Tuesday, March 31, 2009

Litigation Between Investors and Servicers

One of the impediments to loan modifications is the constraints servicing agreements place on servicers in restructuring loans. If a servicer makes a modification in violation of the servicing agreement, they run the risk the investor may sue them.

Some have argued this risk is not substantial. From Naked Capitalism (my bold):

I've been asserting for some time, based on the comments from mortgage counsellors, that mortgage mods that do not substantially reduce principal balances don't make enough of a difference to the borrower to change outcomes. And with banks and servicers looking at 40%+ losses on many foreclosures, they can reduce principal a lot and still come out ahead.
Mortgage servicers have been experiencing high recidivism rates on loan mods, leading commentators to say that mods don't work. However, it has been reported (Calculated Risk) that many of the so-called mods were payment catch up plans, and not true mods, but the composition of the balance was unclear. Thus it was similarly not certain whether my view was correct.
Some support comes from Wilbur Ross, no soft touch, but a distressed investor (they are not called vultures in polite company). He owns American Home Servicing, the biggest third party servicer in the US. He also offers a program for how to deal with the housing crisis.
Note that American Home Servicing has done a lot of loan mods. Ross makes no mention of the supposed legal obstacles to making mods. That suggests the issue is way overblown (as in investors in theory might sue, but no one is a big enough holder in any one trust for it to be worth the trouble).

The idea that no one is a big enough holder to make litigation worthwhile is wrong; between class action suits and the ripple effect a bad precedent would set, there is plenty for servicers to worry about. And the litigation has already started (including litigation against this particular servicer). Housing Wire reports a hedge fund suing American Home Mortgage Servicing over its REO disposition strategy:

A Greenwich-based hedge fund manager is in a desperate fight to keep his subprime MBS investment strategy alive. HousingWire peeled back the layers to uncover what’s really going on behind the scenes in what has become a vicious battle between the hedge fund and legendary investor Wilbur Ross’ mortgage servicing company, Irving, Tex.-based American Home Mortgage Servicing, Inc.

The lawsuit underscores just how complicated servicing non-agency securitized loans can really be, amid a push by legislators and regulators to put a common set of standards into place to help manage a housing crisis that as of yet shows little signs of slowing down.

Bruce Rose, who runs hedge fund Carrington Investment Partners LP – and who purchased a mortgage servicing platform of his own last year when former subprime high-flier New Century Mortgage went bankrupt – filed a lawsuit last month claiming that American Home Mortgage Servicing, the nation’s largest independent mortgage servicer, had been selling the REO homes it manages at ‘fire sale prices,’ because it needed cash to pay off its warehouse credit facility.

The REO sales push was hurting Rose’s hedge fund, because the loans on the homes are tied to mortgage-backed securities Rose had invested in. According to Carrington investors and sources familiar with Rose’s investment strategy, the hedge fund owns the junior tranches of the deals in question.

American Home is now fighting back. From Housing Wire:

After finding itself dragged into court by hedge fund manager Bruce Rose of Greenwich-based Carrington Capital, Irving, Tex.-based mortgage servicer American Home Mortgage Servicing, Inc. fired its own volley back at both Rose and Carrington on Thursday, suing for alleged acts of racketeering and a scheme to profit illegally from holding REO hostage at the servicing firm. American Home is owned by legendary investor Wilbur Ross’ WL Ross & Co., and is the nation’s largest independent residential mortgage servicer.

The allegations made in the complaint by AHMSI against Rose and Carrington show just how complex relations between servicers and investors can be, amid increasing pressure from lawmakers and regulators to find solutions to the nation’s housing mess.

Servicers are being sued on their modification strategies too. A NYT story on December 1, 2008:

On Monday, a hedge fund sued the Countrywide Financial Corporation, the giant mortgage lender, demanding that Countrywide compensate holders of some securities backed by mortgages if the lender changes the terms of the loans.

The fund, Greenwich Financial Services, said it and other investors stood to lose money if Countrywide, now part of Bank of America, modified loans under a settlement that it reached with 11 state attorneys general in October.

Servicing is a low margin business which only makes money when everything goes smoothly. The downturn has already severely strained servicers; Housing Wire again:

“With the dramatic increase in loan delinquencies come staffing and capacity issues, portfolio risk related to adjustable-rate mortgage resets, and the accompanying pressure to find effective loss mitigation strategies, including loan modifications,” said residential servicer analyst Richard Koch, a director in Standard & Poor’s servicer evaluations group.

“In addition, the spike in foreclosures and real estate owned assets, in our opinion, has stretched the limited number of vendors that service the industry to capacity — and as more loans move through foreclosure into the REO category, the need to make loan advances has placed yet another financial strain on servicers.”

The last thing servicers need is subjecting themselves to the tsuris of litigation with deep pocket investors. Expect them to adhere to their side of the servicing contracts.

Monday, March 30, 2009

Information Asymmetry, The Market For Lemons, and Pricing Toxic Mortgage Assets

A number of commentators have noted that the secondary market for mortgage assets suffers from a “Market for Lemons” problem:

There are good used cars and defective used cars ("lemons"), but because of asymmetric information about the car (the seller knows much more about the problems of the car than the buyer), the buyer of a car does not know beforehand whether it is a good car or a lemon. So the buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of a car of known average quality. This means that the owner of a good used car will be unable to get a high enough price to make selling that car worthwhile. Therefore, owners of good cars will not place their cars on the used car market. This is sometimes summarized as "the bad drive out the good" in the market.

Sandro Brusco applies this problem to the secondary mortgage market in “Mechanism Design and the Bailout”:

If the market starts to suspect that some of those Mortgage Backed Assets (MBAs) are more toxic than others and that the managers of the banks know the ones that are more dangerous, then the markets can easily collapse. This is the standard ''market for lemons'' problem, which is by now well understood: investors don't want to buy MBAs at a price equal to their average value, because they are afraid that what they get is not the average but the worse, i.e. they suspect that the banks will first try to unload the most toxic securities. Lowering the price in this case does not work, since it only convinces even more the investors that the securities are truly toxic. The market essentially freezes. Investors will only buy at very low prices, the ones corresponding to the most pessimistic expectations on the assets. But this must mean that on average the MBAs are worth more than the market prices and therefore the sellers will be unwilling to sell.

Leigh Caldwell in “Lemons and Toxic Assets” and Mark Thoma both outline the case for government intervention to get the market working again.

This view starts with the premise there is asymmetric information between sellers and buyers – that sellers know which assets are toxic, and buyers don’t. Is that true in this case? I don’t think so - to a large extent, banks don’t know which assets are toxic and how toxic they are. I’m not just talking about ignorance of their own portfolio (although there’s plenty of that). Real estate is relatively illiquid, highly leveraged, and values are driven by comparable sales that are mostly distressed these days. As I’ve outlined in a previous post, this creates a downward spiral effect as assets are liquidated, and what looks like a good asset now  could easily be a bad asset a year from now.

William Buiter draws this distinction:

  • Toxic assets are assets whose fair value cannot be determined with any degree of accuracy.
  • Clean assets are assets whose fair value can easily be determined.

In this environment, there are not many real estate assets whose fair value can be easily determined. You can take a snapshot value using current income and comparable sales and decide if the mortgage secured by that asset is a good risk today. But, the snapshot only captures the present, and experienced real estate investors know we are in a nasty feedback loop which will drive down values further. The problem is not information asymmetry; the problem is no ones knows at what level the market which reach an equilibrium.

Sunday, March 29, 2009

Economic and Real Estate Post Picks: Week of March 23, 2009

CMBS Performance Trends and Maturities: A comprehensive look at delinquency and loss trends by vintage and asset class, and upcoming maturity risk

Martin Hellwig on the Financial Crisis: A lucid account of how relatively small subprime default losses amplified into today’s financial crisis

Real Disposable Personal Income Up: For the fifth consecutive month

The State of the Economy: A great visualization of seven economic indicators showing normal levels, where we are, and the direction we’re going

Personal Consumption Expenditures Positive for February: Good news on this key indicator.

Saturday, March 28, 2009

Everyone Picks on Detroit

As usual, Detroit once again has suffered the largest population decline and net outmigration of major metropolitan areas on both an absolute and percentage basis (Census data released March 19 here). Mark Perry’s Carpe Diem post, “Supply and Demand in Action,” displays the image below:


But the larger story is the continuing depopulation of rural counties in states like Arkansas, New Mexico, and Oklahoma. Here’s the list of counties with the greatest percentage net outmigration in 2008:


Interesting that no Michigan counties made the top 20. I’ve previously posted on the “natural amenity” explanation for why places like this are depopulating.

Friday, March 27, 2009

The Problem With Models

I’ve meant for a long time to post on the problems with using financial models, but there’s just too much to say, and too much that has already been said more clearly than I can say it. Here are some links on this topic:

Data series too short – for example, extreme economic conditions are not captured in the model. See Underestimating the tails, at  Revolutions.

Overreliance on past patterns – assuming the future will be like the past. See Maths and markets at FT.com.

Bad assumptions – for example, housing prices won’t fall. See Don’t Blame the Quants, Felix, at Falkenblog.

Network externalities – for example, failure of your counterparty’s counterparty was not considered in your model. See Andrew Haldane’s “Why Banks Failed the Stress Test” paper starting at page 9.

Failure to adjust models for evolving conditions – see John Kay, “Financial models are no excuse for resting your brain”.

Failure to properly account for low probability events – see Naked Capitalism, More on Global Alpha, Quant Woes, and Joe Nocera, “Risk Mismanagement”.

Thursday, March 26, 2009

How Did the Losses Get So Big?

Many people still believe that this crisis was created by lenders making bad loans to subprime borrowers, and many people have trouble understanding how the losses to financial institutions can exceed the amount lost on the bad loans themselves. Matt Taibbi (via Rortybomb) makes it all clear:

Do you actually think that it was a few tiny homeowner defaults that sank gigantic companies like AIG and Lehman and Bear Stearns? …What we’re talking about here is the difference between one homeowner defaulting and forty, four hundred, four thousand traders betting back and forth on the viability of his loan. Which do you think has a bigger effect on the economy?

As I posted here, this crisis is a result of an alignment of errors on the part of borrowers, lenders, rating agencies, and securities investors. After reading Taibbi, we should add to that list the failure of the government to properly regulate the CDS market and internal risk controls at companies like AIG.

Wednesday, March 25, 2009

CRE Loans and the Death Spiral of Doom

When CRE markets start to decline, they can spiral downward dramatically over time. Let’s start out by looking at the underwriting for loans on two identical adjacent apartment projects in Los Angeles in 1989:


The two projects are identical, but the lenders underwrote differently – the Bad Lender used a 3% vacancy factor, but more importantly leveraged the deal to the breakeven point. This was very typical of the market then, and was usually accomplished either by underwriting on the pro forma appraisal income instead of the actual operations and/or by underwriting to a 1.25 DSC on a teaser start rate on a variable rate loan and a 1.00 DSC on the fully indexed rate. The theory was the borrower would refinance when the reset occurred (does this all sound familiar)? The consequence of this approach is the bad lender loan about 80% of the asset value, while the Good Lender loaned 64% LTV.

Let’s go forward to 1991. There have been huge employment losses in the market, and rents have decreased while vacancy has increased. Perceived risk has also increased so cap rates are up too. Here are the numbers (the 1989 Bad Lender underwriting is included for comparison purposes):


Rents are down 5% and the vacancy rate has increased to 15%, creating substantial negative cash flow for the Bad Lender borrower. He defaults, and the combination of lower net operating income and higher cap rate results in the Bad Lender takes a 24% loss. The cash flow for the Good Lender borrower has also taken a hit, but because her deal was not leveraged as highly to begin with, she does not default.

Things start to get interesting when the Bad Lender sells the REO property:


The REO buyer bases their purchase on a higher cap (it’s REO, after all) and suffers an additional loss bringing the overall loss to 33%. The Bad Lender finances the sale at 80% LTV. Note that since cap rates have risen relative to interest rates this level of leverage now has substantial debt service coverage.

By 1992 the REO buyer has dropped his rents 10% in order to capture the best quality tenants and reduce his vacancy factor – the result is his cash flow remains about the same and he has a better quality tenant base. The effect on the neighboring building is profound – this borrower already had negative cash flow and can’t match the rent decrease, so her vacancy goes up. The negative cash flow is too great, she defaults, and the Good Lender takes a 33% loss based on the market cap rate established by the first REO sale. When the Good Lender sells (at a higher cap rate, because it’s REO), their total loss is 40%.

REO Buyer 2 now has a much lower cost structure than REO Buyer 1, and can afford to drop rents below REO Buyer 1’s levels to recapture tenants. Do you see how this cycle reinforces itself? I foreclosed on some buildings 3 times over a five year period as the market spiraled down.

The market will eventually reach an equilibrium again – in LA this occurred when job growth finally returned and virtually all the highly leveraged buildings had been foreclosed upon. But, until an equilibrium is reached it’s impossible for anyone to predict the stabilization level. Those who talk about setting a new price level in CRE don’t seem to grasp that it’s a dynamic, multi-step process and not a one-time mark.

Also, note that the conservative lender actually took a larger loss in the example above, because their default occurred at a point further down the spiral. This is why many lenders consider their first loss to be their best loss, and are reluctant to modify loans.

Tuesday, March 24, 2009

Will FASB Mark-to-Market Relief Help Income Property Borrowers?

The short answer is I think not – the relief does not appear to affect the accounting treatment of individual loans.

In general, when a borrower defaults on an income property loan and the lender does not expect to recover full contractual principal and interest, FASB 114 requires the lender to write the loan down to the fair market value of the collateral, including a further discount for the cost to sell the collateral. If a lender follows the rules it might as well foreclose and sell the property and avoid the risk of further declines.

In a distressed market like today’s, when it is very difficult to obtain financing for almost any income property project, the fair market value can be difficult to determine. The proposed FASB changes, summarized in this Housing Wire article, provide additional discretion and guidance for determining value other than relying on current distressed trades.

This changes how securities might be valued, but it doesn’t change how real estate collateral is valued in a distressed market. The mechanism for that is an appraisal, and appraisal guidelines already provide for adjusting values to non-distressed levels. From FDIC Laws, Regulations, Related Acts 2000 – Rules and Regulations Part 323 – Appraisals:

Market value means the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
    (1)  Buyer and seller are typically motivated;
    (2)  Both parties are well informed or well advised, and acting in what they consider their own best interests;
    (3)  A reasonable time is allowed for exposure in the open market;
    (4)  Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
    (5)  The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

Of course, without non-distressed comparable sales it’s difficult for appraisers to figure out what the correct market value is. But, that’s already their call; the FASB changes won’t help them.

Here are links to some other posts on the FASB changes:

Zero Hedge: “Brutalizing the FASB’s Attempts at Piglipsticking”

The Big Picture: “What Does the FASB Proposal Mean for Financials?

Monday, March 23, 2009

Extremely Improbable Events Happen All the Time

Risk managers assert in their defense that the current economic crisis was an unforeseeable, low probability event. From Andrew Haldane’s paper, Why Banks Failed the Stress Test:

Risk managers are of course known for their pessimistic streak. Back in August 2007, the Chief Financial Officer of Goldman Sachs, David Viniar, commented to the Financial Times:

“We are seeing things that were 25-standard deviation moves, several days in a row”

To provide some context, assuming a normal distribution, a 7.26-sigma daily loss would be expected to occur once every 13.7 billion or so years. That is roughly the estimated age of the universe. A 25-sigma event would be expected to occur once every 6 x 10124 lives of the universe. That is quite a lot of human histories.

How is it possible that extremely low probability events occur? The answer is that, while many events are highly probable over a short period of time, over longer periods events are extremely improbable. It is highly probable that when you go to bed tonight, you will get up in the morning from the same bed. But, think back to where you went to bed twenty years ago, and the events in your life that brought you to where you go to sleep now. How likely was it that you ended up where you are? That you have the job you have? That you have the spouse and kids you do?

From Carl Bialik’s The Numbers Guy blog:

We tend to fixate on those events that are memorable, after they happen. Peter H. Westfall, a statistician at Texas Tech University, notes that any given order of a shuffled 52-card deck has about a one in 10 to the 68th power probability of happening, including the sequence in which all 52 cards appear in order. “Everything we see has about a zero probability,” Westfall said. “Calculating these probabilities after the fact is kind of meaningless.”

The present we’re living has impossibly low odds of occurring.

Bank risk managers acted as though every tomorrow would be similar to the short term past, and didn’t account for less probable but still very possible outcomes (like house prices declining) which could rapidly create a much different environment in just a year or two (like the one we’re living in now).

Sunday, March 22, 2009

Economic and Real Estate Post Picks: Week of March 16, 2009

Post Recession Employment Trends: How long does it take for employment to recovery after a recession ends?

Cap Rate Closing/Asking Gap: The spread between asking and closing cap rates is widening.

Maturing Loans Are Coming Home to Roost: The looming problem of maturing income property loans with no exit strategy

Reflation: The risk of deflation has diminished.

Has the Economy Hit Bottom Yet? Probably not, but the rate of decline is slowing.

Your First Loss Is Your Best Loss

Jim Cramer’s reputation as a source of investment wisdom is not at its peak right now, but in the environment today his second commandment of trading is good advice. From a 2005 article on TheStreet.com:

Good trading, no matter what it's based on, technicals, fundamentals, the stars, the news, requires a level of discipline that goes against human nature. We are taught in life to be patient, to let things work out, not to be hasty, yet none of that works when it comes to trading. You have to be willing to cut and run, to use that "flight," not fight, instinct that we supposedly are born with but suppress wholeheartedly when we are grown up.

That's what the second commandment of trading is about, and that's why it is the second commandment of trading:

“Your first loss is your best loss.”

I genuinely believe that most trades need to work almost immediately for them to be right.

John Reeder over at Real Property Alpha has an excellent post making the case that this is true for CRE today, complete with a great example (Lennar’s role in the Newhall ranch development). As John notes, I’ve made the opposite argument –selling in this environment reinforces a downward spiral in values which is hard to stop, with unfortunate consequences for all. It is a classic Prisoner’s Dilemma / Tragedy of the Commons problem, and unfortunately the best individual bank strategy makes the problem worse in the long run. We have met the enemy…and he is us.

Saturday, March 21, 2009

Whose Error was the Housing Crisis?

Who is responsible for the housing crisis? Some candidates are borrowers, lenders, rating agencies, and securities investors.  Attempts to blame one party or another fail, because the crisis is the result of a combination of errors by different parties which all aligned. Think of a wedge of Swiss cheese; to see through it, all the holes must line up. This approach is explained in James Reason’s Human Error, and illustrated in a diagram from that book:


In the housing crisis, here are some errors which had to align to get to where we are today:

1) Borrowers took out loans they couldn’t afford

2) Lenders made loans to borrowers which the borrowers couldn’t afford

3) Ratings agencies rated securities comprised of these loans as safe

4) Security purchasers relied on the erroneous ratings and bought the securities

Any of these parties could have averted the crisis had they avoided their respective error.

I am not saying that every member of each class made their error; plenty of potential borrowers didn’t borrow, not every lender made bad loans, not every rating was bad, and not every investor bought bad securities. But, enough of each class made these mistakes to trigger the events leading to the current situation.

Also, I am not saying that individual actors didn’t benefit from their actions at the time – there were certainly some winners. And, looking at each individual decision made, it’s not clear that any of them were irrational at the time. These were errors in the sense that, in hindsight, collectively we would have been better off if people had acted differently.

In any complex system, it’s often more likely that a major breakdown is the result of an alignment of errors, rather than the failure of a single component.

Friday, March 20, 2009

Why Would a Bank Try to Drive Its Borrowers Away?

Yes, some banks are trying to drive away their borrowers (the usual terms for this are “running off the portfolio”, or ”shrinking the balance sheet”). Why would they do this? It’s not intuitively obvious, but in theory at least it puts the bank in a better position to cope with future losses.

Unfortunately, to understand this it’s necessary to work through the numbers. Here is a simplified bank income statement and balance sheet:


I hope this is all obvious (I’m happy to address any questions in the comments). The scenario assumes all the loans are performing, but banks keep a loss reserve on their balance sheet just in case of future trouble. The bottom number is the key to understanding this topic; if things get really bad the bank is wiped out if it suffers a 12.2% loss on its loan portfolio.

Next, let’s assume a quarter passes with and there are no new loans or payoffs. The bank makes another $50,000,000 which increases its equity and ability to handle losses:


Now, let’s say instead of no new loans the bank drives away $500,000,000 of loans (how to do this is a separate topic). The bank no longer needs the deposits to fund those loans, so it drives them away too. Income goes down, but the ability of the bank to handle losses on the remaining portfolio goes up:


Is this a good strategy? There’s some problems with it (again, a separate post topic), but if your regulator tells you to increase your capital ratio its one of the few approaches you can take in this environment.

Thursday, March 19, 2009

Exurbs: How Far Is Too Far?

I’ve previously posted about why the nation’s worst housing markets are in the exurbs. A reader commented:

There has to be a sweet spot for these exurb communities. How far is just right to commute? 30 minutes one way? 45? Surely people think nothing of traveling across a city for work at 50 minutes per trip, so living 30ish miles out of town really isn't as bad. So, how far is too far?

The short answer is, if the commute is more from 30 minutes one way, it’s too much. Tom Vanderbilt, from his book Traffic: Why We Drive the Way We Do:

In the 1970’s, Yacov Zahavi, and Israeli economist working for the World Bank, introduced a theory he called the “travel time budget.” He suggested that people were willing to devote a certain part of each day to moving around. Interestingly, Zahavi found that this time was “practically the same” in all kinds of different locations. The small English city of Kingston-upon-Hull’s physical area was only 4.4% the size of London; nevertheless, Zahavi found, car drivers in both places averaged three-quarters of an hour each day. The only difference was that London drivers made fewer, longer trips, while Kingston-upon-Hull drivers made frequent, shorter trips. In any case, the time spent driving was about the same…

There seems to be some innate human limit for travel – which makes sense, after all, if one sleeps eight hours, spends a few hours eating (and not in the car), and crams in a hobby or a child’s tap dance recital. Not much time is left. Studies have shown that satisfaction with one’s commute begins to drop off at around 30 minutes each way.

However, obviously many people spend more than an hour a day in total commute time. Why is that? Jonah Lehrer suggests it’s a weighting mistake, in his book How We Decide:

As Ap Dijksterhuis, a psychologist at Radboud Univeristy, in the Netherlands, notes, when people are shopping for real estate, they often fall victim to…what he calls a “weighting mistake.” Consider two housing options: a three bedroom apartment located in the middle of the city which will give you a ten minute commute, and a five-bedroom McMansion in the suburbs which will result in a 45 minute commute. “People will think about this trade-off for a long time,” Dijksterhuis says, “and most of them will eventually choose the large house. After all, a third bathroom or an extra bedroom is very important for when Grandma and Grandpa come over for Christmas, whereas driving two hours each day is not really that bad.” What’s interesting is the more time people spend deliberating, the more important that extra space becomes. They’ll imagine all sorts of scenarios (a big birthday party, Thanksgiving dinner, another child) that turns the suburban house into a necessity. The lengthy commute, meanwhile, will seem less and less significant, at least when it’s compared to the lure of an extra bathroom. But, as Dijksterhuis points out, the reasoning is backward: “The additional bathroom is a complete superfluous asset for at least 362 or 363 days each year, whereas a long commute does become a burden after a while.”

I think it’s a big mistake to locate housing more than 30 minutes from major employment centers. Strategies which depend on people making errors in judgment usually don’t work out well in the long run.

Wednesday, March 18, 2009

The CRE Credit Crunch, Hard Money, and Loan Sharking

It is very difficult to find financing for retail, industrial, and office properties (multifamily properties still have Fannie Mae and Freddie Mac). What effect is this having? An interesting post at Cheap Talk, “Credit Rationing and Loan Sharking,” helps explain what is happening.

Interest rate spreads increase:

The market for credit is like any other market with supply and demand and a price.  The price is the interest rate.  The problem with the credit market is that the price often cannot serve its usual market-clearing purpose.  When the supply of credit goes down, the interest rate should rise to clear the market.  Clearing the market means reducing demand to bring it back in line with the low supply.

Borrowers with good quality projects are sitting on the sidelines:

The problem is that high interest rates reduce demand by disproportionately driving away borrowers who are good credit risks and leaving a pool of borrowers who are now more risky on average.  This makes lending even more costly, reducing supply, driving the price up again…The effect is that there may be no way to clear the market by raising interest rates.  Instead credit must be rationed.

Borrowers with riskier deals turn to hard money sources:

One way to improve rationing is to increase collateral requirements. But borrowers who are already excessively leveraged (the other part of the credit crisis story) will not have additional collateral to compete for the rationed loans.  Here is where the loan shark comes in.  Loan sharks use a form of collateral that banks do not have access to:  kneecaps.  Highly leveraged borrowers who are rationed out of the credit market cannot post collateral to service their debt so they turn to loan sharks.

I see this going on at my day job. High quality lending opportunities have virtually disappeared, leaving the dreck. On the other hand, there are a lot of deals looking for hard money (for background, here’s an article on CRE hard money). The article erroneously suggests my employer offers a hard money program (I was talking about Fannie’s mezzanine program), but my phone rang off the hook for days.

The conclusion is the CRE credit crunch is resulting in lower volumes as borrowers with high quality deals sit on the sidelines, and the business which is getting done tends to be riskier deals with onerous terms.

Tuesday, March 17, 2009

Turning Around the Creston Apartments

Here’s an interesting account of efforts to turn around a high crime, poorly maintained apartment project in Kansas City which was affecting the entire neighborhood. The short version:

  • Aggressive policing
  • Political involvement
  • On site security
  • Maintenance

I’m not sure if this can really be categorized as a success story though, since it apparently ends in the demolition of the project.

Monday, March 16, 2009

A Snake Swallowing Its Own Tail: Mark to Market and Real Estate Values

I’ve previously posted on the illiquidity of the real estate markets and the difficulty and consequences of valuing real estate using distressed sales (see here, here, and here).

Via Newmark's Door, National Review Online has a good summary of the impact of mark to market rules on banks. An excerpt:

Mark-to-market rules damage banks in two ways. The first is that banks have to treat losses on paper as though they were real economic losses, accepting fire-sale valuations of securities that they may not intend to sell. The second is that, because mark-to-market rules are used in assessing banks’ capital requirements, those paper losses can quickly become real losses when banks are forced to sell assets, often at an enormous loss, to raise enough capital to keep the regulators satisfied. Those pressured sales, in addition to locking in losses, tend to drive down the prices of similar assets, creating a vicious cycle of wealth destruction. The market becomes a snake swallowing its own tail.

Sunday, March 15, 2009

Economic and Real Estate Post Picks: Week of March 9

Recession Proof Industries: Government and health care do best

Layoffs versus Quitting: Despite the economic downturn, more people quit than are laid off in most industries

Has the Decline in Retail Sales Stabilized? Charts showing retail sales trends

Wholesale Sales Decline: Wholesale sales by sector; durable goods show the biggest declines

Inventories are Declining Rapidly: A major inventory correction is underway

Saturday, March 14, 2009

Why Fewer Reasons Are Better; Dead Cats and Cul de Sacs

When turning down a workout request or a loan application, you need to explain why. Borrowers expect a fair reason for being turned down, and loan officers and underwriters can learn from each experience and hopefully prevent reoccurrences in the future. You have a choice – you can try to provide a comprehensive understanding of your entire thought process, or you can relate just the factors which are the most important to your decision. In my experience, the latter approach is better, because what people remember won’t be your best reasons.

For example, back in the mid-1980’s I worked for Cambridge Capital originating multifamily loans (the company is long gone and not related to any of the Cambridge Capitals currently doing business). The principals were very hands-on, bright guys who personally inspected every deal we did, and I know I learned a lot about real estate from them. But, my only specific recollection is one deal which was turned down because, when the principal did his inspection of the property, there was a dead cat in the parking lot. I’m sure there were other things he didn’t like about that deal, but I don’t remember them.

I did something similar during a presentation sponsored by a chapter of the Earthquake Engineering Research Institute in Oakland. After the Northridge Earthquake I did consulting work for the Los Angeles Housing Department, and one of the things I did was a drive-by inspection of all the red and yellow tag structures damaged in the earthquake. This was an inductive approach to learning – after you look at a few thousands damaged buildings you start to see patterns. A lot of these patterns were obvious. For example, proximity to the epicenter, hillside or liquefaction zone locations, and brick construction are all know risk factors, and the audience didn’t react when I relayed that information. I did get a reaction, though, when I told them that cul de sac streets were a risk factor. On reflection, this isn’t surprising. Orientation of the structure to the ground motion wave is an important variable, and on a cul de sac one or more structures are guaranteed to be oriented for maximum damage. Also, in Los Angeles a cul de sac is usually related to e geographic risk factor (the cul de sac terminates at a drainage ditch prone to liquefaction or a hillside, for example). But, I didn’t explain this during the presentation, and I know there are people out there who remember me as the idiot who thinks earthquake damage is linked to cul de sac streets.

There is a neurological basis which explains why people lock in on unexpected reasons. From Jonah Lehrer’s “How We Decide”:

The brain is designed to amplify the shock of these mistaken predictions. Whenever it experiences something unexpected – like a radar blip that doesn’t fit the usual pattern, or a drop of juice that doesn’t arrive – the cortex immediately takes notice. Within milliseconds, the activity of the brain cells has been inflated into a powerful emotion. Nothing focuses the mind like surprise.

This is why if you tell a loan officer you’re turning down his loan because the borrower lacks liquidity, the building is poorly maintained, the income is trending down, and there’s a dead cat in the parking lot, you will forever be remembered as the guy who is fixated on dead cats. Unless that’s what you want, you’re better off keeping that reason to yourself.

Friday, March 13, 2009

Americans On the Edge: Income Curtailment, Foreclosures, and Modification Redefaults

One of my earliest posts talked about the root cause of most loan defaults; household income curtailment, typically the result of a job loss, illness, or divorce. Subsequently I’ve posted on the interplay between income curtailment and home values, and the use of home equity as a piggybank when income is curtailed and how the decline in home equity has eliminated this safety net. I’ve also talked about the role income curtailment plays when borrowers who have received loan modifications default again.

So how close to the edge are American households? Way too close. From Housing Wire:

Want a stunning figure? Half of Americans now say they are only one month or less away from not being able to meet their financial obligations if they were to lose their job — just two paychecks or less. And of these, more than half — 28 percent of all Americans — say they could not survive financially for more than two weeks without their current job.

This disturbing data comes courtesy of the 2009 MetLife Study of the American Dream, released Monday, which looks at how the financial crisis has affected the American Dream and consumer perceptions. It’s all the more disturbing considering that unemployment in the U.S. has already surged to 8.1 percent, with 651,000 jobs lost last month alone.

Is it any wonder a large percentage of borrowers receiving loan modifications subsequently redefault?

Thursday, March 12, 2009

Underperforming Assets, Workouts, and Management

Via Newmark's Door, Secretgeek on "The Deadly Cycle of Meetingitis." Here’s an excerpt:


  1. Q:What do managers do when they're stressed?
    • A:They call a meeting.
  2. Q:What gets managers stressed out?
    • A:When projects are not making progress.
  3. Q:When do projects fail to make progress?
    • A:When people spend too much time in meetings.

Secretgeek is talking about programming code crises, but the cycle applies to any situation which creates manager stress. The important part of this cycle is the root cause – it’s not the status of the project, it’s the manager’s stress.

Underperforming assets and workouts are inherently stressful to management, and are particularly prone to meetingitis (and it’s nephew, reportitis). Some managers are not comfortable unless they know the status of every deal, all the time. Secretgeek’s solution:

Communicate more, in order to meet less. Be proactive in your communication. Don't wait for them to call a meeting. Tell them what's going on. Produce regular reports. Don't "promise" to produce regular reports -- just produce them. Let them listen in on some of your day to day chatter. If you have daily standups, bring the manager in. Stop baffling them with technical mumbo jumbo. Feed them edible slices of information. Walk them through it in bite-sized chunks. Give them documentation tasks to keep them feeling important. Give them communication tasks. Draw pictures for them to stick on the wall of their office.

This approach might work for coding, but I don’t think it works very well for special assets. In my experience managers only calm down when they develop confidence their workout people are on top of their deals and elevate issues when necessary. It takes time and positive experience for workout people to develop that kind of credibility with their management (more on that here). Unfortunately, that level of confidence may never develop if the manager believes progress is a result of their involvement and not their staff’s work.

Wednesday, March 11, 2009

When Real Estate is a Liability

We are used to thinking of real estate as something of value. This is not always the case.

The first appraisal I saw with a negative value was for a 10 story office building in downtown Minneapolis back in the early 1990’s. I couldn’t find any errors in the analysis, but I felt I had to be missing something – a major office building just couldn’t be worthless. I made a trip to Minneapolis to take a look, and it still felt wrong. Sure, it was old (1920’s), but it was by no means falling down, it had tenants, and it was tied in to the skybridge system. It had to be worth something to somebody.

The issues on the building were all the usual suspects – rents and occupancy had fallen, utility costs had increased, and capitalization rates had climbed, all of which combined to hammer the value (I’ve posted here showing how relatively small changes in these variables can  combine to create a 50%+ loss of value). This building had three additional problems; there was major friable asbestos problem that was missed in the initial due diligence, we had not escrowed for real estate taxes and the borrower didn’t pay them (real estate taxes are very high in Minnesota), and there were mandatory fire code upgrades (primarily sprinklers) imposed after the loan closed which had to be completed. The cost of curing these three items exceeded the value of the building. We ended up releasing our debt ($7M) for a $200K payment from the borrower.

This kind of problem is increasingly common. NPR has a story about lenders refusing to complete foreclosures, and there is an abundance of stories on the median home sale price in Detroit (around $7,000, see here and here) and $1 bargains available (see here and here). This 5 bedroom, 3.5 bath home was available for $8,995:


And it’s not just Detroit.

The combination of low fundamental values, cost to restore the homes to habitability and cure code violations, and real estate taxes are the reasons these “bargains” exist.

Tuesday, March 10, 2009

Housing and Business and Consumer Cycles

Calculated Risk has a post on the business cycle based on Edward Leamer’s Housing and the Business Cycle paper. The basic thesis is that residential investment is a leading indicator for recessions, and a leading indicator for recovery:



PCEs are personal consumption expenditures. Here are some supporting charts from Leamer’s paper:



(Click on charts for larger versions in a new window)

The suggestion is that until housing turns around the recession won’t end. Business structures (CRE) clearly lags, so we have a long way to go in that sector.

This reminds me of Joseph Ellis’ work presented in Ahead of the Curve. Ellis sees the cycle like this:


(Click on charts for larger versions in a new window)

For Ellis real consumer spending is the leading indicator, and employment and capital spending both lag. Ellis maintains a series of charts showing the components of his model (available here) and commentary on current conditions. Real hourly earnings leads real consumer spending, and earnings are recently up, so under Ellis’ model we may see an upturn in 2009.


(Click on charts for larger versions in a new window)

Monday, March 9, 2009

Loan Underwriting, Financial Cycles, and Ponzi Financing

Loan underwriting of all types (consumer, residential mortgage, CRE) follows cycles. From Edward Leamer’s “Housing and the Business Cycle” paper:


Why do lenders “forget all about risk”? I’ve previously argued it has to do with certainty of outcomes and slow feedback loops (see here).

Sunday, March 8, 2009

Economic and Real Estate Post Picks: Week of March 2, 2009

Price Stickiness and the CPI: The components of the CPI change at very different rates

A Long Recession Ahead?: The decline in household wealth could mean this recession will be a long one

Employment Decline, Recession, and Depression: A comparison of employment declines between this recession, 1981, and the Great Depression.

Credit Crunches and Small Business Finance: How small businesses are financed, and what happens in a crunch

Is the Pace of Layoffs Declining? Trend data from October, 2008 says maybe

Saturday, March 7, 2009

Order, Disorder, and Good Neighborhoods

I’ve posted a few times about the idea that real estate values do better in neighborhoods that are well maintained and perceived as safe by their residents (see here and here).

Via Schneier on Security,, some recent research supporting the Broken Windows theory of policing:

Researchers, working with police, identified 34 crime hot spots. In half of them, authorities set to work—clearing trash from the sidewalks, fixing street lights, and sending loiterers scurrying. Abandoned buildings were secured, businesses forced to meet code, and more arrests made for misdemeanors. Mental health services and homeless aid referrals expanded. In the remaining hot spots, normal policing and services continued…

Cleaning up the physical environment was very effective; misdemeanor arrests less so, and boosting social services had no apparent impact.

Friday, March 6, 2009

The CRE Downward Spiral: Fire!

Real Property Alpha has a good post on deteriorating CRE fundamentals, but the conclusion points in a dangerous direction. Two excerpts:

This analysis, however, is not focused on providing a historical explanation for the office market weakness. Rather, I note the weakness of the fundamentals in order to provide counsel to lender clients with commercial properties on their books. Unfortunately, the downward trajectory of the graph on page 1 shows a market with a steep downward trend. Bank sellers failing to timely dispose of non-performing assets in this environment risk further deterioration in fundamentals and the resulting price decline. Simply based on fundamentals, office pro forma values are off 38% since Q108. The 38% decline is significant as it likely destroys any equity to debt coverage which was assumed during the initial underwriting, assuming that the deal was financed in the last few years…

Despite the tremendous liquidity problem in the financial industry today, I believe that making proactive moves to dispose of non-performing assets will provide reward for banks with the will to do so. Banks that can expedite the process of disposing of non-performing assets will be the first to clean up their balance sheet and begin lending again. The reward for these banks will be a risk environment in the new lending which will be significantly improved from the landscape we see today.

I agree, and disagree. When the banks dispose of their nonperforming assets, those assets become the comparables for and the new basis the remaining portfolio competes against, so those assets are now overleveraged and are disposed, and so it goes. An aggressive disposition strategy reinforces the downward spiral, so unless you get out of the asset class completely, you continue to suffer losses. A disposition strategy that looks smart for an individual asset can magnify your losses in the remaining portfolio. And remember, it’s not just you – the market won’t stabilize as long as other banks are making significant dispositions.

Also, an aggressive disposition strategy is smart, until it isn’t. If you sell an asset and the market continues to fall, you were smart, but if this downturn is like all the rest at some point the market will stabilize and values will start to rise. There is always someone selling at the bottom.

In a perfect world the most highly leveraged assets and the assets controlled by weak operators would be liquidated, and lenders would restructure the debt on marginally overleveraged deals with good operators to allow them a reasonable return and some upside in exchange for maximizing the asset value during the downturn. It’s like a fire in a theater; more people will get out in an orderly exit than if everyone tries to get through the door at once. Of course, we live in a far from perfect world, and at this time it’s hard to argue with Real Property Alpha’s conclusion that lenders should be running for the door.

Thursday, March 5, 2009

More on Loan Modifications and Moral Hazard

I’ve previously argued that moral hazard risks are overrated for a number of reasons (see this post). Niall Ferguson has a piece in the Australian which identifies another really good reason not to worry too much about moral hazard in the context of granting loan modifications. You need to evaluate how often a similar set of circumstances is likely to occur, and if a reoccurrence is unlikely, moral hazard risk is low. An excerpt:

The second step we need to take is a generalised conversion of American mortgages to lower interest rates and longer maturities…Another objection to such a procedure is that it would reward the imprudent. But moral hazard only really matters if bad behaviour is likely to be repeated. I do not foresee anyone asking for, or being given, an option adjustable-rate mortgage for many, many years.

Wednesday, March 4, 2009

The Inevitability of Errors

Errors are inevitable – no matter what the stakes, no matter how much you practice, things are going to go wrong a certain percentage of the time in any complex task or decision. The New York Times has an article with an excellent example: basketball free throws.

There is nothing in sports as straightforward as a free throw; the equipment is always the same, the geometry is constant, and there is no defense interfering. The only variables are the player’s concentration and control over his or her body. And yet, at the highest level of the game, it goes wrong 25% of the time, year after year after year:

In the National Basketball Association, the average has been roughly 75 percent for more than 50 years. Players in college women’s basketball and the W.N.B.A. reached similar plateaus — about equal to the men — and stuck there.

The general expectation in sports is that performance improves over time. Future athletes will surely be faster, throw farther, jump higher. But free-throw shooting represents a stubbornly peculiar athletic endeavor. As a group, players have not gotten better. Nor have they become worse.

“It’s unbelievable,” Larry Wright, an adjunct professor of statistics at Columbia, said as he studied the year-by-year averages. “There’s almost no difference. Fifty years. This is mind-boggling.”

And it’s not like the stakes aren’t high:

Last season, Memphis was 38-2 despite making only 61 percent of its free throws, missing an average of nearly 10 a game. The Tigers lost the national championship game after missing 4 of 5 free throws in the final 72 seconds against Kansas, which had made a late 3-point shot to tie the game and won in overtime…About two-thirds of a winning team’s points in the final minute typically come from the free-throw line…

Obviously, we need to work to eliminate mistakes and design systems to minimize the chance of them occurring. But, a certain percentage of the time errors will happen. Learn what you can from them and move on.

Tuesday, March 3, 2009

Literally Underwater Property, Workouts, and Maintenance

You can temporarily fix almost any plumbing link with an inner tube and two hose clamps. Cut a strip of rubber long enough to cover the leak and wide enough to wrap around the pipe. Orient the long edge of the patch opposite the leak and clamp on either side of the leak. Here’s how it should look:

plumbing leak

I know this from inspecting the aftermath of a ceiling collapse in an apartment building we had foreclosed on. The water lines were corroded, the borrower was strapped for cash, and rather than replumbing, the borrower simply slapped another patch on every section of pipe which sprang a leak. By the time we took the property back there were more patches than there was visible pipe. The cost to repair the water damage was double what it would have cost for us to advance the funds to replace the water lines.

Most of the concern expressed over underwater properties (i.e., properties whose value is exceeded by the mortgage debt) is that the borrowers have become “mortgage slaves” (see, for example, this Calculated Risk post). But, the situation has risks for the lender too. If a property is under water (i.e., the borrower has no equity), what incentive does the borrower have to maintain it? If all the cash flow from a rental property is taken for debt service, what happens when the roof starts to leak?

A frequent mistake lenders make in trying to restructure debt is to leave no incentive for the borrower to maintain the property. Best practices are to allocate enough cash flow to a controlled capital account so funds are available for repairs, and to structure some up side for the borrower if the property value improves. In the short term this results in less cash flow and a larger loss for the lender, but preserving the collateral value generally results in a higher ultimate recovery.

Monday, March 2, 2009

Does the Relationship Between Median Income and Home Values Explain the Housing Bubble?

It’s taken as a given that one of the reasons housing is in crisis is that home value increases have significantly outstripped income growth (see, for example, these posts at The Big Picture, Option Armageddon, and Calculated Risk). Here’s a chart from Calculated Risk showing the relationship over time:


(Click on image for a larger version in a new window)

An excerpt from Option Armageddon explains:

Ask yourself, what is a housing “bubble” and how is one created?  The term “bubble” suggests that prices were, objectively speaking, “too high.”  Clearly this was the case.  A chart of house prices relative to median income makes it abundantly clear.  House prices can’t continue to expand forever, not unless incomes expand at the same time.  If prices are expanding faster than income, then prices are “too high” relative to what people can actually afford to pay for shelter.  In other words, we have a bubble.

This is common sense. But is it true? If it is, you would expect that there would be more foreclosures in markets where the ratio was higher. But that’s not necessarily the case.

Via Creative Class, a study from University of Virginia researchers found:

In San Francisco, for example, median value of owner-occupied housing in 2007 was 9.7 times median family income, yet the foreclosure rate was a mere 0.24 percent. In the District of Columbia, housing values were 6.8 times family income, yet the foreclosure rate was 0.12 percent. And in New York City, housing values were 12.3 times family incomes in Brooklyn (foreclosure rate 0.38), 11.7 times income in Manhattan (foreclosure rate 0.04 percent), and 10.3 times family income in the Bronx (foreclosure rate 0.28 percent). Other central cities lacked such extraordinary house value to income ratios, but in no instance were low foreclosure rates associated with low house value to income ratios (Table 4).

Here’s the table:


If the relationship is true, why does San Francisco, which has a value-to-income ratio triple the national average, have a foreclosure rate that is 1/3 the national average?

There is clearly something going on that can’t be expressed in a simple ratio. My suggestion is that bubble markets tend to have relatively low income levels and relatively high concentrations of single family rentals (see this post for a more detailed explanation).

Keep the Bonuses, Change the Criteria

Thomas Gehrig and Lukas Menkhoff at VOX survey the research on bonuses and suggest we keep them, with some changes. An excerpt:

In fact, banks themselves are trying to correct their internal incentive schemes in order to re-adjust incentives on longer horizons. They seem to largely agree that, prior to the crisis, their systems may have been excessively short-sighted, and they are now trying to base rewards on more sustainable performance criteria such as average growth rates and volumes across longer sampling periods.

My suggestion (posted here) is measuring shareholder equity over a five year period.

Management, Feedback, and US Air Flight 1549

Via The Big Picture, an amazing animation with audio of the US Air Flight 1549 takeoff and landing.

It’s striking how the flight controllers’ understanding of the situation lags actual conditions. I think there’s a parallel with management and regulator understanding of what’s happening on the ground (or in the air, in this case) during rapidly changing conditions.

Sunday, March 1, 2009

Economic and Real Estate Post Picks: Week of February 23, 2009

February Economic Summary in Graphs: A summary of real estate and economic trends from Calculated Risk

This Recession in Perspective: Charts from the Minneapolis Fed which compare this recession to others from many perspectives

Credit Crisis Indicators: Some progress has been made

Is the Worst Over?: Mounting statistical evidence the worst of the recession may have passed

Paul Volcker on This Recession: What caused it, what’s different this time, how to prevent it from happening again