Legacy Loan PPIP versus FDIC Note Sales

It’s difficult to work up much enthusiasm for the Legacy Loan segment of PPIP, a program which will reduce losses for banks by goosing returns for private investors with low cost public leverage. Most people (other than the banks themselves) think banks should be punished with big losses, and most people are not keen on helping the investors who will get richer as a result of the mess do even better. I totally get that. However, I think it’s important to point out that the most commonly expressed alternative to PPIP (just let the banks fail and let the FDIC clean up the mess) will be tremendously expensive to taxpayers.

The argument against PPIP is cogently summarized in this Naked Capitalism post. An excerpt:

As readers may recall, we had been skeptical (and critical) of the Public Private Investment Partnership from the outset. It was the third effort at a program that had failed twice under Hank Paulson, namely, to have banks get dud assets off their balance sheets by selling them to a sucker.
That's why this program has never gotten airborne. It requires a bagholder.
The problem isn't, contrary to PR designed to mislead the public, that the assets are hard to value. That holds only for an itty bitty percentage of the total. The real problem is that the banks are carrying them at above market values, and above any reasonable long term value too (their protests to the contrary). The problem is not the saleabilty of said assets, it's that they don't like the prices. Selling them at below the marked value leads to losses, which in turn would reduce their equity at a time when they have been told, in no uncertain terms, to get more.
So the only way the plan works is if someone overpays. The only party that might have reason to is Uncle Sam. The whole point of the "public private investment" part of this is to disguise the overpayment. So the plan is an opaque subsidy to the banks.

Yes this program is a subsidy to banks. It’s not even opaque; it’s transparent to anyone with a spreadsheet. But it’s wrong to say “the only way the plan works is if someone overpays”. The plan works because someone will pay more if an investment can be leveraged with low cost funds. Imagine a housing market with no mortgage debt; fewer houses would sell, and they would sell for much less.

Here is an example I used in my post, Investor Returns on FDIC Discounted Notes. Let’s say this is a subperforming CRE loan which is still making payments:

Here is the same note sale under PPIP:

Note the low cost leverage allows the bank to get a better price (85) and the investor to get a better yield (12% versus 19%). To state the obvious, more banks will sell assets at 85 than 50, and more investors will invest if they can get 19% instead of 12%. Also, assuming a finite amount of investor money, it will go a lot further with the PPIP program (in this example, $5,000,000 without PPIP, $850,000 with the program). If the loan continues to perform and pays off, the investor is the big winner; they get their yield from the payments, and a nice pop when the loan is repaid at par. But, the Treasury wins too, because under PPIP the Treasury is the 50% equity partner.

Of course, the loan may not perform. If after liquidation costs the underlying collateral value is more than the purchase price, the equity investor will still get a return and the FDIC will get its PPIP loan repaid. If the recovery is less than 80% of the discounted purchase price, the equity is wiped out and the FDIC takes the remaining loss on its PPIP loan. The check against this happening is the fact that the private part of the equity does not want to lose its money. It could happen, but absent collusion with the loan sellers there’s no reason why private equity would intentionally overbid. Avoiding collusion is extremely important. Option Armegeddon gives a good explanation of the risk in this post. However, I think this concern is manageable as long as regulators follow the money trail and severely penalize infractions.

Assuming investors don’t overbid, the only “loser” in this scenario is the FDIC, which only collects a 4% interest rate. Is making this loan the best use of FDIC funding capability? Maybe not, but making too small a return is a lot different than characterizing the FDIC as a bagholder. And, consider the alternative; if the bank fails and the FDIC is the note seller at 50 in the first example, that’s a $3,500,000 loss to the taxpayer, versus a 4% return on a PPIP $6,800,000 loan. If you think FDIC loan sales are the best way to maximize value for the taxpayer, this excellent post from REIT Wrecks will open your eyes.

PPIP is not easy to love, but I’ve not seen a better alternative. If you’re not familiar with the PPIP program see a description here.

Why Did Financial Middlemen Do So Well in the Bubble?

Ryan Avent at The Bellows thinks the compensation finance people received during the boom indicates something was drastically wrong:

When you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.

In a similar vein, Baseline Scenario notes the benefits of financial “innovation” did not flow to the customers:

You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.

By contrast, the historical pattern of the financial sector – rising revenues, rising profits, and rising average individual compensation – is what you get if there is increasing demand for your services and, instead of competing to lower costs and prices, you limit supply. Sure, prices fell on some financial products, but financial institutions encouraged substitution away from them into new, more expensive products, with the net effect of increasing profitability (and compensation).

Why didn’t competitive pressure keep a lid on financial sector compensation? In the mortgage world, it’s because everybody was getting what they wanted. Borrowers were getting great rates, in part because loans were underpriced but also because the broader interest rate environment was very favorable. Loan proceeds were high, terms were relaxed, and loans were quick to be approved on the terms applied for (more on that at my post, “Why Did WAMU Abandon Underwriting Standards?”). On the other side, investors were getting what seemed to be an infinite supply of AAA securities to buy, at yields better than treasuries. No one begrudged the money the RMBS and CMBS middlemen were making.

As it turns out, of course, there was a cost associated with giving everybody what they wanted. That great financing inflated the bubble which is now inflicting huge losses on borrowers, and the securities were grossly underpriced for the systemic risk associated with them.

Does Tim Geitner Read My Blog? Are Regulators to Blame for the Housing Crisis?

From a Washington Post interview over the weekend, via Calculated Risk:

Geithner: "For something this big and damaging to happen it takes a lot of mistakes over time. And it is that combination of things. Interest rate here and around the world were kept too low for too long. Investors made - took a bunch of risks without understanding the risks. They were betting on the expectation that house prices would continue to go up - to go up forever. Rating agencies failed to rate these products adequately. Supervisors failed to underwrite loans with sufficiently conservative standards. So those basic checks and balances failed. And people borrowed too much. It took all those things for it to happen."

From my March 21, 2009 post, “Whose Error Was 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.

Calculated Risk takes Geitner to task for not mentioning two other factors:

Although there were many factors in the housing and credit bubble, the two keys were: 1) rapid innovation in the mortgage industry (securitization, automated underwriting, rapidly expanded wholesale lending, etc), and 2) a complete lack of oversight by regulators. As the late William Seidman wrote in his memoir (published in 1993): "Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid."
Geithner failed to mention the rapid changes in lending and the failure of government oversight as the two critical causes of the bubble. Either Geithner misspoke or he still doesn't understand what happened - and that is deeply troubling.

Although “innovation” and the regulators were factors, they were by no means the key factors. I think the innovations CR refers to should be viewed more as tools than culprits (an NRA bumper sticker for bankers - “Automated Underwriting doesn’t Kill Lenders, Lenders Kill Lenders”). More on this topic at “Why Did WAMU Abandon Underwriting Standards?”

The role of regulators is more complex. Certainly if disclosures were improved or some practices were prohibited, some bad loans might not have been made or bought. However, the errors listed above are so basic and so self-destructive I question the ability of outside intervention to control the behavior.

Low End Infill versus the Exurbs

Lansner on Real Estate has a story and podcast on the successful sellout of a new development in Fountain Valley, CA:

Lissoy tells ocregister.com that the quick Fountain Valley sales may have been a bit of an anomaly due in to its rarity — new homes are hard to find in that city…

Also, the podcast interview reveals Lissoy’s thoughts on how some builders are selling simpler, smaller, cheaper homes and that while the lower-priced end of the market in Orange County is doing well, mid-priced and luxury residences are a tough sell.

The success of this in fill development is an interesting contrast to what’s going on in the exurbs like Victorville. For those not familiar with Southern California geography, here’s a map:

The “A” is Fountain Valley. Victorville is the home of the now infamous development demolished by a Texas lender after foreclosure (watch the video here).

Related exurb posts:

Exurbs: How Far Is Too Far?

Underwater Homes, Exurbs, and Income

Foreclosures in the Exurbs

Why Are the Nation’s Worst Housing Markets in the Exurbs?

How Much REO Should A Lender Have?

Bubble Meter notes this story from Business Week:

Buyers looking to purchase foreclosures should still have plenty of opportunities. Only 30% of bank-owned properties are listed on the multiple listing services, says Rick Sharga, senior vice president at foreclosure listing firm RealtyTrac. He figures banks still own as many as 500,000 properties that they want to sell but haven't put on the market.
A home many not be listed because the bank is wrestling with title, repair or owner right of redemption issues. (Several states such as Michigan and Wisconsin give the previous owners the chance to buy back a home that's been foreclosed on). Banks may also be holding houses off the market because selling them now would lower prices even further. Foreclosures typically sell at a 31% discount to similar homes whose owners aren’t in distress. Listing all those homes now, Sharga says, “would have a devastating impact on inventory and pricing." ...

Let’s take the last idea first. No doubt listing a lot of REOs at once does have a negative impact on the market. But, the idea that lenders are holding properties off the market to maintain prices suggests a level of cooperative action for the collective good which I don’t think is occurring.

Having 70% of your REO inventory sitting around unlisted sounds bad, but is it really? There’s always going to be some down time between the foreclosure sale and the listing (evictions, cleaning and painting, etc., say 45 days). Once it’s listed, say it takes 60 days to sell. Then, it takes a while to close (say 60 days). Taking into account these factors, what percent of your inventory at any given time will be listed?

A high percentage in the list stage probably means the properties aren’t moving because the list price is too high. If you’re running an efficient REO shop, having 30% listed at any given time sounds about right.

Given the inventory of homes for sale, is it possible to sell an REO in 60 days? Apparently it is in Phoenix. The NYT, via Calculated Risk:

The low end of the real estate market [in Phoenix] — and in some equally hard-hit places like inland California and coastal Florida — is becoming as wild as anything during the boom.
One real estate agent was showing a foreclosed house to a prospective client when a passer-by saw the open door, came in and snapped up the property. Another agent says she was having the lock changed on a bank-owned home when a man happened by, found out from the locksmith that it was available, and immediately bought it. Bidding wars are routine.

The New Yorker had an interesting story in their April 6, 2009 issue on the experiences of a broker in LA specializing in REO sales (abstract here).

The Problem With Partners

From Luke Johnson’s column in the Financial Times, “Time of Trial Brings Out Our Litigious Side”:

The truly vicious [lawsuits] are those where professional partners have a dispute…Falling out can arise through envy, through desperation, through honour, and a feeling that some are not pulling their weight. Writs are being served all over the place for non-payment of debts, warranty claims over failed acquisitions, unfair dismissal and who knows what. The air is thick with recriminations and resentment, as the Great Recession leaves lots of people broke, unemployed or looking stupid and out for revenge.

Partnerships in various forms (general partnerships, limited partnerships, limited liability companies, tenancy in common) are very common ownership structures in commercial real estate. Sometimes they represent equals pooling resources to acquire and operate properties larger than the individual partners could acquire on their own. More often, the partners bring different things to the table; for example, investors with money but without a lot of real estate expertise invest funds with a general partner that has expertise but not a lot of money.

This all works well until it doesn’t. When a property severely underperforms, few partnerships survive. If additional cash is required, the money investors often balk or expect the general partner to contribute an equal amount or step aside. Even if contributing additional cash to save the investment makes sense, too often partnership differences prevent an economically rational solution.

Lenders often depend on the financial strength of the investor partners, and don’t realize that more often than not the money partners will not support a deal when they’ve lost confidence in the general partner. The greater the number of partners, the greater the difficulty. The sad story of DBSI (see this link) is an extreme case which is being repeated on a smaller scale on a daily basis.

The safest ownership structure is a single experienced, financially strong operator. If you can’t have that, a partnership of equals is your best bet. Partners with unequal resources are their own source of trouble when the going gets tough.

“Legacy” CMBS?

What is a “Legacy”? From Merriam Webster:

Main Entry: ¹leg·a·cy 1 : a gift by will especially of money or other personal property : bequest 2 : something transmitted by or received from an ancestor or predecessor or from the past <the legacy of the ancient philosophers>

Usually a legacy is good, but sometimes you inherit something really screwed up. When WAMU tanked 18 days after Alan Fishman took the CEO job, no one blamed Fishman (although some thought the $7.5M he was paid for the 18 days was a little excessive). The key point here is that it’s only a legacy if you inherited it. It’s not a legacy if the problem was created on your watch.

So, when the Federal Reserve says “Legacy CMBS” is now eligible collateral for the TALF program, I think they’re misapplying the word. These securities would be legacy securities if the management responsible for buying and/or originating them had been replaced, and new management was cleaning up the mess. But, in most cases that management change hadn’t occurred. Perhaps in their own minds management has changed (“That was the old me – the new me would never do those deals”), but I don’t think that counts.

Granted, calling the securities what they are - “wish we were never involved with these CMBS” – is clumsy. We need something short and catchy to describe them. I propose “Whoops CMBS”, in honor of the WPPSS bond default back in 1982. Of course, that was just a $2.25B default; maybe we should call them “Big Whoops CMBS”. Or maybe we could call them “Do-over CMBS.”

Although the misuse of the word ”legacy” in this financial crisis has been irritating me for a while, the impetus for this post actually came from a non-real estate story (yes, I do have other interests). Ian Media Networks filed bankruptcy yesterday, and this quote caught my eye:

“We are pleased with the support from our first lien senior debt holders to resolve the company’s legacy debt issues and fund our television growth plans,” said Brandon Burgess, Ion’s chairman and chief executive officer, in a statement.

Out of curiosity I took a look at Mr. Burgess’s bio, and it turns out he joined ION in November, 2005. Even if the “legacy debt issues” were the result of debt taken on before then, the debt and equity markets were available on pretty favorable terms until last year. Instead of “legacy debt issues”, I think this is more like “didn’t deal with it when I should have debt issues.”

Recommended reading for more on the way people distance themselves from their mistakes: Carol Tavris and Elliot Aronson, Mistakes Were Made (But Not by Me).

What Should Lenders Do With Maturing CRE Loans?

We’ve had some conversation in the comment thread on this post about what lenders should do with maturing loans. Today I will attempt to address that question in more detail, starting out with what I would do if it were my money, and moving on to some of the reasons lenders adopt different strategies.

Foreclose on properties the borrower is driving into the ground. At this point in the cycle there is no point in giving an extension or modification to a borrower who is taking actions (or inaction) which is hurting the value of the collateral. A recovery is not imminent, and if a borrower is deferring maintenance or is ineffective at leasing the property, an extension will just result in a bigger loss down the road. This situation can come about for a variety of reasons, and often  the borrower is not the villain. Usually, it’s because a borrower is under severe financial pressure on other deals, or lacks the experience to deal with difficult market conditions.

Foreclose on properties when the submarket is in a downward spiral. No matter how good a borrower is at property operations, it is very, very difficult to compete when you owe $100,000 a unit on a property and the building next door has gone through a foreclosure and the owner next door only owes $50,000 a unit, because the new owner can substantially undercut your rents and still get a good return. For an example with numbers that shows how this works, see my post CRE Loans and the Death Spiral of Doom. If your property is in a submarket with multiple foreclosures in process you will probably minimize your loss by foreclosing too.

Extend loans which have experienced, solvent borrowers in relatively stable submarkets when the property can pay a reasonable interest rate. You want an experienced borrower who is not tapped out because fundamentals will probably get worse before they get better, and you want someone who can make the right decisions and kick in some cash if necessary. You don’t want to be in a downward spiral submarket for the reasons discussed in the paragraph above. To keep the borrower motivated, you need to offer an extension long enough to get through this part of the cycle (2 years minimum, 3 or 4 more likely). A reasonable interest rate is hard to define in this market, but I think the best structure is a floating rate deal around 3% over your cost of funds, which, if you’re a bank, will probably result in a rate of 4% to 5%. I would keep the structure interest only, but require 50% of any excess cash flow to go into a reserve account to cover operating deficits, capital costs, and perhaps pay down principal if the reserve account reaches a threshold level (maybe 5% of the loan amount). This structure gives you a reasonable return, gives the borrower an incentive to maximize cash flow, and gives you both a piggybank to draw from if conditions continue to deteriorate.

These are the strategies which I think would give you the best recovery on individual deals. However, not all banks and investors pursue them, for a variety of reasons.

The lender or investor wants out of the asset class. Right now banks and institutional investors pay a price in their market value and ability to attract new investors if they have heavy CRE exposure. There is a lot of value created if you can say a problem is behind you. To create this value, the lender sells notes or forecloses on deals for less than they might realize with a hold strategy.

Regulatory Direction. Many banks are under pressure to reduce their CRE exposure. An REO may create a loss, but at least the asset is gone. A modified loan, on the other hand, will be reviewed by examiners every time.

Your First Loss is Your Best Loss. Many lenders follow this strategy on all loans until it is clear a recovery is underway (more detail here).

Avoiding Second-Guessing. Many modifications don’t work out (see this post on single family modification failures; in my experience the CRE modification failure rate is even higher). If you modify the loan and end up taking the property back anyway it’s probably because conditions have continue to deteriorate and you will recover less than you would have if you had foreclosed to begin with. It’s easy to quantify that loss, and it looks like poor judgment. On the other hand, if you foreclose, no one will quantify how much you could have saved by modifying the loan.

Pooling and Servicing Agreement constraints. If the loan is a CMBS loan, the servicing of the loan is governed by a Pooling and Servicing Agreement. Generally, in a maturity default the special servicer is charged with maximizing recovery for all investors. Although this could mean doing a long term extension at a lower interest rate, given that there’s an excellent chance the investors that actually own the loan may want out of the asset class or believe in the “first loss is the best loss” strategy, a special servicer is vulnerable to second guessing. Foreclosure is a safer strategy. Thompson Hine has a good summary of CMBS modification and extension procedures here.

Dual Track Costs. Many lenders will not begin negotiation until there is an actual or imminent default. This may be a function of a Pooling and Servicing Agreement, or the lender could just be hoping the borrower will find a way to pay the loan off. Once a default happens, many lenders will start the foreclosure while negotiating an extension so no time is lost if an agreement is not reached. This adds costs, and frequently at least some payments are not made because the borrower is also not sure an agreement will be reached. As a result, to close the extension frequently a substantial amount of money needs to be paid, and borrowers sometimes decide to walk at that point.

Workload. Modifications are enormously time consuming. The deal needs to be negotiated, approved, and documented, and frequently multiple rounds occur. A complex deal can be a full time job for an asset manager for months. It is much simpler from an asset manager point of view to foreclose. If the justification for a modification looks marginal or the borrower is difficult, this factor can swing the recommendation to foreclosure.

Given all these hurdles, it’s not surprising few long term extensions are done. If an extension is offered, it’s usually short term (90 to 180 days) and predicated on progress being made towards marketing or refinancing the property.

CRE Problems: Rate Structure, Maturity, and Vintage

Zero Hedge’s post, “The Special Servicing Problem,” talks about the ballooning transfers to Special Servicing status. The post includes a table of large CMBS loans which have been transferred, which I think gives a nice snapshot of the types of loans which are in trouble:

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

Rate Structure. The only floating rate loans in this group are loans which have matured. Given the very low floating rates today, we are not going to see many payment defaults, but given the decline in values, tightening of underwriting standards, and lack of financing available for CRE deals, many floating rate loans can’t be refinanced or sold for the outstanding loan balance at maturity.

Maturity. There are four loans in the group which are five years or older (i.e. originated before 2005). All of these loans have matured. There are not many old loans in the table because many older loans were successfully refinanced during the boom years. The remainder were underwritten conservatively enough that they have been able to make their payments, but in the current environment they can’t be refinanced or sold without a loss.

Vintage. The vast majority of the loans in the table are fixed rate loans underwritten in 2005-2007, at the peak of the market and when underwriting standards were weak. With the decline in fundamentals these loans are having trouble making their payments, and can’t be refinanced or sold.

It may be possible to work out the first two groups with term extensions. The only hope for the last group would be a drastic reduction in the interest rate (for example, switching to a floating structure).

Lender Conspiracy to Destroy Competition?

The developers of the Fontainebleau casino and hotel development in Las Vegas believe Deutsche Bank is out to get them. From Zero Hedge:

In a stunner of a development, Las Vegas casino operator Fontainebleau has amended its ongoing lawsuit against a set of banks, and has alleged that Deutsche Bank is now "seeking to destroy the Fontainebleau in order to minimize competition" with the Cosmopolitan Resort and Casino, which was acquired by Deutsche Bank in a foreclosure auction in September 2008 for $1 billion, after the casino had defaulted on a $760 million loan. Allegedly, DB is doing this by pulling Fontainebleau's revolver, making it impossible for the development-stage casino to survive…

As both the Fontainebleau and DB's Cosmopolitan developments are in their final stages of development, their "successful" opening would result in yet another flood of hotel rooms in the already oversupplied Las Vegas market. The Fontainebleau casino would provide 3,800 brand new rooms and condo units, while the Cosmopolitan would supply yet another 3,000 rooms and condos.

How plausible is this argument? This plan would require monumental stupidity at Deutsche Bank. Shutting down the Fontainebleau development would ultimately lead to a new owner who would acquire the development at a much lower basis than the current owner. This would allow the new owner to substantially undercut the Cosmopolitan, pulling that project down too. I’ve discussed this downward spiral effect in more detail in my post CRE Loans and the Death Spiral of Doom.

If you view an income property submarket as an ecosystem, the whole system does best when all the competing properties have similar cost structures. When a predator property with a much lower cost basis enters the system (as a result of a greatly discounted purchase out of a foreclosure or note purchase, for example) it can offer much lower rents, which in turn can destabilize other properties. Eventually a new equilibrium is established, but at a much lower level than before the system was destabilized.

If Deutsche Bank is really trying to shut down Fontainebleau to benefit Cosmopolitan, it’s shooting itself in the foot.

Investor Returns on FDIC Discounted Note Purchases

John Reeder over at Real Property Alpha and I have a discussion going on the implications of the FDIC selling performing CRE loans at 50 cents on the dollar (see John’s posts here, here and here, and mine here). One of John’s commenters asks about cap rates on these transactions, which I’m taking as an opportunity to show how these deals can be such a home run for the note buyer.

I’ve expanded my previous example to show net operating income, cap rate, and collateral value. There’s not enough information in the FDIC sales info to use an actual example, so I’ll show a couple of hypotheticals. The first example is a marginally performing loan where the property generates just enough income to cover the interest payment:

I’ve picked an 8% cap rate – the real life non-distressed transactions I’m seeing have cap rates in the 7%s for multifamily on up to the 9%s for retail. At this cap rate the property has negative equity, so at maturity the borrower will presumably be unable to pay off the loan and the note holder will foreclose. Here are the numbers for a note buyer who bought at a 50% discount:

Even though there’s a $2,500,000 loss on the $10,000,000 loan, since the note buyer only paid $5,000,000 for the note they are up $2,500,000 on their position.

Let’s say the original loan is performing well and the NOI is more than the interest payments:

In this example, the borrower has equity and will be able to pay the loan off by selling the collateral. That works out even better for the discounted note buyer, because even though they only paid $5,000,000 to buy the note they get repaid the whole $10,000,000 (100% return).

This kind of apparent no lose proposition is what gets people very excited about buying notes at a discount. There are risks, of course; property income might deteriorate, cap rates might continue to increase, or the borrower might file bankruptcy and get the loan restructured on terms less favorable to the note holder. That’s why note investors are looking for a relatively high yield and a big discount going into the transaction; a 50% discount gives a lot of room for things to go wrong and still get an acceptable return. However, selling at a 50% discount is a huge hit for a bank to take (I’ve posted about the impact on the bank’s balance sheet here), so as far as I know the FDIC is the only active seller that is discounting to this extent.

Why Are Performing CRE Loans Selling for 50 Cents on the Dollar?

Zero Hedge and Real Property Alpha have picked up on the results of recent FDIC auctions of CRE loans (Zero Hedge posts here and here, Real Property Alpha posts here and here). A graph from Real Property Alpha shows performing CRE loans are being sold at roughly 50% discounts:

You might think the sales price on the performing loans indicates the collateral backing the loan is worth only half the loan amount, but that’s not the case. This is about a change in investor yield requirements, not CRE fundamentals.

Let’s say you have a well secured, performing $10,000,000 CRE loan paying a 6% interest rate:

Now, let’s say you are taken over by the FDIC, and the FDIC wants to sell the loan. You might think that since the loan is well secured you could sell it for the full principal amount, but you would be wrong; note buyers want a 12% yield on their investment (actually, they want more – I get two or three calls a day from people wanting to buy notes, and return requirements are 12% to 25%). To get a 12% yield on a loan paying 6% interest, you need to buy it at a 50% discount:

You might question why the FDIC would sell – 6% is not a bad yield when 5 year Treasuries are at 2%. If the answer is the same as when I worked there in the late 1980’s, it’s because their job is to liquidate assets at the best price they can get for them. But, most banks would be content to collect 6%, and that explains why you don’t see many banks selling performing CRE notes.

The Commercial Real Estate Risk Culture at Deutsche Bank

Zero Hedge has published a letter from a former risk manager at Deutsche Bank which speaks to the difficulties of being a risk manager in a lending institution. Some excerpts:

For more than two years, I have been working internally to improve the inadequate governance structures and lax internal controls within Deutsche Bank. I joined the firm in 2006 in one of its foreign subsidiaries, and my due diligence revealed management failures as well as inconsistencies between our internal actions and our external statements.
Beginning in late 2006, my conclusions were disseminated internally on a number of occasions, and while not always eloquently stated, my concerns were honest. Unfortunately, raising concerns internally is like trying to clap with one hand. The firm retaliated, and this raises the question: Is it possible to question management’s performance without being marginalized, even when this marginalization might be a violation of law? Two years later, our mounting losses are gaining attention, and I offer my experiences and my thoughts in the hopes of contributing to the shareholder and public policy debate…

I joined Deutsche Bank in 2006 to build an investment business within its commercial real estate lending operation, and I was generally surprised by the aggressive sales culture within our firm. While many people consider the banking sector’s problems to be caused by residential lending, I witnessed multibillion-dollar loan proposals for commercial property.
With funds provided at more than 90 percent loan-to-value, these loans were “priced to perfection” and assumed that property prices and rental rates would continue to rise. For perspective, a single billion-dollar commercial real estate loan is equivalent to 2,000 residential loans of $500,000.
In general, my colleagues are hard-working, decent people, but the system of incentives encourages people to take risks. I have seen honest, high-integrity people lose themselves in this cowboy culture, because more risk-taking generally means better pay. Bizarrely, this risk comes with virtually no liability, and this system of O.P.M. (Other People’s Money) insures that the firm absorbs any losses from bad trades…

There’s much more at this follow up Zero Hedge post.

Related Post: Fox Guarding the Henhouse?  Bear Stearns Risk Manager Now at the Federal Reserve

Indications of a Credit Bubble

From Socializing Finance’s post Flashback: The Quality of Credit in Booms and Depressions, some commentary from 53 years ago:

In the past few years important new historical evidence has been developed on the cumulating deterioration in the quality of credit during the period of prosperity that precedes severe depression. […] With respect to the current situation we must concern ourselves with the fact that some, at least, of the economic conditions are in evidence today. What are these conditions? First and foremost is a rapid increase in the volume of credit or debt. Second, a rapid, speculative increase in the prices of the assets that are brought with the rapidly increasing credit, such as real estate, common stocks, or commodity inventories. Third, vigorous competition among leaders for new business. Fourth, relaxation of credit terms and lending standards. Fifth, a reduction in the risk premiums sought or obtained by lenders.” – Moore, G.H. (1956). The Quality of Credit in Booms and Depressions. Journal of Finance 11, 288-300.

How accurately did these conditions predict the current CRE bubble, and where are we today?

1. Rapid Increase in the Volume of Credit or Debt. This clearly occurred during the bubble. As of today, the amount of debt outstanding hasn’t really declined, because few assets have retraded at reduced value levels.

2. Rapid, Speculative Increase in the Price of Assets. Again, this obviously happened. Some distressed sales are starting to occur, but for the most part values have not been marked to market yet.

3. Vigorous Competition for New Business Among Lenders. That clearly went on. Today, there is very little competition occurring; the few lenders that are making loans can pick and choose.

4. Relaxation of Credit Terms and Lending Standards. Terms and lending standards were clearly relaxed during the bubble (Loan to Value, Debt Service Coverage, Interest Only payment structures, etc.). For the most part these standards have tightened, although arguably LTVs are still based on cap rates which are too low, and DSCs calculated on historically low interest rates may not be high enough to ensure an exit if rates return to historical averages.

5. Reduction in Risk Premiums. Again, this obviously occurred during the bubble, with spreads over Treasuries in the 100bp to 200bp range. Today, spreads are much wider, but again maybe not enough in light of the historically low Treasury rates.

So, it appears lenders in 2006 were not attuned to the risks publicized by this article 50 years earlier. And, it appears we are only part way to establishing a normal lending environment.

Abandoned Projects Everywhere

Calculated Risk has a post featuring a video of an abandoned condo project in Irvine, CA:

Yesterday, the Wall Street Journal had a story on abandoned construction projects. An excerpt:

No one tracks precisely how many construction projects nationally have been stopped by developers midstream. But an indication of the scale comes from New York-based Real Capital Analytics Inc., which estimates that there were 3,929 distressed commercial properties across the U.S. as of March 31 -- a 55% jump since Dec. 31, 2008. Roughly a quarter of the properties involve developments, unfinished, Real Capital said.

The story mentions a website, UnfinishedConstrution.com, which specializes in liquidating such sites. Here are some photos of featured properties:

The site also features an alligator farm for sale:

That seems entirely appropriate given the difficulties of jump starting a project which has been shut down.

Related Posts: Roads Before Roofs, Roofs Before Retail, When Real Estate is a Liability: The Movie, and Workouts 101: Complete the Project!

Economy and Real Estate Post Picks: Week of May 3, 2009

Wholesale Sales Continue to Slide: Commodities are the hardest hit

The Latest Employment Report: Not as bad as previous months, but still not good

Does a Decline in Initial Jobless Claims Signal the Recessions End? A discussion of the impact of initial, continuing, and net jobless change

Regional Disparity in Unemployment Rates: The West Coast is faring poorly in this recession

CMBS Loan Performance: Transfers to Special Servicing are up sharply

Seeing Patterns Where There Are None: Geography

Humans are wired to detect patterns, but sometimes there isn’t one. For example, what distinguishes the best and worst performing submarkets in Orange County?

You might focus on geography first; the real estate mantra is location, location, location. Are the best and worst performing submarkets concentrated in a particular area?

Here’s a map, with the five best performing markets (as measured by combined occupancy and rent change) highlighted in green, and the worst ones in red:

Looking at this, you would have to conclude there’s not a pattern; the best performing and the worst performing markets are pretty will mixed up.

The data is for the first quarter 2009 from RealFacts, as reported by Lansner on Real Estate.  Here’s the chart accompanying the story; can you find a pattern in the occupancy and rent changes?

Is General Growth Properties in Denial?

The CEO of one of their largest competitors thinks so. From an April 27, 2009 Bloomberg story:

Simon Property Group Inc., the largest U.S. shopping-mall owner by stock-market value, tried to buy real estate from rival General Growth Properties Inc. before it filed for bankruptcy, Chief Executive David E. Simon said.

“They didn’t realize they were a distressed seller,” Simon said in a panel discussion at the Milken Institute Global Conference today in Beverly Hills, California. Few commercial real estate sales are being completed because sellers aren’t willing to take losses on their investments, Simon said.

With due respect to Mr. Simon, I don’t think that’s the real issue; the real issue is GGP doesn’t want to give up properties at fire sale prices when they can still service their debt. General Growth Properties report on first quarter results says their net operating income on consolidated properties was $509,085,000 while their interest expense was $328,489,000. That’s a 1.55 debt service coverage, which is generally regarded as a conservative ratio. Loopnet provides an example of an individual GGP property:

…the roll of loans added to special servicing in April only includes one substantial General Growth loan, a $165 million mortgage on the 939,085-square-foot Jordan Creek mall in West Des Moines, Iowa. The loan, securitized through JPMorgan Chase Commercial Mortgage Trust, 2005-LDP5, matured in March. According to servicer data compiled by Realpoint, the property generated $19.6 million of net cash flow last year. That's 1.8 times the cash flow needed to fully service its amortizing debt.

GGPs immediate problem is not the inability to pay debt service; it’s loan maturities. From their quarterly report:

The Company intends to pursue a plan of reorganization that extends mortgage maturities and reduces its corporate debt and overall leverage. We intend to work with our various lenders and other constituencies to emerge from bankruptcy as quickly as possible while executing on a plan of reorganization that preserves GGP's integrated, national business operations.

There’s no reason at this point to expect GGP can’t successfully reorganize in such a manner, because income at their properties is actually holding up fairly well (more on that at this Traffic Court post).

I’ve previously posted on the maturity issue and worked through the numbers in some examples here.

Successful, Until You Aren’t

Lansner on Real Estate reports Pacific Property Assets has defaulted on the interest payment due on $90,000,000 in notes held by its investors. PPA has a 2,400 unit multifamily portfolio in Southern California and Arizona. Some excerpts:

Company CEO Michael Stewart said interest payments on about $90 million in notes would be suspended for an undetermined period, adding that he’s hoping investors will bear with the firm to give it “breathing room…”

“We’ve never missed a payment in over 10 years. It’s probably the toughest decision (we’ve made),” Stewart told the Register.

The fact that no payments were missed for ten years doesn’t mean much. I was Chief Credit Officer at ARCS Commercial Mortgage from 1997 to 2006, during which time we originated about $2B a year in multifamily loans with virtually no delinquencies, foreclosures, or losses. I would love to believe that was a result of my stellar judgment, and maybe it was. But, I’ll never know for sure, because during the time I was there any bad decisions I made were bailed out by declining interest and cap rates. Periodically, someone would complain we should do a risky deal I had turned down, because the fact we had no defaults indicated we weren’t taking enough risk. My response was that if the average CRE default rate was 2%, that was arrived at by 9 years of no defaults and one year of 20% defaults.

Commercial real estate performance, to paraphrase the quotes about airline travel and war, is years of boredom punctuated by periods of terror. If you’re a CRE investor who never missed a payment between 1995 and 2008, that puts you in the same class as 99% of all CRE investors. If you never missed a payment between 1979 and 1982 or between 1990 and 1994, I’m impressed. I expect 2009 to 2012 will be another period where never missing a payment will be something to brag about.

One of my grandmother’s sayings was “You don’t know if your roof leaks until it rains.” It hasn’t rained hard in the CRE world since the early 1990’s, and many lenders and owners (like Mr. Stewart) have assumed that, because they weren’t getting wet, they had a good roof.

Here’s a link to another story about Mr. Stewart during happier days just 8 months ago, in which he explains PPA’s decision to diversify into the Phoenix market (oops!), and how risks were lower in October 2008 than when he started PPA in 1999.

Roads Before Roofs, Roofs Before Retail

The stories and video of new houses being demolished in Victorville are continuing to pop up in blogs and other news sources (see Calculated Risk, the LA Times, and the Wall Street Journal, for example). It’s a compelling story, but the way it’s being presented almost everywhere is misleading.

First, here’s the video if you haven’t already seen it:

The video, and every story I’ve seen referencing it except one, gives the clear impression the bank thinks it makes economic sense to demolish completed and virtually completed but unsold houses because the market is so bad. However, the original source of the story (see this post) interviewed an officer at the bank, who makes clear the real issue is the homes were built before the roads and other site improvements were completed. Completed homes could have been sold at some price, but if there’s no road to the home you can’t sell it.

This is obviously bad construction lending practice; you should complete site improvements first (or make sure you’ve held back enough money to do so). Hence the headline, roads before roofs. This seems obvious, but it happens more often than you might think. When I was at Capmark a few years ago one of our workout deals was a project where we funded the equity portion of a purchase of a multifamily land parcel, and then discovered the access road we needed couldn’t be built because it would cross a stream which was the home of an endangered fish species. That investment was a total loss.

It’s also obvious it takes more than a few mistakes to bring down a lender, but when you have a major due diligence breakdown like this, you have to wonder if it’s not the tip of an iceberg of bad decisions. From the WSJ story linked above:

Guaranty Bank has significant exposure to construction loans to home builders. Last month, its parent company, Guaranty Financial Group, was issued a "cease and desist" order by the federal Office of Thrift Supervision, citing the firm's "unsafe and unsound banking practices."

I’ve previously posted about Capmark’s problems here. Since then, they reported a $1B loss in the first quarter.

The second part of the headline is roofs before retail. Before you develop a retail project, you want to make sure there are enough people living in the market area to support it. Because subdivisions were being developed at such a rapid rate, this rule was frequently violated, and when the music stopped on the residential side many retail projects were left without a customer base. Between the two retail sites indicated below, which do you think is doing better?

The lesson is, it’s important to develop in the right order; infrastructure, then residential, then retail.

Rent or Buy: San Jose or Columbus?

David Leonhardt has an article in The New York Times (hat tip Wehr in the World) about his decision to switch from renting to buying a house. There is an accompanying graphic showing the ratio between the purchase price of a house and the annual rent for an equivalent house by city. I’ve highlighted the ten markets with the highest ratio in green, and the ten markets with the lowest ratio in red:

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

To me the most interesting thing about this information is the premium people are still willing to pay to own a house in bubble markets. The ten markets with the highest ratios are all California coastal cities, south Florida, and New York and Boston. The cities with the ten lowest ratios are all Midwest cities, plus Pittsburgh, Dallas, and New Orleans.

The city with the highest ratio is San Jose (30.7); the lowest ratio is Columbus, Ohio (11.4). Keep in mind we are not comparing house prices and rents between the two cities, we’re comparing the ratio between house prices and rents within the city. People value ownership in San Jose much more than in Columbus.

There is a long term trend away from the Midwest and to the coasts. The reasons are complex, but boil down to changes in the employment base and geographic attributes of the areas like weather and topography. For more on the employment base issues, a good starting point is Richard Longworth’s Caught in the Middle: America’s Heartland in an Age of Globalization. For more on the role of geographic attributes, see the research of David McGranahan, an economist with the United States Department of Agriculture (summarized in this post).

Fighting Foreclosed Home Blight

Calculated Risk has a post here detailing efforts some cities are making to force lenders to maintain the vacant homes they’ve foreclosed.

Apart from the obvious fact that blight upsets constituents, attacking blight aggressively is good policy because it helps maintain values (and tax bases). I came to this view via Wesley Skogan’s Disorder and Decline and George Kelling’s Fixing Broken Windows, both of which should be required reading for real estate investors, appraisers, and lenders. The latest research provides additional support for the idea that disorder leads more disorder, creating a self-reinforcing downward spiral.

Although Detroit’s economic problems are severe, I wonder if it would have made a difference if funds had been available in the past to keep the place cleaned up.

Economy and Real Estate Post Picks: Week of April 27, 2009

GDP Growth 1950 – 2009: First quarter GDP decline the worst since the early 1980’s

Credit Crisis Indicators: Credit indicators are headed in the right direction

Recession to End by Fall: Indicators are turning positive

April’s Economic Data in Graphs: Big collection of graphs showing economic data released in April for everything from new home sales to restaurant performance

Consumer Spending Rebound: Personal Consumption Expenditures rebounded in the first quarter

CRE Construction Loan Rates Today

The Wall Street Journal has a story here (hat tip Deal Junkie) about a $215M construction loan Boston Properties obtained on a mixed use project in Boston.

As you would expect, the terms are much tougher in many respects than were available a few years ago. The loan is for only 40% of the cost of the project (compared to loan-to-cost ratios of up to 90% during the boom days), and there are recourse provisions to the borrower (these provisions were often waived in the past).

But then there’s the interest rate:

The five-year loan carries a floating interest rate equal to the London interbank offered rate plus 3% annually. Two years ago, rates on similar loans were lower, said Mr. LaBelle [Chief Financial Officer at Boston Properties].

I suspect the reporter got that wrong; I suspect Mr. LaBelle said two years ago the spreads on similar loans were lower. The spread on this deal is 3%, and the spreads a few years ago were 1-2%. But, two years ago 30 day LIBOR was 5.320%, so the all in rate was 6.32-7.32%; Today LIBOR is 0.435%, so with Mr. LaBelle’s loan spread of 3% the all in rate is 3.435%, which is around half what the rate was two years ago.

If you told someone two years ago that you would be able to get a construction loan for a CRE project at less than 3.5%, they would have thought you were crazy.

When Real Estate Is A Liability: The Movie

I’ve previously posted about how real estate values can fall close to zero here and here, and the importance of completing projects here. This video of new homes being demolished at the direction of the foreclosing bank takes the concept to a whole new level:

This is not as crazy as it appears when you know the bank’s side of the story, available on this post from Vision Victory Manifesto (also the video source). An excerpt:

“Our only option is to either proceed with putting more than a million bucks into the land, which we’ve already taken a huge hit on and lost a lot of money, or, we tear down the houses,” Smith [Guaranty Bank official, Real Estate Officer Dean Smith] said.

He said the builder put up the homes before completing the site improvements and failed to have enough money to finish roads, walls, and other improvements that bring the community into code.

“Everything just fell apart at that point and we can’t sell homes that are not up to code,” Smith said.

He said the city of Victorville fined the bank once because the home are out of code and would have faced daily fines if Guaranty didn’t do something with the vacant houses.

“There are still substantial dollars that need to be put into the land before the city of Victorville will give certificates of occupancy on the houses and the bank isn’t willing to put forward that amount of money,” Smith said.

If the bank was just looking at the cost of finishing the houses, it probably would have made sense to do so. But, when you have to put in roads and other site improvements too, that probably tipped the scales in favor of demolition. Obviously, it’s really bad lending practice to advance funds for house construction and not have enough in the budget to build the roads to the houses.

Another factor was that, in the bank’s view, it would be at least five years before the market recovers to the point the houses would sell. That’s believable, given the market is Victorville. The video mentions other homes being demolished in Temecula, which is also a distant exurb:

More on the problems exurbs are experiencing here, here, here, and here. Neither the video nor post identifies an exact location of the homes being demolished, but here’s an image of the crossroads mentioned:

The combination of exurb market, fringe location, and poor construction loan administration will result in losses in this kind of market.