Sachs ambassador to the US – Tim Geithner refused to comment on the report. He did point out the problem is most acute for smaller banks that control only a minor share of the banking system, "so we are probably likely as a country to be able to manage through and withstand those remaining pressures." I.E. it is not going to crush the super banks – they will get another bailout and the small banks will be shut down to make the big banks even bigger – just like last time.

Commercial loans are used to fund the development of business properties such as shopping centers, offices, hotels, and apartments. In case you haven’t noticed, there has been a whole lot less business going on in the US. As a result, much of this property lies empty and producing no income for the developers. These loans usually have terms of three to five years, with a balloon payment at the end. Therefore at the end of the term, the entire balance comes due and payable. The usual assumption is the building will be full of clients and generating revenue and so the developer can sell the property to someone who can easily arrange long term financing for a successful property. That is the usual method. How the industry plans to deal with a deluge of empty properties with negative cash flow remains to be seen.

Small and medium sized banks are struggling to put away reserves to handle expected losses in the future. Small banks are doing this because they know that the Treasury and Federal Reserve are showing no mercy to banks outside the super 6. By the strictest definition this would be: Morgan/Chase, Citibank, Bank of America, and Wells Fargo plus the two phony banks Goldman Sachs and Morgan Stanley. The super banks fully expect to be bailed out again and they are galloping to leverage all the tax payer money they received right back into the same fraudulent schemes they were running in 2008. With a Goldman Sachs executive at the head of US Treasury, the Federal Reserve and many national banks, preferential treatment to the big guys is a universal assumption. If they were too big to fail in 2008, they are even bigger today.

This oncoming dilemma has the potential to create yet another American financial meltdown. With 3 to 5 year terms this means that the loans coming due in the next 2 years are those made in 2005 to 2007, at the very top of the real estate bubble. Prices were insanely high and loans were given to almost anyone who requested them. You have some of the worst loans ever made to some of the weakest borrorers all coming due for a complete refinancing in the middle of a huge credit crunch. Banks are far less likely to extend any credit at all to risky clients as they are scrambling to build up enough reserves to cover the loans which completely default.  

It has the potential to be a self fulfilling cycle of implosion. In other words, hording liquidity to insure against the bottom third of loans will dry up credit. This will prevent refinancing of the middle third which could survive if they could get reasonable refinancing. The inability to get that refinancing will mean the middle group will default and dump even more assets on the market. This flood of foreclosed commercial property will lead to a drop in prices which will further strain the ability to refinance old loans made at the peak of the bubble. Eventually, even the top third of good solid credit customers may be under pressure. 

According to the COP report almost 1.5 trillion in commercial real estate loans will reach the end of their terms in 2010 to 2012. Commercial property values have fallen more than 40 percent since the peak. More than half the loans are underwater as of today. Vacancy and the downward spiral of business in general have led to a 33 to 40 percent decline in rental income. The loss of earning potential has reduced property values even further.   

These over-priced, under-earning properties must somehow find complete refinancing of loans that are more that the property evaluation in a time of unprecedented reduction in credit. It is a deadly spiral. Each loan that defaults requires more reserves at the bank, reducing the pool of credit further. More empty properties on the market lead to lower values which push loan to asset values even further underwater. The deterioration in loan terms means more loans default starting a whole new cycle of reinforcing negative consequences.  

Of course, the government will step in, but almost surely after most of the small and medium banks are closed or gutted. Once again, the super banks will be the sole recipients of bailout. The rich will get richer. The big will get bigger. This brings up one more little problem. The super banks are playing with all their money in financial instruments (AKA gambling). It is the small banks that finance almost all of American small business. With the small banks gone, credit for small business is gone. No new small business, more closures, more unemployment.  

The Congressional Oversight Committee clearly warns us “Because these banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery, and extend an already painful recession.” It would be nice to think the warning will be heeded. Nice to think that – but it would fly in the face of all evidence and past behavior. The pragmatic expectation would be that Elizabeth Warren will be ignored again and a predictable and possibly correctable calamity will be visited upon the American public to the benefit of a few mega millionaires.

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