Wednesday, April 1, 2009

Why Aren’t Banks Selling More Distressed CRE Debt?

People who are trying to buy distressed CRE debt tell me banks aren’t willing to sell at prices which will clear the market. Why?

In a New York Times piece, Casey Mulligan argues banks anticipated a government program to subsidize sales, and have held back waiting for it. An excerpt:

[…The] secondary market for legacy mortgages has stagnated largely because of the (ultimately correct) anticipation of a huge government subsidy. Banks were not “unable” to sell their legacy mortgages; they were prudently unwilling to sell because they expected the government to eventually step in and help push the prices of those assets higher.

We all witnessed last week the big capital gains to banks that came with the unveiling of the Geithner plan. A bank would have been foolish to sell off its legacy mortgages during the fall or winter, before such a plan was unveiled and executed, because a fall or winter non-bank buyer of legacy mortgages would likely be ineligible for the ultimate subsidy.

Thus, the secondary market for legacy mortgages has failed so far because of the lack of a plan rather than a lack of clarity. To get the market operating again, the Geithner plan does not need to alleviate the market weakness improperly identified by its authors, but needs only to stay on the path to execution.

The subsidy Mulligan is referring to is the PPIF program. David Kotok of Cumberland Advisors lays out the clearest explanation I’ve seen on how the program boosts prices and reduces buyer risk here (it takes eight minutes to read, but it’s well worth it if you’re interested in this topic).

I believe Kotok’s example overstates the value of the subsidy because the “win” side of the bet is too high.  A more realistic example is provided by the example from “a hawkeyed reader who embellishes the math”, about three quarters of the way down the post. Even with this example, the price support provided by PIFF is a big boost.

So will PIFF free up the market? I think it will definitely help, but there are still three very large issues. The first is that many banks are still hoping for the best on their loans and will hold back. This position will be harder to sustain if CRE continues to deteriorate, but it may take some time. The second issue is that some banks will be unwilling to take the hit required even at subsidized price levels because it will put them out of business. Waiting and hoping for a turnaround may be the only survival strategy for some banks. The final issue is that, even with the PIFF subsidy, buyers will hold back because they believe CRE still has a long way to fall. This view is succinctly summarized by the “expert in a rating agency” quoted in the Kotok post:


CMBS prices are terrible, but underlying asset prices are soon to follow, so prices reflect collateral, not liquidity discount.

I think this will be a real problem. I’ve posted on how CRE prices tend to spiral down here.