Vacation Alert

K10 is taking off with the family for a much-needed vacation. It's bound to be a fairly slow week for financial market news so I'm not packing the laptop. Having said that, if anything wild and crazy happens, I'll track down a computer somewhere and blog about it. Otherwise, I'll be back mocking the market on September 1, 2009. Hope everyone has a great week.

Prime Loan Delinquencies Mounting

According to the MBA's latest survey, 13.2% of mortgages on homes with one to four units were at least a month overdue or in the foreclosure process in the April-June period, up from 12.1% in the first quarter and 9% a year earlier. While foreclosure starts have slowed on subprime mortgages, they have picked up on prime loans. Among prime loans 9% were past due or in foreclosure at the end of June, up from 5.35% one year ago. For subprime loans, the rate was 39.5% compared with 30% last year. Prime loans, however, accounted for 58% of foreclosure starts, up from 44% last year, while subprime accounted for 33% of foreclosures down from 49%.

The spike in foreclosures that began two years ago in the subprime market was triggered by a halt in rising home prices. Once subprime borrowers couldn't use their magical equity that the bubble created out of thin air to refi into a better loan, they could no longer avoid the painful resets on their mortgage rates. So they began defaulting in droves. This led to more downward pressure on home prices as foreclosures starting hitting the market and adding to the growing supply of houses for sale. Problems in the subprime market have now spilled over into the prime market as the economy has taken a turn for the worse. Prime borrowers are defaulting now for more traditional reasons, such as the crappy economy. They can't refinance or sell their house because they are upside down on their mortgages. While subprime defaults may be peaking (although this too might be temporary due to various moratoriums), prime defaults are just beginning to pick up steam. Way more pain ahead on the housing front.

Here's the chart from the WSJ article:

Pension Plans and Private Equity

Bloomberg reports on pension plans' enormous contribution to the recent boom in private equity. Three of the biggest investors in private equity are the state pensions of California, Oregon and Washington, which shelled out $53.8 billion in the past decade to private equity funds. In return they have recouped just $22.1 billion in cash by the end of 2008. One can easily assume that they've collected nada in 2009 as private equity-backed firms have done nothing other than go bust since the start of the year. In fact, the three pension funds haven't reaped a paper gain from funds formed in the past seven years.

According to the Bloomberg article, investments made in 2006 and 2007 are currently valued at $15.8 billion on the pension funds' books as of the beginning of the year. Whether those valuations, which are theoretically marked to market due to FAS 157, will bear out is anyone's guess, but I'll go ahead and try. My sense is that the equity in private equity deals struck in 2006 and 2007 is virtually worthless. The deals were all highly leveraged and done at ridiculous prices. Maybe not all of the companies will go bankrupt, but certainly very few of them will have any equity value left for investors. This might be why college endowments such as Harvard were punting their private equity holdings at 50% of their value. It's a very easy scenario to envision these investments going straight to zero, and Harvard has bills to pay.

Now that everyone expects a large V-shaped recovery, supporters of illiquid private equity investments for pensions and endowments are coming out of the woodwork claiming that a turn-around in valuations is now beginning. An Oregon spokesman is quoted as saying "The market is in a trough. The picture would've looked different at the end of 2007." Sure, it would have. Because back in 2007 everyone was marking all of their holdings way too high based on silly expectations for growth that turned out to be dead wrong. 2007 valuations weren't real. They were a mirage. And maybe we're in a trough, but it's also highly likely that valuations will go much lower. These are illiquid, highly leveraged investments.

Instead of pulling back from private equity deals as the bubble grew, pensions actually continued to raise their allocations. The three state funds more than doubled their buyout commitments in 2005 to $8 billion from $3.1 billion. Then they committed $18.7 billion the following year. Essentially, they invested most of their allocation towards the asset class at the very peak. A foolish choice that will certainly cost their retirees greatly.

More From the Property Report

A couple more highlights from the WSJ Property Report this morning:

Calpers has given up control of its stake in a trophy office tower in Portland, Ore. The Koin Center, nicknamed the "mechanical pencil" for its signature shape, was purchased for $109 million in 2007 by a partnership that included Calpers and CommonWealth Partners, a real-estate investment company based in LA. The partnership has defaulted on the $70 million debt, and New York Life, the lender, has appointed a receiver to control and possibly sell the property. The article has a great quote from a senior vice president of corporate services for Colliers in Portland "Calpers is the gold standard, and its surprising that their backup plan is to walk away." I wonder why that is so surprising since it appears to be Calpers' least expensive option. That's sort of the whole point of an option. I might have paid $1 for the Microsoft $50 calls, but since the stock is only trading a $23, I'd be an idiot to exercise them. The building's office vacancy rate is set to rise from about 7.9% in the second quarter to the 26% range by about October. I'm sure that California retirees are cheering Calpers decision to walk away from this turkey.

Stockbridge Real Estate Funds is considering a takeover bid for the management of a $2.6 billion fund run by Deutsche Bank's real estate investment unit. Apparently, this is a rare move in the real estate world. In this instance, however, some of Stockbridge's top executives are intimately familiar with the 92 investments in the fund because they used to work there and manage the fund. The former managers of the Deutsche fund bolted in 2007 when their five-year retention pay plans ended and were hired by Stockbridge. They did such a great job managing the fund at Deutsche that the fund has warned investors that it may seek bankruptcy protection. Safe from their new perch at Stockbridge, the former managers would like to buy back the crap that they left behind at Deutsche. Isn't it fun doing this with other people's money? As long as you get a nice retention package to pay you for all your talent, who really cares about the consequences when you saddle your former investors with a bunch of really crappy real estate investments?

Meanwhile, the "Technically Speaking" section of the WSJ has a ridiculously bullish piece on REITs. It explains why REIT stocks are going to continue to rise despite the many, many problems in the commercial property market. The article gives such solid evidence as "Because the sector's heavy debt load was such a big contributor to its precipitous drop last fall, REIT stocks are expected to go nowhere but up if debt refinancings occur." Also "Given the appearance that the banking system has stabilized, that leads you to the belief that most of these REITs will be able to get their refinancing in order." And my favorite "From a technical view, REITs look set to rise as much as 35% from current levels." I don't know about you, but I'm convinced. Forget everything I said in the past two posts about commercial property values plummeting, "gold standard" investors walking away from their investments and saddling lenders with half empty buildings, defaults, declining cash flows and covenant violations. I'd better go load up on some REIT stocks!

Tishman Speyer's Commercial Real Estate Debacles

The WSJ Property Report has an interesting piece on Tishman Speyer this morning. For those who haven't heard the name, Tishman is a venerable real estate property developer that holds an approximately $35 billion portfolio of properties from all over the world. Tishman, the cream of the cream of the commercial real estate crop, finds itself in the unfortunate position of being in default on debt tied to one of the largest office portfolios in the Washington area. Back during the Great Bubble Pandemic of 2006, Tishman Speyer paid $2.8 billion for what was known as the CarrAmerica portfolio, a collection of 28 buildings leased to law firms, lobbyists and other hoity toity tenants. Naturally, Tishman borrowed from the piles of easy money lying around at the time, levered up, and paid way too much for the properties based on unrealistic cash flow assumptions. Cash flows have since declined so much that they barely cover the debt service. The company is in violation of its covenants and must find a way to refinance the debt due in 2011. By the way, who were the lenders? Lehman was involved, of course, and also happened to put equity into the deal too. Because every good investor knows that the best hedge against a debt investment is a side-by-side equity investment. The seller of the CarrAmerica portfolio to Tishman was Blackstone, who proved to be the winner in the 2006 commercial real estate hot potato tournament by flipping the portfolio for an enormous profit months after buying it.

But fear not, Tishman Speyer itself isn't threatened by the problems with the CarrAmerica portfolio, according to the WSJ. No, Tishman is probably more threatened by other bigger, dumber deals like the monster $20 billion LBO of Archstone- Smith, which closed after the credit crisis was in full swing, and the brilliant $5.4 billion acquisition of Peter Cooper Village and Stuyvesant Town that paid a fabulous 2.5% cap rate. The Archstone deal was also done with debt and equity investments from Lehman, (seriously, did that firm even have a risk management department?) which recently received bankruptcy court approval to put $230 million more into Archstone, hoping the apartments will regain their value on the other end of the recession (you can take a few minutes to laugh, I did.) Tishman pointed out that it has been very profitable over the years and it has $2 billion in liquidity for new deals. Seems like it should focus on cleaning up the old deals first before they throw any money into new deals. After all, Bear Stearns had $17 billion in cash and Lehman was most definitely NOT HAVING ANY LIQUIDITY PROBLEMS days before they went bankrupt.

Financial Headlines 8/18/2009

• Housing starts declined 1% to an annual rate of 581,000, the first drop in three months. While single family starts actually rose slightly, a 13% plunge in multifamily homes weighed on starts. Building permits also fell 1.8% in July to a 560,000 annual pace from 570,000. Hardly the upbeat economic report economists were hoping for.
• Wholesale prices in the US fell 0.9%, following the 1.8% gain in June. Excluding food and energy, core prices unexpectedly fell 0.1%. Score another point for the Deflationists out there.
• Reader's Digest filed for Chapter 11 bankruptcy protection. Another day, another bankrupt publication. What makes this one so special is that it didn't have to happen. Two years ago, the geniuses at Ripplewood Holdings, a private equity concern, thought it would be a brilliant idea to pay too much for Reader's Digest and pile a bunch of debt onto a company that had steadily declining revenues. I'm sure Ripplewood spoke proudly of all the "operational efficiencies" they would wring out of the deal, but a leveraged deal is still just a leveraged deal. When revenues fell off a cliff, the company defaulted on its debt. Ripplewood's equity stake has been wiped out and JP Morgan, the lender to the deal is the new owner. I'm happy to see that Capitalism is still alive and well in this country but wonder what on earth I'm going to read next time I'm sitting in the dentist's waiting room.
• Home Depot reported better than expected earnings of 66 cents a share, down from 71 cents a share a year ago. Revenues decreased 9.1% to $19.07 billion on a 8.5% decline in same store sales. The company reaffirmed its forecast for sales to fall 9% but raised its guidance for earnings.
• Researchers at the University of Houston's C.T. Bauer College of Business have identified at least 141 companies that appear to have awarded options to their executives at particularly advantageous prices. I smell another options backdating witch hunt in the works. As an avid options trader, I too would love to retroactively purchase call options at the absolute lowest stock price of the year. Unfortunately, my patented method of throwing darts at the dart board is not nearly as lucrative as looking at a chart one year later and picking the lows. If options backdating is indeed widespread, I expect many heads to roll as I consider this practice corporate looting.

Failed Banks Weigh on FDIC Insurance Fund

So the count of failed banking institutions hit 77 on Friday, with the FDIC seizing its biggest fish to date: Colonial. Fortunately, the FDIC found a buyer for the bank with $22 billion in assets, but not without providing the purchaser, BB&T, with one of its famed loss-sharing agreements. You know, the kind of deal you'd like to get on your trading account? I'll take 100% of the upside, and let the government eat the losses on my crappier trades. The loss-sharing agreements with the FDIC lessen the ultimate cost to the insurance fund, which is rapidly shriveling, and probably shivers with fright every Friday afternoon awaiting the news of the latest subtraction from what remains of its meager pool.

As I've noted several times before in my posts about bank failures, it is surprising how costly the recent bank failures have been as a percentage of assets. Lo and behold, the WSJ reports today that the recent period of bank failures are even more costly when measured as a percentage of assets than those during the S & L Crisis. The largest hit so far is coming from Community Bank of Nevada where the cost to the FDIC's insurance fund is estimated to be roughly 51.4% of the bank's $1.52 billion in assets. For the 102 banks that have collapsed in the past two years, the FDIC's estimated cost averaged 25% of assets. This is up from the 19% rate between 1989 and 1995 when 747 financial institutions were closed by regulators. What accounts for the increase in cost? First of all, many regional banks that were shut out of the mortgage boom chose to delve into risky construction lending that is now coming back to bite them. Is it any wonder that the most expensive bank failure to date as a percentage of assets is based in Nevada where the construction boom was particularly pronounced? Also, clearly regulators did a horrible job of supervising these banks, allowing them to grow at unsustainable rates through high-risk lending. For example, Integrity Bank of Alpharetta, Ga was permitted to continue accepting deposits while promising unusually high interest rates for more than two years after examiners noted deficiencies in its loan underwriting. The funny thing about lax regulatory supervision is that we wind up paying for it twice. First we pay the salaries for a bunch of bank examiners to sit around and do nothing while the largest real estate bubble we've ever witnessed percolates around them. Then we pay to clean up the mess when all of the institutions fail. Sure the FDIC's deposit fund is financed by premiums collected from banks. But the fund is down to $13 billion and there are 300 banks on the problem bank list. Does anyone really think the FDIC isn't going to have to draw down on that $100 billion line of credit with the Treasury?