Fed Worries About Commercial Real Estate

Ok, so maybe it's a bit too late to start worrying about the impending commercial real estate crisis, since it's already begun. But at least one of our regulators has finally woken up and smelled the rot lying on our nation's banks' balance sheets. The WSJ reports that the Federal Reserve made a presentation to banking regulators last month that claimed that banks in the US "are slow" to take losses on their commercial real-estate loans that are being battered by slumping property values and rents (please see prior two posts.) The Fed document was prepared by an Atlanta Fed real-estate expert who is part of the central bank's Rapid Response program to spread information about emerging problem areas to federal and state banking regulators. While this is hardly a rapid response to a problem that reared its ugly head over a year ago, I'll give the boys at the Atlanta Fed bonus points for being ahead of the bank regulators, who allow reckless lending at a financial institution right up until the day the FDIC locks the front doors.

Banks with heavy exposure to commercial real estate loans set aside just 38 cents in reserves for every $1 in bad loans, according to an analysis by the WSJ. This is a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007. The WSJ's analysis included more than 800 banks that reported having more than half of their loans tied up in commercial real estate. To make a precarious situation even worse, many US banks have adopted a policy of extending loans when they come due even if they wouldn't make these loans now. It beats the heck out of going through the hassle of seizing the property, attempting to dump it on a market that has little appetite for commercial real estate, and taking a loss because the value of the property is below the loan amount. Best to keep your head firmly buried in the sand, and continue rolling that loan until everything returns back to "normal circa 2007." Another really ingenious tactic used by banks is the practice of using interest reserves to mask bad construction loans. When the loans are made, banks typically calculate interest that would be paid and set that money aside, paying themselves until the loan becomes due or the property generates cash flow. What happens when the developer is stuck with a half-empty building because he couldn't sell or lease the units and he can't get another loan at the same terms? That's when the bank finally takes the hit, even though all the clues were there to begin with.

How big is this problem? $3.4 trillion dollars of commercial real estate debt is outstanding, with more than half held by banks. Obviously not all of it is going to go bad, but much of the issuance from the past five years might unless a solution is found to the refinancing problem. With commercial real estate values already down over 30% and headed for steeper losses, nearly every property financed in the past few years is under water. Most commercial real estate loans are short-term in nature and investors just assumed they could refinance when the loans came due. Are they really going to cough up extra equity to hang on to buildings that they overpaid for? Or are they just going to hand the keys to the bank? Seems like banks need to beef up their property management arms because they are going to wind up owning alot of buildings. But don't worry, the Fed's Rapid Response Team is on it.

Office Rents Decline, Vacancies Rise

On the heels of yesterday's dismal news about apartment vacancies comes today's update on office space. Nationwide, effective office rents fell 8.5% in the third quarter compared with the same period a year ago, according to Reis. Companies returned a net 19.6 million square feet of space to landlords in the third quarter, slightly more than the second quarter. The net decline in occupied space totaled a record 64.2 million square feet, the highest negative absorption recorded by Reis since 1980 (excluding the 2001 terrorist attacks.) The vacancy rate hit a five-year high of 16.5%.

Declining rents and rising vacancies are a really bad combination, unless, of course, you are looking for new digs. The biggest office rent declines over the past 12 months came from New York, the epicenter of the financial meltdown. The highest vacancy rates, however, come from areas with poor housing markets and industrial cities such as Southern California, Las Vegas, Phoenix, southwest Florida, and Detroit. Of the 79 metro areas that Reis tracks, office vacancies rose in 72 of them and effective rents declined in 68 of them. Some charts from the WSJ below:

Apartment Vacancies Grow

US apartment vacancies hit their highest point since 1986, with the vacancy rate hitting 7.8%, according to Reis Inc. The rate is expected to climb further in the fall and winter when rental demand is typically weaker. Consequently, rents are down across the board, with the biggest declines in San Jose, New York and Orange County. The slump in rent and increase in vacancies is tied to rising unemployment, particularly in the under-35 age group. Reis anticipates that the vacancy rate will peak at well above 8% in mid-2010. Some charts below from the WSJ:

FDIC's Bair Gives "Secured" a New Definition

Bloomberg has an article this morning claiming that FDIC Chairman Shela Bair believes that regulators should consider making secured creditors carry more of the cost of bank failures. "This could involve potentially limiting their claims to no more than, say, 80% of their secured credits," Ms. Bair said yesterday while giving a speech in Istanbul, where hopefully nobody was listening. "This would ensure that market participants always have some skin in the game, and it would be very strong medicine indeed." I'll say. In fact, the medicine would be so strong that it might kill a few banks along the way. The whole point of secured financing is that secured investors can rely on being first in line to collect 100 cents on the dollar before anyone else gets a penny in a bankruptcy filing. If you are no longer assured of that outcome, you are no longer a secured investor. You are now "slightly secured and charging a much higher rate" or maybe "mostly secured and asking for WAY more collateral" or possibly "just not doing secured lending anymore." So, I'm thinking that cutting off secured funding on struggling banks is not going to help those banks stay alive, which is not going to help the FDIC's insurance fund, which doesn't really help Ms. Bair do her job of paying for bank failures.

Hovnanian Plans $775 Note Sale to Pay For Tender

First, let me just commend Hovnanian for still being in business. The beleaguered home builder is number one at the top of many investors' lists in the homebuilder death pool. The problem? The company took on too much debt to go on a land-buying spree during the boom and is struggling to pay off that debt while the value of its inventory has declined along with its revenues and profits. To solve the problem, the homebuilder came up with a brilliant plan. Hovnanian will buy back its debt that is trading at a discount, allowing it to book a profit. Of course, it doesn't really have the money, which is kind of the problem to begin with. But, no worries. They'll just issue some debt. Debt investors have proven time and time again that they are total suckers, so the plan should work well. Issue debt, buyback debt, book profit, stay in business a few more years. It's called kicking the can down the road.

On Jobs and Cars

Nonfarm payrolls declined by 263,000 in September, according to the Labor Department, bringing the total jobs lost since the recession began in December 2007 to 7.6 million. The unemployment rate climbed to 9.8%. Those cheery economists, all of whom have been busy ratcheting up expectations for growth next year, were only expecting a loss of 175,000 jobs. While a job loss of 263,000 is not half bad compared to some of the horrific numbers we were seeing earlier in the year, continuing job losses of this magnitude cannot possibly support the "green shoots" crowd's hopes for a V-shaped recovery.

Car sales didn't do much to paint a rosy economic picture either. US auto sales fell 23% in September after the end of the federal government's "cash for clunkers" program. Both GM and Chrysler's sales dropped precipitously, with GM's declining by 45% and Chrysler's by 42% while Ford had a better month, with sales only declining by 5%. It's really too bad that consumers didn't feel any sense of patriotism when they were picking out their new cars. After all, the government wrote them a check. The least they could do was support their investment in GM in Chrysler by buying their cars. But it was not to be. With total car sales declining back to a 9.2 million pace, roughly in line with the numbers we were seeing before the government's program, it appears highly likely that this stimulus measure was merely a temporary blimp that did nothing to jump-start demand for the longer haul. Hard to have demand for a new car when you can't find a job.

Ken Lewis Steps Down

In what is being billed as a "completely surprising" move, Ken Lewis is stepping down as the CEO of Bank of America. What is most surprising is that he had the chance to voluntarily depart. While credited with building the behemoth into a large money-center bank, Mr. Lewis also nearly destroyed it by continuing his acquisition spree during the credit crisis. Purchasing Countrywide and Merrill Lynch may have been good "strategic" moves, but they would've been much better has he paid less for them. It is still hard for me to believe that anyone in their right mind would've offered to pay so much for Merrill Lynch when the investment bank wouldn't have lasted another week without some sort of financial intervention. Maybe he missed out on taking that negotiations class in business school?

It's unclear whether it was the investigation by the SEC, the House Committee on Oversight and Government Reform or the New York attorney-general finally got to Mr. Lewis. All we know from press accounts is that Mr. Lewis came back from an Aspen vacation with a beard and resigned to a very shocked board, who'd been sitting around doing lord knows what for the past several years. The board certainly didn't do anything to stop the ruinous acquisitions, or keep Bank of America from paying out huge bonuses to Merrill for pissing away $15 billion. Why would it have occurred to them that they might need to actually do some work, like find a new CEO? The FT speculated about a few likely successors, the most interesting of which was Bob Steele. Mr. Steele was the former Goldman Sachs executive who was recruited to save Wachovia when it was falling apart last year. He did a bang-up job of turning the firm around as it was eventually seized by the FDIC and auctioned off to Wells Fargo. But he did work at Goldman once, so he's obviously a genius and will probably get the job.