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.

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.

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

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

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

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

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

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

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

Carol Baum has an opinion piece on the Bloomberg site about the New York Fed decision to hire Michael Alix, who was former chief risk officer at Bear Stearns at the time of its collapse. This story is interesting in itself, but it also provides an update on the status of a number of others associated with financial fiascoes, all of whom appear to have landed on their feet. Hopefully this is survivorship bias at work. I would like to believe for every scoundrel who lives happily ever after there are ten scoundrels toiling as clerks at Walmart whose stories won't make the paper.

Actually, as a former chief credit officer (for a much, much smaller organization than Bear Stearns, just $12B in income property loans), I have some sympathy for Mr. Alix. Although he had the chief risk officer job since just 2006, Alix was an 11 year employee at Bear and he had to be aware of the high wire the company was walking. But, if you were him, what would you do with that knowledge?

I think an apt analogy is the classic WWII movie scene in which there's a bunch of guys in a foxhole, and the enemy throws a hand grenade into the hole. Some credit officers in that situation see their role as saying something like, "Excuse me, but an object that looks like a hand grenade is now in our foxhole, and if it is a hand grenade and it explodes we could be injured or killed. But it might not be a hand grenade, and if it is it might not explode, and even if it does explode we might survive." Under this approach the credit officer has done his duty, tried to mitigate risk within the system, and he and his compatriots are probably dead.

Another approach is for the credit officer to yell "Grenade!" and, if no one reacts, throw himself on it. This would be the equivalent of telling your coworkers they're screwing up, and if they don't stop, calling up your regulator to shut the place down. Like throwing yourself on a grenade, this involves some personal risk and a great deal of courage. Here's a link to the fascinating story of a former coworker of mine who took that route at Indymac.

A third route is to shout "Grenade!" and, if no one reacts, exit the foxhole as quickly as possible. I think most people would say this is the course of action Mr. Alix should have taken, and before 2001 I think I would have agreed without thinking much about it. When I took my first big credit job (1997), I viewed myself as a circuit breaker. If the company I worked for overloaded, I would trip, and while I knew I was probably done with that company I thought I could go to another company who needed a circuit breaker. When the 2001 recession started and it made sense to turn deals down, it dawned on me that finding a replacement position during a recession might not be all that simple. The times when an assertive credit person is most likely to find his or her services no longer needed are the times they are least likely to find a new job. My response to this realization was to stockpile food in the basement and prepare for a long period of underemployment if necessary (thankfully, it wasn't), but another understandable approach would be for the credit person to step back and not make waves.

Compensation enters into this balancing act, but not in the obvious way. The standard view is that a credit person sells their soul to keep the big bucks rolling in, and I am sure that happens. However, the converse is also true; if you're not financially independent doing the right thing can be a hardship. This is especially true if others are dependent on you. Economists would like to believe you can structure compensation to incentivize people to do the right thing. I don't think that's possible with credit officers; in the end it's a character issue, not an economic one.

So, I have sympathy for Mr. Alix; he was in a difficult situation facing difficult issues. But, he should not have been hired by the Fed, as any economist knows. A basic tenet of principal-agent theory is that the threat of termination of the relationship is one of the ways to keep an agent from acting against the interests of the principal. If a credit person knows association with a major financial disaster will terminate his or her credit career, he or she is more likely to do the right thing. The hiring of Mr. Alix by a regulator to be a regulator is the most effective action I can think of to undermine that principle.