Construction Loans At Small Banks Concern Regulators

According to the Wall Street Journal Property Report, regulators have grown concerned over the $280 billion in outstanding construction loans to condo developers and home builders sitting on small banks' balance sheets.  Of particular concern is the practice of putting interest that will be paid into an "interest reserve" and then paying themselves out of the reserve until the loan becomes due or the property generates cash flow, thus masking potential problems with the loans until they blow up.  The FDIC is on alert for banks that are not coming clean about problem loans.  A potential hint that a bank has been using interest reserves to hide delinquencies is a large jump in the percent of nonaccruing loans from one quarter to the next without any prior buildup in the percent of delinquent loans.  The banks draw from the interest reserve until the reserve runs out and then they must reclassify the loan as nonacrruing, without ever noting that it was delinquent.  For example, ANB Financial, the failed Bentonville, Ark bank had 2.8% of loans delinquent in the fourth quarter of 2007 followed by 39.6% of nonaccruing loans in the first quarter of 2008.  The ironically titled Integrity Bank had 13.5% delinquent loans in the fourth quarter of 2007 followed by 35.1% nonaccruing loans in the first quarter of 2008.  Integrity Bank has stopped using interest reserves on loans used only for purchasing land without immediate plans for construction and loans on projects that have been delayed or abandoned.  Well, that's a relief.

It is very interesting that banking practices that have more than likely been business as usual for years can be used to mask potential problems during a major downturn.  I'm certainly not a bank accounting expert but I can see how using interest reserves was viewed as a perfectly reasonable practice when delinquency rates and default rates were low.  Unfortunately, when lax lending standards finally caught up with the industry, it became yet another loophole that banks could utilize to delay reporting the inevitable.  It is practices like these that have investors terrified and lead to suspicion about what other surprises are lurking on bank balance sheets. 

First Quarter Commercial Real Estate Sales Statistics

Perhaps the commercial real estate market is releasing a collective sigh of relief over the successful sale of the GM building by the struggling Macklowes to an investor consortium led by Mortimer Zuckerman over Memorial Day weekend. However, a few enlightening statistics representing the true state of the commercial real estate market were presented in the Wall Street Journal's Property Report this morning. First quarter sales of apartment buildings have declined over 40% from the first quarter of 2007. Office and retail building sales have dropped by 80% and 70% respectively. Meanwhile, capitalization rates (rental income in the first year of ownership divided by the purchase price) have increased for most commercial real estate sectors. In April, the average cap rate for apartment buildings rose to 6.19% from a revised 6.15% the previous month. The average cap rate for office properties in central-business districts rose to 6.25% from a revised 6.0% in March. Although an increase in cap rates is a sign that property values are finally beginning to reflect current market conditions, the average cap rate is still very low compared to historical levels. At the beginning of 2002, cap rates were over 9% and have steadily declined, hitting lows of around 5.75% in the first quarter of 2008 before ascending again. It seems inevitable that cap rates will continue to march higher. Although easy monetary policy has nearly always caused cap rates to decline in the past, it seems unlikely to happen this time around. Sales activity in the commercial property market has declined so significantly that it may take several quarters for a true clearing price on property values to emerge. Exacerbating the problem is a dramatic increase in properties offered for sale in addition to significantly tighter lending standards from banks that are unlikely to offer any new financing until they can successfully clear their books of all crap they currently own at inflated prices. The only thing the commercial real estate market can hope for is a return to spiraling inflation, which always increases the value of hard assets. Investors under that scenario, however, would be looking at financing rates of 20% and grinning with joy. Given the Fed's genuine attempts to bring back 1970's style inflation, that situation may not seem so far-fetched.

Fiscal Stimulus Package Fails to Stem Rising Foreclosure Filings

According to RealtyTrac, 243,353 foreclosure filings were recorded for the month of April. This was a 65% increase year-over-year and a 4% rise from March. The areas with the highest number of foreclosure filings continue to be the usual suspects. California recorded 64,683, the highest among all the states with Florida, Ohio, Arizona and Texas following behind. Nevada still had the highest rate of foreclosures with one in every 146 households receiving a filing.
Our clever Government officials, despite their attempts to boost the economy by sending everyone a check for $600, have yet again failed to address the real problem in this country. As long as foreclosures are rising, borrowers are defaulting, and homeowners face declining equity, the glut of housing inventories can only rise. A one-time check of $600 does nothing to reverse this situation. What the government should have done was send everyone in America a foreclosed property. All of that "pride of ownership" that was trumpeted by the administration for so many years can now become a reality for every household. I, for one, wouldn't even mind if my free foreclosed property was a condo in Ft. Lauderdale. I would certainly stimulate the economy by flying across the country to see my new digs. As long as the HOA dues weren't too high. And it was on the beach.

Median Home Prices Continue to Decline, Taking Homeowner Equity With Them

The median price for a single-family home in the US dropped 7.7% in the first quarter to $196,300. The median price for a single-family home fell in 100 of 149 metropolitan areas, with Sacramento posting the largest decline of 29%. The metropolitan area around Riverside and San Bernardino was next with a 28% decline, followed by Lansing, Michigan with a 27% decline. Little surprise then that Bank of America increased its loss estimates on its home-equity loans to 2.5%, up from the 2% it projected just last month. Liam McGee, president of the consumer and small business division said at an investors conference today that Bank of America expects the economy to shrink in the second quarter.
Possibly causing some consternation at the investor conference was MeGee's statement about mistakes made during the housing boom. "We made some mistakes in 2005 and 2006 in how we grew this portfolio." He claimed that the bank has tightened lending standards since then. Although I personally did not have the opportunity to attend the conference, I can only imagine the furious rustling among analysts who jumped at the chance to pepper the banker with the questions:

Analyst I : Mr McGee, are you trying to tell us that the problems in your loan portfolio are the result of actual mistakes your bank made? Are you sure it wasn't linked to the credit crunch?

McGee: Yes, I'm certain we made some mistakes.

Analyst II: But that just doesn't make any sense. The losses in your portfolio had to have been caused by outside market forces that you had no control over.

McGee: No. I'm pretty sure, we lowered our underwriting standards to keep up our market share numbers and now we have to take some losses.

Analyst III: But would you say the worst is over?

McGee: No. As I said before, we just raised our estimates for loan losses just from the prior month based on new data. We'll probably need to raise them again.

Analyst IV: How do you expect us to buy your stock if you don't tell us that the worst is over?

McGee: I'm sorry. Was that a question?

Analyst V: What you are saying then is that you are the only bank that made mistakes, so it must be a terrible investment to buy your stock.

McGee: No, other banks made mistakes too. Possibly even bigger ones than we made

Analyst VI: Who made bigger mistakes than Bank of America?

McGee: Countrywide.

Toll Brothers CEO Urges Buyers to Come Out of Woodwork

Toll Brothers anticipated revenue declines of 30% for the quarter ended April 30th. Robert Toll, the luxury home builder's CEO stated that "The just-completed spring selling season was quite weak in most markets as buyers remain on the sidelines." He further asserted "We believe there is significant pent-up demand which is growing." He characterized the current market as a "buyer's market, but buyers can only take advantage of it if they buy; sooner or later they will, but unfortunately we can't predict when." Mr. Toll then took out his trusty pent-up-demand-o-meter that he carries with him to open houses to show how he measured all of that "growing pent-up demand." But his COO hissed "Put that thing away! We don't want the competition to see that!"
Mr. Toll went on to give some dismal stats on the company's current and future money-making prospects. The number of signed contracts fell by 44% from a year earlier, leading to a 58% decline in terms of dollars. The math on that works out nicely because the average price per unit on contracts signed was $590,000, down from $711,000 a year earlier. These numbers strike me as particularly interesting because I had the pleasure of listening in on Toll's earnings conference call earlier in the year. At the time, Mr. Toll was adamant about the company not needing to cut its prices because it was a luxury home builder that operated in a different segment than the other home building clowns. Mr. Toll claimed that the company did less speculative building and would just wait for the market to turn around so margins shouldn't decline. Essentially he was saying that his company really sells houses on the Moon, where the laws of physics and hopefully economics do not apply. It's an entirely different competitive landscape. You see? There's practically no gravity on the Moon, so prices can't go down. People will continue to pay top dollar for our great houses even though every other new house on Earth is being discounted by at least 30%. Then he turned to his COO and whispered "When is that stupid Moon initiative getting off the ground so I can officially announce it, instead of beating around the bush?"