Regulation By Populist Know Nothings

Regulation By Populist Know Nothings                                  

It is very unnerving to see people like Al Frankin –professional clown, and Ron Paul, a certified lunatic,  getting traction for amendments to the financial regulation bill. Neither of these guys has a clue what a financial market is, how it functions, nor the critical role of the Fed. Then we see all sorts of other add-ons like debit card fee issues, and other things. Blanche Lincoln is trying to single handedly wreck the corporate derivatives market so she can try to look like she is against us fat cats.  This is truly the lunatics now running the asylum. While some parts of the legislation makes sense, and regulatory reform is needed, it is very clear Congress has no idea what really needs to be done and that there is a good chance now that they will end up doing more damage than good.

This is what happens when the president only knows how to extract campaign contributions from the financial community, but then harks back to his community activist mindset. In March of 2009, the top bankers met with Obama and told him he was doing serious damage by bad mouthing Wall St and for a short time he backed off. Now that it is clear his popularity has collapsed and unemployment is not improving materially, he does what he always does, blame everyone else. Carl Levin and Barney Frank then hold made for TV unreality shows, with their band of clowns and the public goes away more misinformed than ever. The media, not really any better informed than Congress, jumps on the band wagon and just reports how Wall St professionals are all crooks and bad guys and then the populist rhetoric is ramped up to a frenzy. Then the real trouble starts when the politicians start to try to pass new laws with absolutely no idea what is really going on. It is all about the sound bite on the evening news and a spot on CNN or Fox.

There is no question we need reform. Unbridled greed and stupidity by residential mortgage brokers, subprime lenders, and issuers of CDO’s, which then led to commercial mortgages following the same path, is something that needs reform. However, the right answer is to not reward originators for volume, but for quality. All the incentives were set up wrong, just as they have always been with lenders. Lending officers should be rewarded for fewest delinquencies over 3 years, and not how much volume they closed for the next pool. There should be no reward for creating the next most complex derivative program. I am for a 5% holdback of capital for a securitized pool to become the bonus pool for the originators over a 3 or 5 year period. The whole idea of CDO’s to me just invites what happened. They are really just dumping grounds for what cannot otherwise be sold off- they are the ultimate garbage dump of excess junk.

While I don’t think Goldman broke the law, and the whole thing is a White House scheme to get regulation passed, there is an issue with creating a security that has no inherent identifiable underlying value, which nobody can truly value and is only a trading vehicle. It is this uncontrolled race to create the next more complex security with no regard to underlying real estate value, which is the metaphor for many of the other things that happened and caused the crisis.  

When Congress, the White House and the media get done, there will be serious damage done to the financial markets and the price will be paid by the general economy.

Fannie and Barney-The Great Cover Up

Fannie and Barney –The Great Cover Up

In 2002 John Snow, then Secretary of Treasury, appeared before Barney and his band of clowns and tried to get the committee to adopt major changes to the functioning of Fannie. Barney blew him off in a successful effort to cover up for the accounting fraud perpetrated by Franklin Raines and his cohorts.  Raines got a bonus and we got a financial crisis. Barney would not allow Fannie to be touched and insisted that we needed more home ownership, especially by people who could not afford to be owners. So began the subprime disaster.

Today there is no effort to change things at Fannie. There is a major effort to change banking and Wall St, which is needed, but Fannie goes on losing $20 billion of taxpayer hard earned money every month. 46% of all loan modifications by Fannie are going into default again. The cost when all done will be close to $400 billion of taxpayer money vs TARP which all of the large banks repaid with an 8% profit to the taxpayers. Yet who gets called names. Who gets hauled before TV cameras and accused of misdeeds. Who does the media make to look like criminals. Not Franklin Raines or Fannie executives of the past.

Fannie and Freddie and FHA are perpetuating the problems in the housing market, all in the name of the Obama administration wanting to make people believe they are solving the foreclosure problem.  While the Fannie Freddie entities do currently provide all the mortgage funds, that is not how it should be. This is simply more government control of a vital part of the economy. It is subject to the political whims of Congress and the administration, and not the market place. There is no on book budget item for Fannie losses. They just get swept away under the rug and no hearings ever occur to ask where all the money has gone.  

We are building up a huge unrecoupable debt that Treasury will have to continue to fund with your tax dollars. The HAMP program was made to sound good but it was a bad idea that never took reality into account. As one who had attempted to buy defaulted mortgages and rehabilitate them, I have a first hand understanding of the problem. Most homeowners in trouble have no possible way out other than to sell or send jingle mail. They are way in over their heads and no modification is going to ever work. There is a 355 portion of the population that cannot, should not own a home. Many defaulters know they can just stop paying while HAMP games delay the inevitable. Meantime they live rent free in the house. They do not provide income data because they know they fail any test of ownership because they never had the income. The game is delay, delay and obfuscate until finally there is no choice but to foreclose or short sale. As of today only 17% of HAMP modification efforts result in actual mods, and these likely could have been done without all the money spent making believe there is a program. The only way the housing problem is going to get solved is mass foreclosures and quick short sales to clear the market. All the government is doing is to force the banks to drag out the problem for years and not solve it.

Greece Is The Canary In The Coal Mine

Greece Is The Canary In The Coal Mine

The massive Euro TARP program just announced is simply a bailout of the PIIGS who way over spent and under taxed for all these years. In Greece few pay taxes and most who pay do not pay what they really owe. All of Europe has social safety nets programs that keep the voters happy so long as the string does not break, which it now has. The willingness of governments to just spend and raise pensions, raise healthcare benefits paid by the government, raise other benefits, and not pay for them is the root cause of this crisis. We were within hours of October 2008 all over again. The media and the administration can rant all they want about wall St, but the exact same irresponsible behavior was going on at all levels all over the world. Greece, California, New York, Spain, and now the US Congress and administration.

All the EU did this weekend is kick the can down the road again. It is highly unlikely that the austerity programs now being put in place will last long as the cost to the EU economy will be very painful and unions and the politicians will likely not endure this pain. At some point soon the Euro has to be devalued in whatever way this plays out. That is the only real solution and then a lot of pain has o be suffered as a result. We are just at the start of this phase of the crisis and there is nobody in Europe who is a true leader like Maggie or Churchill in the moment of need. Merkel should have stepped in but she completely blew it.

We all need to pay close attention to what is happening. Greece is California, New York and Illinois. The teachers union here is like the unions in Greece. Give me, give me. Tax the rich. In the US it is getting like Greece. Only 52% of Americans pay tax. If the Democrats have their way that number will drop to under 50%. Less than half of voters will have any skin in the game so they will not mind higher taxes on those of us who employ the rest and who create the capital which is the milk of economic growth.  The new healthcare bill subsidizes even the middle class making the successful pay for all. Business owners are now being charged much higher taxes and capital gains tax is about to rise. They are taking away the incentive to create capital and to create jobs.

The next crisis is states and cities in the US going bankrupt. Many are, they have just not declared it yet. We live on more and more debt, delayed pension funding, and other gimmicks. When the states and cities go under it will have the be Washington to the rescue and that means more borrowing, more taxes and more deficits.

While it may seem the economy is healing and the good times are ahead, be very careful. Long term is going to be ugly. In seven or ten years things will be in serious problems unless there is a complete reversal of direction and Washington and the states and cities take the lessons of Greece and recognize that the canary died this weekend and we better change our ways fast or we will get crushed.

The Consequences Of Making Real Estate A Commodity

The Consequences Of Making Real Estate A Commodity

While I found the Goldman hearings to be a travesty, and a rerun of the Army McCarthy hearings of 1954, the underlying issue is the Street tried to make real estate into a commodity that can be traded and hedged like a commodity. Instead of trying to understand any of what was really happening, Levin and McCaskill and the other clearly uninformed senators simply wanted to have political theater and denigrate Goldman.

Real estate is not a commodity. It is an asset which does not trade or physically move. It’s value does not shift hourly. There is not a liquid constant world market for a building or for a mortgage. It is not oil, scrap, or corn. Therein lies the real underlying problem. Each building is unique. It is different by many measures form the one even next door. Commodities are exactly the same. Oil is oil. Gold is gold. There may be differences by type of oil, but Brent North Sea is essentially all the same. Just because a building has a mortgage on it does not make that mortgage the same as other mortgages.

When we created the initial hotel mortgage CMBS programs in 1993, we were very clear in our underwriting that a Ramada was not a Ritz Carlton. A 25 year old exterior corridor hotel is not a new Courtyard. A hotel is not just a hotel and it is clearly not a retail center, nor a package of home mortgages.

When you mix subprime residential with B pieces on hotel mortgages, with derivatives of indexes and whatever, all you have is a pile of stuff. The real underlying values cannot ever be discerned. It is just a package of disparate paper. Then you use more indexes and then derivatives of the indexes and you get a security that has no value and no meaning other than an imaginary value that has no underlying basis. It is simply a directional bet as was the case in Abacus. There residential real estate was supposedly converted to securities to be used to take one or the other side of market directional bets. There was nothing illegal about any of what Goldman did, it was just stupid. The Street was creating more and more esoteric paper that had nothing at all to do with the underlying assets. In fact, at some point in this there were not really any underlying assets. Just pieces of paper.

If we are to fix the problem we need to make the clear distinction between real estate assets being unique hard assets with very individual characteristics, and securities or commodities, which real estate is not. As one of the securitization pioneers, at least in the hotel space, I think I understand securitization fairly well. There was very good reason to create it for residential in the eighties so that there was a capital market to fund residential growth when the S&L’s collapsed, which they did by being allowed to make commercial loans. When the concept of securitization was brought to commercial real estate it opened the door to inevitable abuse. It created massive amounts of capital looking for a place to go and that led to the over lending. That got compounded by the inevitable use of derivatives, and the loss of any connection between the real asset and the security.

If we are to avoid the next crash, then we need to go back to tying real estate mortgages  directly to the underlying hard asset and valuing the paper by properly underwriting the asset. If you cannot walk over to the asset and touch it then you have no way to properly value it. Securitization has a place, but we need clear and well considered rules to avoid the runaway insanity we just lived through where children with high powered math degrees, and no understanding of real estate, are allowed to create securities that had no connection to any assets and were simply complex trading vehicles with no reason to have been created in the first place.

Lending Is Back

Lending Is Back

Many groups raised funds to buy distressed loans or REO, but found there was almost nothing to buy. Having raised the funds they needed to do something with the money so they have now almost all become lenders/preferred equity providers. There is now a rush of money to loan and the race is on to put it out. Spreads have already started to come in and leverage levels are rising already. We already have competition between lending sources. On transactions I am personally doing, and others I am familiar with, there is funding for deals none of us would have imagined just 60 days ago. For example I am arranging funds for a brand new condo project at 75% of DPO cost. Another is a cash flowing portfolio of select service hotels some of which are still in the ramp up phase being brand new. Again a 75% LTV is apparently achievable through an A/B structure. Another transaction I am advising on is to raise a fund for hotel debt at similar LTV with a similar structure. These are all non-recourse, but underwritten on today values and today existing cash flows.

The banks are getting back in slowly and it depends on what condition the bank is in as to capital. The major banks are lending, although more conservatively than the funds. Insurance companies are lending to core properties. Spreads on the top quality loans with low LTV and top rated borrowers can be as low as 300-350 over with 30 year amortization. Some insurers are now lamenting that they did not act more aggressively late last year and early this year, as they are now having strong competition to put out dollars. One foreign bank is considering a construction loan in New York at fairly low spreads.

Several bankers I recently had dinner with this week were discussing how they are still working the old book of bad loans while the push is starting for new originations. They commented that originations are much more interesting and a lot more fun than modifications, which leads on to believe modifications are going to be accelerated to get them over with so the lending officers can get back to enjoying their work by making new loans.

A number of the grown ups in the business are already worried, including me. We can see where this is headed. We are astounded that any lending is happening at all this fast compared to the early nineties when it took until mid to late 1993 to restart having stopped in 1989-4 years. Now we see it stopped in late 2007 and here we are in spring 2010-2 ½ years later- and just past the worse collapse since 1932, and we are off to the races again. It will not take long before the amount of money chasing loans ramps up and spreads come in further and competition is underway for each good loan. While there is still hundreds of billions to refi over the next few years, the rush will be on by borrowers to lock in lower rates while they still exist.

Securitized lending is coming to your neighborhood sooner than we all expected. Treasury pulled a wonderful massive head fake with TALF making believe it was a real program, which it never was. The capital markets thought it was real and a few prime deals happened and securitization was jump started. TALF was never real and it was designed to do just what it did. Fool everyone into thinking it was real and to get securitization going again. It worked. Now we just need to wait to see what comes out of Congress as to the proposed 5% holdback and possibly other restraints to try to prevent the insanity of securitization of the past. They can regulate all they want, but unless stringent underwriting is adhered to and the rating agencies hold the line on subordination levels, we will be back to dumb lending a lot sooner than anyone would have believed. Here I personally think tying bonuses to long term success of a securitized pool is what is needed to make it clear there are real consequences to bad underwriting. Otherwise in several years we will be doing all the dumb things all over again. I have seen this picture show several times in my career.

Appraisals Are Causing Damage

Appraisals Are Causing Damage

It is clear from feedback from a variety of appraisers that there is great debate within the appraisal community as to the veracity of many appraisals and the methodology. It is very clear to me that the methodology is completely wrong and that some appraisers just did whatever they were instructed to do. Just because this is the way appraisers always did it and it proved totally wrong, is every reason to change it.

In discussions with friends who run banks and sit on boards of trustees of major pension funds, as well as many of my capital markets colleagues, it is clear that almost nobody believes appraised values any more. They are either too frothy in good times or overly negative in bad times, but rarely correct. For banks they are dangerous. In good times they lead to bad lending decisions, and in current times they lead regulators to require banks to foreclose even when the loan is current on interest and the borrower is a responsible owner. Pension funds revalue assets by appraised value in some cases and that undervalues assets currently. CMBS resolutions of defaults require appraisals and they are frequently wrong and lead to bad outcomes. As proof we know that each side gets its appraiser and the results are usually very different. As a former lender, I know that it is easy to get some appraiser to gin up whatever was needed to justify a loan, even when the value was known to be too high. The whole system and methodology is badly in need of new rules and procedures.

Appraisers who responded to my blog admitted that they merely reflect the current thinking of investors- as though there was some universal edict among all investors. How do they explain that some investors got out of the market in 2007, while others got in. Which set of investors were the appraisers reflecting. Why do a 10 year cash flow and projected terminal values and discount rates if at the start you are trying to reflect the current investor thinking. That just proves the projections have to be architected to fit the answer which was pre determined to reflect current market prices. It is all nonsense. That is why MAI stands for made as directed. The appraisers have actually admitted in several responses to my blog and my column in Hotel News Now, that they do make their appraisal fit what the borrowers or lenders demand.

It is time that the Appraisal Institute convene a roundtable to include bankers, investors, pension trustees and underwriters to set new methodology so that appraisals do what they should, provide a true, independent valuation with all the potential risks brought to the fore of future events. We had thought after 1990 and the new rules then, that things might change, but they only got worse. It is time for true resetting of the definition of what is an appraisal and how is it to be accomplished to give real ranges of values. I am not trying to eliminate appraisals, just to make them much more accurate and usable so they are not misused as they have been and continue to be.

Investment Time Horizons

Investment Time Horizons

While it appears the economy and real estate will improve over the next several years, subject to various geopolitical events which could disrupt everything, such as Israel attacking Iran which is a strong possibility in late fall 2010, or another major terror attack which is predicted by all of the intelligence agencies. These black swan events need to be closely watched as there are many in the world these days.

Leaving aside those unpredictable events, the real issue is what is a reasonable investment time horizon to work to. Given the direction of things in Washington under Obama and Pelosi, shorter is better than longer. The healthcare law is going to prove to be a fiscal disaster in about 7-10 years. We will have to have higher taxes at all levels of government. Unions are getting their payoff for pouring hundreds of millions into Democratic coffers. The general approach of this administration has been well stated to redistribute the wealth of all of us who created it and who create jobs.

It is my contention that in seven years it is time to be out of most major investments. By that time taxes will have risen, but the deficit will have risen even more.  By 2017 the deficit will be on a track to eat the ability of the country to grow the economy. By 2020 we will be at a point where the deficit will be approaching 85% of GDP and that is simply not sustainable nor consistent with a strong economy or strong dollar. Inflation will be higher, interest rates will of necessity be higher to try to sustain the dollar and to try to control inflation. The government expenditures for pensions to government workers, which are already crushing state and local governments, will cause services to be curtailed. The baby boomers will be in full retirement mode eating up social security and Medicare. Higher tax rates on the most productive people who are the high earners, will disincentivize people from making the extra effort or risk required to move the economy forward as fast as it otherwise might.

Many top economists are screaming about this coming crisis, but the administration and Pelosi seem deaf to it. As opposed to fixing the Medicare problem, they just made false accounting entries to make it look like they saved $500 billion. Social security will not get touched until it is too late so payroll taxes will rise even more than the new Medicare tax on capital investment income.

As a result of all of these trends, it is best to get in now and get out in 2015 or soon thereafter with the substantial profits I believe can be achieved over the next several years,and then take a look at where we are to decide to buy gold, invest in Brazil and China, or to reinvest in more traditional US based assets. Maybe things will change in time, but I have serious doubts. Washington has become so dysfunctional it is starting to look a lot like Albany and Sacramento. Just be very careful when investing to make sure your exit is realistically achievable in a timely manner, and don’t count on the long run to make it all OK. This time may really be different. It is very hard to know what the world will be in seven years, which is why investment horizons beyond then are too risky.