Humans Are Wired to See Patterns Where There Are None

From Jonah Lehrer’s post on Frontal Cortex, Patterns and the Stock Market:

Alas, the human mind can't resist the allure of explanations, even if they make no sense. We're so eager to find correlations and causation that, when confronted with an inherently stochastic process - like the DJIA, or a slot machine - we invent factors to fixate on. The end result is a blinkered sort of overconfidence, in which we're convinced we've solved a system that has no solution.

Look, for example, at this elegant little experiment. A rat was put in a T-shaped maze with a few morsels of food placed on either the far right or left side of the enclosure. The placement of the food is randomly determined, but the dice is rigged: over the long run, the food was placed on the left side sixty per cent of the time. How did the rat respond? It quickly realized that the left side was more rewarding. As a result, it always went to the left, which resulted in a sixty percent success rate. The rat didn't strive for perfection. It didn't search for a Unified Theory of the T-shaped maze, or try to decipher the disorder. Instead, it accepted the inherent uncertainty of the reward and learned to settle for the best possible alternative.

The experiment was then repeated with Yale undergraduates. Unlike the rat, their swollen brains stubbornly searched for the elusive pattern that determined the placement of the reward. They made predictions and then tried to learn from their prediction errors. The problem was that there was nothing to predict: the randomness was real. Because the students refused to settle for a 60 percent success rate, they ended up with a 52 percent success rate. Although most of the students were convinced they were making progress towards identifying the underlying algorithm, they were actually being outsmarted by a rat.

Loan underwriters and credit officers are constantly searching for patterns that aren’t there. This is the first in a series of posts that will look at this problem.

I highly recommend Jonah’s book, How We Decide.

Occupancy and Rent Change News Can Mislead You

When you see a headline saying rents or occupancy in a market has declined, you need to remember you need to consider both rents and occupancy to understand what’s going on.  Lansner on Real Estate reports multifamily rents and occupancy are declining in Orange County, based on a RealFacts first quarter survey. The chart accompanying the story illustrates my point:

Which is the best performing city? Which is the worst?

A few seconds spent trying to answer this question makes it clear; you need to consider both rent and occupancy trends to arrive at the right answer. Costa Mesa is the best performing city, because even though its rent decline was one of the worst, that decline was more than offset by the improvement in occupancy. Placentia was the worst performing market; even though neither its rent nor occupancy decline was the worst, on a combined basis its performance was substantially worse than the other cities.

You might think that occupancy and rent levels move up and down in tandem, and usually you would be right. However, there are actually four possibilities:

• Your occupancy goes up, but your rents go down (see Newport Beach and Costa Mesa). This can happen if you reduce your rents and attract more tenants.
• Your occupancy goes down, but your rents go up (see Buena Park, Laguna Niguel, Garden Grove, and Cypress). This can happen if you raise rents but drive tenants away.
• Your occupancy goes up and your rents go up (no place in Orange County this quarter). This happens in tight markets which are seeing tenant growth in excess of supply additions.
• Your occupancy and rents both go down (all the other Orange County places in the table). This happens when there are fewer tenants in a market (the case almost everywhere today).

So, when you read about a decline in either rents or occupancy, remember you need to consider both in order to understand what’s going on.

Complexity is not a Virtue

The General Growth Properties bankruptcy filing actually involved 166 entities (here's a link to the petition). To help everyone understand the relationships between the entities, a helpful organization chart was provided:

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

Clear? Oh wait, there’s more:

And more:

And more:

And more:

In fact, there are 25 pages of organizational charts like these. No doubt there were clever reasons to create this web of entities, but it seems obvious now that some of the intellectual firepower that created this rat’s nest should have been directed at managing debt maturities.

There isn’t any available data to test this hypothesis, but one of my rules of thumb is the risk of default is positively correlated with the complexity of the borrower’s organization.

Problems Mounting in Orange County Multifamily

Lansner on Real Estate reports it’s taking twice as long to rent vacant units in Orange County, rents are falling, vacancies are rising, and landlords are looking the other way on tenant credit issues and cutting back on maintenance.

None of this is surprising; all these things go together in a softening market. But, it’s nice to see an article which puts all the symptoms of a soft market in one place. For more on the relationship between rents, vacancy, and turnover time, see Multifamily Occupancy Rates: Four Things to Think About. For a discussion of the nasty feedback loop cutting tenant credit standards and maintenance creates, see The Slippery Slope to Default.

Economy and Real Estate Post Picks: Week of April 20, 2009

Will the Recession End in a Few Months? Two economic forecasters think so

Can the Economy Function Without Securitization? This post argues restoring  securitization markets should be a top priority.

Commercial Real Estate Values at 2005 Levels: Moody’s Commercial Real Estate Indices indicate gains over the last four years have been reversed.

Which Way Are 10 Year Treasury Rates Headed? Two opposing views

What Will be the Shape of this Recession? V, L, or D?

Innovation versus Old School, Big Lenders versus Small Lenders

Matt Yglesias is not comfortable with how easy it was for him to get a mortgage, and talks about it in his post, “Financial Innovation Takes the Homework Out of Banking.” An excerpt:

An old-school local bank can expect the people supervising loan applications to have specific knowledge about situations. And perhaps more importantly, the head of a small institution can directly monitor what his subordinates are doing. And while he perhaps can’t have detailed information about everything that’s going on, he can have general knowledge of the local economic situation.

But when I got my mortgage from Bank of America, it’s not like there was some plausible worry that Ken Lewis was going to knock on the guy’s door unexpectedly and make sure that everything was being done right. You can’t really have a homework-based system at a giant institution. Things need to be handled through bureaucratic processes and rules and formulae.

I like the post, but what I really like is the quality of the comments, most of which are on point and contribute to the discussion. The comments include discussions of the expense of good due diligence, the role of rules in preventing discrimination, whether or not due diligence makes a difference in a severe recession, whether or not predicting someone’s employment prospects is possible, the scalability of underwriting supervision, the failure rate of large versus small lenders, the role of securitization. There are some of the usual “CRA/Fannie Mae/minority lending are to blame” commentators, but on the whole Matt’s got a good group of readers.

I have two contributions to the discussion. The first is that even if big lenders and small lenders want to do their homework, they don’t know what to study (see Why What You Know About Income Property Performance is Probably Wrong). My second observation is that by cutting underwriting steps the lender can reduce costs, decrease the time spent from application, and reduce uncertainty in delivery, all of which improves their competitive position (see Why Did WAMU Abandon Underwriting Standards?).

Let the Judge Sort Them Out: How Bankruptcy Remote are Single Purpose Entities?

CRE lender standard operating procedure is to make loans to entities whose sole purpose is to own the real estate collateral. The goal (as I’ve posted about here) is to ensure the loan is not entangled in a bankruptcy related to other obligations of the borrower. From an Arent Fox article:

Lenders customarily require that the real estate projects they finance be owned by SPEs. In this context, use of the SPE structure is designed to confine the lender's risk to the particular real estate asset being financed and to avoid the problems encountered when a borrower with multiple assets files a bankruptcy petition…

The SPE structure will, in fact, isolate the property from other assets and focus the bankruptcy risk on the specific property.

So, the fact that the General Growth Properties’ bankruptcy filing includes a list 12 pages long of what appear to be more than 100 single purpose entities is causing some consternation. From Law 360, “For Commercial Market, Mall Giant May be 1st Domino:”

The number of entities that were listed on GGP's bankruptcy petition has raised the eyebrows of some attorneys who question the justification of putting solvent entities with no debt into bankruptcy in the first place.

Burroughs [Katherine A. Burroughs, a partner at Dechert] said a preliminary issue in the proceeding will be whether the court should allow the parent company to cause the independent entities to take on additional debt solely to benefit the parent.

“If GGP is successful in having these entities stay in, this could have a significant chilling effect on structured finance going forward,” Burroughs said, explaining that many structured finance deals are premised on keeping solvent entities out of the bankruptcies of parent companies.

Foley [Doug Foley, chair of the bankruptcy practice at McGuireWoods LLP] said GGP could have included these entities in the filing as a means of protecting them if the debtors had some cross-collaterization issues with other lenders.

They could also have been included to provide collateral to support the DIP loan, he said.

Nolan [Thomas Nolan, chief operating officer of GGC] said that the primary consideration for including certain properties in GGP's filing was the capital structure of each individual property, including the amount and terms of each property's mortgage.

Some properties were not included because they already have extended maturity dates, and there was nothing that could be gained from the restructuring process, Nolan explained.

A simple explanation could be that, although each asset is owned by a separate SPE, they are security for credit facilities which include many assets and which need a maturity extension (some of the org charts accompanying the filing support this theory). Or, it could be the bankruptcy equivalent of the Special Forces slogan, “Kill them all and let God sort them out.”

General Growth Properties’ Bankruptcy: An Example of a Balance Sheet Default

I’ve previously posted on the difference between an operating statement default (when deteriorating income means a borrower can no longer service its debt) and a balance sheet default (when a maturing loan can’t be paid off through sale or refinance). General Growth Properties’ bankruptcy filing is a result of a balance sheet default. From their press release announcing the bankruptcy filing:

The decision to pursue reorganization under chapter 11 came after extensive efforts to refinance or extend maturing debt outside of chapter 11. Over many months, the Company has endeavored to negotiate with its unsecured and secured creditors to obtain the time needed to develop a long-term solution to the credit crisis facing the Company. Unable to reach an out-of-court consensus, the Company reluctantly concluded that restructuring under the protection of the bankruptcy court was necessary. During the chapter 11 cases, the Company will continue to explore strategic alternatives and search the markets for available sources of capital. The Company intends to pursue a plan of reorganization that extends mortgage maturities and reduces its corporate debt and overall leverage. This will establish a sustainable, long-term capital structure for the Company…

“Our core business remains sound and is performing well with stable cash flows. We believe that chapter 11 is the best process for restructuring maturing mortgage loans, reducing the Company’s corporate debt, and establishing a sustainable, long-term capital structure for the Company,” said Adam Metz, Chief Executive Officer of the Company. “While we have worked tirelessly in the past several months to address our maturing debts, the collapse of the credit markets has made it impossible for us to refinance maturing debt outside of chapter 11,” he said.

Look for many more bankruptcy filings on CRE properties by borrowers with similar goals.

Maturity Kills: Operating Statement Defaults Versus Balance Sheet Defaults

No question CRE rents are falling and vacancy rates are rising, and these trends are getting a lot of attention (see, for example, Calculated Risk posts here, here, and here, and Zero Hedge posts here, and here). However, this threat is minor compared to what’s happening on the balance sheet side of the business.

There are two ways a CRE loan defaults; an operating statement default, or a balance sheet default. Here is a typical CRE deal illustrating an operating statement default:

The assumptions are an initial interest rate of LIBOR+2.25% with a 30 year amortization, no changes in interest rates or cap rates, but a 25% decline in NOI. This results in negative cash flow, which could lead to a default (one would hope on a $10,000,000 deal the sponsor could cover a shortfall this small, but that capability is not something CRE lenders focused on). The takeaway point is, even with a major decline in NOI the shortfall is not huge, and because there is equity on the balance sheet the problem can be solved with a sale of the property.

Here is an example of a balance sheet default with the same structure, but a smaller decline in NOI coupled with an increase in cap rates:

Note that the operating statement side of the equation is fine; the borrower can still make the payments. However, the increase in cap rates has wiped out the equity in the property, and if the loan matures the borrower can’t repay it. The takeaway here is that cap rate changes have a much bigger impact than operating statement changes (for a more thorough analysis of this point, here’s a link to Philip Conner’s and Youguo Liang’s Income and Cap Rate Effects on Property Appreciation).

Here is what things are actually looking like for 2010 – a substantial decline in NOI and an increase in cap rates, combined with a substantial decline in interest rates:

Note that the operating statement is fine; the decline in interest rates more than offsets the decline in NOI, and cash flow has actually improved since origination. However, the decline in NOI combined with the increase in cap rates creates a huge balance sheet problem, and if the loan matures the problem can’t be solved with a refinance or sale of the property.

This is why there is so much concern over upcoming loan maturities. Here’s a link to a Deutsche Bank CRE presentation which goes into more depth (the maturity discussion begins on page 25).

My Securitization Misconceptions

I am not a CMBS insider – although I’ve been doing nothing but income property finance for 30 years, it’s almost always been for whole loan lenders. However, a good chunk of that time was spent originating Fannie Mae multifamily loans and competing against CMBS lenders for business, and we lost that competition on many, many deals. I found this surprising – how could pricing be better on a securitized deal than the pricing offered by an institution with an implicit government guarantee? How could CMBS lenders offer better pricing on deals that had screamingly obvious flaws? At the time, I came up with some answers I thought made sense, but it turned out I was wrong.

Simple securitization is not complicated. You take a pool of loans and project the aggregate principal and interest cash flows from the pool. Picture the cash flow as a river with a series of waterfalls. First the cash flow goes to the A piece buyer, and the remainder goes to the B piece buyer. If the cash flow falls a little short because there are losses on some loans, the A piece buyer still gets his return but the B piece buyer gets shorted. If the cash flows are massively short (for example, many loans default as a result of a global financial meltdown), the B piece buyer is wiped out and the A piece buyer will also suffer some losses. If you’re a do-it-yourselfer, I recommend Keith Allman’s book, Modeling Structured Finance Cash Flows with Microsoft Excel; spend an afternoon with it and a laptop and you can do your own securitization model.

My first misconception was how value was created out of this process. The idea was the aggregate value of the allocated cash flow was worth more than the whole, much like the value of the packages of meat in the supermarket cooler are worth more than the whole cow. Some people want sirloin, some want hamburger, and by giving people what they want the parts are worth more than the whole.

Although to some extent value was created in this process, the real problem is the securities were simply mispriced. From The Economics of Structured Finance, A paper by Joshua Coval, Jakub Jurik, and Erik Stafford:

The rapid growth of the market for structured products coincided with fairly strong economic growth and few defaults, which gave market participants little reason to question the robustness of these products. In fact, all parties believed they were getting a good deal. Many of the structured finance securities with AAA-ratings offered yields that were attractive relative to other, rating-matched alternatives, such as corporate bonds. The “rated” nature of these securities, along with their yield advantage, engendered significant interest from investors.

However, these seemingly attractive yields were in fact too low given the true underlying risks. First, the securities’ credit ratings provided a downward biased view of their actual default risks, since they were based on the credit ratings agencies’ naïve extrapolation of the favorable economic conditions. Second, the yields failed to account for the extreme exposure of structured products to declines in aggregate economic conditions (i.e. systematic risk). The spuriously low yields on senior claims, in turn, allowed the holders of remaining claims to be overcompensated, incentivizing market participants to hold the “toxic” junior tranches. As a result of this mispricing, demand for structured claims of all seniorities grew explosively. The banks were eager to play along, collecting handsome fees for origination and structuring. Ultimately, the growing demand for the underlying collateral assets lead to an unprecedented reduction in the borrowing costs for homeowners and corporations alike, fueling the real estate bubble that is now unwinding.

My second misconception was that the B piece buyers were the canaries in the mine. Rating agencies blessed the cash flow projections, but the real safety valves were the B piece buyers – since they were to take the first loss, they had a strong incentive to make sure the projections were reasonable. If the deals were too risky, B piece buyers would stop buying. This is what happened when CMBS spreads widened in 1998 after Russia defaulted on its bonds, so I thought that B piece buyers were an effective check on the market.

We now know, however, that B piece buyers were repackaging their exposure, obtaining a triple AAA rating of most of it, and selling their pieces as CDOs. Baseline Scenario provides a good explanation of how this worked in this post. Since the B piece buyers weren’t retaining the risk, there was no canary to signal the problem.

For more on securitization, Derivative Dribble is an excellent source. I recommend starting with Tranches and Risk.

Economic and Real Estate Post Picks: Week of April 13, 2009

Is the Cutback in Consumer Spending Abnormal? Consumer spending patterns in prior recessions

Job Loss Patterns in this Recession: An interactive map showing the geographic pattern of job losses in this recession over time

General Growth Property Bankruptcy: A set of stories exploring various aspects of the bankruptcy of the nation’s second largest mall owner.

What Direction is the Economy Headed? Russell Investment’s Economic Dashboard shows most indicators are headed in the right direction

Retail Sales Down in March: Declines in gasoline and motor vehicle sales were big contributors

Value, Cash Investments, Equity, Cash Out Refinances, Anchoring, and Sunk Costs

When I’m talking to a borrower about a loan workout, there is often a major disconnect between the reality they see and the reality I see. One of the disconnects almost always relates to the equity in the property.

Let’s say Bill Ant buys a property in 2005 for $10,000,000, and I make him a 75% LTV loan. Here are the numbers:

Bill’s equity is the difference between the value and the debt, and is equal to his cash investment.

Now, let’s roll forward to 2007. Values have increased 20%:

The cash investment remains the same, but Bill’s equity has increased 80% (the magic of leverage).

Now it’s 2010, and values have decreased 50% (think that can’t happen? Here’s my post, “Commercial Property Values Down 50%?”):

Here is when the disconnect occurs. When you talk to Bill Ant, he will refer to his $4,500,000 or $2,500,000 of equity in the property. Borrowers tend to anchor on their equity at peak value of the property, or on their cash investment in the property, instead of the equity based on the current value. Bill doesn’t have equity in the property any more – all he has is a sad story.

But, he does have $2,500,000 in sunk cost on the deal. Is that worth anything when it comes to his decision to continue to make the payments in a workout context?

Let’s say Tom Grasshopper did the same deal in 2005, and refinanced in 2007, pulling out all his cash investment with a new loan based on 75% of the higher value, and spent the proceeds on a big house and a boat. Here are the numbers:

Now, it’s 2010. I’ve put Ant’s and Grasshopper’s situations side by side for comparison purposes:

Some people think borrowers who have done cash out refinances are less committed to the property and less likely to support the loan than people who never pulled their cash out. After all, Grasshopper no longer has a sunk cost, and he can walk away and keep his house and boat, while Ant has nothing.

This makes sense in theory, but I can tell you with absolute certainty that in practice both of these borrowers are equally focused on their loss from the peak value, and are equally angry, in denial, willing to bargain, and depressed (depending on what stage of the process they’re at). Grasshopper is more likely to default and is likely to default earlier than Ant, but that’s because he owes more relative to the current value of the property, not because he has less commitment to the property.

To recap, borrowers anchor on what they had to start out with or at the peak of the market, measure their losses from those points, and are not much influenced by any gains they made along the way if they end up underwater.

CRE Performance by Property Type: It’s the Tenants

Zero Hedge has a chart this morning showing CRE loan performance by property type. The information supports the idea that loan performance in a downturn is largely driven by tenant type, and specifically the term of the tenant lease.

Here’s the chart:

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

The Zero Hedge post has an attribution to Lehman, but not enough information to identify what exactly we’re looking at. About all I can say is it’s clearly CMBS data.

I’ve taken the data, excluded Credit Tenant Leases and Health Care (given the small balances involved, the performance of a few deals could skew the result), and sorted by worst-to-best performance:

Why does it stack up like this? In a market with declining fundamentals, the deterioration in cash flow is largely a result of tenant turnover (more on that here). When a tenant leaves, the new tenant comes in at the new, lower market rate, while the tenants still in occupancy continue to pay at the higher rate. The higher the turnover rate, the faster the reset to the lower market rate. Also, if there are fewer tenants looking for space, when a tenant leaves the vacated space stays vacant longer.

Hence the rankings above. Hotels, obviously, have the highest turnover. In most multifamily projects more than half the tenants move every year, while retail, industrial, manufactured housing, and office tenants move much less often.

The only real surprises here are full service hotels and self storage. Both are performing around 2% better than I would have predicted. The outlook for full service hotels in this recession is not good (see for example, this news release from PKF Consulting), and I would have expected performance more in line with other hotel types. The average self storage tenant rents space longer than you might think (15 months, according to this article), but I’m still surprised by how well that property type is performing.

How Big a Hit Can Lenders Take on Note Sales?

I’ve previously posted on how driving away borrowers can leave a bank in a better position to handle losses on the remaining portfolio (link here). Here is the simplified balance sheet side of the math:

In this example, $250,000,000 in loans are paid off and used to reduce liabilities. The loss reserve and equity are unchanged, but have increased in size relative to the remaining portfolio, so the bank is in a better position to absorb losses in that portfolio.

This suggests that a bank could sell loans at a discount without damaging its ability to deal with future losses. Here is the same transaction above, but the bank sells the loans at an 11% discount:

Note that there is an actual loss of $27,500,000 which needs to come from somewhere in order to pay off the liabilities. In this example, it comes from cash and a reduction in the cash held in the loss reserve (but still maintaining a reserve level of 2% of remaining loans). Even though they took an 11% hit, the banks ability to weather additional losses remains unchanged. However, note the bank’s cash position has declined substantially.

What happens when the discount is 22%?

The bank is in a worse position, and has wiped out it’s cash position.

The real world is obviously much more complicated, but the rule of thumb is a bank can take a 10% hit on a note sale without much pain because the capital and loss reserves are already on the balance sheet to handle the loss. In general, as the market deteriorates banks have been building reserve levels, and specific loss reserves are being taken against some assets. To the extent these reserves exist, bigger discounts can be taken.

According to Zero Hedge, the FDIC commercial loan auctions are clearing at a 50% discount. For a bank to take that kind of hit on a note sale of any size, they would need to have built up very large reserves, or have substantial excess capital, or both. There aren’t many (any?) banks with substantial CRE exposure in that position, hence there are not a lot of note sales going on.

This Time is Very Different: Attack of the Zombie Properties

The last time we had a severe CRE downturn was 1990 – 1995. For those of us who were around, the current situation feels similar – plummeting employment, deteriorating income fundamentals, spiking cap rates, and loss of liquidity in the market. However, there are some huge differences this time which have important implications.

First, some history. Here is a chart of cap rates taken from a paper by Philip Conner and Youguo Liang (Income and Cap Rate Effects on Property Appreciation, worth checking out):

Current value cap rates bottomed at around 6.7% in 1990, were around 8.25% in 1992, and peaked at around 9.5% in 1995. Based on the sales and appraisals I’m seeing and talk with colleagues, current cap rates seem to be in the 8% to 8.5% range, so today is somewhere around 1992 levels.

Now, let’s consider interest rates. A typical variable rate CRE deal in 1990 used an 11th District Cost of Funds index (COFI) plus 2.25%. An equivalent CRE deal in 2007 would have been priced at 30 day LIBOR + 2%. Here is how the interest rate would have changed on those two deals over the last 2 years:

Interest rates this time are much lower. In 1992, the cap rates were right around the interest rate, which meant a property with no equity also probably couldn’t make it’s payment. Today is much different; cap rates are 5.5% to 6% higher than the interest rate. This means a property could be severely under water and still make it’s payment. Here’s an example:

In an ordinary world, a property overleveraged to this extent would be foreclosed on and sold, but because interest rates are so low it can continue to make its payments.

What are the implications?

• CRE loans are collateral based, so under FAS 114 the bank probably needs to recognize the loss even though the loan payments are current. If the loan term is long enough, it’s possible the bank can make an argument the value will recover, and avoid recognizing the loss. But regulators and accountants these days tend to be pessimistic in their outlook, so the bank is probably stuck with recognizing the loss.
• If a bank attempts to foreclose on a basis other than a payment default (for example, loan maturity or a non-monetary covenant violation), the borrower will probably file bankruptcy. It is very difficult to obtain relief from stay and foreclose on a borrower willing to make their contractual interest payments (more on that here). So, the bank is probably stuck with the deal until interest rates go up and there is a payment default, unless they sell the note.
• If the bank sells the note for the collateral value, the return to the note purchaser is equal to the cap rate (in the example above, 8.25%). Note buyers are looking for returns in the 20% range, so these deals won’t appeal to them either.

I believe the result is we will have a lot of zombie loans on bank books, and a lot of zombie properties that are grossly overleveraged, but which can’t be cleared to market values because the borrowers can make the payments at today’s incredibly low rates.

Why CRE Lending Needs its Own Center for Disease Control

Imagine there is a disease that lies dormant for between 5 and 20 years, and then, over a 3 to 5 year period, kills 5 – 10% of our population. Now, suppose the first signs of a new outbreak are occurring. Would it surprise you if there was no central data repository to monitor the spread of the disease? That no teams of scientists study who survives, and who doesn’t? That no theories are developed to avert the next outbreak?

Of course, that would never happen in the United States. Virtually every disease outbreak and death in the US is reported to the Center for Disease Control (CDC), which identifies trends and coordinates research on the causes and prevention of disease. Any serious outbreak receives almost immediate attention and study.

There is nothing like the CDC when it comes to reporting and studying underperforming CRE loans. Obviously, human lives are more important than avoiding losses on loans, but it still puzzles me that there is no systematic, comprehensive effort to track defaults, diagnose the problems, and autopsy the failures. It’s apparent we are going to see major performance issues on CRE loans (see, for example, this post from Zero Hedge). Who is going to collect data and study what happens this time so we can avoid or minimize future losses?

There are some counterarguments to making the effort. Some people believe the problems are already diagnosed – for example, underwriting standards (LTV, DSC, interest only structures, etc.) were too aggressive. Undoubtedly that’s true, but it doesn’t explain everything. For example, here’s a table from the previously mentioned Zero Hedge post showing losses some CMBS loans:

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

The last loan on the list is Coastal Carolina Campus Point. Costar had this to report when the loan hit the watch list:

Coastal Carolina Campus Point, Myrtle Beach, SC
The loan on this 144-unit multifamily student housing apartment complex was transferred to the special servicer in January 2005 due to monetary default and became real estate owned in November 2005. The property is 67% occupied. The total exposure on the loan was $11.6 million as of November 2006. The property is listed for sale with Marcus & Millichap with an anticipated February 2007 disposition date.

I’d like to know how it’s possible to lose almost 70% of principal on a multifamily deal that became REO in 2005. Does anyone really believe there are no lessons to be learned from deals like this?

You might say that figuring out the lessons are the responsibility of individual lenders. However, even the biggest lenders only see a small portion of the defaults. You might say that this is a function for the rating agencies, and I would agree with you, but do we really want this information to be proprietary? Also, rated deals are only a fraction of all CRE deals, and there are some sectors which are not covered by the rating agencies at all (for example, construction loans). Finally, as I’ve previously argued, most lenders and rating agencies are not focused on the right variables. 

Like the CDC, I think this is something that is best done by the government. The information should be in the public domain, and only regulatory agencies have access to all the information. As I’ve previously discussed, CRE loan underwriting never seems to improve, in part because the feedback cycle is very long. The current downturn is the first severe test of CRE loans since the early 1990’s, and is an opportunity to learn from our mistakes which probably won’t be repeated for many years. Will we take advantage of it, or just bury the bodies?

Workouts 101: Bankruptcy Basics and the Problem With Non-Monetary and Loan Maturity Events of Default

CRE lenders who have led sheltered lives often believe the events of default listed in their deed of trust and loan agreements will allow them to foreclose on a property if a breach occurs. A material adverse change in the borrower’s financial condition? Unauthorized subordinate liens? The loan has matured? Let’s foreclose!

Sorry, it doesn’t work that way. Here are some bankruptcy basics (and I mean really basic; feel free to skip sections if you know about the topic headlined).

The Automatic Stay

If a borrower file bankruptcy, your foreclosure is automatically stayed. From the US Courts website, Bankruptcy Basics-Chapter 11:

The automatic stay provides a period of time in which all judgments, collection activities, foreclosures, and repossessions of property are suspended and may not be pursued by the creditors on any debt or claim that arose before the filing of the bankruptcy petition. As with cases under other chapters of the Bankruptcy Code, a stay of creditor actions against the chapter 11 debtor automatically goes into effect when the bankruptcy petition is filed. 11 U.S.C. § 362(a)… The stay provides a breathing spell for the debtor, during which negotiations can take place to try to resolve the difficulties in the debtor's financial situation.

Lifting the Automatic Stay

How do you get your foreclosure going again? You need to file a motion to lift the stay:

Under specific circumstances, the secured creditor can obtain an order from the court granting relief from the automatic stay. For example, when the debtor has no equity in the property and the property is not necessary for an effective reorganization, the secured creditor can seek an order of the court lifting the stay to permit the creditor to foreclose on the property, sell it, and apply the proceeds to the debt. 11 U.S.C. § 362(d).

It is very difficult to obtain relief from the automatic stay if there is equity in the property. The bankruptcy judge determines if there is equity or not based on evidence presented by the lender and the borrower. The lender presents an appraiser who thinks the value is low, the borrower presents an appraiser who thinks the value is high, and typically the judge decides somewhere in the middle. At this point in the cycle it is not hard for a borrower’s appraiser to support a high value given the value downturn has just started, so in most cases lenders will have a tough time getting relief from stay.

Adequate Protection

So you can’t foreclose. How long might this go on? The best case is for single asset entity real estate debtors (other debtors get longer to file a plan):

On request of a creditor with a claim secured by the single asset real estate and after notice and a hearing, the court will grant relief from the automatic stay to the creditor unless the debtor files a feasible plan of reorganization or begins making interest payments to the creditor within 90 days from the date of the filing of the case, or within 30 days of the court's determination that the case is a single asset real estate case. The interest payments must be equal to the non-default contract interest rate on the value of the creditor's interest in the real estate. 11 U.S.C. § 362(d)(3).

Bolding mine. This provision poses an obvious problem for non-monetary and maturity defaults – the borrower has been willing all along to pay you the interest payments. In fact, their plan will be to pay you your full contractual interest payments for a period they project will be required for the market to recover. That is a very confirmable plan, and as long as the borrower performs under it, no foreclosure.

So why do lenders put nonmonetary default provisions in their documents? In theory, they allow a lender to take action in a deteriorating situation before there is an actual monetary default. That works fine in a stable or rising market, because the threat of a foreclosure might motivate the borrower to sell or refinance. However, it doesn’t work well when the borrower has no exit.

The best use of non-monetary default provisions is to trigger an event other than foreclosure which enhances your security (for example, unauthorized liens often cause a non-recourse loan to become recourse). That might get you somewhere. Foreclosing on a matured loan or a non-monetary default rarely works out favorably for the lender in a declining market.

Economic and Real Estate Post Picks: Week of April 6, 2009

Wholesale Sales Up, Inventories Down: Good news on these indicators

Why This Recession is Different: Unlike most recessions, this one is balance sheet driven

Has the Housing Market Bottomed? Builder stocks and the spread between mortgage and treasury yields are both hopeful signs

Why is Consumer Debt Declining So Sharply? An explanation for the sharp decline in credit card debt

Initial Unemployment Claims and the End of Recessions: Does the recent peak in initial unemployment claims signal we are nearing recovery?

Which Transactions are the Riskiest?

Medium sized, infrequent ones. That’s Bob Blakley’s conclusion in his post, The Zone of Essential Risk. An excerpt:

If you conduct infrequent transactions which are also small, you'll never lose much money and it's not worth it to try to protect yourself - you'll sometimes get scammed, but you'll have no trouble affording the losses.

If you conduct large transactions, regardless of frequency, each transaction is big enough that it makes sense to insure the transactions or pay an escrow agent. You'll have occasional experiences of fraud, but you'll be reimbursed by the insurer or the transactions will be reversed by the escrow agent and you don't lose anything.

If you conduct small or medium-sized transactions frequently, you can amortize fraud losses using the gains from your other transactions. This is how casinos work; they sometimes lose a hand, but they make it up in the volume.

But if you conduct medium-sized transactions rarely, you're in trouble. The transactions are big enough so that you care about losses, you don't have enough transaction volume to amortize those losses, and the cost of insurance or escrow is high enough compared to the value of your transactions that it doesn't make economic sense to protect yourself.

The chart below summarizes the problem:

Blakley is talking about eBay transactions, but I think there is a loan underwriting parallel too. If you’re doing large transactions frequently, you probably have the staff and expertise to do them right. If you do large transactions infrequently, you probably are very focused on your execution and/or bring in the required expertise to help. If you only do a few small transactions you’re never going to lose much, and if you do a lot of small or medium size transactions you will both develop expertise, and an occasional miss will be spread over a large base. But, if you do infrequent medium size transactions you can get into trouble because you never develop the expertise and the transactions aren’t large enough to justify hiring experienced people to do them.

This could be an explanation of how community and small regional banks ran into trouble in the residential construction and land development segments.

Lenders Blew a Solved Game: When Goals Go Wild

When is the last time you unintentionally lost a game of tic-tac-toe? It probably goes back to when you were around six years old – it’s a solved game. From Alec Wilkinson’s article in the New Yorker, “What Would Jesus Bet?”:

Games for which flawless strategy is known are said to be solved. Tic-Tac-Toe is solved; blackjack is solved; checkers is solved. Chess is not solved, and poker is not, either. Solutions theoretically exist; they are simply too intricate, so far, to be comprehended.

It took 10^14 calculations and 18 years to solve checkers; more on solved games here.

I believe real estate lending was a solved game. Loan to a borrower with good credit and a 20% down payment on a well maintained piece of real estate, and make sure income was sufficient to cover debt service and expenses with at least a 25% cushion. If everyone stuck to those rules, what could go wrong? So, what did go wrong?

I think the short answer is the goal of increased market share caused lenders to go outside the rules of the game. From an article by Drake Bennett on Boston.com (which I found via Wehr in the World):

The argument is not that goal setting doesn't work - it does, just not always in the way we intend. "It can focus attention too much, or on the wrong things; it can lead to crazy behaviors to get people to achieve them," says Adam Galinsky, a professor at Northwestern University's Kellogg School of Management, and coauthor of "Goals Gone Wild," a paper in the current issue of a leading management journal.

Paul Kredosky links to the “Goals Gone Wild” paper, too, and cites this excerpt in his post, “Goals Gone Wild, Ponzis, and the Banks”:

An excessive focus on goals may have prompted the risk-taking behavior that lies at the root of many real-world disasters. The collapse of Continental Illinois Bank provides an example with striking parallels to the collapse of Enron and the financial crisis of 2008. In 1976, Continental’s chairman announced that within five years, the magnitude of the bank’s lending would match that of any other bank. To reach this stretch goal, the bank shifted its strategy from conservative corporate financing toward aggressive pursuit of borrowers. Continental allowed officers to buy loans made by smaller banks that had invested heavily in very risky loans. Continental would have become the seventh-largest U.S. bank if its borrowers had been able to repay their loans; instead, following massive loan defaults, the government had to bail out the bank.

I’ve previously posted on how the quest for market share led Fannie to increase its subprime lending.

Why Doesn’t CRE Loan Underwriting Ever Get Any Better?

Via Zero Hedge, S&P reports lax loan underwriting is responsible for the upcoming losses on CMBS loans:

The rationale for the variation in results among the 2005-2007 vintages is that the underwriting standards, already looser than for past vintages, became progressively worse as the property cash flows and valuations rose quickly during those years. For example, most of the large pro-forma loans were underwritten during 2006 and especially 2007, and 2007 deals also claimed the highest average Standard & Poor's LTVs and lowest average Standard & Poor's DSCs (followed by 2006, then 2005). Thus, when commercial real estate prices and cash flows peaked in 2007, the most recent origination was by far the most vulnerable to cash flow declines…

This is the same explanation used to explain losses during the 1990-1994 real estate recession, the S&L debacle of the 1980’s, and probably every other major real estate downside since lending began. Why don’t we get any better at this?

An obvious explanation is that underwriters knew of the risks, but were ignored by management seeking profits and market share (I’ve posted on the pressures on credit officers here, and on the market share issue here). These are real issues, but I think there is a more fundamental problem; I think most underwriters, and many credit approvers, don’t know how to tell a good loan from a bad loan.

If you take the S&P approach outlined above, you don’t need to get into the details – at the top of the cycle, just tighten your LTV and DSC requirements. Of course, this advice is about as helpful as telling an investor to buy low and sell high. And, anyone who has been in a credit approval position knows how difficult it is to pull back in a strong market. Given that you are going to have to do business during market peaks, how can you select the deals most likely to succeed?

The way people become experts is through thoughtful practice. In his book, How We Decide, Jonah Lehrer profiles Herb Stein, a television director who has shot more than 50,000 scenes and won eight Emmies over a twenty five year career. After shooting an episode, Stein says:

I watch the whole thing, and I just take notes. I’m looking really hard for my mistakes. I pretty much always want to find thirty mistakes, thirty things that I could have done better. If I can’t find thirty, then I’m not looking hard enough.

Bill Robertie, a world class chess master and poker and backgammon player (backgammon World Champion twice), is also profiled:

Robertie didn’t become a world champion just by playing a lot of backgammon. “It’s not the quantity of practice, it’s the quality,” he says. According to Rpbertie, the most effective way to get better is to focus on your mistakes… After Robertie plays a chess match, or a poker hand, or a backgammon game, he painstakingly reviews what happened. Every decision is critiqued and analyzed. Should he have sent out his queen sooner? Tried to bluff with a pair of sevens? What if he had consolidated his backgammon blots? Even when Robertie wins – and he almost always wins – he insists on searching for his errors, dissecting those decisions that could have been a little better. He knows that self-criticism is the key to self-improvement; negative feedback is the best kind.

Underwriters don’t have the opportunity to do this kind of analysis, for three reasons. The first is that lenders do very little meaningful analysis of existing loan performance. Asset management monitors debt service coverage, occupancy, property condition, and that’s about it, which is like trying to diagnose an illness from the patient’s weight, blood pressure, and temperature. These performance metrics are monitored because they’re easy, but they’re just not that revealing. I don’t know of any lenders who systematically analyze underperforming deals to understand why they are underperforming (see my posts, “Why What You Know About Income Property Performance is Probably Wrong”, and “The Slippery Slope to Default” for more on what lenders should be paying attention to).

The second problem is that there is rarely a feedback loop to the underwriters giving them even the minimal performance data collected. The back-end asset management group and front-end underwriting are not connected, and the lessons to be learned at the back from actual performance are rarely conveyed to the front in a useful form.

These two problems are correctable, but the third problem is more difficult. Stein has daily rough cuts to review for mistakes. Robertie has many games each day he can review and analyze. But, CRE underwriting mistakes are generally only revealed when markets are under economic stress, and such events may happen only four or five times in an underwriter’s entire career. The consequences are twofold. First, bad deals are never revealed because they never are stressed by a downturn -almost every CRE loan made from 1995 to 2007 has performed to date, because it was never stressed. Secondly, good deals are overwhelmed by economic events – there were good loans made in 2006-07, but it is very likely many of those loans will default given the severe distress of this market. Stein and Robertie have an opportunity to excel because they have frequent, clear feedback. Even under the best of circumstances, CRE underwriters get infrequent, unclear feedback. I’ve written more on feedback issues in my post “Why Do Lenders Take Excessive Risks? Certainty and Feedback Issues.”

To summarize, underwriting does not get better because the opportunities to learn are infrequent, little effort is made by lenders to learn even when the opportunity presents itself, analysis is confined to superficial symptoms, and the little that is learned is not conveyed to the people who need the information. The only good thing I can say is there is plenty of opportunity for improvement.

Borrower Credit Standards and CRE Loans

CRE lenders are much more focused on the real estate than on borrowers. Loans to people like Shashikant Jogani are the result.

I’ve already mentioned Jogani a few times in previous posts (why single asset borrower structures are a good idea, and Jogani was the owner of the building with the collapsed ceilings I mentioned in this post on maintenance). His story is an interesting one, which is publically available courtesy of Shashikant Jogani v. Haresh Jogani, et. al., California Court of Appeals B181246 (Los Angeles County Super. Ct. No. BC290553). In this case Jogani was suing his brother and other family members for $250M. Some excerpts:

In 1979, plaintiff Shashikant Jogani (who prefers to be called Shashi on appeal) began investing in residential apartment properties in and around Los Angeles County. By 1989, he owned properties having a fair market value of $375 million and a net equity of $100 million. Because of an economic recession that started in the late 1980’s and continued into the mid-1990’s, Shashi faced defaults and foreclosures on valuable properties.

In April 1995, Shashi entered into a general partnership (Partnership) pursuant to an oral agreement (Partnership Agreement) with his brothers, Haresh Jogani, Rajesh Jogani, Chetan Jogani, and Sailesh Jogani. Shashi transferred ownership of his properties to the Partnership. Thereafter, the properties were held nominally by several corporations created for that purpose, namely, J.K. Properties, Inc., H.K. Realty, Inc., Hansa Investments, Inc., Commonwealth Investment, Inc., Mooreport Holdings Limited, and Gilu Investments Limited (collectively Partnership Entities). Under the Partnership Agreement, the Partnership actually owned these corporations notwithstanding nominal ownership in the names of certain of Shashi’s brothers and other relatives…

Shashi’s brothers were to receive all proceeds (“profits, sale, refinancing”) until they recouped their investment plus a return of 12 percent. Once that occurred, Shashi was to receive one-half of all “profits, proceeds, and value” concerning the Partnership and its properties.

Market conditions got worse:

By the mid-1990’s, the equity in Shashi’s real estate holdings had fallen from $100 million to a negative $50 to $70 million. There were several lawsuits against him, brought by tenants, creditors, employees, and an insurance company. By 1998, many creditors had obtained judgments against him.

Then market conditions got better:

In November 2001, after several years of work, Shashi became entitled to his 50 percent share. He was paid $2.4 million at that time.

The falling out:

In June 2002, the Partnership owned properties having a fair market value in excess of $1 billion and a net equity of around $550 million. Under the Partnership Agreement, Shashi was entitled to $225 million. Nevertheless, Haresh, acting on behalf of himself and the other brothers, refused to honor the Partnership Agreement, removed Shashi from management of the Partnership’s properties, and recharacterized the $2.4 million payment as a loan, demanding it be repaid.

In February 2003, Shashi filed this action against his brothers, other relatives, and the Partnership Entities.

Now, you would think that a borrower who had multiple lawsuits and judgments of record might have trouble getting CRE loans. and that the lawsuit excerpted above might raise a red flag. But you would be wrong. Deutschebank, JP Morgan Chase, and Wachovia all funded multiple loans to Jogani after these events.

And how are Jogani’s deals doing this time around? Here are some indications:

From a December 27, 2008 NewsOk story:

City officials have been wrangling with Eagle Point’s owner, Shashikant Jogani of Glendale, Calif., over its deteriorating condition.

Jogani owns two other Del City complexes, Logan Point Apartments, 481 Scott St., and Kristie Manor Apartments, 5236 SE 29. City officials have deemed both unfit for human occupancy due to health and safety violations. Remaining tenants have been given until Jan. 15 to find new homes.

And this November 17, 2008 NewsOk story:

Tommy McDonald said the view of the apartment complex from his back porch is like glimpsing into a war zone. And now that a pizza delivery driver was shot to death there last week, he’s certain it’s turning into one.

Nov 16 Residents of Lantana Apartments in Oklahoma City are frustrated with the conditions and unable to force the apartments owners to fix the problems.

McDonald’s home is about 50 feet from Lantana Apartments, with its graffitied walls, shattered windows, doors teetering off broken hinges and waist-deep grass.

"I want to see them bulldozed,” McDonald said. "It’s disgusting.”

Lantana Apartments, 7408 NW 10, is one of 14 properties in the state The Oklahoman has linked to California real estate investor Shashikant Jogani. Oklahoma City, Del City and Pauls Valley officials are grappling with Jogani over poorly maintained complexes.

Lantana specifically has been targeted for numerous code violations and maintenance issues with Oklahoma City, county and state officials. Police say its condition makes the area conducive to crime.

A borrower’s track record doesn’t fit as neatly into a model as a property’s LTV or DSC, and there’s always a story to explain what went wrong last time, and what will be different this time. As a result, there is always a lender for any borrower regardless of what’s happened in the past.

Land Values at Zero?

Land loans are generally regarded as the riskiest type of real estate lending. Here are the FDICIA regulatory maximums for the various types of construction and development loans:

Why? Because land values evaporate in a severe downturn. From an interview with Bob Voit, a legendary Southern California real estate investor posted on Lansner on Real Estate:

Bob: …You could build a case that many real estate assets have zero value today that were worth millions a couple of years ago.

Us: Why?

Bob: It’s because, let’s say you have a beautiful site to build a high-rise office building on in downtown wherever. The combination of market forces, which would include construction costs, lack of availability of financing and the lack of available tenants that support your rental rate. What makes the development of an office structure economically unfeasible. If it’s unfeasible, nobody wants to buy it. Whoever may want to buy it can’t get the money.

Us: You’re talking basically of a collapse.

Bob: A relative collapse in temporary values. The same thing happened 20 years ago. Then market forces readjust, and off we go again.

An example shows how this is possible. Here is a breakeven analysis on a development project:

Now let’s suppose, for the reasons Bob talked about, the completed asset is worth 10% less. Here are the new numbers:

There goes the equity, the lender is now at 100% LTV. Same example, but suppose the completed asset is worth 28.6% less:

The land value is now $0. How likely is it asset values will fall 28.6%? Very possible, as discussed here.

But, of course, you don’t see many signs offering land for free. The reason the land value is zero is because the construction cost equals the end asset value. Build it for less, or find an end use worth more, and there’s still value there. Unfortunately, although construction costs are down, they’re not down that much, and the end values of all types of real estate tend to move down together. So, as Bob says, you wait for the market to readjust. Here are a couple of alternative uses for the land in the meantime:

Workouts 101: Complete the Project!

If you have a construction loan in trouble, your focus needs to be on completing the project. Lansner on Real Estate tells the sad story of Atherton Newport’s Stonehaven development here.

An excerpt details the consequences of the project shutting down while on partially complete:

• After a year of standing idle, the development now is undergoing “forensic” inspections, examining the wood, the concrete slabs and the site to see what needs to be replaced and what can be salvaged.
• “There obviously is some weather damage and vandalism that has occurred,” Patton said. “Luckily, all the roofs are on.”
• Eight buildings have been standing with exposed wood framing and rusting nails. Seals around windows have been flapping in the wind, and drywall is stacked on floors inside the walls that have yet to be enclosed with tarpaper.
• Once inspectors determine the scope of materials that need to be replaced, the new owner will treat the structures for mold and termites and recertify the slabs.

Sometimes a project shutdown is triggered when the lender stops advancing funds. That was the case on a Staybridge Suites hotel in Chicago.

As described in this Chicago Real Estate Daily.com story from October, 2008:

Though the building’s shell is largely complete, construction crews walked off the job over the summer, a sign that CapitalSource had stopped advancing funds for the project. Subcontractors have filed liens with the Cook County Recorder seeking payment of more than $2.5 million for work on the building.’’

The loan was “out of balance,” and CapitalSource demanded that the joint venture come up with another $5.9 million in equity to bring the loan back into balance, according to the foreclosure complaint, which was filed earlier this month in Cook County Circuit Court.

The lawsuit doesn’t specify how the loan fell out of balance, but the loan agreement indicates that cost overruns could have pushed the construction budget higher than its original figure of $52.3 million, leaving the project with a funding shortfall. The loan is in balance only if remaining funds can cover remaining costs, according to a loan agreement filed with the complaint.

Often, if a bank is taken over by the FDIC there are transition problems. From a Nation’s Building News story in November, 2008:

Home builders with outstanding construction loans are reporting that they are having to stop work on new housing developments and are losing sales as the result of failed banks and thrift institutions being taken over by the Federal Deposit Insurance Corporation (FDIC).

“Builders with outstanding loans that are placed under FDIC control are frequently unable to contact a decision maker to deal with routine but time-sensitive matters related to loan draws or extensions,” NAHB President and CEO Jerry Howard said in a Nov. 20 letter to FDIC Chairman Sheila Bair…

Earl Snyder, a veteran FHA/VA home builder in Englewood, said that he has run into problems finishing eight homes in various stages of construction ranging from slab to almost finished. Six of the homes have already been sold to buyers with FHA mortgages. Although he was never late on loan payments, after being taken over by the FDIC his bank gave him 60 days to repay a $2.5 million construction loan.

In the case of the Stonehaven project, the the project seems to have been caught up in a much larger bankruptcy case. In a multicreditor bankruptcy action it can be difficult to fund additional advances to complete a project even if a lender wants to do so. Or, perhaps the developer realized they had no upside to the development and saw no point in working on it while the bankruptcy proceeded.

In any case, shutting down a partially completed project is one of the fastest ways to destroy real estate value.

Economic and Real Estate Post Picks: Week of March 30, 2009

The Oversaturated Restaurant Sector. The number of restaurants of all types has significantly exceeded population growth.

Which Markets Are People Moving To? UHaul records say Atlanta, Houston, and Los Angeles top the list. Portland is #6, Seattle did not make the top fifteen.

Grim Employment Report. The latest employment report suggests we have not seen the bottom yet.

Credit Crisis Indicators. The indicators show some improvement in credit markets.

Hotel Sector Hit Hard. Occupancy and room rate trends are both deteriorating.

Where Do Tenants Go in a Down Market?

Everyone knows multifamily vacancy rates increase during a recession. Where do these tenants go for housing?

I’ve not seen any studies on this topic, but the obvious explanations are they move back in with families (children back to their parents, parents and grandparents move in with their children), and doubling up (unrelated households combine to share space). And, some drop out of the housing market altogether. Here are some links to stories which explore what’s happening this time around:

Rooms for Rent. From the Seattle Times, In tough times, the rented room is resurgent:

Because most of the arrangements are informal, it's hard to assess just how many people now share their homes with strangers for money. But as the economy plummeted during the past year, mortgage foreclosures soared and layoffs became common, the ads for people seeking roommates increased by more than 70 percent nationwide on craigslist.com.

Homeless Shelters. From TimesOnline:

Joan Burke, director of advocacy for the homeless charity Loaves and Fishes, said: “The folks we deal with typically are the working poor. But right now the economy is in such turmoil that it is affecting a new layer of middle-class earners - construction workers, farm labourers, retail workers, restaurant staff.

Shantytowns. From the New York Times, Cities Deal With a Surge in Shanty Towns:

While encampments and street living have always been a part of the landscape in big cities like Los Angeles and New York, these new tent cities have taken root — or grown from smaller enclaves of the homeless as more people lose jobs and housing — in such disparate places as Nashville, Olympia, Wash., and St. Petersburg, Fla.

Squatting. From Slate, Homesteaders in the HoodSquatters are multiplying in the recession—what should cities do?:

As the current recession picks up speed, we are again confronted with the ingredients for a squatting boom. Unemployment is closing in on double digits nationally, and homelessness is on the rise. Between late 2007 and late 2008, the number of families presenting themselves at homeless shelters in New York City increased by 40 percent. In Massachusetts during the same period, the statewide increase was more than 30 percent. At the same time, housing vacancy rates are at all-time highs. According to the Census Bureau, about 15 percent of housing units in the United States were vacant during the last quarter of 2008. That's 19 million homes sitting idle, largely in the hands of banks. The difference between the 1970s and today is that the crisis last time was focused on the urban centers, while this time around the suburbs are the site of the greatest mismatch between people without homes and homes without occupants.

And so, the squatters are squatting.

CRE Lender Trouble

If you’ve followed this blog for any length of time you know this is not the place to come for breaking news. However, I think what’s going on at Capmark is news, and I’m not seeing it covered elsewhere.

Capmark was GMAC Commercial Holdings Corp. until 2006, when a KKR/Goldman Sachs investment group acquired a 78% stake in 2006 and changed the name. The philosophy was to do one thing and do it well, and that was income property finance. It was a major CMBS originator until that market froze up, and has been the number one Freddie Mac and FHA multifamily originator for many years (more on their agency business here). They are also a direct lender, but to all appearances not a crazy one – as of third quarter 2008, weighted average LTV was 68.1%, nonperformers were only 2.4%, and construction loans were only 10.4% of funded loans, although there are substantial unfunded construction commitments (portfolio and financial data here). It appears they have a little CMBS and CDO security exposure, but not much. And, they are not solely dependent on new origination and loan performance – they have a huge servicing portfolio ($260B, the third largest commercial/multifamily servicer, according to this news release) which throws off a steady income stream.

Despite all these apparent strengths, Reuter’s reported on March 30 that Capmark credit default swaps had been triggered by failure to pay a bridge loan, and Bloomberg reported on March 23 that Capmark’s bonds were trading in the 18.5 – 19.5 cent range. What’s going on?

The immediate problem is a maturity issue. From an April 2 GlobeSt.com article:

Capmark is extending its annual report filing by two weeks and management anticipates submitting the document by April 15, but is not making promises that it will be able to do so. The company also recently received an extension on the maturity date of its $833-million bridge loan for two weeks, until April 9. So far, one lender of $48 million has not agreed to an extension and is asking for full payment.

If no agreement with lenders is met soon, says Fitch analyst Christopher Wolfe, Capmark will have to file for bankruptcy and ultimately go out of business.

Maturing loans are the biggest single problem the CRE sector faces (more on that at a Zero Hedge post here). It’s ironic that the biggest threat to its borrowers is also the immediate threat to one of the largest CRE lenders.

There are more fundamental issues as well. Capmark’s own loan portfolio is heavily weighted with loans originated during 2006-07, the peak years of the CRE boom.

I’ve previously posted on the key role vintage plays in losses. 2006-07 is probably the worst possible time to have originated a CRE loan since the early 1990’s, and almost 75% of Capmark’s portfolio was originated in this period.

Also, as mentioned above the portfolio appears conservatively underwritten based on a 68.1% weighted average LTV. But, the financial release contains this footnote:

Since the bulk of the portfolio was underwritten during the peak years, there’s an excellent chance the projected values are no longer realistic. I’ve posted here showing how a relatively small deterioration in the fundamental variables can have a very large impact on values.

It seems clear there are substantial risks in the portfolio, which helps explain why the bridge lenders are reluctant to extend.

Why Do Bankers Take Excessive Risks?

There are plenty of economic explanations being offered  to explain bankers’ risky behavior (e.g., poorly designed incentive plans, inadequate risk modeling). On a more basic level, the old standbys ignorance, hubris, and greed are called on. I’m sure some people were ignorant of the risks, and some people were in it for the money. But how do you explain the participation of very intelligent people who were aware of the risks, had every reason to protect their good reputations, and had no economic reason to jeopardize their already very lucrative positions? And it’s not just bankers – why do successful real estate investors continue to leverage their portfolios to the max and take on high risk deals, when they could secure their positions and be able to ride out any storm?

Maybe it’s their brain chemistry; human brains get high on challenges. From Gregory Berns’ book, Satisfaction: The Science of Finding True Fulfillment:

Any stressor, especially a physical one, results in the release of cortisol. The biochemical interaction of cortisol and dopamine in the striatum suggests that these two chemicals are involved in the achievement of satisfaction, perhaps even transcendence. Alone, neither compound can provide a state resembling satisfaction. Dopamine may be associated with transient euphoria, but you need cortisol to get that satisfying feeling. And because cortisol is released most effectively by stressful situations, the road to satisfying experiences must necessarily pass through the terrain of discomfort.

At the most basic level, people take risks because the biochemical results make them feel good. Understanding this goes a long way towards explaining obviously self-destructive risky behavior.

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.