Knowing When to Stop

When you think about bad CRE loans, most people picture homes being demolished in Victorville, unsold high rise condos in Miami, or vacant office buildings in Orange County. But how about Minnesota? From a Minneapolis Star Tribune story (hat tip Calculated Risk):

Minnesota ranks fifth nationally, with 50, or 12 percent, of its banks carrying particularly high levels of dead real estate loans, according to an analysis done for the Star Tribune by Foresight Analytics, a financial research firm in Oakland, Calif. Only Florida, Georgia, Illinois and California have more banks at such levels.

A key quote:

Bank consultant Robert Viering, principal of River Point Group Inc. in Monticello, had that lesson drilled into him when he was a regional credit officer at the former Norwest Bank. A credit manual, circa 1990, warned him and his colleagues: "The pivotal issue in CRE lending is knowing when to stop. Restraint must be initiated by bankers because historically borrowers have been unable to recognize the warning signs. Commercial real estate lending should not be viewed as the cornerstone of a loan portfolio."

Stopping, of course, involves saying no before the problem is evident. This is something people are very bad at doing (for more on that, see my post Rising Markets Create Lender Losses).

REITs Positioning to Take on CRE Debt

As banks pull back from CRE debt and the CMBS market lies dormant, REITs are raising capital to step in. From REIT Wrecks:

In addition to LRCF, Alliance Bernstein, Angelo Gordon, Apollo Global Management, Colony Capital, Starwood Capital and Western Asset Management have all registered to raise equity for their own Mortgage REITs…

The filings make for great reading. Ladder said there is now an “unprecedented market opportunity" to originate well-priced loans. Colony said that the the credit crisis was causing an "over-correction" in commercial real estate debt and that there would be a "protracted opportunity" originate attractive loans. Alliance's new REIT, Foursquare Capital, said that the "current distressed condition in the financial markets" would allow it to buy mortgage assets at "significantly depressed trading prices and higher yields." As for Barry Sternlicht and Starwood, their filings were even more emphatic: "the next five years will be one of the most attractive real estate investment periods in the past 50 years."

For more on the logic of this move, see my post, “Why Now is a Great Time to be a CRE Lender.”

Zombie Banks’ Distressed Assets

John Reeder’s post Distressed Assets Market and FDIC Closures on Real Property Alpha is a must read for those that want to understand what’s going on with regional banks. An excerpt:

Our business working in the commercial real estate industry (see the Deal Breaker site, or upcoming Sperry Van Ness auction) puts us on the front lines of the current blow-up that is going on in the banking industry.  Capitalization levels in financial institutions have a large impact on whether they are willing or able to dispose of distressed construction loans, commercial REO, or A&D loans.  The general rule of thumb is that the more distressed the bank, the less potential that you are going to be able to make a deal with that Bank on their non-performing assets.  It’s difficult to digest this reality as the potential that a distressed bank offers in the way of inventory can be enticing.    However, the chances are that the bank has not written down the value of the asset to real current market, so selling at today’s prices means that the bank has to take an additional hit to their capital and the really distressed banks can ill afford the additional hit.

Read the whole post, there’s much more. I have two small contributions to John’s points:

• Even if a bank conscientiously marks its bad assets to market, it will still probably incur smaller losses at any given point in time if it holds the asset instead of disposing it. The marks are based on appraisals less a discount for sales costs. This number will almost always be higher than what a bank actually realizes on a sale, because appraisal values tend to lag actual market trends (more on that in the Lansner on Real Estate post “Were Appraiser’s Late to the Price Collapse?”). So, a bank can adopt a hold strategy and still be in regulatory and accounting compliance. The risk, of course, is that by hanging on to the asset, the bank continues to be exposed to further value losses if the market continues to deteriorate, and may ultimately incur an even bigger loss.
• In most cases the management and staff working on the problem assets at the smaller banks are the same people who originated the deals. There are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). The consequence is the management at these banks may genuinely believe these assets can be salvaged given time, while someone with less involvement would say it’s time to take the loss.

My point is that, while I am sure some banks are consciously manipulating their accounting, I am also sure many banks believe they are doing the right thing.

Are Banks Failing to Mark Down Toxic Assets?

There is a widespread believe that banks are failing to mark their toxic assets to their true value (see, for example, the Economist’s View post “The Fall of the Toxic Asset Plan”). A commenter on this post, however, has a rejoinder that rings true to me:

I believe banks are generally marking to market their troubled assets at appropriate levels, not due to empirical evidence but in view of the audit & regulatory environment faced by the employees who have to sign off on the prices. I must temper the conspiracy theorists who believe banks have not made a sincere effort to mark down prices to "fair value", whatever that is in these markets. On the ground, today's audit teams are paranoid about valuation (PCAOB is watching) and a small cottage industry has grown up around the now 2 year old problem of valuing illiquid assets. Nobody at the big banks wants to sign off on prices they will later be accused of keeping too high. It's just not how it works inside these firms. They may wind up being in error but not for lack of analysis and pulling in every piece of imperfect market info available.I have performed a lot of valuation work that suggests prices are fairly conservative relative to base case expectations of future losses on a given asset-- certainly in the residential private label securities area where much of the problem resides.

There is just no upside to signing off on unsupported values. On the other hand, there is plenty of uncertainty about what values will actually be realized – see my post “Valuing Note Purchases” for more on this.

Why Now Is a Great Time to Become a CRE Lender

What would you do if you won the lottery? My wife and I have speculated about this, and we’ve always been pretty much in agreement (travel, a big loft in a major city, more travel, etc.). We haven’t played this game lately, however, because now I want to buy a bank and specialize in CRE lending, which is a goal I can tell she is not enthusiastic about.

To be clear, now is not a good time to have been a CRE lender. From Jeff Bernstein post on Urban Digs, “Holes in the Dike”:

According to Globe Street, Realty Finance Corp. has sold an original $47 million loan on a Class A office building at 250 Montgomery Street in San Francisco for approximately $25MM. The building was reportedly only 55% occupied, so obviously debt service by the borrower, Lincoln Property Co., was an issue.

I do not want to be Realty Finance – I want to be the bank loaning to the buyer. Jeff continues:

What we have to do is look ahead at how the new owner of 250 Montgomery Street is likely to act. The new owner has not been disclosed in this case, but is said to have been another real estate private equity firm. This firm now has a great new basis cost in the building and lots of incentive to be aggressive in getting it leased up. This is the transmission mechanism whereby lower rents are enabled in a market due to distressed properties being turned over at a much lower prices. It just doesn't take a lot of this kind of activity in a soft market with high vacancy rates to crush rents.

The most secure loans are loans where the real estate has plenty of upside, and the only real estate with upside these days are deals which have a low basis compared to the rest of the market. Those are the loans I want to make.

There are other reasons for lenders who have not previously done CRE lending to jump in now:

• Spreads are really good. Borrowing at 1-2% and loaning at 6-7% is a nice business.
• The most important rule in CRE lending is to loan to people who have experience in the property type and their market. By definition, those people already have lending relationships. However, many of those relationships have been disrupted as lenders have pulled back, and the lenders that remain are generally not known for their customer service. Imagine half the NFL teams disbanded over the summer; there would be a lot of talented players looking for a new home. Now is a great time for a smart, customer-focused bank to pick up some great free agents.
• CRE lending is relationship oriented, and the relationship is between the borrower and the loan officer. Loan officers are in the same position as the borrowers described above; many are twiddling their thumbs because their employers have pulled back. Now is a great time to build a team of high producers who have established client networks. The same is true for other necessary talent (underwriters, processors, etc.).

Of course, I’m not likely to win the lottery, especially since I don’t play (you probably knew that if you follow this blog). My wife does play, but if she wins I’m pretty sure we will not be buying a bank. However, some people are going to take this opportunity to jump into CRE lending and do very well.

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.

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.

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 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.

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

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

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

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

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

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

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

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

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

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

Why Would a Bank Try to Drive Its Borrowers Away?

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

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

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

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

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

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