This Time Is Different

This Time Is Different

Having lived through several major downturns, including the eighties interest rates of over 20%, it is instructive to compare and contrast. This time is very different. While the S&L industry imploded in 1989, the rest of the world was not so affected, nor did the US financial system collapse. The S&L’s were a small sector in terms of dollar impact. This time we have the entire world financial system nearly ceasing to function and suffering enormous long term damage. Foreclosures will not be mitigated by the modification plans and it is entirely possible that the problem will be with us for a considerable time. Home equity lines are mainly a thing of the past. Unemployment will take 4-5 years  to recover to more normal levels of 5.5%, and real estate loans will not permit high leverage on inflated projected values.

All of this indicates that the over inflated values of 2007 will not possibly be recaptured for probably at least a decade on an inflation adjusted basis. There will not be the ability of consumers to over leverage to buy things they can’t afford including homes, take trips they can’t pay for, and speculators will not get the absurd funding to take what amounted to options on assets they intended to flip.

Just because the 1990 and 2001 recessions happened does not mean they are relevant to this time. Almost all the metrics are different. The politics are very different, the regulations will be different, and the risk officers and auditors will be under enormous pressure to restrain the free wheeling over leverage of investment banks and others. Real estate has returned to fundamentals finally, and it will not be the trading vehicle it had become over the past 15 years.

What does this mean. You need to be a lot more careful on the buy this time. Values are not going to take off. Net effective rents will remain constrained for many years. Leverage will remain constrained. In about two years inflation will begin to drive up operating costs but leases signed in 2009-2011 will be at lower rates than had been the case in 2007-8. Interest rates will go up. Most importantly, property taxes will have to rise to cover the massive deficits at the local and state levels where the budgets of these levels of government are simply unable to pay the bills. The federal budget will continue to rise unrestrained to dangerous levels. It is clear Pelosi cares nothing about fiscal responsibility and neither does Obama. They will do anything to pass healthcare and all of their agenda no matter the damage it is doing. That has to mean higher taxes for all of us who actually still pay taxes-which is just a little over 50% of the population. Those of us who are able to earn high incomes will be paying far more.

The bottom line is you need to take all of these issues into consideration when pricing an asset for acquisition. Discount rates and terminal values need to be adjusted to take these metrics into consideration. Your risk adjustment when making assumptions about discount rates and cap rates need to be cognizant of these future restraints on value over the next 5 years. It is all in the buy. Don’t let a few recent deals where too much money was bidding on just a couple of properties let you get lulled into making a mistake that cap rates are low again. They are not indicative. When a lot of assets are finally put to market, so supply of deals is again normal, cap rates are likely to rise a little at that time. Don’t buy at any price just to spend those available funds- you could regret it later. Stick to old time fundamentals.

Silverton And FDIC Bids

Silverton And FDIC Bids

The bids are due in about 30 days on the Silverton portfolio. It is mainly hotel loans, and it is only a portion of the hotel portfolio. It consists of whole loans and loans participated out to small community banks. The whole loans are probably reasonable properties with mostly decent borrowers. There are supposedly 65 bidders for everything from the entire portfolio of $416 million face amount of which $254 million is participated loans, down to individual borrowers bidding for their own loan.  It is highly likely the winner will be a bidder for the whole portfolio, but politics will possibly interfere with the bid process, and they may sell some loans to the borrowers.  FDIC will retain a 60% interest in the buying entity, so it will have substantial control rights over how the workouts are handled. The confi required was so onerous some potential bidders backed away.

Here is one major issue. The participating loans are held by tiny banks who have essentially no capital if their assets were written to true value. Whoever buys the loans from Silverton will be faced with the FDIC likely interfering with normal restructures so that the little banks do not take the hit to capital. This is very bad policy and will not allow borrowers to get the restructures they need. It also means many bidders will not bid this part of the portfolio, and those who do, will way underbid due to the FDIC interference. FDIC is likely to require more extend and pretend, and a lot of little banks who do not deserve to exist, will be kept alive by FDIC only to die another day.

Now we have already seen a whole host of people involved with these banks screaming that it is unfair to recognize truth and the FDIC is already under huge pressure to lie about the true value of these loans. If reality would be permitted, then we could have a true arms length bid for these assets which would set the market value in a proper way. Then all banks would be forced to recognize reality and the bad loans would be forced to come to market. That would start the loan sales which we have all been waiting for and begin the healing of the banking sector by closing all the small, poorly run banks across the country that should never have been allowed to exist in the first place. They made real estate loans they were not qualified to underwrite, and they have no idea even now what these assets are worth.

The politicians and media love to blast the big banks who made many bad decisions as well, but the real problem today lies at the regional and small bank level where all of these small loans still reside, and will continue to reside for several more years so long as FDIC insists on hiding the truth. The Silverton auction is not going to reveal true market values due to this misdirected politicized policy.

Government Interference Delays Solviong The Problems

Government Interference Delays Solving The Problems  

In his latest misguided proposal, Obama wants to halt all home foreclosures until the borrowers have been afforded 5 chances to get a modification. 1. Government interference in the sorting out of distressed markets is never good unless it is in the form of the RTC which was able to simply seize assets and resell them to the highest bidder. The Japanese have painfully learned that the market needs to clear itself at whatever the market clearing price is. 2. The proposed program is nothing but price fixing. 3 The program assumes borrowers are all responsible and well meaning, and they want to have a modification. 4. This is another example of the Democrats thinking they know better than the market and the rest of us.

Reality is most troubled loans are held by homeowners who are either speculators, or by irresponsible borrowers who were simply greedy and did not care if they lied on their application or that they knew they could not afford the house. I have been in the business of buying residential mortgages. The entire culture of borrowers has changed. Even those who are true homeowners, and not speculators, have no sense that it matters to keep your mortgage current. Such thinking is further encouraged by the liberals who think it is the big bad banks who are wrong and not the borrowers.

When we tried to modify loans we found it was often impossible to communicate with the borrower. They did not answer calls or letters. It was often necessary to send a person to the house to make contact and then it was usually a waste of time. People  at the low end of the income ladder have generally low credit scores and so it does not seem to bother them that a default on their mortgage will hurt their FICO score. After all, Obama and Pelosi tell them they are not at fault and then the government offers to help them in their defaulting behavior by telling the banks they can’t act. What message does that send. In many states now the local courts are as bad and it is very hard to foreclose. This just reinforces the concept that as a borrower I can do as I please and they can’t bother me. Borrowers view is this is a way to live in the house rent free for a year or more, no mortgage payments, no rent, and when they finally throw me out I rip out the appliances and sell them for a couple of thousand dollars. In short, the government has created a whole new culture that there are no bad consequences to default and be irresponsible.

All they have done is delay the inevitable, cost the banks millions of wasted dollars chasing ghosts, and they keep house prices artificially high by not letting the defaulted inventory reach the market quickly to once and for all set a real price. This keeps poorly maintained houses in the neighborhood and hurts everyone. Investors who buy foreclosed houses generally spend $8,000-$12,000 per house to paint, re-appliance and fix it for new tenants or owners. This upgrades the area and the overall quality of low cost housing. It resets the pricing to where it belongs. That helps everyone.

In addition, just as they did in Chrysler, the government is proposing to interfere in contract rights which will have substantial negative consequences on future pricing and credit approvals, thereby hurting the very people they claim to be helping.

If Obama, Barney and Pelosi keep this trend of blame the banks, interfere with contract law, and protect the irresponsible borrowers, then we will have unintended consequences for many years to come which will grow to a problem of major proportions.

New Lending Platforms

New Lending Platforms

There is wide recognition that the demand for refinancing and for acquisition debt funding is very large and unmet. It is highly likely that there will not be a large scale securitized lending market again for at least 2-3 years, until a variety of regulatory and legal issues are resolved, and until the bond buyers are comfortable the underwriting is back to 1993-94 rules, and the rating agencies have materially amended how they analyze risk. All of this is going to take time.  While there will be a few large securitized offerings that make news, there will be a long wait for the ordinary mid size to small property to get conduit funding again.

To fill that demand there are various groups who are setting up, or have already set up lending platforms.  I have spoken to several and am involved in working with a few. The issues are quite interesting. None are very large since funding for them is limited and warehouse lines are not yet readily available. The ones that have been or are formed rely on equity investors to provide the funds. Those investors are generally seeking a 15% yield-part current and part PIK.  They generally are not interested in pure equity participations, but do want equity like returns through the PIK interest.

The other issue is the investors want relatively lower risk than is required to obtain equity like returns. There in lies the rub. This has hampered some of the fund raising that is underway. It is why some of the proposed mortgage REITs have not been successful. It is also why some that have been raised are buying paper in the hope of higher returns.

Buying existing paper, depending on vintage and originator, can be deeply flawed, and so may or may not turn out the returns intended if one is not careful what is being bought. Originating new paper for refi may also not drive the returns since a lot of better borrowers simply will not pay the price and will use extend and pretend for now. The main market is more likely the acquirer who will look at the PIK or participation as bridge equity. The issue there is the borrower will want short call protection so he can refi this loan as soon as there is a revitalized lending market at more normalized pricing- likely in 2-3 years.

The groups now forming are likely to offer 80% -85% leverage on cost to acquire or current value, on the very reasonable bet that we have hit bottom and values will only rise from here ., making the leverage in 3 years more conservative and thereby refinancable.  The issue is that the investors who provide the capital to the lending platform are risk averse and view 85% leverage as too risky even though is probably is not if well underwritten under today’s numbers.

Having created a lending platform myself in 1993, I have always believed that the exact right time to lend is at the very bottom of the cycle, like now, and to then stop lending 5-7 years into the upturn. That is when everyone else is lending and margins are squeezed, and underwriting and covenants start to get too easy.  When securitization is back in a sizable way, it is time to get out. In the meantime, high leverage lending if underwritten right, and priced to fully reflect the equity component risk of the B piece can be safe and very lucrative.

Securitization Was As Much To Blame As Anything

Securitization Was As Much To Blame As Anything

I created the first hotel CMBS programs in March, 1993 so I have a lot of first hand understanding of what happened. Low interest rates and high mortgages were not the cause, just the manifestation of the crisis. While many things and people all came together to create the crisis, the underlying thing that made it all come together was securitization.  If there is no wide availability of capital to loan, then low rates alone cannot have a major impact. Housing and the irresponsible lending could not have happened if there had not been the excessive lending capacity made possible by securitization.  While there was gross ethics failure by Barney Frank covering up for Raines producing phony financials, and pushing subprime lending by Fannie, it was the ability to securitize any mortgage with no real underwriting which really blew the top off the subprime lending market. Wall St enabled the crooked mortgage brokers who were encouraged to make any loan, and to produce even more volume to fill the securitized pools. If it were not for securitization, the warehouse lines would not have been available to the mortgage brokers to make the bad loans. This then flowed over to commercial mortgages where filling the securitized pool became the only goal, not underwriting quality, which was thrown out entirely near the end. If I can sell it, I will loan it, became the mantra.

Subprime lending was not new. It had been around forever. Except that it was done by very experienced small lenders who knew how to judge the risk of a cab driver or waiter who earned money off the books. Risk was carefully controlled and volume was relatively low. It was only when securitization arrived to provide the fuel, along with Barney Frank pushing home ownership for all, and the CRA rules against redlining, that subprime got out of control. It was easy then for Wall St and mortgage brokers to move on to over lending to everyone in order to fill the pools with more and more loans. All it took was someone falsely claiming that house prices never went down in the US, and the party was on.

When we created the original securitized programs in 1993, the underwriting was very tight, there were only a few tranches, there were no CDO, SIV’s, no mezz, and no CDO indexes or other esoteric derivatives dreamed up by a bunch of quant kids who had never developed so much as a bird house, but who were allowed to create models of how real estate risk was to be assigned and priced. They had zero understanding of real estate,  and they became enamored with their computer algorithms. The truth is, nobody can really slice and dice a mortgage or piece of real estate in so many tranches and have any real understanding of the relative risk and pricing of the risk with any degree of reality.

In November,  1993, two of us had a discussion of how we had just created the next S&L crisis except it was going to be far worse. We knew then that Wall St would not be able to resist the temptation to take securitization to ever riskier levels and volumes, and eventually the whole thing would collapse. The outcome was very predictable for those of us who had been around the Street for a long time. We also knew then, that the servicing protocol would never work in a crisis.

The crisis was the fault of everyone-the regulators, politicians, Wall St bankers, crooked mortgage brokers, irresponsible borrowers and the media insisting that everyone should own a home, or that commercial real estate prices were in a new paradigm of cap rate compression. Had it not been for securitization to provide the fuel, the disaster would have been far more contained.

The Sovereign Debt Issue is Being Way Overplayed

The Sovereign Debt Issue Is Being Way Over Played

I am not suggesting at all that the PIGS problems are not serious, they are. However, the thing everyone is missing is that the EU cannot allow these minor countries to drag down the budding economic recovery, nor can the US Fed. The European bank and the IMF, with the help of Bernanke, will find ways to shore up these economies and nobody will go into insolvency. The huge jumps in CDS rates on the PIGs is way overblown, and just a bunch of traders who do not see the big picture once again. Europe and the US cannot let these countries collapse, or we risk radical left and right  wing regimes taking them over, and that would then be real problems.  That was how Fascism got started. That is the real issue, and not bond ratings. You need to look at the real geopolitical and related issues when assessing how these events will play out, and why they will not be allowed to blow up. The real risk in the whole financial crisis is the future of capitalism, and preventing the radical left or radical right from using it to gain major political advantage and a replay of Hitler.  

The other issue many are not realizing is that the GDP of these countries really is not all that relevant. Portugal and Ireland could fall into the ocean and nobody would even notice. Greece the same, other than some great vacation spots would be gone. The GDP of Greece and Portugal is less than New Jersey.  Spain is just $1.4 trillion, or there about. Italy has not had a real functioning government since WWII, so why is anyone upset by what they do. There is nothing new there. They run their country in their own screwed up way, and that will probably never change.  Somehow they manage to keep going.

The European banks exposure to securitized debt, bad real estate loans and derivatives was vastly greater than to these meaningless countries. So let’s not worry that the European economy is crashing-it is not. If France, Germany and the UK start to crash, then you can get worried, but the PIGS are not taking down the major banks nor the EU.

If you want to be concerned, worry about California, New York, New Jersey and many large municipalities. They are much larger than the PIGs as to economic impact, and their irresponsible spending of the past years and their labor contracts and pension liabilities are really something to be worried about. To fix their problems they will have to raise taxes, fees and other cash generators. That impacts you. Property taxes have to go up. Sales taxes have to go up. Income taxes at all levels of government will go up. Lending for new development will remain almost non-existent for a couple of more years.

Focus on what really matters and ignore all of the silly emotional rhetoric around Greece and the other noise.

Where Are All The Deals

Where Are All The Deals

Everyone is asking when will the lenders start to sell paper and REO in a meaningful way. The answer is- not for a long time. The problem is twofold. First the banks are so damaged that they cannot bear the hit to capital that a true recognition of current value would require. While the suspension of mark to market was necessary to avoid a complete collapse of the bank balance sheets in 2008, it created an Alice In Wonderland world. Now everyone is living in the land of make believe. Almost all real estate is worth 40% less than at the peak in 2007, and 40% less than it is being carried. We are not going back to those frothy values for a very long time-maybe 10 years on an inflation adjusted basis. So now we have been forced into extend and pretend loan extensions to continue the fairy tale. If there were no such extensions, then the lenders would have to recognize reality, and we would be back to the problem of lender capital being hard hit by recognition of true values. Many lenders are also under the illusion that they can repeat what a few did in 1993-94, which was to hold the assets and later book a material profit on later sale. Lastly they looked at the huge profits many opportunity funds and individual investors made in the RTC deals, and they think they should now reap those profits by holding the REO and loans.

Borrowers remain in denial. They grossly overpaid in the froth period, and they cannot now accept that they have been wiped out, so they also are making huge bets that their equity values will return if they just put in more through a loan reduction and extension of two years. They never look at the reality of the lack of any return on investment on the new equity which will be the result, and they live in hope of substantial inflation in the next two years to bail them out. They think that all that cash they pulled out when the refinanced their properties is really their money and they fail to accept that was their profit, and now it is time to turn over the asset and move on with that cash still in their pocket. They would be far better in many cases to use the cash they are paying to the lender for an extension, and instead use it to buy a new asset at today’s deep discounted values. Servicers have told me they view that cash as really theirs, and they are forcing borrowers to disgorge it by loan pay downs and extend and pretend.

Special servicers are not lenders. They are essentially high yield investors running distressed debt shops. Most will not see it that way, but it is what is happening. Real example: A servicer told me this week that they had taken back a distressed hotel. They invested $1 million of funds in the trust to renovate and reflag the hotel. Then they resold it for a $4 million profit. He did a good thing for the trust, but this is not the actions of a traditional lender. This mentality and action on the part of special servicers, combined with extend and pretend, means hundreds of billions of potential REO sales will not happen for a long time.

Everyone needs to finally accept that this delaying of truth is going to continue for a long time. Eventually truth will prevail and the extend and pretend periods will run out. The special servicers and lenders and auditors cannot continue this delusion forever. Assets need to be moved out of the hands of weak and unskilled owners, to the hands of well funded and skilled operators. No financial crisis has ever been cured by make believe and ignoring real value recognition. The RTC, in retrospect, was a wonderful solution. It will not happen this time. The regulators need to force the small and regional banks to take the hits, and then close the weak lenders who will then fail. That is not politically palatable so it is not going to happen. We have a very long way to go as a result.

TALF, PPIP, TARP and the real politics behind them

TALF, PPIP, TARP and the real politics behind them

We no longer hear the media and politicians talking much about toxic assets and restarting securitization. The reality is all of this was pure politics. In late 2008 Paulson and Bernancke had to make a dramatic move to prove that the government was going to essentially guarantee the soundness of the financial system, or we would have had a complete collapse in November, 2008. TARP was designed to do that and it worked. Other than Citi and GMAC, nobody really needed the capital. It was all designed to send a giant message. The stress tests were designed to do the same. Treasury and the Fed knew the outcome before they ever proposed the tests, or they never would have done it. The regulators had all the numbers. The tests were set to be able to say things are OK, and to be able to force the big banks to raise added capital. It was designed to be another confidence builder.

PPIP and TALF were both purely political programs specifically designed to sound good, do a tiny bit, but to essentially fail quietly. Anyone who thinks these programs were designed to really do anything, simply does not understand what was really going on behind the curtain. The government needed to look like it had answers and was taking action. In early 09 Volker and others pressed for RTC 2 instead.

A number of people in Wall St attribute the substantial narrowing of CMBS spreads to TALF. If CMBS spreads had narrowed and no other spreads had done so, then one could make the argument. However, all spreads, across most of the world, also came in substantially around the same time, and that had nothing at all to do with TALF.  The reality is the markets calmed and investors and traders were much more willing to move out the risk curve fairly rapidly once it was clear the world was not ending and governments around the world were not going to allow the system to crash. TALF had little to do with spreads narrowing-it was coincidence. Spreads were going to come in anyway. All TALF did was accelerate the timing of the narrowing for CMBS. Securitzation will restart when the markets are ready to accept the paper and underwriting is reset to reflect reality. TALF is not relevant.

Even though a few PPIP programs were set up, we hear nothing of them any longer. Debt is being issued without TALF. Hardly anyone wants to be bothered dealing with the hassle that comes with it. The markets are now willing to buy the non-TALF paper, which is exactly what Treasury counted on. The political gamble worked.

The real inflection points in all this were two major events. The first was the big bank CEO meeting with Obama in March when they essentially told him to stop bashing the banks, or he would create worse problems.  You can closely correlate the turn in the equity markets to that day. Obama still has not got the full message. The second was the disgraceful media circus when Barney Frank and his band of clowns held a made for TV spectacle to use Liddy as a punching bag. After the Liddy political theater, nobody wanted anything to do with government funding ever again if they could avoid it. Barney Frank has done more damage to the system than almost anyone. He protected Fannie and Freddie and Raines, and he has now made it clear nobody should deal with the government if they can avoid it, unless you are a union, then you get taken care of as was the UAW, and now all unions with healthcare.

As always, markets correct themselves and revert to the mean. There is a group of traders in every situation who are able to see past the chaos, and will step in to bid when they perceive the price to be irresistible. A base is formed and then others follow. Spreads come in, the early actors make a killing, and markets start to function again. This was no different. Now the markets will be in a more normal trading range.