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State of the Economy Part II
- Capital Markets
- Case-Shiller
- Commercial Real Estate
- Consumer lending
- CRE
- CRE
- Credit Conditions
- default
- Excess Reserves
- Federal Deposit Insurance Corporation
- Financial Accounting Standards Board
- Foreclosures
- Great Depression
- Gross Domestic Product
- Home Equity
- Homeownership Rate
- Investment Grade
- Las Vegas
- M1
- McKinsey
- Monetary Base
- Money Supply
- Mortgage Backed Securities
- None
- Obama Administration
- Real estate
- Recession
- recovery
- Regional Banks
- Securities and Exchange Commission
From The Daily Capitalist
This is Part II of my three part series on the state of the economy going into 2010. Part I appeared yesterday, and Part III will appear tomorrow. This weekend I will combine the three parts into one downloadable PDF.
The Importance of Debt
The Fed, the Obama Administration, and a Democrat-controlled Congress are doing everything they can to prevent a recovery by delaying or preventing the liquidation of debt on the books of financial institutions.
In a credit-induced business cycle, such as this one where the Fed pumped vast amount of money into the economy (1.0% Fed Funds rates), some asset goes crazy. This time it was real estate, residential first and then commercial real estate. It led to an unprecedented explosion of debt--worldwide. This fake money expansion directed capital into bad investments as we've sadly learned.
There is a reason banks have tightened credit: they are worried about their capital base because they have too much bad debt on their books related to real estate. If they lend the money out, they worry that they might need it to cover their existing bad debt if things get even worse, so why take the risk and lend, they reason.
The Administration is doing everything they can to prevent debt write-downs because they fear the ongoing debacle in commercial real estate and its impact on the banking system. Last year they approved new FASB Rule 115, a de facto suspension of-mark-to-market accounting for loan portfolios which artificially inflates a bank's Tier 1 capital base. Banks are undercapitalized; ignore the (not so stressful) stress tests.
Recently the FDIC adopted new "extend and pretend" rules that say if the lender believes that the borrower can still pay the loan, regardless of the value of the asset relative to the amount of the loan, they can ignore valuations and not have to reserve for the loan. This gives lenders no incentive to write loans off, so they remain on their books. Ever optimistic real estate investor-borrowers are happy to extend in order to avoid huge income tax hits as a result of debt relief.
The Big Freeze
The Fed has tried to induce liquidity by buying GSE residential mortgage backed securities, a $1.25 trillion program that will end in April. The net effect was to take about $1.55 trillion of RMBS out of the market. In essence, private debt was off-loaded to the public. A side effect is that they have monetized Treasury debt yet they have not improved the credit markets. At some point the Fed will have to sell them back to the market in order to tighten credit (a part of the so-called "exit strategy").
None of these programs have loosened bank credit. The vast majority of small(er) business banking in America is not done by the giants, but rather by regional banks. And the regional banks are the ones holding most of the bad commercial real estate loans. They are facing massive write-offs, a deteriorating capital base, and so they hold their capital close.
The point here is that banks will restrict lending until their loan portfolios and balance sheets are cured. The cure will be to raise more capital in order to improve their Tier 1 capital ratios and write down debt.
This explains why banks are sitting on large "excess" reserves and why we don't have inflation.
This is the Monetary Base/M1 conundrum: the Fed has opened the monetary sluice gates (Monetary Base) to combat the credit crunch, yetmoney supply (M1) is declining. Why? Because there is nothing "excess" about these reserves: they are held by banks for business reasons--as a reserve against future problems. The result is that banks aren't lending and credit is not reaching the economy and money supply is declining. This is an international phenomenon.
This won't change until banks deleverage.
Deleveraging
In a recent report by McKinsey Global Insight, "Debt and Deleveraging: The global credit bubble and its economic consequences," they conclude that deleveraging will start about now in the U.S. In their study of 32 world financial crises since the Great Depression, the average period of deleveraging lasts about 6 to 7 years. The biggest GDP slowdowns are in the first two or three years of develeraging and the average hit to GDP is 25%. (See chart and more, below.)
What this means is that without deleveraging, we will catch the "Japanese Disease": economic stagnation.
Banks are now realizing that commercial real estate is not getting better. I don't believe lenders will wait too much longer in spite of the government's effort to prevent it. We need to carefully watch bank balance sheets, credit conditions, and money supply.
Commercial Real Estate and Liquidity
Commercial real estate is killing regional banks.
Unpaid loans on malls, hotels, apartments and home developments stood at a 16-year high of 3.4 percent in the third quarter and may reach 5.3 percent in two years, according to Real Estate Econometrics LLC, a property research firm in New York. That’s a bigger threat to regional banks, which are almost four times more concentrated in commercial property loans than the nation’s biggest lenders, according to data compiled by Bloomberg on bailout recipients.
“Community and regional banks basically became real estate banks in the past 25 years, and now real estate is on its back,” said Jeff Davis, an analyst at FTN Equity Capital Markets Corp. in Nashville, Tennessee. “The largest banks have other areas where they can make money, be it consumer lending, capital markets and asset management.”
A new report by Standard & Poor said:
Even though most highly exposed banks with weaker balance sheets are already rated below investment grade, more downgrades are possible; indeed, approximately 75% of the rated banks with the largest exposure to CRE carry negative outlooks ... We see no reason to believe the impact of this credit cycle in CRE will be less severe in terms of losses banks incur than that of the 1990s. ...
About 40% of rated banks' CRE loans are made for construction, acquisition, and development purposes, of which 22% (or 8% of total CRE loans) are for residential construction ... nonperforming loans in the homebuilding sector to rise to 18% as of Sept. 30, 2009. Homebuilder-related net charge-offs rose steeply to an annualized run rate of 4.8% for third-quarter 2009.
Non-residential commercial construction loans have gone sour as the fundamentals in those markets deteriorated ... office vacancies reached 17.3% as of third-quarter 2009, and C.B. Richard Ellis (CBRE) estimates they will go to 19.5% in 2010, higher than the peak of 18.9% in 1991. Likewise, retail vacancies, currently at 12.3%, are headed to 12.9% per CBRE estimates, versus 11.3% in 1991. Multifamily vacancies are at 7.4%, versus 7.0% in 1991. Nationally, rents for offices are down substantially more than in 1991--by 15.7% versus 9.4%. This time around, a particular trouble spot is the hotel sector, especially the casino hotel sector, where overbuilding has been a factor. The occupancy rate for this asset class is a low 60.9%, a level last seen after Sept. 11, 2001. Nationally, rents for offices are down substantially more than in 1991--by 15.7% versus 9.4%.
And,
A whopping $585 million of CMBS loans were liquidated in December, the largest monthly volume of liquidations ever. Special servicers, facing growing workloads, have become far more active in disposing of the loans they're handling. Meanwhile, CMBS delinquencies continued to climb, hitting a rate of 5.22 percent.
And,
The FDIC recovered $497.3 million, or [only] 29.6% of the face value of commercial real estate loans it sold during the third quarter. ... That's the lowest recovery rate the agency has had since its whole-loan sales program got into high gear late last year ... In contrast, the agency's recovery rate was 54.7% for the 2,487 loans sold in the second quarter, according to FDIC data.
I don't mean to beat this issue to death, but from a report prepared by Property and Portfolio Research (PPR):
"Due to government intervention, the concept of distressed selling and buying did not materialize anywhere in North America [in 2009]," said Mark E. Rose, chairman and CEO of Avison Young in Chicago. "The U.S. government put money into the major banks, which in turn extended every loan they could to avoid realizing losses. The Securities and Exchange Commission watched from the sidelines and allowed the impacted lenders to postpone the inevitable."
PPR predicts that by Q2 2010 lenders will more aggressively write off "distressed" CRE loans. That will attract lots of deal capital waiting on the sidelines. If so, then deleveraging will have begun.
Residential Real Estate
Residential real estate gets the award for "Most Bubbly Asset of the Great Recession!" This is where the river of Fed credit flowed, aided by loose lending standards encouraged and institutionalized by Congress, Fannie, Freddie, and the FHA. Wall Street, using faulty risk models, wrapped it up and sold it worldwide. They fooled themselves for years until they realized they couldn't spin dross into gold.
Rising prices fed the bubble, debt skyrocketed, homeowners pulled cash out and went on a spending spree. This spawned the boom in retail which spawned the boom in shopping centers. Which has collapsed. The boom was fake; hundreds of thousands of residences built were a huge malinvestment of capital. This is when the damage was done. The bust is the cure.
The residential real estate market is still deleveraging, price deflation goes on, and sales are up: "For all of 2009, there were 5.16 million home sales, up 4.9% from 4.91 million in 2008. It was the first annual sales gain since 2005." Much of that increase was due to the first-time buyers' tax credit which some say was responsible for 400,000 of sales. Starting in November, sales have tanked (down 16.7% in November for previously owned homes).
Regardless of sales, prices keep falling. People may be motivated by tax credits, but mostly I believe they are driven to the market by falling prices. Political reports say that the tax credit will not be extended. The most recent Case-Shiller 20 cities report showed prices declining 5.3%. Some areas are stabilizing (Dallas, Denver, San Diego and San Francisco) but Las Vegas was down 25% taking the average down.
I believe bargain hunting will continue to occur and sales will continue to rise. Here in California, housing supply has shrunk to a 5-year low (3.8 months). The GSE's and the FHA are providing massive amounts of credit to the mortgage market and I don't see this stopping anytime soon.
What will prevent a new bubble, and cap prices, for at least this year is the shadow inventory--potential foreclosures. About 1 in 4 homeowners are underwater:
The proportion of U.S. homeowners who owe more on their mortgages than the properties are worth has swelled to about 23%, threatening prospects for a sustained housing recover. ... Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American CoreLogic, a real-estate information company based in Santa Ana, Calif. Home prices have fallen so far that 5.3 million U.S. households are tied to mortgages that are at least 20% higher than their home's value, the First American report said.
There could be 3 million foreclosures this year, up from last year's 2.8 million.
Here are a few more points to consider:
US 2009 foreclosures shatter record despite aid
More Homeowners Struggling As Option ARMs Reset Higher
'Shot in the Arm' or Shot in the ARM?
US Prime Jumbo RMBS Delinquencies Nearly Triple to 9%; CA Drives Trend
This is threatening the financial integrity of the FHA:
In last year's third quarter, the FHA insured 25% of mortgages, according to Inside Mortgage Finance, a trade publication…. FHA-insured mortgages made in 2007 and 2008 are largely responsible for the agency's precarious position, with default rates approaching 24%. ...
The government's plans to help beleaguered homeowners is falling flat because they aren't requiring lenders to write down mortgage principal, or require a renegotiation of secondary home equity mortgages. It takes homeowners about 3 seconds to figure out that even with lower payments, there is no point paying for a home when the value is less than the amount of the loan.
If there were 5.16 million home sales in 2009, without the boost from a tax credit and with a substantial shadow market, expect prices continue to fall moderately. Sales will continue to increase as people search for bargains. The FHA and the GSE's will provide ample credit for the mortgage market. The government announced in December they were giving Fannie and Freddie unlimited guarantees for the next three years; they have thus nationalized them.
There is one more factor to consider about residential real estate: homeownership rates are declining (Megatrend No. 5). At the end of 2009 the homeownership rate fell to 67.3% from the high of 69%. "Between 2007 to 2009, nearly four million homes were lost to foreclosure. And home ownership rates are now moving closer to the level that was common in the 1990s."
A recent study from the NY Fed concluded, "This [negative equity] situation is likely to put downward pressure on future homeownership rates, and has potentially important implications for the maintenance of the housing stock, the stability of neighborhoods, and future household saving behavior.
The residential real estate market is deleveraging and the government can do nothing to prevent it.
See Part III tomorrow
»
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That's a whole pile of verbosity for what 6 billion people instinctively know is about to happen anarchy & A new American Revolution .
http://www.marketwatch.com/story/how-to-invest-for-the-debt-bomb-explosion-2010-02-09?pagenumber=1
martin armstrong
What we have now is a massive acceleration of public debt that has increased the timetable for sheer economic disaster. The year 2012 will in fact be a year that history will remember.”
In the field of economics and especially its cycle movement, we are in the Dark Ages.
watch the 10 year and 30 year.. making some good moves lately..
This is a bad article. Poor analysis.
One simple line tells it all: "credit markets have not improved."
So... you dont look at markets AT ALL, do you?
-BBH
"You don't look at markets AT ALL" ...?
You're new around here, aint'cha?
Here's a hint, noobcakes: if you want market analysis, try looking at other articles besides this one. You can even look in the archives!
Correction to my previous post:
Recall that in World War II [sic] there was a housing shortage in US from 15 years of negligible new home building.
-anonymous
Good article. Just posted to twitter. Im very passionate about eductating the average american and most of the info out there is way over the average persons head. This is very simple yet informative. Thanks. You might like my weekly videos. find me at www.thebondgurl.com or on twitter @thebondgurl
Good Article , Lots of info you won't see on TV...
Reason number >> 26 to buy more gold and silver..
Foreclosure stats are intentionally being grossly overreported.
According to RealtyTrac, there were only 1.4 million new foreclosures last year (confirmed via my long conversation with RealtyTrac's data department and review of their detailed monthly reports). The RealtyTrac statistics of "3.9 million notices sent to homeowners in default" for 2009 are routinely cited by the mainstream press and are highly misleading on the downside. They include ALL notices related to foreclosures, meaning – multiple filings on the same house for various stages of the foreclosure process. But the actual rate of new foreclosure filings, according to the same RealtyTrac is only 116,000 per month, or approximately 1,400,000 per year and the monthly filings number is down 15% in California since March. Your average reader is wondering if it isn't the CDS holders who aren't perpetuating the negativity.
This is why Moody's telling people on Bloomberg that they plan on 10 million foreclosures. Don’t ignore the reality that the same guys who created the bubble aren't benefiting dramatically by pushing asset prices down now. When the Financial Times is arguing that pensions and hedge funds will be 'securitizing branded residential rental products' and they have the infrastructure to do it, why wouldn't they? If I were a bank, I would love to have the taxpayer bail out my losses on my bad loans, retain all the trust deeds and re-rent the properties, getting FREE INCOME IN PERPETUITY. It is a banker's dream. Wall Street is planning on syndicating home mortgages in REIT's as rental properties for great profits for hedge funds to the detriment of Americans. Please read Westwood Capital's "Freedom Recovery Plan" promoting conversion of the US housing stock to rental properties at www.westwoodcapital.com as a case in point. This is an important component of the effort to crash the housing market and privatize Fannie and Freddie that needs to be explored.
Recall that in World War I there was a housing shortage in US from 15 years of negligible new home building. Most stats don't account for that, nor new household formation, nor the immigration reform bill which will certainly pass within the next 2-3 years and will increase the US population dramatically. My friends' maids are all having 5 kids before 30 because LA County pays them a good income to do so.
If we learned anything from the Crash last year, it's that the financial press usually tells you the opposite of what is really happening. American homes are now dirt cheap by international standards. Even The Economist mag reported in Jan-10 that U.S. homes are now priced at rental value.
+1
buy houses.
Must be a realtard. No way is housing "cheap". We are still way above the long term trend in valuations. It will take another 10-15% to the downside just to get back to trend which means we probably overshoot to the downside by an additional 5-10%. And how in the world is over 9 million empty housing units and climbing akin to a housing shortage? And with no jobs what makes you think people will continue to come to "the land of opportunity"? Go ahead and jump on real estate now. I'll wait for the true bottom in 2012 or 2013 and maybe later.
You can't believe anyone about foreclosures as long as the banks refuse to foreclose. The politically correct (corrupt) FASB has allowed the banks (and government) to report anything they want. The whole real estate market is one gigantic short sale.
Adding to the bank balance sheet pressure is the need to pay those pesky CA property taxes on the shadow inventory.
www.doctorhousingbubble.com
market may crash say experts: http://www.iamned.com
nice to see the 10 year and 30 year tresury yields rising lately...
Excellent article. Thanks for it.
no cycles has yet to be broken, no trend has yet to be reversed. If anything the monster is just starting to show itself beneith the surface. As long as net worth, or that ability to maintain a balance between loss and gain, continues to slide, the snowball will grow. Buying because it is 'low tide' is why so many are underwater. Make no mistake, the tide is still going out not in. It is the big picture that everybody still overlooks, and you can't see it if you concentrate on single points alone.
Debt destruction must happen....
Tax structure change must happen....
If either one does not happen....
Then real improvement will not happen....
....................
Obama says he is pro business....
Here is the list of sustainable govt. solutions to date....
a)
b)
c)
......................
of course he is pro business....
we have mandatory health insurance about to pass
Bankers are making wads of cash daily
and payrolls are the lowest in decades....
sounds like good business for me.... what would suck is if they had to PAY PEOPLE WHAT THEY ARE WORTH.
Nice to see an article that doesn't have the following words, Fiat Currency, Goldman Conspiracy, Gold. Great info. The delevering is for real... a group I work with has been buying apartment complexes (with great occupancy rates) for prices between .68 and .78 on the $$. Freddie will finance (at 70-75% LTV) but the days of 90% LTV with interest only are hopefully gone forever.
I wonder how much longer Congress will let FNM & FRE finance existing apartment assets. There is ZERO benefit to the economy from this activity. I think FNM & FRE should only finance new construction of apartments. It is not the job of the government to provide subsidized financing so that owners of existing apartments can realize capital gains (or pull out dollars on a tax-deferred basis on a refi).
Cap rates on apartments are 150 bps below other comparable commercial assets strictly due to the FNM/FRE subsidy. Time for this to end!!
I work for one the the 5 biggest apt developers in the country. And Yeah you can get em that cheap. But beware most of the ones that were developement jobs have up to 5 loans against them. Primary, second, construction, bridge, and intercompany. And we run 200 complexes with some ~80,000 units. And BTW Freddie or Fannie was the 1st and or 2nd lender! Capmark usually the 3rd. HAH!
the whole thing is about fiat currency, hence gold, at least as in "it couldn't happen with a fully gold-backed currency"
i had a guy on another forum tell me he would give me $1million FRN's if i could prove that this recession/depression was caused by fiat currency. the economic voodoo that Keynesians will go through to ignore reality is amazing.
What happens when governments steal the gold, in a gold back monetary system???? Like when FDR stole all the gold and revalued it overnight.
In theory the system is good, in practice it can be just a bad as the printing press we have today.
A small step to improvement would be to let contracts be written with a gold clause (its illegal today only fiat dollars are allowed for payments). This would allow the market to remove some of the fiat currency risk.
Why invest now in real estate?
I just put a lot of money in pretty good but cheap funds who still have a nice div. of about 15 to 20%.
I used to have 9 appartments, and I went crazy sorting all the mess out and following up on the renters. I sold it at very nice prices (21 times year revenue), and 4 months later the markets crashed :)
Sure you are and sure you did.
Where are you getting 15 to 20 percent returns???
Don't forget "false flag operation" Jesse, haha. Like El-Erian said, its structural, not cyclical, so it is going to take a long time to sort out.
The group you work with needs to get ready to get smoked in that apartment investment... looks to me like the probably overpaid by about .28 on the dollar.
I could have explained clearer, they are acquired at 68-78% of current estimated replacement cost. Getting smoked is always a risk for sure... but you don't get rich siting in your moms basement beating off and speculating on the value of assets others hold. I will immediately inform the partners that you think they overpaid. So sorry some people are out their actually stimulating the economy by investing in necessary things- Acquiring properties creates jobs for others and contract work for quite a few folks. This is private equity with operational expertise- I would agree passive real estate investing would be a bad path. They'll rent you a place if your mom can help you with the deposit.
Thank you ...good articles
maybe the worst is yet to come...
You link to a steaming pile of poo. Please leave.
DOOOOOD you clicked on it?!!? Ca'MANNNN!!!!
He linked to two girls one cup?
Worse than that, Don ... Much, much, much worse. DON'T CLICK THE LINK!
It's truly horrible and I've been tricked into clicking (thanks to constant spam by endless fake aliases that lead to redirecting URLs) more times than I care to admit.