Housing Doom

A recent court ruling forcing Citibank to continue funding a New York development might be a case where developers win a battle, but loose the war:

A ruling that Citigroup Inc. must resume lending to a stalled Syracuse, N.Y., mall project could push banks to revisit how they draft construction-loan agreements.

The New York State Supreme Court Appellate Division, in a split decision, upheld an lower court’s injunction requiring Citigroup to continue funding a $155 million construction loan on the Destiny USA Holdings project, even though the bank believes the project is a failure. Citi says the ruling is unprecedented in the state’s history. Now, New York lawyers are pondering how to write construction loans that would allow banks to stop funding what they believe are failing projects.

The ruling isn’t a total victory for Robert Congel, the developer behind Destiny. The court required the company to post a $15 million bond before Citi has to fund the rest of the money, roughly $29 million.
 

Why is this so significant?

This ruling definitely puts further strain on the market for construction financing.  Lenders are willing to take a bit of risk if the yield is right and it is clear that they have the option to back out of their commitment if the developer does not live up to his end of the deal.  But I can’t think of a single lender who would walk into a risky financing—no matter how high the yield is—if they cannot be certain on whether or not they have the right to back out when the developer fails to perform.  NY State Supreme Court’s decision in this case does nothing to provide that certainty.  Until lenders and their counsel can figure out a way to build that certainty back into their lending agreements, we can say goodbye to ground-up construction financing.

Commercial real estate lending might not be the only casualty of court rulings:

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1:36:34 … This crisis was caused by massive government subsidies to purchase homes by people who couldn’t really afford them. So what does Congress do? They pass an $8,000 tax credit for people who can’t really afford to buy a home to buy one. I mean, how stupid can you get? - John Makin

Doom Transcripts: Index & Guide

Housing Doom is pleased to present a complete unauthorized annotated transcript for the American Enterprise Institute’s October 22, 2009 event "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis".¹ The event site has a variety of resources including both an audio and a video of the proceedings. There is as yet no official transcript.

Table of Contents

[link navigation works best when full article displayed]

1. 0:00:00 - Alex Pollock intro (preview post)
2. 0:11:43 - Tom Zimmerman presentation (preview post)
3. 0:26:50 - Chris Whalen presentation (preview post)
4. 0:37:03 - Nouriel Roubini presentation (preview post)
5. 0:54:19 - John Makin presentation (preview post)
6. 1:08:20 - Desmond Lachman presentation (preview post)
7. 1:21:56 - Panel discussion (preview post)
   1. 1:22:08 - Roubini discussion
   2. 1:22:59 - Whalen discussion
   3. 1:23:57 - Lachman discussion
   4. 1:25:24 - Makin discussion
   5. 1:28:01 - Whalen question
      1. 1:28:18 - Makin response
      2. 1:29:19 - Pollock response
   6. 1:29:51 - Pollock (with Roubini) aside on Canada
8. 1:31:26 - Q&A (preview post)
   1. 1:32:00 - Bert Ely question
      1. 1:33:04 - Zimmerman (with Roubini) response
      2. 1:34:29 - Whalen response
   2. 1:34:58 - Brian Gardner question
      1. 1:35:43 - Makin response
      2. 1:36:59 - Whalen response
   3. 1:38:18 - Steve Votaw question
      1. 1:38:59 - Lachman response
      2. 1:40:38 - Roubini response
      3. 1:41:22 - Zimmerman response
      4. 1:41:49 - Pollock response
   4. 1:42:11 - Jack Phelps[ph] question
      1. 1:42:54 - Makin response
      2. 1:43:24 - Whalen response
   5. 1:44:40 - John Serrapere question
      1. 1:46:02 - Roubini response
   6. 1:46:27 - anonymous question
      1. 1:47:44 - Whalen (with Pollock) response
      2. 1:48:44 - Roubini response
      3. 1:49:52 - Makin response
   7. 1:50:42 - Barry Wood question
      1. 1:51:12 - Roubini response
      2. 1:54:36 - Whalen response
   8. 1:55:02 - Christine Eisner[ph] question
      1. 1:55:24 - Zimmerman response
   9. 1:57:22 - Dale Kinsella[ph] question
      1. 1:57:55 - Makin response
   10. 1:58:44 - Pollock brief wrap-up
9. 1:59:06 (end)
   • Notes and References

Alex Pollock: [0:00:00] Good afternoon ladies and gentlemen. [slide² 1]

When in the course of financial events we have a huge bubble and the inevitable succeeding huge bust, a decent respect for the the opinions of mankind requires that we try to learn something useful from the painful experience. That’s the point of these deflating bubble series of AEI conferences, which you all have so kindly supported with your participation. So welcome to Deflating Bubble Roman numeral VI, "The Lessons of the Bubble and Crisis."

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Unrealistic assumptions, multiple layers of investors, and stratospheric prices, helps illustrate why this downturn is more complicated than previous ones…

I don’t  know about you, but I’m so tired of hearing about supposed "green shoots" that I’m ready to forgo the salad bar any more.  When you dig behind the green stuff though, you start reading things like the above quote from Michael Panzer’s A Tsunami Of Red Ink.  This tsunami is in commercial real estate:

Already, prices have plunged 41% from the peak in 2007, according to Moody’s/REAL Commercial Property Price Index—worse than the 30.5% fall in the housing market from its 2006 apex. "We’ve never seen this extreme a correction as far back as the data go, which is the late 1960s," says Neal Elkin, president of Real Estate Analytics, the research firm that created the index. Adds billionaire investor Wilbur Ross: "Commercial real estate has gone from being highly liquid at sky-high prices to being extremely illiquid at distressed prices."

To appreciate why this bust is like no other, first consider the typical commercial real estate downturns that used to crop up every 5 or 10 years. The pattern was predictable: When prices for apartment complexes, office buildings, shopping malls, and other properties began to rise, developers sped up their projects to cash in on the bull market. Eventually, some of those developers, unable to fill all the new space, began to default on their loans, and lenders were stuck with the buildings they’d financed. The slump lasted no longer than the time it took for the property glut to be worked down.

But overbuilding isn’t the culprit in this bust. An oversupply of money is what pushed commercial real estate over the edge.

It turns out the same excesses that drove the housing market’s crazy rise and fall were present in commercial real estate, too—but they have largely gone unnoticed until now. Bankers, in their haste to make more and bigger loans, blindly accepted borrowers’ wildest growth assumptions and readily overlooked other shortcomings on loan applications. They did so in part because they could easily sell their dubious loans to investors in the form of commercial mortgage-backed securities. As the market overheated, it became a breeding ground for fraud: A flurry of new court cases reveals the disturbing extent to which commercial mortgage borrowers may have doctored loan documents.

So how bad can this wave get?

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Doom Transcripts: Index & Guide

Housing Doom is pleased to present a sixth selection from our under-construction transcript of the American Enterprise Institute’s October 22, 2009 event "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis".¹

The event site has a number of resources, including an audio and video of the proceedings. There is as yet no official transcript.

This is the presentation by AEI’s Desmond Lachman.

Desmond Lachman: [1:08:20] Alex, thank-you very much again for organizing this conference at a 6-monthly interval.

I think one’s got to go through life counting one’s blessings, and one of the blessings that I’ve realized that I’ve got to count on now is that my name isn’t Tom Zimmerman, and that I come at the end of the presentation.

Because much of what is said, I really agree with. So I can walk through a presentation. I’ve entitled it "A False Dawn for the Housing Market?" [slide 1²]

In the interests of being optimistic I’ve put a question mark whereas I really meant putting an exclamation mark. [laughter]

Let me start just with the lessons that one can draw from this crisis, and I think that there are a whole bunch of lessons. We’re going to be writing books about this for many years to come, much like The Great Depression we’ll be looking through this crisis. And I very much agree with what both Nouriel and John have said, that one really needs to be paying attention to bubbles, that we’re just creating another bubble that is going to be bursting. But I think that there are just a whole bunch of other lessons to be learned.

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With the notable exception of Lehman Brothers, it has seemed that there wasn’t much that the Fed wasn’t willing to bailout, backstop or guarantee.  Friday however, the Federal Reserve released a Policy Statement On Prudent Commercial Real Estate Loan Workouts.  Tyler Derden of Zero Hedge had an interesting read of this statement.  He said of one section:

[This] seems to imply that the Fed is now encouraging active loan workouts as a matter of policy. The other implication is that firms with CRE exposure can no longer rely on the Fed as a perpetual guarantor of risky exposure. Not only that, but in adopting a new policy strategy, the Fed is acknowledging the major problem that CRE writedowns will represent for banks, yet is telling banks to resolve problems on their own, while subsequently they will "not be subject to criticism for engaging in these efforts."

The implications of this Fed action for the economy could be staggering as the $3.5 b,quadr,trillion CRE market will likely not receive the same largesse that residential real estate has been the recipient of ever since the conservatorship of the GSEs. And the biggest loser in all of this will be banks that still have not used the massive risk rally to offload whole loan and CMBS CRE holdings, and moreover, still have these marked at par or close thereby.

Treasury Secretary Timothy Geithner discounted the potential problems in CRE:

U.S. Treasury Secretary Timothy Geithner expressed confidence Thursday that the woes of the commercial real-estate sector would not drag the economy back down.

Geithner acknowledged that it was difficult for policymakers to tackle the problem of sliding asset values and write-downs.

However, he said, "I think the economy can handle it" when asked if commercial property could reverse a domestic recovery.

"I think you can say with confidence that the financial system is stable [and that] the economy has stabilized," he told an audience of the Economic Club of Chicago.

Not everyone share’s his confidence however:

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Harold Brubaker of the Philadelphia Inquirer wrote this morning about the bankruptcy of Capmark Financial Group and how it tells us a lot about the future of commercial real estate:

Capmark Financial Group Inc.’s weekend bankruptcy filing surprised no one, but it was still a harsh reminder of the hard times ahead in the commercial real estate industry.

"It’s not a turning point. The problems are only starting," Dennis Yeskey, a senior adviser at AlixPartners L.L.P., a business-advisory firm in New York, said yesterday.

Yeskey and other experts warned that as long as the economy keeps shedding jobs, the commercial real estate market will be plagued by declining demand and falling property prices.

In its Chapter 11 bankruptcy filing Sunday, the commercial-property lender listed assets of $20.1 billion and debts of $21 billion.

What happened to Capmark?

[It] relied heavily on selling loans it had made into the secondary market. When that froze and property values fell, the company got stuck owing more to its own lenders than its loans were worth.

"It’s a template that you will see multiply itself many times over over the next three years," said Matthew McManus, chairman of NAI BlueStone Real Estate Capital, a real estate investment bank in Philadelphia.

Why will we be seeing more problems?

The problem for the industry is that between now and 2013, more than $2 trillion in commercial mortgages, which typically have a five- to 10-year term, will need to be refinanced, according to a July report by Richard Parkus, head of commercial mortgage-backed securities at Deutsche Bank AG. It is not turmoil in the capital markets that is causing the bottleneck, but rather the fact that properties are not worth enough to retire the old debt in a refinancing, Parkus said.

The value of commercial properties has fallen 40 percent from their peak in October 2007 through August, according the Moodys/REAL Commercial Property Price Index.

But we’ve been told that the smaller banks that did the commercial loans were in better shape than the big guys, right?

Regulators expect closures to ripple through hundreds of small banks over the next couple of years, especially in the Midwest and Southeast, where lenders have been hard hit by the recession.

These banks loaded their balance sheets with loans to home builders and other property developers to make up for lost business in credit card and mortgage lending that bigger competitors wrested away. They eased their lending standards during the boom years and made big bets on new housing developments, strip malls and office projects. Now, many of those deals are falling apart, and the lenders are scrambling to raise capital to cushion the losses.

“These banks were big enough that they could do loans that were fairly sizable,” said John R. Chrin, a former investment banker who is now an executive in residence at Lehigh University. “If they go bad, they are toast.”

Burned toast.

Doom Transcripts: Index & Guide

… It’s now [down] 40 percent as of the reports of the Moody’s index today. A peak to so-far for commercial property. And National Mortgage News had a nice article on this which they said this induces a strategy which might be described, they said, as "extend and pretend," but can also be described as "delay and pray." [no laughter]

Have a look at this preview of Alex’s slide #3 and you’ll see why Lingling at the WSJ has been spending so much time on CMBS stories lately.

Housing Doom is pleased to present a first selection from our under-construction transcript of the American Enterprise Institute’s October 22, 2009 event "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis".¹ The event site has a number of resources, including an audio and video of the proceedings. There is as yet no official transcript.

This is the brief introductory presentation by moderator Alex Pollock.

Alex Pollock: [0:00:00] Good afternoon ladies and gentlemen. [slide 1²]

When in the course of financial events we have a huge bubble and the inevitable succeeding huge bust, a decent respect for the the opinions of mankind requires that we try to learn something useful from the painful experience. That’s the point of these deflating bubble series of AEI conferences, which you all have so kindly supported with your participation. So welcome to Deflating Bubble Roman numeral VI, "The Lessons of the Bubble and Crisis."

This conference, like its predecessors, is co-sponsored by AEI and by the Professional Risk Managers International Association, represented by Chris Whalen, who is here on the panel with us; and Chris, thank-you for your great partnership.

We have for you today our usual excellent and insightful panel, whom I will introduce in just a moment. But first, I’d like to try a brief setting of the stage for the current act of the intense financial drama which the bubble created.

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It was tough enough to sell condos in Phoenix in this market.  Now it just got darn near impossible:  [Thanks L!]

New federal loan-guarantee rules imposed to fend off future government losses from plummeting condominium prices have rendered condos utterly worthless, Valley real-estate experts said.

The Federal Housing Administration rules, which took effect Oct. 1, prohibit any new FHA-backed loans on condo units in projects that include more than 25 percent commercial space.

In addition, no single investor - including the developer - may own more than 10 percent of the units in a particular project. That particular restriction alone creates a catch-22 from which condo builders most likely cannot escape, said mortgage originator Jill Hoogendyk of Wallick & Volk in Glendale.

Another rule that has sellers and brokers scratching their heads prohibits FHA loans in condo developments that aren’t "primarily residential," which could be taken to mean the FHA won’t guarantee loans in future mixed-use projects.

"I’m predicting that what we’ll see is whole condominium complexes sitting empty," Hoogendyk said.
 

So why is FHA willing to throw condos under the bus now?  Because, after nearly single handedly financing the recent "recovery" in the housing market, they’ve got problems of their own:

[W]e now are beginning to discover that the boomlet at the bottom of the housing market has been driven not just by the tax credit but by the government’s subprime lending program — FHA. The bailout is coming for that one and it’s not going to be small. In effect, the Congress and Obama administration [As well as the Bush administration before it.] have engineered their own little bubble in an attempt to buy political time and the bill is coming due quicker than they might have imagined. In many respects all they have truly accomplished is to ensure a steady supply of fresh foreclosures which will keep the market in a state of flux for much longer than it might have taken had it been left to its own devices.

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Maybe the whole state of California isn’t going into default, but it’s starting to feel like it: [Thanks L!]

About 1 in 10 Californians with a home loan is now in default, and there’s growing evidence that the mortgage meltdown is spreading to commercial real estate.

The home mortgage delinquency rate — the percentage of borrowers who have missed several payments and are in the first stage of foreclosure — climbed in June to 9.5% in California and 9.9% in Los Angeles County, according to First American CoreLogic.

The staggering number of home mortgage defaults probably will lead to large numbers of foreclosures through at least this year, housing experts say.

"It’s probably a given we’ll see a high number of foreclosures in the next couple of quarters due to the level of defaults plus the recession and jobs lost. There’s plenty more pain to come," said Andrew LePage, an analyst for real estate research firm MDA DataQuick of San Diego.

The rumblings continue in commercial real estate:

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While the MSM is for the most part pretending that the crisis in real estate is over, we are really only starting to see the bigger problems in commercial real estate- and it sounds like the government is worried:  [Hat tip Freedom's Phoenix]

Last week a story which gained very little traction hit the financial newswires.  The U.S. Treasury is working on an internal project informally called “Plan C” which seeks to deal with further problems in the economy before they occur.  The anonymous report came out stating the administration is reluctant to commit any additional money especially to the level mentioned in the report.  However this is a disturbing new development in our bailout nation since this is one of the first times that the U.S. Treasury will try to preemptively deal with a financial problem.

The issues with this Plan C is that it is setup to be a buffer on further deterioration in various loan categories but the big one is commercial real estate.  The commercial real estate market is gigantic and many of those loans are still active:

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