An Insider’s View of the Real Estate Train Wreck, Part II

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Right now there are an awful lot of banks that do an awful lot of commercial real estate lending, and for about a year now you’ve been telling me that you saw the first and second quarter of 2010 as being particularly risky for commercial real estate. Why this year, and what do you see happening with these loans and the banks holding them?

MILLER: It’s an educated guess, and it hasn’t changed. I still think that it’s second quarter 2010.

The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there’s some alternative in place, it’s going to be a very hideous picture for the bond market and the banking system.

The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I’ll give you an example.

In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn’t have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.

That’s very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they’ll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that’s horribly destructive.

Just to be clear on this, let’s say I own an apartment building and I’ve been making my payments, but I’m having trouble and the value of the property has fallen by half. I go to the bank and say, “Look, I’ve got a problem,” and the bank says, “Okay, let’s work something out, and instead of you paying $10,000 a month, you pay us $5,000 a month and we’ll shake hands and smile.” Then, even though the property’s value has dropped, as long as we keep smiling and I’m still making payments, then the bank won’t have to reserve anything against the risk that I’ll give the building back and it will be worth a whole lot less than the mortgage.

MILLER: I think what you just described is accurate. And it’s exactly a Japanese-style solution. This is what Japan did in ’89 and ’90 because they didn’t want their banking system to implode, so they made it easier for their banks to sit on bad assets without owning up to the losses.

And what’s the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it’s not going to sell them.

Why is that bad? Well, the money tied up in the loans the bank is sitting on is idle. It is not being used for anything productive.

Wouldn’t banks know that ultimately the piper must be paid, and so they’d be trying to build cash – trying to build capital to deal with the problem when it comes home to roost?

MILLER: The more intelligent banks are doing exactly that, hoping they can weather the storm by building enough reserves, so when they do ultimately have to take the loss, it’s digestible. But in commercial real estate generally, the longer you delay realizing a loss, the more severe it’s going to be. I can tell you that because I’m out there servicing real estate all day long. Not facing the problems, and not writing down the values, and not allowing purchasers to come in and take these assets at discounted prices – all the foot-dragging allows the fundamental problem to get worse.

In the apartment business, people are under water, particularly if they got their loan through a conduit. When maintenance is required, a borrower with a property worth less than the loan is very reluctant to reach into his pocket. If you have a $10 million loan on a property now worth $5 million, you’re clearly not making any cash flow. So what do you do when you need new roofs? Are you going to dig into your pocket and spend $600,000 on roofing? Not likely. Why would you do that?

Or a borrower who is sitting on a suburban office property – he’s got two years left on the loan. He knows he has a loan-to-value problem. Well, a new tenant wants to lease from him, but it would cost $30 a square foot to put the tenant in. Is the borrower going to put the tenant in? I don’t think so. So the problems get bigger.

Why would the owner bother going through a workout with the bank if he knows he’s so deep underwater he’s below snorkel depth?

MILLER: It’s always in your interest to delay an inevitable default. For example, the minute you give the property back to the bank, you trigger a huge taxable gain. All of a sudden the forgiveness of debt on your loan becomes taxable income to you. Another reason is that many of these loans are either full recourse or part recourse. If you’re a borrower who’s guaranteed a loan, why would you want to hasten the call on your guarantee? You want to delay as long as possible because there’s always a little hope that values will turn around. So there is no reason to hurry into a default. None.

So that’s from the borrower’s standpoint. But wouldn’t the banks want to clear these loans off their balance sheets?

MILLER: No. The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against their capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. Remember, you suffer if the bank succumbs and turns around and liquidates that asset, then you really do have to take a write-down because then your capital is gone.

So here we are, we’ve got the federal government again, through its agencies and the FDIC, ready to support the commercial real estate market. They’ve taken one step, in allowing banks to use a very loose standard for loss reserves. What else can they do?

MILLER: Well, obviously nobody knows, but I can guess at what’s coming by extrapolating from what the federal government has already done. I believe that the Treasury and the Federal Reserve now see that commercial real estate is a huge problem.

I think they’re going to contrive something to help assist commercial real estate so that it doesn’t hurt the banks that lent on commercial real estate. It’ll resemble what they did with housing.

They created a nearly perfect political formula in dealing with housing, and they are going to follow that formula. The entire US residential mortgage market has in effect been nationalized, but there wasn’t any act of Congress, no screaming and shouting, no headlines in The Wall Street Journal or The New York Times about “Should we nationalize the home loan market in America.” No. It happened right under our noses and with no hue and cry. That’s a template for what they could do with the commercial loan market.

And how can they do that? By using federal guarantees much in the way they used federal guarantees for the FHA. FHA issues Ginnie Mae securities, which are sold to the public. Those proceeds are used to make the loans.

But it won’t really be a solution. In fact, it will make the problems much more intense.

Don’t these properties have to be allowed to go to their intrinsic value before the market can start working again?

MILLER: Yes. Of course, very few people agree with that, because if you let it all go today, there would be enormous losses and a tremendous amount of pain. We’re going to have some really terrible, terrible years ahead of us because letting it all go is the only way to be done with the problem.

Do you think the US will come out of this crisis? I mean, do you think the country, the institutions, the government, or the banking sector are going to look anything like they do today when this thing is over?

MILLER: I know this is going to make you laugh, but I’m actually an optimist about this. I’m not optimistic about the short run, and I’m not optimistic about the severity of the problem, but I’m totally optimistic as it relates to the United States of America.

This is a very resilient place. We have very resilient people. There is nothing like the American spirit. There is nothing like American ingenuity anywhere on Planet Earth, and while I certainly believe that we are headed for a catastrophe and a crisis, I also believe that ultimately we are going to come out better.

Regards,

David Galland
for The Daily Reckoning Australia

David Galland
David Galland is the Chairman of Casey Research, publishers of BIG GOLD, an inexpensive monthly advisory dedicated to providing unbiased and actionable research on simple, effective and cautious ways to participate in rising gold markets.
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31 Comments on "An Insider’s View of the Real Estate Train Wreck, Part II"

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Fiscal Phil
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Don’t worry it’s different in Australia.

Paul
Guest

oooooo geff

Tom Sugar
Guest

Actually Australia does have one big difference from the USA and UK…..

The vast majority of people who emigrate to USA / UK are basically $2 peasants.

The vast majority of people who emigrate to Australia are skilled migrants who earn good wages.

Australia has good population growth, the USA / UK have bad population growth.

That is a huge difference that may just keep Australia’s property market from crashing.

Biker Pete
Guest

Tom: “The vast majority of people who emigrate to Australia are skilled migrants who earn good wages.”

Have to agree, Tom. Some pay rent three months ahead, _unasked._ We asked one couple why they did so. Their response indicated they feared we’d sell the house (they had a one year lease… and it wasn’t on the market!)

New immigration policies will mean even more focus on professional skills.
These folk arrive with substantial a$$ets… and enjoy great salaries here.
We really can’t see an end to it in WA, while demand for resources lasts…

Nirvan
Guest

Tom , you must be kidding. In India , the first choice of a grad who really wants to make it in the sciences and finance head off to the US and then UK. Australia just figures last!. Nowadays they stay back there is just too many opps in India itself.

Biker Pete
Guest

Must confess we’ve seen no ‘Indians’ here, Tom. Mainly S. Africans, Zimbabweans, western Europeans: mining engineers, technical engineers, doctors, dentists, IT specialists, secondary teachers, etc. The UK might still look attractive to Indian graduates, who may have some immigration priority, having once been part of that decaying empire… .

Ned S
Guest

Oz isn’t into scientists and financiers – We dig holes in the ground to make a buck; Then our builders make it all go round internally.

So apart from miners and builders, we need some accountants to help us count the coin and dodge the tax; Plus some docs to keep us healthy while we do; And some hairdressers to paint our hair purple so we feel good about ourselves while it’s happening … Eeezy Peazy! :)

Nirvan
Guest
Well “here” is not all of Australia. Read this to find out what kind of people are heading where. http://www.theage.com.au/national/victoria-the-place-to-be-20100219-oly9.html Well let me put it this way. There are two kinds, one that can be employed and the ones that create employment. The US by far is the best in attracting entrepreneur type material for high tech industries from Asian countries. The small recent reversal in trend is with some of these bright minds staying back to start their own companies or other startups in their own countries. Well Ned S if thats about it, we wont really need the… Read more »
Ned S
Guest

I suspect I don’t understand the issue Nirvan? Or even if there was one issue or more? But should it be in any way relevant, please do be aware that I feel no special level of fondness for those who were born in the same country as me over those who weren’t???

Nirvan
Guest

The issue is about
“The vast majority of people who emigrate to USA / UK are basically $2 peasants.”
which is very untrue.
Your fondness noted.

Ned S
Guest

I don’t know a great deal about that at all, but I certainly saw some potential possible truth in it given what I’ve read about Yank moans over Mex immigrants and Brits barking about Poles. But yep, no firm opinion – Just a general impression or two.

Ned S
Guest

“Your fondness noted” – Hmmm … Very much a case of “no special level of fondness” as I stated Ta.

Lachlan
Guest

My visual concept of you has just changed Ned…just inserted purple hair..hmmm interesting. Hope ya feelin better now mate! ;)

Ned S
Guest

Make it a flowing blue beard with a few burning candles in the plaits and my ego will know no bounds Lachlan! :)

Lachlan
Guest

Will do Ned but make another appointment in 2 weeks. We’ll measure your ego then add or subtract candles accordingly.

Biker Pete
Guest
It may well be that WA _is_ attracting a different group of immigrants than the east coast… (and Britain!) Just as Aussies are generally valued as hard-working, competent employees in overseas countries we’ve visited, we’ve found our association with 457 visa holders here productive and mutually beneficial. They respect our property, care for gardens, pay rent on time, and seem keen to take advantage of opportunities and freedoms which don’t exist in their home countries. They also join local community and sporting groups quickly and enthusiastically. An observation: Some commonalities between those we know well appear to be: * a… Read more »
Biker Pete
Guest

Ned, I wondered about that bright light… and the smell of burning chook feathers… emanating from the north-east…! ;)

Ned S
Guest

I could tell you a yarn about the time back in the “hippy impressionist” era when I lit one side of my beard and hair up whilst lighting my pipe. And my mate’s response when I started frantically whacking myself about the chops. But won’t! – As it reflects rather poorly on me mate’s compassion levels – IMO. :)

Ned S
Guest

“As it reflects rather poorly on me mate’s compassion levels” … *** TOWARDS IDIOTS!!! :) :) :) *** – Might have summed it up better??? :) IMO.

Cuban Pete
Guest
Demand for resources is a fantastic thing, it surely lines the pockets of the people in our banana Republic’s chief industry – hole digging and dirt shipping. For the rest its not that easy, but maybe property is the best way to benefit from the hole barons’ cash, who knows? It seems to make sense though. Hole barons dig holes, sell dirt, buy houses – houses increase in value – everyone owning houses benefits! The only question I have is: If China buys our fancy dirt to make stuff to sell for money, and US, UK, Europe aren’t buying China’s… Read more »
Dellusional
Guest
WE HAVE WEALTHY IMMIGRANTS and the rest of the world take the left overs?? What dellusional rubbish do you ‘propery spruikers’ believe in. People do not migrate on mass because they have untold riches in the country from wence they come. People migrate in the hope they will find better lives and better fortune. The largest proportion of immigrants to this country are STUDENTS, not millionares from the planet fantasia. The second highest are skilled migrants on the 457 Visa, which as pointed out by someone above are average wage earners who will struggle to get by like the rest… Read more »
Biker Pete
Guest

“The people moving here with large sums of money are temporary, roughly 3-4 years and will take that wealth back to wherever on this big round ball they came from.”

Uh… you mean Zimbabwe and South Africa, Dellusional(sic, unless you’re IT.)

Ned S
Guest

Rock on Great Depression II – All banks go broke! All savers are wiped out! 35% unemployment! 70% house price declines! Yeehah!!! :)

With Steve Keen for Prime Minister. :) :) :)

Biker Pete
Guest
Reflecting on Keen’s recent re-emergence as media star, we often single out his flawed prophecies on home prices (40% fall… actually 5.5% across Australia); without remembering that his two other guesses were almost as inaccurate. He projected two-digit unemployment figures (now 5.3%) and _zero_ interest rates (now 4%). The news media need to be _reminded_ of these wild hunches of Keen’s, especially around the end of March… . Meanwhile the Good News rolls on for the True Believers: http://www.watoday.com.au/business/buyers-more-than-a-match-for-years-first-real-test-20100220-omr6.html and… http://www.watoday.com.au/wa-news/perth-first-home-affordability-plunges-20100222-opy0.html
Biker Pete
Guest

One of mine was just marked ‘awaiting moderation’, Ned.

“… free speech and frank and open conversation…” ?

We’ll see if it comes through intact*… ! ;)

* I’ve learned to copy before hitting the Submit button… . :)

Steven
Guest

”Unfortunately their foresight is so poor that they don’t realise that in 10-20 years time, as they struggle to move from room to room and go to the toilet unaided, their children and grandchildren will be too busy working off their mortgages to come and visit them at the nursing home.” – Eve Roberts

Biker Pete
Guest

“Unfortunately their foresight is so poor that long before they’re eligible for nursing homes, they’ll squat in cardboard shanties under bridges, eking out a hand-to-mouth existence, at the mercy of the elements…” Biker Pete,
who has seen that scene, even in western cities, all over the world.

(What, you think you’ll expire before you reach old age, Steve? Gotta laugh either way… . :) )

Don
Guest

Comments by property bulls are always “awaiting moderation” biker :)

Come to the dark side Biker *insert Darth Vader breathing here*

Biker Pete
Guest

It did get through though, Don. Not sure if it was the URL links, or the Steve Keen reference… . ;)

Dellusional
Guest
“Rock on Great Depression II – All banks go broke! All savers are wiped out! 35% unemployment! 70% house price declines! Yeehah!!!” This is my point, i know you say this tongue in cheek but it is a distant but distinct possibility. By allowing prices to exculate, i raelise you and biker get the short term benefit but to what end. No one wants to see you lose what you have worked hard for and no one wants to see this unravel because of mindless uneducted sheep being led by greedy investors, vendors, mortgage brokers, banks etc. The damage is… Read more »
Christina
Guest
I once read a newspaper from Scotland online and it said that the whole world economy is stuffed, but Scotland is different because the Scoth have a great resilient Scoth spirit. Then I read an Australian newspaper, which said the whole world economy is stuffed, except Australia, as we have a great fighting Aussie spirit. Then I watched the Greek news live from Greece at my friends house who has the Greek channel. You’ll never guess what they said. They said that Greece will pull through and be just fine thank you very much, , because the Greeks have a… Read more »
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