Hat tip Barry Ritholtz

Related posts:

• Hugh Hendry: China – The Emperor has no clothes
• Jon Stewart’s indictment of CNBC
• Which homebuilder will go bankrupt next?
• National City is on probation
• Circuit City as canary in the coalmine for commercial real estate

The long-coming commercial real estate bust has arrived in the U.S. and elsewhere, a result of sky-high prices met by a severe downturn.  Prices could only work in a best-case economic scenario and large busts are now coming (see my posts on Stuyvesant Town and Capmark Financial).

This bust is certainly another major impediment to a sustained recovery – along with a host of other wild cards like unemployment, trade conflict, and oil prices. But, the most worrying aspect about the CRE market is the marks on the balance sheets of our capital-constrained banks, which do not reflect the level of distress evident in the marketplace. And since securitization plagues the CRE market, some analysts expect bankruptcy to be the only workout option for many troubled deals. You will recall, this problem with securitized assets is a dynamic which has also plagued residential real estate (see posts here and here).

The video below explains how this real estate bust is different and what it will mean for the U.S. economy and likely bank failures. (Sorry that it starts automatically. If the wrong video pops up, see the link below).

Related posts:

• Circuit City as canary in the coalmine for commercial real estate
• Commercial Real Estate bust
• Commercial real estate is next
• Commercial poperty ‘im Visier’
• Commercial real estate: down even more than residential

Three years ago, MetLife agreed to sell the community of Stuyvesant Town (Peter Cooper Village) to Tishman Speyer and BlackRock for the exorbitant sum of $5.4 billion at the top the market. That deal has now gone completely pear-shaped and bankruptcy is expected soon in another bizarre chapter in the history of one of the most iconic 20th century planned communities in America.

Brief History of Stuyvesant Town

Stuyvesant Town was born in controversy. The Stuyvesant Town Wikipedia entry gives a fairly even-handed description of the events surrounding its development (more history found in the NYTimes article from 2006 second in the links at the bottom).

Due to a housing crisis building since the Depression, Stuyvesant Town was already being planned as a post-war housing project in 1942-43, some years before the war’s end. Provision was made that the rental applications of veterans would have selection priority.

Stuyvesant Town was controversial from the beginning. It was championed by Parks Commissioner Robert Moses, who, at the behest of Mayor La Guardia, sought "to induce insurance companies and savings banks to enter the field of large-scale slum clearance" (Moses, Letter to The New York Times, June 3, 1943). It was enabled by various state laws and amendments which permitted private companies to enter what was previously a public field of action. The new public-private partnership, and the contract entered between the city and the developer, the Metropolitan Life Insurance Company, were the source of much debate.

Among the issues at stake were use of the power of eminent domain for private purposes; the reversion of public streets and land, such as public school property, to private ownership; the 25-year tax exemption granted by the contract; and the rights of the company to discriminate in selecting tenants.

When the $50 million Stuyvesant Town plan was approved by the City Planning Commission on May 20, 1943 by a five to one vote, discrimination against African Americans was already a significant topic of debate.

Let’s call this redlining. Just as an addendum to this factoid on the ignoble beginnings, I should also add that Robert Moses  used his coercive power as Triborough head on slum clearances throughout New York City to make way for progress in the form of roads, bridges, and development (see the eponymous mid-70s book, “The Power Broker” for more – a true testament to coercive power in an advanced democracy). Another notable slum clearance of a similar nature was the Park West Village which went up in the Bloomingdale District of Manhattan just west of Central Park. Thousands were displaced in these actions and while Stuyvesant Town is a notable architectural achievement, Park West Village is not a wonder of post-War architectural design.

The bubble and the end of rent control

But Stuyvesant Town eventually thrived and developed a vibrant community of renters. When Tishman Speyer and BlackRock took over the days of below-market rents were over as the companies needed to get market prices to finance the enormous debt used to purchase Peter Cooper Village. See last year’s NYTimes article “Renters Forced Out of Stuyvesant Town” for more. However, this move was blocked on Thursday in court and now the New York Times is reporting that Stuyvesant Town is about to go bust.

Despite all the wailing and celebrating by opposing parties, it may be years before landlords and tenants in New York City know the full impact of a decision by the state’s highest court on Thursday that the owners of two major residential complexes improperly charged market-rate rents for thousands of apartments.

The New York Court of Appeals ruled that the owners of Stuyvesant Town and Peter Cooper Village, adjoining complexes in Manhattan with 11,227 apartments, improperly raised rents and deregulated 4,400 apartments while receiving special tax breaks from the city.

Landlords immediately criticized the decision, saying its impact would throw thousands of building owners who did the same thing into financial distress. At the same time, tenants looked forward to rent rebates going back years and damages worth tens of thousands of dollars.

But lawyers on both sides of the issue said on Friday that it could take years of litigation to determine if the owners of Stuyvesant Town and other landlords must repay tenants for years of rent overcharges, or simply adhere to the court’s decision from now on.

By that time, this property will be bust because there is no way this top of the market purchase is affordable with rent control and under anything but the the best of economic circumstances. All of the top of the market mistakes are eventually going to come a cropper. Consider this in that vein.

Other Sources

The Upscaling of Stuyvesant Town – NYTimes, 28 Jan 2001

Megadeal: Inside a New York Real Estate Coup – NYTimes, 31 Dec 2006

Big Landlord Found to Have Wrongly Raised Rents – NYTimes, 6 Mar 2009

Related posts:

• Circuit City as canary in the coalmine for commercial real estate
• Manhattan real estate now getting decimated
• Banks can do ‘You Walk Away’ too
• Looking for a bottom in Manhattan real estate
• Muncipalities can tear up contracts

A sign that the commercial real estate (CRE) market continues to cause headaches comes this weekend in the form of news of Capmark Financial’s imminent demise. Capmark is one of America’s largest commercial property lenders with about $10 billion in assets.

The New York Times’ Dealbook reports:

The Capmark Financial Group, the big commercial real estate finance company cobbled together from pieces of GMAC, may file for bankruptcy as soon as this weekend, a person briefed on the matter told DealBook on Saturday.

If that happens, the move would be unsurprising: Capmark warned last month that it might seek Chapter 11 protection after it reported a $1.62 billion quarterly loss.

Last month, the company agreed to sell its mortgage loan and servicing business to Warren E. Buffett’s Berkshire Hathaway and Leucadia National for as much as $490 million. That agreement carried a 60-day expiration date, or around Nov. 2 — unless Capmark filed for bankruptcy, which would give it another 60 days to complete the sale.

The company is only the latest to fall victim to continued trouble in the commercial real estate market, which many analysts have said will continue to deteriorate. Many small banks have collapsed this year under the weight of commercial loans.

Kohlberg Kravis Roberts, Goldman Sachs Capital Partners, Five Mile Capital and Dune Capital bought GMAC’s commercial real estate businesses in 2006 for about $1.5 billion, with GMAC retaining a 25 percent stake in the operation. K.K.R. has already written down the value of its Capmark investment to zero.

With the closure of seven small banks that brought the total this year to 106, this weekend shows a financial industry still under enormous strain. Commercial property, where Capmark was busy, is the area of greatest concern.  This is one reason the Federal Reserve Bank of New York has received $2.12 billion in requests for government loans in October to purchase legacy commercial mortgage-backed securities (CMBS) under the TALF program.

Related posts:

• Commercial property hits the front page
• Commercial Real Estate bust
• Frankfurt property market in freefall
• GMAC has been nationalized
• Six Flags: setting the record straight on bankruptcy

The following post is from Stratfor via John Mauldin, who is a Best-Selling author and recognized financial expert. He is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore.

I think you will find this post reminiscent of Hugh Hendry’s YouTube video which I highlighted in July.

Today I offer you an insightful look at China’s real estate market – a "burgeoning bubble" that deserves a close eye as the possibility for breaking increases. Remember the chaos in Japan after their own housing dreamscape got violently yanked back to earth? As investors, we have to recognize opportunities – and know what to avoid. With a global economic crisis – and now surging housing prices in China – investors in any global market need to keep watch on political and economic developments around the world.

Today’s analysis comes courtesy my friends at STRATFOR, a global intelligence company. They provide unique and on-the-money analysis and forecasts on all things global, essential for any alternative investment strategy. They’ve got a free newsletter as well, for which I encourage you to sign up by clicking here – so you’re not limited to my caprice.

John Mauldin
Editor, Outside the Box

The China Files (Special Project): Real Estate

October 13, 2009 | 1149 GMT

Summary

The real estate market in China, particularly the residential side, is a burgeoning bubble that is growing bigger and more breakable by the day. Land and housing prices were already rising steadily when Beijing’s stimulus package hit the sector in early 2009. Now prices are surging, with developers, bureaucrats and investors cashing in while urban Chinese – once encouraged to invest in home ownership by the central government – become less and less able to buy.

Editor’s Note: This analysis is part of a series that explores China’s industry, finance and statistics.

Related Special Topic Page – The China Files (Special Project)

PDF Version: Click here to download a PDF of this report

On Sept. 10, China Overseas Land and Investment, a Hong Kong-listed company and a subsidiary of state-owned China State Construction Engineering Corp., purchased a prime piece of real estate in the Putuo district in downtown Shanghai. The company paid 7.006 billion yuan ($1.026 billion) for the undeveloped property, which will amount to an average of 22,409.3 yuan ($3,283.9) per square meter of floor space (just in land costs) once the designed residential building is constructed.

The purchase created China’s newest "land king," a term for the real estate developer who pays the highest price for a piece of real estate during a land auction. And 7.006 billion yuan was the highest price ever paid for a piece of Chinese real estate for any purpose – residential or commercial. The milestone is a result of an increasingly intense competition for land in major cities that began early in the year, when Beijing began distributing stimulus money to various industries – including the real estate sector – to sustain the economy. As a result, land prices have soared throughout China. And with increasing speculative investment in residential real estate, the market faces a surging bubble that jeopardizes the country’s long-term economic development.

Since 1998, real estate investment in China has accounted for more than 10 percent of the country’s gross domestic product (GDP), compared to only 3 percent to 5 percent in the United States. Such investment is also closely associated with many other industries, such as construction and finance, and it provides an abundance of jobs. Therefore, it is seen as a critical pillar of China’s economy and enjoys favorable policies from the government and state-owned banks (more than 70 percent of real estate investment in China comes from bank loans). At the same time, real estate developers, local government officials and investors have escalated housing prices across the country by acquiring massive land holdings, limiting the supply and inflating prices, creating a real estate bubble that is not sustainable in the long run.

The bubble has grown mainly on the residential side of the market, where there is more demand and higher profits to be made. However, while fewer developers and investors have been chasing nonresidential projects, Beijing’s 4 trillion yuan ($586 billion) stimulus package in early 2009 has generated more interest and activity in the commercial side. Indeed, there are signs that commercial real estate may also be headed for a bubble, and STRATFOR will be watching the situation closely.

Origins of the Bubble

Since 1978, China’s pace of urbanization has increased dramatically, with the number of middle-size and large cities (those having nonagricultural populations of more than 200,000) growing rapidly. Beginning in 1985, economic reforms implemented in urban areas to make China’s planned economy more market-oriented added even more momentum to the real estate boom, with real estate investment increasing by 71 percent by 1987. The government’s macroeconomic policy of monetary belt-tightening helped cool this overheated market, which was further tempered by the government’s continuing to provide housing for state employees (fu li fen fang, or "welfare housing").

However, when the state significantly cut back on its welfare housing program in 1998, the Chinese perception of personal property changed, and this would have an important impact on the real estate sector. The government began this privatization process by making a private dwelling a "commodity" and granting the purchaser the right to own a newly built house for 70 years. (Likewise, the developer who buys the property on which residential or commercial buildings are to be constructed may own that property for 70 years.) Home ownership in China could now be a sound financial investment.

Thus, the residential real estate market would boom in almost every urban area in China – and particularly in the "first-tier" and "second-tier" cities (only Beijing, Shenzhen, Guangzhou and Shanghai are in the first tier, with more than 20 cities, and mostly provincial capitals or coastal ports are in the second tier). But rising land prices would eventually put housing prices out of reach for the general public. In Dongguan, a coastal second-tier city in Guangdong province, land prices averaged 4,957 yuan ($726.42) per square meter in 2007, a more than 500 percent increase from 2003, while personal disposable income increased 24 percent during the same period (from 20,526 yuan [$3,008] to 27,025 yuan [$3,960] per year).

A 2006 survey conducted by the National Development and Reform Commission showed that the average ratio between housing prices and income was approaching 12:1 in many large and middle-size cities in China (in Beijing it had reached 27:1). Twelve to one is significantly higher than the World Bank’s suggested affordability ratio of 5:1 and the United Nations’ 3:1. The problem was compounded by the fact that, of the more than 80 percent of Chinese who owned their own homes in urban areas (generally considered cities with populations of more than 20,000), 54.1 percent were making monthly mortgage payments that constituted 20 percent to 50 percent of their monthly incomes.

The Recovery Bubble

Following a temporary drop toward the end of 2007, land prices rose steadily, then began surging again with Beijing’s stimulus package and a flood of easy credit in 2009. With much of this money flowing into the real estate sector, major beneficiaries included large state-owned enterprises (SOEs) involved in speculative real estate and housing investment, contributing to the inflating bubble. Among the 10 highest-priced land purchases in major cities in the first half of 2009, 60 percent went to SOEs.

Paradoxically, as the global financial crisis continues, China sees little choice but to loosen its monetary policy even further, fearing the opposite would curtail economic growth and result in massive unemployment, which could lead to social instability. Beijing knows that one of the country’s underlying economic problems continues to be an overheated real estate market, but it also knows that the real long-term solution – limiting the flow of cash and credit – could have dire socio-economic ramifications. Meanwhile, real estate developers, government officials and investors continue to speculate on real estate, raising land and housing prices.

As housing prices continue to rise, a parallel trend is manifesting itself – rising vacancy rates in urban areas. A 2009 report by the Shanghai Yiju Real Estate Research Institute revealed that, by the end of 2008, the average vacancy rate for "commodity housing" (as opposed to welfare housing) in Beijing was 16.64 percent, and vacancies reached as high as 30 percent in some districts. Most of these vacant houses, however, are not unsold ones. They have been purchased by investors as speculative investments. While there are fewer and fewer ordinary people who can afford to buy houses, there is still excessive demand for investment housing – pressure that continues to drive up the prices.

This closed loop in the Chinese real estate market is facilitated by the country’s political and bureaucratic system. In China, all land is initially owned by the state, and local governments have the sole authority to sell it. And income from property taxes and land sales are a primary source of revenue for local jurisdictions. According to estimates by the State Council’s Development and Research Center, tax revenue from the land in some jurisdictions accounts for 40 percent of the local budget. Moreover, net income from land sales accounts for more than 60 percent of the local governments’ extra-budgetary revenue. The soft budget and lack of accountability to the people reinforces the local governments’ incentive to expand their real estate investments without much concern for cost or impact on public services.

Economic performance also is the prime prerequisite for bureaucratic advancement, which gives local officials the incentive to generate as much revenue as possible through land auctions. And this generally involves a level of collusion – and corruption – among government officials, real estate developers and investors.

One typical strategy is for a developer to buy a big chunk of urban land from the local government but leave the land undeveloped, or build on only a small portion of it, thereby keeping the housing supply limited. Despite various state policies to lower land prices in order to make homes more affordable, local government officials and real estate developers control the land auctions. When a lower sale price is dictated from above, it is easy enough for the local sponsors to officially deem the auction a failure. Even when the developer does build houses on the property, a speculative investor, working hand in hand with the developer and government officials, can bribe both parties to ensure that he can buy all the houses at a low volume price and keep them off the market, thereby maintaining a limited supply and high prices.

Another factor that enters the equation is a cultural one. The Chinese people generally prefer to buy new houses, as opposed to renting homes or buying secondary houses in which people have already lived. Indeed, in urban areas, marriage proposals often include a promise to buy a new commodity house. As a result, the secondary housing market remains very small in comparison (due also to fewer available bank loans for lived-in houses and the complicated process involved in transferring ownership).

All of these factors contribute to the burgeoning real estate bubble – and make it difficult to predict when that bubble will burst. With 70 percent of real estate investment in China coming from bank loans, a dramatic drop in land values could send shock waves throughout the economy. There are already signs of decline. In Shenzhen, one of China’s first-tier cities, real estate prices have been dropping for the past two years (30 percent for housing), and many developers and speculators have suffered great losses. The threat looms in other large cities such as Beijing and Shanghai and may be emerging in many second-tier cities as well.

Given the current global economy and the economic balancing act it must maintain domestically, Beijing has few good choices. It must keep enough cash flowing to maintain economic growth and social stability in the short term while tightening credit to avoid a tsunami of bad loans and a market collapse over the long term. Certainly, Beijing does not want to face the kind of collapse in the housing market that Japan experienced in the 1990s, which triggered a financial crisis and more than a decade of economic malaise.

But in China’s real estate, as in most sectors of this vast and complex land, implementing and enforcing prudent regulation has never been an easy task.

Related posts:

• Chinese stock market bubble inflating
• Spain: who is responsible for the property bubble?
• Beijing starts a ‘Buy China’ policy
• China is now on the same bubble path as Japan post-1987 crash
• Manhattan Q2 Apartment Sales down 22%

If you recall, at the end of May, I wrote a post “Both initial claims and continuing claims now pointing to recovery” that said jobless claims data were pointing to an imminent recovery.  The general gist of my argument was recovery would come by year’s end or early in 2010. But we needed to focus on the shape that recovery would take. Although claims data suggested recovery was right around the corner, we should be sceptical as to how soon this recovery would come and how robust it would be due to the overhang of low savings and high debt – what Richard Koo calls a balance sheet recession.

That post generated a lot of negative commentary because it has become fashionable to be all bearish all the time in the econoblogosphere.  But, reality is almost never as extreme as some would have you believe.  In that vein, do re-read the jobless claims post. Three months on, it is looking a lot more on target than it might have done in May.

I mention this because James Hamilton over at Econbrowser has a nice post up called “It’s not over yet” which dovetails nicely with the themes in my May post. In May, I ended the post saying:

The real question is how robust a recovery are we going to have and this is directly related to why the jobless claims series has been sending a false signal.  Now, initial claims has been sending a recovery signal since January. Yet, continuing claims continued to rise more quickly until last week.  In the past, one had seen these two series as harbingers of imminent recovery.  But, I am talking Q4 here.  Why? Deleveraging.

In the end, consumers are going to be forced to reduce debt and save more in this more cautious financial environment.  Team Obama does seem intent on re-kindling animal spirits but the personal savings rate has gone up nonetheless.  This will be a drag on GDP growth going forward and means that the economy’s rebound will be more tenuous and slower to develop.  In my view, this means recovery will be delayed and once it gets going it will be weak.  The potential for a double dip is very high.

So, to be clear, first derivatives are starting to turn up and since recession is a first derivative event, we are probably going to see an end to this recession soon enough.  But, with structural problems still remaining, the U.S. economy will be weak for a long time to come.

And I still hold to those comments.  If anything, my comments were too bearish regarding when a technical recovery would take hold. Just yesterday, Hamilton made a similar argument:

Some are greeting Friday’s employment report as an all-clear signal. But my advice is, keep your helmet on– they’re still shooting real bullets out there.

Let’s start with the good news. I first called attention to the favorable turn in new claims for unemployment insurance on April 9, noting that in each of the previous 6 recessions, an economic recovery began within 8 weeks of the peak in new claims. On May 7, I concluded we had enough statistical evidence to predict with 85% confidence that new claims for unemployment insurance had indeed peaked at the beginning of April. Although there was some concern as to whether seasonal adjustment could be confounding the July readings, it’s pretty clear now that the substantial decline in new claims is the real deal.

And many cheered Friday’s BLS release showing that nonfarm payroll employment fell by 247,000 workers in July, the smallest drop since August, 2008. But the problem is, if a traditional economic recovery had actually begun in June (8 weeks after the April peak in claims), the number of people with jobs should have increased in July rather than fallen by another quarter million.

Hamilton goes on to say that he has done some figures on where employment numbers should be in comparison to previous peak in unemployment claims.  The chart below shows where he comes out:

Notice how much of an outlier to the negative 2009 data is. What does this mean? For Hamilton and a lot of other economists (Krugman, Roubini, and Stiglitz for example), it means just what I said in May – “we are probably going to see an end to this recession soon enough.  But, with structural problems still remaining, the U.S. economy will be weak for a long time to come.”

To my mind, the real question now is whether weak consumer demand couples with other lingering problem areas like commercial real estate to bring any technical recovery down before it starts. If we do experience a double dip, the second leg of the recession will likely be even worse than this leg.  Policy makers would be well-advised to address these problems here and now rather than waiting for them to take full form.

Related posts:

• Both initial claims and continuing claims now pointing to recovery
• Unemployment claims falling faster than in half of past recessions
• Jobless claims may signal the end is near
• U.S. employment data in line with estimates
• More thoughts on the fake recovery

This is an astonishing video in China with Hugh Hendry, the money manager who is bearish on China who I profiled earlier this month.  In it, he shows us building after building after building – all of them massive and all of them empty.  And you see yet dozens of others still in construction in the background. Who is going to pay for all of this stuff?

Breathtaking.  Hat tip Ravin.

Related posts:

• Hugh Hendry: “China is Santa Claus”
• China’s empty city: the emperor really has no clothes
• Huge property bubble in China
• Stephen Roach sees a W-shaped recovery for China
• China is now America’s largest creditor

When you think about property, you should really be looking at its worth as the present value of future cash flow streams.  This is true for residential, commercial, rental or travel property.  One reason is that property is fungible, meaning what is a owner-occupied primary residence ca just as easily be a rental accommodation. It might even be a Bed & Breakfast.  What is a hotel today can always become a condo, like New York City’s Plaza Hotel.  An apartment building can become a condo conversion as well.  It is this fungibility that creates an arbitrage opportunity when one property market gets out of whack with the others as the residential property market did.

Now that residential property is coming back to earth, it is increasingly apparent that other markets like commercial real estate (CRE) were also bid up to unsustainable levels.  Hotels are another area of excess where there is going to be a lot of pain.  Witness this recent post from Calculated Risk:

“OK, so now it’s official. The first quarter of 2009 experienced the worst year-over-year revenue per available room drop in the U.S. lodging industry’s organized history.”
Jeff Higley: Catching up on hotel topics

Note: RevPAR is Revenue per available room – a key measure in the hotel industry.

From HotelNewsNow.com: STR reports U.S. data for week ending 2 May

In year-over-year measurements, the industry’s occupancy fell 11.6 percent to end the week at 55.7 percent. Average daily rate dropped 8.6 percent to finish the week at US$99.42. Revenue per available room for the week decreased 19.1 percent to finish at US$55.33.

Along those lines, I caught a story in today’s New York Times which suggests hotel owners are cutting back on renovations in order to meet their cash flow needs.  The Times article has this to say:

A $6 million renovation of the hotel was supposed to be completed earlier this year. But Personality Hotels, which owns the Vertigo, formerly known as the York, and six other hotels in San Francisco, decided to save money by leaving part of the building untouched.

Yvonne Lembi-Detert, the president of Personality Hotels, said that she had already bought everything needed, from tiles to TVs, to complete the transformation of the hotel’s 97 rooms. But the one thing she doesn’t have right now is enough money.

All over the country, hotels are halting or postponing renovations in numbers not seen since 2001, when the terrorist attacks led to a retrenchment in the travel industry, according to Chad Crandell, the president of Capital Hotel Management. This time, the cause is a decline in revenue — both occupancy and room rates are down in most cities — coupled with the difficulty of obtaining credit.

For hotel owners, “the name of the game is capital preservation,” said David Loeb, an analyst with Robert W. Baird & Company in Milwaukee.

Most large hotel companies, Mr. Loeb said, “have ratcheted down their capital plans, to focus only on life safety kinds of concerns.” Companies want to have cash reserves, “in case things get worse for the industry,” he said.

“If they started something, they’re going to finish it,” he added. “But we’re seeing very little optional spending.”

If this doesn’t sound familiar, it should.  There have been lots of stories about homeowners cutting back on repairs and maintenance in order to make their mortgage payments.  This was one of the problems with stretching to buy ‘as big a house as you can,’ the conventional wisdom in the bubble years.  Owning comes with lots of hidden expenses.

The long and short of this is two-fold.  First, we should expect the cost cutting to continue unabated in terms of non-residential property investment – and this includes the travel & leisure sector as well as commercial real estate. Obviously, this will be a drag on GDP.  Investment levels at least thirty percent below today’s investments are not an unreasonable expectation as I argued in a recent post (see the section on fixed investment). Second, a lack of maintenance has negative social implications.  Whole neighbourhoods will fall into disrepair in the American exurbs and in the inner city, increasing crime and violence there.  When all is said and done, many Americans are going to find renting a more palatable option than they have in this past decade.  In my view, that’s a good thing. As people start renting, over time the great property arbitrage of this past decade will cease to exist.  Rental and purchase prices will come into line, making real estate an interesting market again. Until then, expect continued writedowns in residential property and many more writedowns now from travel & leisure-oriented firms as well as CRE-oriented REITs.

For more on the social aspects of renting versus buying, see an April article from the Economist called “Shelter, or burden?”

Related posts:

• Hotels: Starwood faces black hole
• Manhattan real estate now getting decimated
• Folks trade down and shift to house parties to get a buzz
• Case-Shiller: House prices up for second month
• Cruising foreclosures, REO and short sales with Jim the Realtor

The first bank nationalization in German history is about to take place. At issue is Hypo Real Estate (HRE), a troubled Munich-based company that lends to commercial property developers and to build offices, hotels, roads, airports, you name it.

This issue has been building for nearly 7 months. Back in late September, just after Lehman went under, the Germany government was forced to bail HRE out as it ran into funding problems at its Irish subsidiary, Depfa. Since then, the situation at HRE has gotten considerably worse. Cognizant that it had a Lehman situation on its hands, the German government went so far as to change the laws to allow it to nationalize HRE. This is about to happen.

The Financial Times writes:

The government has given HRE shareholders until May 4 to accept the offer. As of Thursday more than 7.5 per cent of HRE shares had been tendered, giving the government control of 16.2 per cent of the company. It already held a stake of more than 8.6 per cent after a small capital increase last month.

At the end of the offer period the government hopes it will control enough HRE votes to force through a much larger capital increase at a shareholder meeting. It could eventually use “squeeze-out” rules to force out JC Flowers and other remaining minority shareholders.

If this does not work – as it may not, if enough shareholders reject the tender offer – a recently passed law will allow expropriation of HRE shares. It would be the first nationalisation of a German bank since the 1930s.

Expropriation would be compensated but the government has warned this is likely to be at a lower price than that proposed in the tender offer.

The US firm hinted at a legal challenge to try to stave off expropriation, pointing to expert opinions that “indicated considerable reservations” about the expropriation law and another piece of legislation approved last month. “JC Flowers is reviewing, in the interest of its investors, all options,” the firm said.

Some JC Flowers investors, holding less than 1 per cent of HRE shares, will accept the government’s offer.

I have written a number of posts about the situation at HRE:

• European banking collapse including nationalisation of three banks – 29 Sep 2008
• Germany: banking system collapse possible due to Hypo Real Estate – 4 Oct 2008
• The Germans guarantee all savings deposits – 5 Oct 2008
• The German $400 billion toxic asset time bomb – 17 Jan 2009
• Hypo Real Estate: 600 billion in off-balance sheet assets – 20 Feb 2009
• More problems at three European financial institutions – 29 Mar 2009
• German banks loaded with 816 billion in toxic paper – 26 Apr 2009

I have been following this story closely because I used to work for the predecessor bank of HRE. In the mid-1990s, I worked at a consulting company in Munich under the now head of HVB Group in a project to re-engineer HRE predecessor Bayerische Vereinsbank’s credit processes. My boss, an extremely decent man, later moved on to Goldman Sachs and then over to HVB as their CEO.

I mention this because I see HRE’s problems as linked to its predecessor organizations and the culture of risk that developed after the Berlin Wall fell. Obviously, this is just my view given that I in no way have worked for HRE.

Here’s my understanding of the matter. Bayerische Vereinsbank and Bayerische Hypothekenbank both ran into trouble due to ‘Verspekulierungen (bad speculation)’ in the period immediately after German re-unification. Vereinsbank and Hypobank were front and center in the speculative property bubble that developed in the former East Germany after the Wall fell. This was one reason my consulting firm was working at Vereinsbank.

In 1996, Hypobank revealed huge losses in eastern Germany even though the Board of Directors had been aware of the problem since early 1994 (does this sound familiar).  In fact, fraud was a factor at Hypobank.

Vereinsbank had their own problems.  So, subsequently, in 1998, those two organizations came together as Hypo Vereinsbank (later HVB Group) in a merger of necessity despite being bitter crosstown rivals. They are the largest banks in Bavaria with a long crosstown rivalry and history dating back to 1780 at Hypobank and 1869 at Vereinsbank.  The deal was touted as a Munich counterweight to the big three German banks Deutsche Bank, Dresdner Bank and Commerzbank, all based in Frankfurt.

Unfortunately, they were forced to write off 3.5 billion that same year because of Hypo’s eastern German speculation. (Later in 2005, 7 years later, bad bets on the Vereinsbank side were uncovered as well costing the bank 2.5 billion).

Fast forward to 2003 and HVB spins off HRE before HVB itself gets taken over by Unicredito two years later. Now, I haven’t been integrally involved with HVB or HRE since, but again the history of risk taking is there.  And I should mention that HVB and Unicredito are problem children with huge exposure to Eastern Europe.

By 2007, HRE was a force to be reckoned with and they looked to increase in size. They bought Depfa at the top of the market in a deal not unlike the Golden West Financial deal that Wachovia did in 2006.

Now Depfa, which caused HRE’s near collapse in October, is not an Irish company at all. It is in Ireland merely as a tax dodge (another example of how the Irish are massively and unwisely leveraged to the financial services industry). In reality, Depfa is a German institution, the Deutsche Pfandbrief  Bank. (As an aside, back in 2008, Hank Paulson talked a lot about Pfandbriefs as a panacea for the U.S. mortgage market.  I have two posts on that from last summer here and here).

So Depfa was lending long and borrowing short. When Lehman collapsed it ran into liquidity problems, so a consortium of German bank creditors struck a deal to bail out HRE and its subsidiary.  But, this deal collapsed and the German government was forced to step in.

In reality, HRE was a ticking time bomb and this is the reason it had run into liquidity problems (By the way, this is much the way I see Northern Rock – which was also nationalized by the UK government).  The company has massive commercial property (CRE) exposure and the CRE market is imploding in financial centers like Frankfurt, London and Dublin and elsewhere.   HRE is highly leveraged to these places.

HRE is also systemically important because it has a huge loan book in commercial property in Germany, Ireland and in Europe more generally. It also has a lot of off-balance sheet exposure a la Citigroup. Its failure would cause great distress to the market it operates in.

Moreover, it has counterparties and lenders. So, its demise would adversely impact those institutions. I don’t have a list of those lenders in front of me but the consortium banks which failed to bail it out in October are the biggest ones. I’m sure it’s a list of who’s who in German finance.

What has the press left out in all of this? Dunno. I would say the bailout is similar to what we are seeing with systemically important institutions in every single Western country (Fortis in the Benelux, RBS in the UK, Citigroup in the US).  In short, a property bubble and massive bust has meant that the most imprudent lenders now face ruin. Unfortunately, the web of actors in our financial system is so intricate and the imprudent lenders so large that governments are loathe to allow them to simply collapse. The demise of Lehman Brothers has sent a signal that this raises a very real spectre of Financial Armageddon.

Come May 5th, a large part of this problem will be solved for the Germans.  The only German non-state bank left with massive exposure is Commerzbank, and its day is coming too.

Sources
JC Flowers rejects Berlin’s offer for HRE – FT.com
HRE: Die erste Enteignung in Deutschland – Handelsblatt
HypoVereinsbank – Wikipedia (German)
HypoVereinsbank – Gourt (German)
Depfa Bank – Wikipedia (German)

Related posts:

• The German $400 billion toxic asset time bomb
• Commerzbank gobbles up Dresdner
• Germany: banking system collapse possible due to Hypo Real Estate
• German banks loaded with 816 billion in toxic paper
• Hypo Real Estate need for 10 billion also reveals huge problems in Spain

The Bloomberg video below makes it seem that Whitney believes the stress tests are a sham. She says the tests are a theoretical exercise whereby banks ask: “what will our earnings power be in two years after we sell off these ‘toxic’ assets?” She goes on to suggest that the answer to this question will be a self-serving, upbeat response not wholly reflective of the real dangers lurking.

In reality, much more capital is still going to be required.  Some of this will happen via asset sales, as she suggests.  However, one should anticipate a real need for yet more capital still.

You should also note she says the regionals will struggle because they have A LOT of commercial property (CRE) exposure – something I mentioned quite often in 2008. Case in point is Zions, which had a horrendous earnings announcement just yesterday.

“Zions’ capital position will come under significant pressure in the short-term because of its large commercial real estate lending concentration and collateralized debt obligation portfolio,” Moody’s said. “Future credit costs in Zions’ residential construction book and CDO portfolio cause a significant risk of the firm becoming undercapitalized.”

The long and short is: it is good to be a “too big to fail” big bank. It is not so good to be a regional or local bank.

Related posts:

• At least six banks need more capital under stress tests
• What the stress tests reveal about Obama’s thinking on banks
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• Is Meredith Whitney bullish now?
• Ackman and Stigliz talk Stress Tests with Charlie Rose

The S&P Real Estate Index is down 60%. This segment gives a good overview of how commercial real estate is doing and what to expect going forward.

Related posts:

• Commercial Real Estate bust
• The collapse of commercial real estate
• Commercial real estate is next
• Circuit City as canary in the coalmine for commercial real estate
• Commercial property hits the front page

Recently, I was discussing the economy with a lawyer expert in both commercial real estate (CRE) and taxation, workouts, and bankruptcy.  He made a few statements that I felt relevant enough to pass on here.

First, he said that the anchor stores in shopping centers always get sweetheart deals. It is the smaller stores that pay full price.  He also said that he was involved in tens of billions of dollars in CRE deals in the last few years that he can look back on as being highly questionable in this economy.  He expects to see many of these deals again in bankruptcy.  However, the most worrying statement he made had to do with securitization.  He said that the workouts (process of negotiation to avoid bankruptcy) in which he had been involved where assets were securitized were never successful.  In his experience, if the assets were securitized, workout was impossible and bankruptcy was the only option.

With that in mind, I want you to read this snippet from a Reuters story:

The collapse of electronics retailer Circuit City could drive down shopping and strip mall rents, and deal another blow to commercial mortgage-backed securities’ (CMBS) investors who have already seen their bond prices slide.

After a dismal holiday shopping season and several failed attempts to sell itself, Circuit City — having filed for Chapter 11 bankruptcy protection in November — last week said it would close all its 567 U.S. stores and liquidate its assets.

The move left 30,000 employees of the Woodland Hills, California-based company without work, and creditors — including landlords — lining up to get whatever they can after the company sells its inventory.

“Now those landlords are in line like the rest of their creditors — and probably in the back of the line to get paid,” said Suzanne Mulvee, Property & Portfolio Research real estate strategist.

The loss of the large tenant, whose stores typically run from 35,000 to 40,000 square feet, is likely to be felt by some publicly traded shopping center owners, such as Developers Diversified Realty Corp DDR.N, where Circuit City accounted for 1.7 percent of its annual base rent revenue, and Kimco Realty Corp KIM.N, where the chain accounted for 1.5 percent of its annual base revenue, according to Green Street Advisors analyst Nick Vetter.

Not that Circuit City is always an anchor, but this has to be a negative for CRE defaults and asset-backed bonds.  It robs many shopping centers of anchor stores, putting the squeeze on smaller vendors (who must now pay even more to make up for the loss), even while they are left adrift because of the loss of the anchor.  Commercial property is to 2009 what subprime was to 2007 and 2008.

Source
Circuit City collapse could hit real estate investors – Reuters

Related posts:

• The collapse of commercial real estate
• Commercial Real Estate bust
• Commercial real estate is next
• More CRE reporting
• Commercial poperty ‘im Visier’

Last year, the British economy was one of the hardest hit by the now evident commercial property (CRE) implosion. Prices fell 27.1% in 2008, including a record 5.8% in December alone, suggesting the trend is accelerating. I mentioned in my “Top Ten Predictions for the 2009 global economy” that I believed commercial property writedowns would be numerous because of securitzation. Ireland, the U.K. and the U.S. are tops on the list for a CRE correction. You should note that this trend is very much related to declines in the real economy as retail is where the greatest problems now reside.

Values fell by a record 5.8pc in December, meaning the overall decline for the final three months of the year was 15pc.

The commercial property market has been ravaged by the reduced available of credit and falling demand for new space as the economic downturn leads to businesses collapsing or downsizing.

A recent report by investment bank Close Brothers warned that UK banks could be forced into another Government bail-out because of the amount they have loaned to the troubled commercial property sector.

From the peak of the market in July 2007, values have now fallen 35.5pc, described by the IPD as “totally without precedent”.

Keith Steventon, head of research at Atisreal, said the size of the 5.8pc drop last month suggests the bottom of the market is some way off.

“Not only is it a record but the rate of decline continues to accelerate, which suggests that not only has the market not found its floor, but that the floor is still some way off,” he added.

According to the figures, retail property was the worst hit sector, with a 2008 fall of 28pc. Office properties lost 27.2pc and industrial 25.5pc.

Mr Steventon added: “What is particularly striking is that the decline is fastest in retail, implying that valuers are very conscious of the poor prospects for retail.”

Sources
Commercial property values plunge – Telegraph

Related posts:

• UK commercial property market falling as well
• Commercial property hits the front page
• Commercial real estate is next
• Nationwide: British home prices now higher than a year ago
• Nationwide: U.K. house prices down 16.6%

As you know from reading my blog, I am expecting a lot of writedowns from regional banks as real estate loans sour.

In fact, I expect a number of bankruptcies because of defaults in commercial property where much exposure is hidden.  This is an issue I have been writing about since May. Many of the larger regionals, which have already received TARP funds will suffer large writedowns despite having low subprime exposure.

Below is a clip of Bain Slack of Keefe Bruyette & Woods, who has a few words to say about the regionals, especially in the Southwest.

Take a look.

Related posts:

• Gateway Financial and Midwest Banc have one-third of capital in Fannie and Freddie Preferreds
• Regional banks: examples of risk from SoCal
• More warnings on regional banks
• Wave of regional bank write-offs?
• Regional banks are suffering

In my most recent post, I gave a fairly comprehensive retrospective of the year that was.  Near the end of that post, I listed a number of posts I wrote in October and November which point to how I see 2009 shaping up.  Let me give you a more direct assessment here.  I will finish it off with my top ten predictions for 2009.

2008 was a disaster.  The subprime meltdown actually started in February 2007, giving policy makers plenty of time to act. However, inaction proved fatal as the subprime crisis metastasized into a global credit crisis that did not take full form until this past year.  In so doing, it revealed a number of inherent weaknesses in the global financial system which I believe will play out in 2009.

Banking weakness

The first problem to note is global banking fragility.  It bears noting that after the Japanese banking crisis, many prognosticators pointed to the weak capital structures at Japanese banks as a cause for the crisis.  I felt then and still do today that they had it backwards.  Poor lending practices made institutions in Japan that previously seemed well-capitalized into capital weaklings.  This will be very much the case globally in 2009.

In the U.S., Ireland and the U.K. in particular, there are significant loan losses that have yet to be taken.  This is part due to the fact that loans are carried at book value until the borrower cannot pay.  On the other hand, freely traded securities like Mortgage-backed securities must be written down immediately to reflect market values.   That has meant that institutions which have credit risk held in the form of marketable securities have taken the lion’s share of the pain.  I expect that to change in 2009.

Going forward, real economy problems i.e. default and bankruptcy will become an issue.  That means that those hidden loan losses will have to be taken.  You should note that I am definitely suggesting the following: had loans been traded in the same way that mortgage-backed securities were, we would have seen a tidal wave of losses here already.

Which countries and which asset classes are vulnerable?  From a country perspective, one could look first to the first bubble economies to pop as canaries in the coalmine: Ireland, Spain, the U.K. and the U.S.   I will not make any predictions about Spain, but I will say that I do expect to see horrific loan losses in the other three countries.

Asset Class Weakness

From an asset class perspective, here is my thinking:

• Residential Property – In the U.S., Alt-A payment resets approach and recession will start to hit through unemployment. Therefore, expect to see Alt-A loans go sour as their subprime brethren did before.  This class includes those exotic mortgage types like no-payment, option ARM, and negative amortization loans to prime borrowers.  As there are many Mortgage-backed securities  of the Alt-A variety, these loan losses will lead to writedowns at those same banks that have had massive writedowns already, further impairing their capital base.  The subprime crisis is less of an issue at this point.In the U.K. and Ireland, property prices will decline in 2009 and unemployment will rise. This double whammy will mean mortgage defaults will rise and loan losses will increase at those institutions most levered to the residential property markets.
• Commercial Property (CRE) – I was way too early on this asset class, expecting to see major losses in 2008.  But, CRE will be front and center in 2009.  Why?  It stands to reason that in recession, businesses are hit as consumption growth slows or goes negative.  This will depress demand for commercial property, driving down lease prices. Simultaneously, retailers will struggle and this will increase defaults.  That means much less income and huge loan losses for CRE REITs and commercial property-oriented financial institutions.  This will be true in the U.S., Ireland and the U.K. at a minimum.  However, although I am not making a forecast here, I am also hearing much the same across the Eurozone.
• Leveraged Loans and High Yield – These asset classes are sporting record yields because credit quality has deteriorated significantly across the board. For instance, at the tail end of the boom, there were many more low quality single B rated bonds. Leveraged loans are those loans given to finance higher risk, leveraged buyouts. High-Yield is simply a moniker used for lower quality bonds. It stands to reason that poorer asset quality loans and bonds will be hit first during a downturn.  That means leveraged loans and high yield will suffer before any other corporate bond and loan class.  This is going to be true in the U.S. and in Europe across the board.  (See Wikipedia’s entry for High yield debt).
• Credit Card and Auto Loans – Here is another class that will implode the balance sheets of major banks because of tradeable asset-backed securities (ABS).  We have already seen credit card chargeoffs increase significantly.  Even American Express, generally considered the highest card quality provider, has been experiencing increased loan losses.  Now, remember, there are boatloads of auto and credit card ABS bonds trading in the open market.  These securities will be severely impaired and writedowns will be enormous.  I predict some institutions will fail as a direct result of these writedowns.
• Eastern European loans – Countries like Ukraine, Hungary, Latvia, Estonia and Poland are going to see major downturns.  Unfortunately, this will mean currency weakness.  That has a major impact on debtors in those countries as they have borrowed in Euros (much like Icelanders had).  Combine the currency impact with recession and you have the makings of a debt crisis. The banks loaning Eastern European corporates and homeowners these funds are situated in countries like Austria, Germany, Denmark, and Sweden.  Therefore, expect to see significant writedowns at major European institutions as these loans sour.  Will this be Europe’s equivalent of the Latin American debt crisis of the 1980s. Yes.
• Other asset classes – We are talking about prime mortgages, ordinary bank loans, and corporate loans. These will suffer impairment because of the recession, but the problems here should be much less than in the asset classes I identified above.

Currency Weakness

It is extremely difficult to call currencies.  In 2009, it will be especially difficult because there are potential trouble spots everywhere.

However, on the whole, one should expect the British Pound and the U.S. Dollar to be weak currencies as their central banks are going to resort to quantitative easing in order to forestall depression.  The ECB is less likely to do so despite the problems in Ireland, Spain and Greece.  At its core, the ECB is an institution controlled by the Germans, French, and Belgo-Dutch.  These hard money types will be reluctant to resort to ZIRP (a zero interest rate policy) or quantitative easing.  So, I expect the Euro to be strong.

Why the Yen remains strong is beyond me because the Japanese are about to engage in quantitative easing and ZIRP.  They have experienced a very hard landing.  But, the carry trade is no longer as appealing because foreign interest rates are falling as other central banks cut rates. So the desire to unwind carry trades is supportive of the Yen.  I expect a strong Yen.

I’ll leave it at that for currencies, except to say that Latvia will be a test case for Eastern Europe as the IMF did not require a competitive currency devaluation there as part of a bailout package.  It remains to be seen how that will play out.  I reckon we will see economic pain followed by capitulation and devaluation.  Russia is doing the right thing in devaluing, although that reduces the standard of living (through high import prices) and invites civil unrest.  Let’s wait and see.

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Ten Predictions for 2009

So, now it is time for me to lay it on the line and make my ten predictions.  Here they are:

1. The Obama Administration will not be a significant change from the status quo economically.  As a result, they will drag their feet on offering a comprehensive banking solution, leading to another (fatal) banking crisis in 2009 from ABS losses.
2. The Obama Administration will satisfy cultural liberals by re-regulating the banking industry heavily and by massive spending on public works.  Liberals will be ecstatic about American jurisprudence: Obama will appoint at least two liberal Supreme Court justices to the bench as Ruth Bader Ginsburg and John Paul Stevens step down.
3. The Obama Administration will be faced with a state government bankruptcy. They will bail out the state and promise to do the same again, much to the liking of liberals and municipal bond holders.
4. Eastern Europe will face depression, much as Asia did in 1997.  The result will be civil unrest and a near collapse of the European banking system.
5. The Irish banking system will suffer a crisis of confidence as the Irish will come to be seen as the next Iceland: oversized banking sector, huge loan losses.  The European Union will bail out the entire Irish banking system.
6. Oil prices will sink to $25 a barrel before rising back to $55 by the end of the year.
7. China, damaged by a huge decline in export demand, will undergo a massive stimulus campaign.  It will not be enough.  GDP growth will drop to 2% and civil unrest will ensue.
8. Tariffs, export subsidies and currency devaluations will roil the desire for free trade.  Initially, countries will seek relief at the WTO (World Trade Organization) but later they will begin to act unilaterally.  The U.S. will be the first to unilaterally retaliate.
9. U.S. house price declines and subprime defaults will slow.  Prime and Alt-A defaults will increase.  Meanwhile, Irish and U.K. mortgage defaults will increase dramatically.
10. The U.S. will begin initiate detente with Venezuela, Cuba or Iran.  The moves will be heralded as a foreign policy coup on the lines of the Sino-American detente under Nixon.  Obama’s status abroad will be boosted.

So, there it is.  My ten predictions.  I think this set of ten is pretty bold, actually.  So I expect to be very wrong on many of them.  Hopefully, it gives you food for thought.  Please feel free to call me out on a especially good/bad prediction or opine on your own predictions in the comment section.

Related posts:

• Where is the global economy headed?
• The U.S. banking crisis: where are we?
• Europe is next
• Ten predictions for 2008
• JPMorgan Chase: Large exposure to real economy downturn

The financial services sector has been the hardest hit sector in the credit crisis so far.  Banks with large exposures to mortgage-backed securities like Citigroup, UBS and Merrill Lynch have suffered the most. This is largely because the crisis has been in asset prices — chiefly home prices.  However, as credit has become severely restricted, the credit crisis has become a global recession and that means the real economy will be impacted.  This spells trouble for JPMorgan Chase.

As the global economy slips into recession, the categories of credits that will sour in the U.S. will expand to include:

• Residential Property (like Alt-A, Payment Option, Negative Amortisation Mortgages)
• Commercial Property (Commercial Real Estate and Construction Loans)
• Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
• Credit Card Receivables and Asset Backed Securities
• Auto Loan Receivables and Securitised Auto Loan Bonds

And JPMorgan Chase is more exposed in many of these categories in addition to being one of the largest players in credit default swaps and other derivative instruments.  Below is a good article from yesterday’s Financial Times which highlights this fact.  While I greatly respect the managerial acumen of Jamie Dimon, JPMorgan Chase’s CEO who came to the bank via Bank One after losing out in a Citigroup power struggle, I do expect the company to be hit hard by writedowns in the coming quarters. JPMorgan Chase is no Citigroup but it is going to take a beating nonetheless.

“As the credit crisis ripples through the real economy, perceptions about strength and risk management will change,” says Charles Peabody of Portales Partners, a research boutique. Mr Peabody predicts that losses from commercial loans can increase up to six-fold. He says he is especially concerned about JPMorgan Chase, so far the symbol of prudence. JPMorgan has a far bigger book of corporate loans than Citi, far bigger exposure to the commercial real estate market and it is at continuing risk from its exposure to leveraged buy-out deals. Indeed, according to the calculations of Mr Peabody, those exposures amount to some $288bn.

The buy-out loans include such troubled deals as the $6bn JPMorgan put up to help Cerberus finance its purchase of ailing Chrysler.

The bank has already marked down its $12.9bn leveraged loan book almost 30 per cent to $9bn, but investors in private equity deals say they expect there are far more drastic markdowns to come.

Most of the corporate targets of recent buy-outs have so much debt and carry such low ratings that defaults on such private equity-owned companies are expected to reach record highs and recoveries record lows. All that means is that companies owned by private equity, whether retailers or semiconductor companies or media firms will be the first hit – not the only ones.

JPMorgan’s management and its risk management are far more impressive than any of its peers among the commercial banks. It has been conservative and is becoming more so. So far, its charge-offs have been modest and a spokesman says that the level remains low even by historical standards.

Still, in anticipation of harder times, the bank has been adding to reserves, which now stand at 3.85 per cent just for the non-retail loans made out of the investment bank. In addition, JPMorgan has extensive hedges to help safeguard its exposures. Still, precisely because JPMorgan is so big, it cannot escape unscathed, as CEO Jamie Dimon frequently warns. Moreover, one of the lessons of the past two years is that sometimes hedging activity, instead of reducing risk, actually amplifies it. For example, JPMorgan is one of the biggest dealers in the credit default swap market. As a massive lender, appropriately, it has bought more protection against declining creditworthiness and defaults than it has sold. Still, the total gross face value of its credit derivatives book is $9,200bn. That means JPMorgan is on one side or another of one out of every six contracts in the opaque market. It has counterparty risk on the contracts it has bought, even with collateral and faces losses on the contracts it has sold.

Source
Economy bears brunt of the biggest banks’ miscalculations – Financial Times

Related posts:

• JPMorgan: Beats expectations despite writedowns
• JPMorgan has record revenue and $2.7 billion in profit
• Commercial real estate is next
• The U.S. banking crisis: where are we?
• Moody’s anticipates huge increase in leveraged loan defaults

At this stage in the financial crisis, it is difficult to discern exactly where things are headed. However, let me give a general road map of how I see things shaping up.

The credit crisis started in August 2007 as a result of the dual realization amongst investors and global financial institutions alike that large credit writedowns due to subprime exposure were imminent and that nobody knew where that exposure lay. Therefore, at its core, the credit crisis has two specific proximate causes:

1. Credit losses from the lending in the past business cycle upswing will be much larger than had been previously anticipated
2. Due to derivatives, off-balance sheet exposures, poor disclosure requirements and the interconnectedness of the global financial system, it is unclear which institutions are most exposed to potential credit losses

The crux of the problem is unexpected losses and fear that those losses could be any- and everywhere. This will continue to be the case going forward, with significant implications for the financial sector and for the real economy globally.

History since Fall 2007
Rewinding to the fourth quarter of 2007. The monetary authorities had done great work in calming the credit markets after the initial shocks in August due to BNP Paribas’ fund freeze and again in October due to the collapse of Britain’s Northern Rock.

But, it was also then when the magnitude of losses first became apparent as large global institutions started to come clean with significant credit writedowns that necessitated new rounds of capital raising to bolster balance sheets. However, as the losses increased and it became apparent that poor credit quality was not limited to the subprime sector, the credit markets began to freeze up as banks’ mutual trust dissipated.

Bear Stearns then collapsed and the monetary authorities were again successful in calming things down quite a bit. However, it was in the summer that I believe this calm disappeared. Until then, banks were able to raise enough capital to recapitalize themselves after their writedowns because the magnitude of losses was believed to be contained.

But, in June, Lehman Brothers posted a $3 billion loss, sought $6 billion in capital and looked to shed $130 billion in assets. Just months before, Hedge Fund nemesis John Paulson had been derided by Lehman management for shorting the stock because of Paulson’s belief that Lehman was smoothing earnings to hide huge losses.

In July, a story broke in the German press, which first appeared in English on this very website about well-connected and reputable Bridgewater Associates study that credit writedowns would eventually reach $1.6 billion trillion and large losses were unaccounted for everywhere. Five days later IndyMac went bust and the world hasn’t been the same since.

The future
Fast forward to today and we have seen the nationalization of Fannie Mae, Freddie Mac and AIG, the bankruptcy of Lehman Brothers and Washington Mutual in the U.S. We have also seen nationalizations in Iceland, the UK, Denmark, France and the Benelux as well as crises and bank deposit guarantees in Ireland, Germany, Austria, Greece, Denmark and a host of other countries.

And despite what the monetary authorities have done, the credit markets are seizing up, letters of credit which control trade are being rejected, and stock markets are plunging. What will all of this mean?

First and foremost, this means that the real economy effects of the credit crisis will be much more severe than previously anticipated. Recessions have already been noted in places as far afield as Denmark, Singapore, the UK, and New Zealand. In all likelihood, Japan, the U.S. and Eurozone will all suffer major recessions due to the credit crisis. Few of the real economy effects from this have yet been felt. In recession, businesses go bust, people lose their jobs, consumers spend less, and credit defaults increase for businesses and individuals.

All of this translates into further credit writedowns from the following categories of debt, where credit excesses are concentrated in both North America and Europe:

• Residential Property (like Alt-A, Payment Option, Negative Amortization Mortgages)
• Commercial Property (Commercial Real Estate and Construction Loans)
• Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
• Credit Card Receivables and Asset Backed Securities
• Auto Loan Receivables and Securitized Auto Loan Bonds

But, in addition, the following categories will see increased losses due to the real economy recession in Europe and North America:

• Bank Loans (general loan quality will sour)
• Corporate Debt (As recession hits, some previously credit worthy corporates will fail)
• Prime Residential Real Estate Loans (this is all ready occurring)

As far as Asia and Emerging markets go, it bears keeping in mind that demand for commodities is slowing rapidly as major industrialized economies slow. Therefore, Asia, Latin America, New Zealand, South Africa and Australia will not be immune. We have recently seen enormous currency moves in Australia and South Africa that are harbingers of impending recession there. Moreover, signs of slower export growth are evident all over Asia from Japan to China to South Korea. Other economies in Latin America that are highly dependent on commodity exports like Mexico, Venezuela, Argentina, Chile or Brazil will not decouple. They too will see a slowing in their economies.

Ultimately, this credit crisis is going to create a global downturn that will be the most pronounced since World War II. From my perspective, the key to minimizing the down turn rests on how effectively policy makers respond with a coordinated global effort to the following categories:

• the need to unfreeze credit markets
• the need to re-capitalize and shrink the influence of near-bankrupt financial sectors
• the need to restore confidence to all capital markets globally

I started by saying that this crisis is at its core a crisis due to over-lending and the resultant credit losses magnified by distrust. Therefore, the solution is clear: policy makers must not only purge and re-capitalize the financial system, they must also restore confidence in global finance. Ultimately, it is confidence and trust that is the most precious quality we have lost.

It is my fervent hope that the G-7 and G-20 meetings this weekend bear fruit so that we can avert a more pronounced crisis.

Related posts:

• Jim O’Neill on the Global Economy
• Bank bankruptcy or bailout?
• Top ten predictions for the 2009 global economy
• Finding a bottom
• Three views of the global economy

This morning Chris Whalen made some comments on CNBC that hit the nail on the head regarding the U.S. banking crisis: there is a huge wave of old-fashioned loan losses coming down the pike. The writedowns we have seen to date are largely confined to tradeable securities that must be marked to market.

There are much bigger unrealized losses sitting on balance sheets right now. $700 billion will not be nearly enough to cover these losses. If the Federal government doesn’t step in and re-capitalize the U.S. banking system with more money, we are going to suffer a major deflationary spiral as these losses are realized. The WaMu-JPMorgan transaction is an example of a best-case scenario in recapitalizing the sector. However, the government will need to get involved now proactively as opposed to waiting until crisis hits again.

Where are these losses hiding?

• Residential Property (Alt-A, Payment Option, Negative Amortization Mortgages)
• Commercial Property (Commercial Real Estate and Construction Loans)
• Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
• Credit Card Receivables and Asset Backed Securities
• Auto Loan Receivables and Securitized Auto Loan Bonds

While everyone is breathing a sigh of relief about the bailout package that Congress is about to pass, we need to keep our eye on the ball. There is still much work to be done. Do not be fooled into thinking that this will be the end of it.

Most people think $700 billion is a lot of money and are angry at having to fork over this sum. However, the scope of the problem in U.S. finance is much bigger than that. The bailout of the financial services sector has just begun and we need the government to admit this to the American people and get on the case.

Ultimately, if done correctly, bailouts will cause a net loss to U.S. taxpayers that could be much less than $700 billion despite large nominal outlays. If we wait until crisis again, the losses will be greater.

Related posts
Consolidation through merger over bankruptcy
Why is this blog named Credit Writedowns?
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Credit Crisis Timeline

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• JPMorgan Chase: Large exposure to real economy downturn
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• Why is this blog named Credit Writedowns?
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I named my blog “Credit Writedowns” because I anticipated an historic wave of credit writedowns in the global banking system which would lead to a wave of deleveraging, systemic risk, and bank failures — in short, a massive financial and economic bust to rival the Great Depression.

Up until now I have masked this dire view because, honestly, most people do not want to hear this sort of thing. I reckon they are watching “America’s Next Top Model” or “Grey’s Anatomy” to escape the grim reality out there (Those are two shows I like very much, thank you). So, I apologize in advance for the downbeat nature of this post.

This is probably the first time I am on record admitting the depth of my concern for the U.S. and global economy. But unfortunately, present events are now confirming my thesis and I want to step up the attack on our policy makers by highlighting the lurking dangers. Maybe that way we can get real solutions to our problems.

The largest equity bubble of all times spells economic pain?
Rewind back to 2001.

Soon after the tech bubble hit, it was obvious to me that the United States and the United Kingdom were two societies that had developed an unusual and excessive reliance on financial services as an engine for economic growth.

Back then, it was a foregone conclusion that the United States would be hard pressed to escape what was the largest stock market bubble in history with a garden variety recession. I felt that the United States, at minimum, faced a deep and protracted downturn similar to the 1973-1975 or 1980-1982 period, if not one of Japanese proportions.

All of the problems that felled the U.S. economic juggernaut in 2007 were evident in spades in 2001. And quite honestly, that would have been a healthy cleansing process for a global economy hooked on a savings-short, over-leveraged American economy as its growth engine. The problem was severe but manageable.

Reckless Fed policy
However, I was wrong. Alan Greenspan’s Federal Reserve resisted this necessary unwind by lowering interest rates to 1%, well below the rate of inflation. While U.S. businesses did reduce leverage from 2001-2003, low interest rates and poor bank and financial market regulation led to risk taking on a massive scale.

Because interest rates were low, lower-risk assets offered poor returns. The financial services industry was unable to make significant return on equity without increasing risk. Therefore, most players increased both leverage and risk. This includes banks, investment banks, mortgage lenders, asset managers, private equity companies, and hedge funds.

Asset classes included:

• Residential Property (Subprime, Alt-A, Payment Option, Negative Amortization Mortgages)
• Commercial Property (Commercial Real Estate and Construction Loans)
• Leveraged Loans and High Yield Bonds (from Private Equity LBOs)
• Credit Card Receivables and Asset Backed Securities
• Auto Loan Receivables and Securitized Auto Loan Bonds

Alan Greenspan literally gambled with the world economy on a bet that low interest rates would allow the U.S. economy to recover before the magic elixir of leverage and risk became a systemic risk. Rather than fold his hand and accept a protracted period of weakness, Alan Greenspan decided to go all in. The result was not just a housing bubble but a credit bubble more generally, involving unsustainable price increases in all of the asset classes above and more. Trends in all of these asset classes suggest large credit writedowns to come from these assets as well.

Housing Bubble
When Greenspan went all in in 2003, the U.S. residential property market was arguably already in a bubble. The same was true in many parts of the UK as house price increases had already far outstripped the rise in inflation and house rent increases. So, had the Fed decided to follow a more hawkish and appropriate monetary policy in 2003, it is quite probable that house prices would have been pressured and none of the excesses since that time would have occurred.

However, the Fed allowed these excesses to occur and allowed the shadow banking system to become yet more leveraged in the process. All of the data pointed to excess: average debt per household, debt servicing costs as a percentage of income, debt to GDP, the savings rate, the value of housing stock as a percentage of GDP, the ratio of house prices to rent, the median/mean equity owned in homes, etc., etc., etc. Why could I rent a house for $2000 that would cost $4000 for 10% down on a 6% 30-year fixed mortgage? Why would I buy a house in that scenario?

I found this period — 2003-2006 — to be very, very frustrating because the data were all pointing to an unsustainable bubble. Yet, everyone seemed to be caught up in the tonic of paper wealth and excess consumption. The more house prices rose, the more they were taken as prima facie evidence of the sustainability of the previous increases. I felt like your classic Cassandra.

Systemic risk- credit writedowns
If the numbers looked bad in 2001 and we hadn’t unwound the excesses, but had simply papered over them with more debt, the problem in 2006 was obviously even bigger. That was my greatest concern in 2005-2006. But, more of concern to me was deleveraging and credit contraction. See, the Tech bubble was limited to shares and capital spending. The banking system was not as affected. So credit was not as restricted as a result of the popping of that bubble.

This is not the case in a housing bubble. Housing goes to the core of our credit system. When a housing bubble pops, loans go bad and credit losses must be recorded. These credit losses are called ‘Credit Writedowns.’

What is a credit writedown? It is a reduction in the value of an asset carried on a company’s balance sheet. As these losses must also be reflected on the income statement, credit writedowns result in massive losses. For example, a company may believe a number of mortgage-backed securities are permanently impaired and are carried on the balance sheet at values that do not reflect market prices. As a result, they may decide to take a writedown by reducing the valuation.

The bubble we have just experienced was the mother of all housing bubbles. It saw large and sustained price increases across a greater percentage of the developed world than any other housing bubble we have ever witnessed in history. The amount of credit writedowns that we should see from this period of credit excess will be much, much more than is currently anticipated by the mainstream media or the general public.

So, that is why this blog is named Credit Writedowns. My hope had been to draw attention to the systemic risk associated with the deleveraging process necessary to purge these excesses. Quite frankly, I was cautiously optimistic that our policy makers would avoid the worst of the potential policy mistakes which could worsen the situation. However, over the past month we have witnessed key policy mistakes, which I believe will likely lead to further downside risk going forward.

Realistic future assessment
I am not painting a particularly rosy picture here. And it pains me to not be able to do so. We have seen over $500 billion in credit writedowns at the world’s major financial institutions, the collapse of the largest mortgage lenders in the world in Fannie Mae and Freddie Mac, and the bankrupting of two of the largest investment banks in the world in Lehman Brothers and Bear Stearns. We have witnessed the end of the investment banking business model as Merrill Lynch was acquired and Goldman Sachs and Morgan Stanley became bank holding companies. And finally, we are now experiencing the largest series of bailouts and government market interventions since the Great Depression.

I would like to say that this thing is going to be over soon. However, the truth is that we are not even halfway through this. We have at least $500 billion more in writedowns to come. As a result credit will contract generally and many banks will fail. The knock on effects of this credit contraction will be higher unemployment, major commercial bankruptcies and a deep recession. The other bubble asset classes like commercial real estate will also fall. And the stock market will follow the real economy and probably bottom lower in inflation-adjusted terms than 2002 or 1998.

We need leadership
To deal with this crisis, we need policy makers who understand the gravity of the situation and its effect on people’s lives. None of the current proposed bailouts are addressing any of this. Do you think Paulson’s plan will help people find jobs? Do you think Barney Frank’s plan will help people from losing their homes. Will any of the market manipulations like banning short selling stop even good banks from falling prey to liquidity concerns? The answer to all of these questions is no.

So, my role at Credit Writedowns is to continue to point out where the minefields are, what we can do to avoid them, and what has historically been done before. I do not like to be the messenger of bad news. But, someone has to hold our policy makers’ feet to the fire. My hope is that I can play my small part in helping ensure the policy response we get going forward is better than the one we have had thus far.

Related posts:

• Connecting Fed cuts with credit writedowns and quantitative easing
• Liquidity trap of a different sort
• More credit card writedowns are coming
• What’s different about 2008?
• The inflation-deflation debate

In case you missed it, the financial system in the U.S. is near collapse. This weekend was unbelievable. Lehman Brothers filed for bankruptcy. The world’s largest insurer AIG is looking for the Fed to help it avoid collapse and Merrill Lynch was forced to close a deal with Bank of America to save it’s own hide.

Just another day at the office? Hardly. Dow Futures are down 350 points and the FTSE in London is already off nearly 5%. So get ready, this is going to be a very, very difficult day in the markets. Here’s the news of importance:

It all started on Monday last week. In the aftermath of the Fannie and Freddie bailout, market nerves were not calmed. Washington Mutual fired its CEO and announced it had an ominous agreement with the OTS (Office of Thrift Supervision).

Meanwhile Lehman Brothers released an early third quarter earnings report that was widely panned by analysts.

Then, it became obvious that some major losses in the Credit Default Swaps (CDS) market were in the offing due to the takeover of the GSE’s by the government. That was going to hit companies like AIG, which had a huge exposure to the CDS market.

The result was a meltdown in shares of WaMu, Lehman and AIG on Friday.

The Fed called an emergency meeting to deal with Lehman. No agreement was found and Lehman declared bankruptcy early this morning. They have assets of $500 billion

AIG dealt with three buyout shops to shore up its capital base but rejected an offer and went hat in hand to the Fed instead. They have assets of $1 trillion.

WaMu has not seemed to do anything. But rumors are swirling and they will come under great pressure this morning. Oh, and they have assets of $300 billion.

Merrill Lynch was the coup of the day. They struck a deal with Bank of America at a significant premium to both book value and the prevailing market price of their shares. Given what we are likely to see today, Merrill Lynch and its shareholders have to be very very happy. They can say, “thank you very much, John Thain.” Oh, and they have a assets of $1 trillion.

So, we’re talking about combined assets of $2.8 trillion here.

Conclusion
So, the day begins with one company gone (Lehman). Two companies under heavy selling pressure (AIG and WaMu) and one company loving life (Merrill Lynch). Who else should we watch?

All the regional financials, the home builders, and the Commercial Real Estate REITs are all going to be under heavy selling pressure.

Brace yourself!

Related posts:

• Mea Culpa: I was too bullish on the BofA-Merrill deal
• Why Lehman failed
• AIG down; Lehman and WaMu looking to be sold
• SEC charges BofA of lying to investors over Merrill but settles
• Merrill – Bank of America deal

As far back as May, I had warned that commercial property was destined for a bust — collateral damage in the real economy. In particular, I mentioned the U.S. commercial real estate (CRE) market as a particular problem for local and regional banks, which have large exposure to the CRE market. In May, I also mentioned incipient declines in the London commercial property market.

However, Marshall Auerback recently alerted me to an article about the downturn in the Frankfurt property market, a casualty of downsizing in the global banking system. Unfortunately, this news provides another headwind for the ailing German economy.

Below is a translated snippet from the article (original text in German).

The international financial crisis has precipitated a tumble in the office markets in banking metropolises. In London, New York City and Frankfurt a dramatic price decline is underway. Investors are afraid to take on deals. Some properties are being discounted 30 percent.

The crisis in the capital markets is reverberating back to the great financial capitals. With redundancies at large banks, less and less office space is needed. Therefore, the real estate market in the financial centers is coming under pressure. “The crisis in Frankfurt is palpable,” complains Edwin Black, planning agent in the metropolis on the Main river. It is even worse in London and New York. There, the price for office towers during the global real estate boom was shooting to absurd heights – and is now crashing to new depths. About 60,000 employees of international banks such as Bear Stearns, Citigroup, Lehman Brothers and UBS have already been dismissed because of the worldwide capital market crisis, according to a study of the Swiss Bank Staff Association already dismissed. More will follow. Wachovia, the fourth largest U.S. bank, has recently proposed the elimination of 6950 additional jobs alone – after a loss of 8.9 billion U.S. dollars (5.97 billion euros) in the second quarter.

This is driving up vacancy rates in the amount of office space and driving down rents and prices of real estate in the major financial centres. In the German banking metropolis of Frankfurt am Main, office buildings with a total value of only 373.5 million euros changed owner in the first six months of this year, according to a just released expert committee report. This represents a decrease of 88.5 percent compared with the transaction volume of 3.3 billion euros in the year-earlier period. The cause was “almost complete withdrawal of American investors, the rise in interest rates and restrained financing by the banks,” says planning agent Schwarz.
-Der Markt für Bürogebäude kracht zusammen, Die Welt

I reckon Deutsche Bank, with its huge U.S. CRE exposure is the bank most exposed here as it also has large exposure in Frankfurt – though it owns all of its own buildings. But, the report has implications for commercial property in London and New York as well.

Given this news, one might consider avoiding Commercial Real Estate REITs.

Related posts:

• Irish property dam about to burst
• UK commercial property market falling as well
• Commercial property hits the front page
• German banks loaded with 816 billion in toxic paper
• Hypo Real Estate: 600 billion in off-balance sheet assets

Stories of commercial real estate distress in the U.S. are mounting. As the residential real estate fallout takes form, commercial real estate has come under pressure as well. The Wall Street Journal has a front-page story out today that highlights the situation in the Sun Belt. We should see the distress in commercial property in bank writedowns very soon.

Flamboyant real-estate financier Scott Coles penned a farewell letter, put on a tuxedo and climbed into bed, where he was later found dead in what police believe was a suicide. The tragedy last month is drawing attention to the condition of the nation’s commercial real-estate market, which is beginning to show mounting signs of distress.

Mr. Coles, who was 48 years old, had built his company, Mortgages Ltd., into one of Arizona’s biggest private lenders during the real-estate boom. It specialized in short-term, high-interest-rate loans to commercial developers — builders of malls, office parks, condominiums and other projects — who either had bad credit or a need for quick cash with no red tape. But he overreached, and the debacle that has devastated the U.S. housing market the past year is now squeezing Mortgages Ltd.

To keep growing and outrun the problems, Mr. Coles leaned increasingly on loans — totaling roughly $200 million — from an obscure company, Radical Bunny LLC, run by his accountant. He also sought to raise new money on terms that undermined his existing investors. These moves triggered the departure of several senior managers at the firm in recent months.

So far, the commercial-property market has been spared the devastating losses felt in the housing market because there wasn’t flagrant overbuilding. But declining property values and a weakening U.S. economy are starting to bite: Mortgages Ltd. and other lenders are reporting a significant jump in loan defaults. That’s placing enormous new pressure on the lenders, which have bet billions of dollars on new construction of commercial properties.

“Scott got overly optimistic and thought the good times would go on forever,” says Elliott Pollack, a prominent Scottsdale, Ariz., economist and real-estate consultant who invested in Mortgages Ltd. “The world changed, and it’s going to crush a lot of other lenders in the country.”

-WSJ, 16 Jul 2008

Related posts:

• Commercial Real Estate bust
• UK commercial property market falling as well
• CRE: GMAC-related Capmark Financial near bankruptcy
• Commercial real estate is next
• British commercial property prices down 27% in 2008

Back in June, I wrote about financial investors in bank shares having lost $10 billion. Then, I predicted that losses would mount and bank shares will fall. It seems that one part of that equation is true already as bank shares have fallen precipitously in the last several days on the heels of turmoil with the GSEs and with IndyMac.

However, I think it is time to revisit the chatter about why bank shares are falling and why investing in them is like catching a falling knife.

In June, FT Alphaville, a blog for the Financial Times said this about the early investors in financials:

Investors who backed the recent drive by U.S. financial companies to raise capital are sitting on nearly $10bn in paper losses amid a continued slump in the sector’s shares, an FT analysis shows. The negative returns suffered by investors are likely to make it more difficult and expensive for U.S. financial groups to tap equity markets if, as expected, they are forced to raise more capital. Investors who bought the $65bn-plus in common and convertible shares issued by large U.S. financial institutions since last October have seen their total investments fall by more than $9.7bn – a negative return of about 15% – according to an FT analysis of Dealogic data.
-FT Alphaville, 16 Jun 2008

Today, Bloomberg had an article highlighting the worsening state of losses in banking shares:

TPG Inc.’s plan to profit from Washington Mutual Inc., the biggest U.S. savings and loan, may be sinking with the housing market.The private-equity firm, led by David Bonderman, anchored a $7 billion cash injection into Washington Mutual in April by purchasing stock at a discount. The Seattle-based lender’s share price has since plummeted, wiping out two-thirds of the investment’s value.

Washington Mutual tumbled to the lowest since 1991 yesterday on the New York Stock Exchange, leading the drop in home lenders after IndyMac Bancorp Inc. was seized last week by U.S. regulators. Bonderman’s firm, which invested $2 billion in Washington Mutual for a 13 percent stake, has been stung by record foreclosures, particularly in California, home to half of the bank’s loans.

-Bloomberg, 15 Jul 2008

With share price losses having mounted significantly (the S&P500 Bank Index is down below 150 from near 300 in February and almost 400 one year ago), one gets the feeling that actual losses on net income and bankruptcies are coming.

Where?

Soon after this crisis began in February 2007, U.S. Treasury Secretary Henry Paulson said the sub-prime mess is:

“going to be painful to some lenders, but it is largely contained.” “We have had a significant housing correction in the U.S.,” Paulson said in an interview on CNBC. “The correction has been significant. You can’t have a correction like that without causing some dislocation. It is too early to tell whether it has bottomed. We’ll know more in the next month or two.”
-13 Mar 2008, MarketWatch

However, the mess continued on and on until $400 billion in assets had been written down. But that part is done. Bridgewater Associates, a respected hedge fund in the US, recently said that sub-prime is 90% over. So the losses are obviously not going to come from sub-prime.

There are three obvious places to look:

1. Other mortgage areas beyond subprime that have been ‘tainted’ by the subprime mess and that are showing signs of distress.
2. Other credit classes that exhibited the same levels of euphoria during the upswing
3. Other unrelated credit classes that might be affected by a negative feedback loop that credit contraction has on the real economy.

As far as Mortgage classes go, Alt-A is the class to watch now. This class between sub-prime and prime is now exhibiting many of the hallmarks of distress previously seen in sub-prime before it cratered. (See posts under the tag mortgages and home loans for more). IndyMac, now bankrupt, was a major provider of mortgages in this sector. In April, Moody’s began downgrading Alt-A Residential Mortgage-Backed Security (RMBS) bonds.

Moody’s Investors Service issued more Alt-A downgrades on Thursday morning, this time taking a heavy hand to 32 different Aaa-rated tranches from 10 different Alt-A deals. Many of the downgrades even pushed former Aaa’s into non-investment grade categories — a stunning descent for top-rated Alt-A mortgage bonds that underscores two key points.

First, defaults are obviously accelerating. Second, many Alt-A deals were issued with less in the way of overcollateralization — which, in plain English, means that these deals will start to see downgrades sooner, compared to the relative stress that a typical subprime RMBS deal can withstand before the hits start coming at the Aaa level.

The rating agency placed an additional 254 Aaa-rated Alt-A classes on negative ratings watch Wednesday.

All underlying collateral for the downgrades issued Thursday was originated by Impac Mortgage Holdings., Inc., the agency said in a press statement, making the Irvine, Calif.-based lender among the first major Alt-A lenders to see significant Aaa- downgrades to mortgages it originated.

-Housing Wire, 24 Apr 2008

One shouldn’t rule out prime mortgages either.

When it comes to other asset classes that were exuberant on the upswing, my list includes:

• CRE (Commercial Real Estate)
• Construction Loans
• Leveraged Loans
• Credit Card and Auto ABSs (Asset-backed securities)
• High Yield corporate debt
• Emerging market sovereign debt

Now, those same classes are all ones that should suffer along with the global real economy downturn.

Conclusion
My prediction is that Alt-A RMBS losses will be the first to appear en masse followed by other asset backed securities as these have to be marked to market. This will mean significant additional losses for the money center banks in particular. But not only in the U.S. but elsewhere as many global players have exposure in these areas.

Construction and CRE loans will sour next as the regionals are forced to increase loan loss provisions in the commercial and residential real estate sectors. Real estate is the hardest hit sector to date. Therefore, I would look for losses to come there first.

Finally, we will begin to see losses in other asset classes as the real economy starts to struggle. High Yield (particularly lower grade bonds) and leveraged loans will suffer. When and how sovereign issues enters the picture is dependent on asset class contagion. Spread products like high yield sovereign debt is vulnerable to wholesale risk repricing and could fall at any point with other debt asset classes.

This scenario certainly spells bankruptcy for a few money center global players ad a raft of regional and local banks. With IndyMac as a canary in the coalmine, I suspect we will see these bankruptcies in the very near future.

All of this is reason to believe that investing in financials is going to be like catching a falling knife for some time to come.

Related posts:

• New Writedown Risk: Alt-A
• Investors in Financials lose $10 billion
• Prime looks terrible
• Bailouts: catching a falling knife
• Bank bankruptcy or bailout?

Mike Morgan is a Florida real estate professional with years of experience. He is often featured on Mike Shedlock’s site with his commentary of Florida real estate as ground zero in the housing bubble. He writes about his basic premise that we have been in the eye of the storm, but that there is more storm to come. I saw his article in Barron’s when it came out but it is now publicly available on Mike Morgan’s site. Now might be an opportune point to re-visit his themes.

In the Eye of the Housing Hurricane
Here’s a lesson many Floridians have learned the hard way: All hurricanes have three parts—the front half, the eye and the back half. The eye is a deceiving quiet period at the center of the hurricane. The eye lulls you into believing the storm has passed and all is well.

In fact, the back half of a hurricane can be far more devastating than the front half. The front half of a hurricane does a lot of damage and weakens many structures. Then, when the back half hits, houses, buildings and personal property teetering on the brink of failure are utterly destroyed. Moreover, since the wind is coming from the opposite direction, anything strong enough to resist the first half is tested again by the back half.

This is exactly what’s happening in Florida’s housing and financial markets. We are in the eye of the hurricane, and the back half will hit us twice as hard as the front.

The front half of the Florida real-estate hurricane was fed by a bidding frenzy that drove prices to a peak far above real demand: Flippers were not buying homes for function, just for trading. And with the Fed’s free-money policy, flippers were leveraging themselves at the same 30-to-1 and 50-to-1 levels as the financial wizards on Wall Street.

This artificial demand created an inflated supply of homes. By 2006, the inventory of unsold real estate reached a crisis level (“Florida’s Housing Hurricane,” Other Voices, Oct. 2, 2006 – Click Here). The combination of rising inventory and prices, which had no relation to demand for housing that people wanted to live in, fed the front side of the hurricane.

Recently, however, there has been a lull in the windstorm. Would-be buyers are returning to the market. Over the past few weeks, we’ve been seeing 300% increases in traffic at our open houses from a year ago. Builders and real-estate agents report that offers are up, along with traffic.

But this is not the end of the hurricane; it’s still the eye. What the builders and agents neglect to report is that most of the traffic couldn’t qualify to buy a moped. Nor do they report rising rates of pending contracts that fail to close. And they don’t mention the damage being done by falling prices, which put more and more homeowners into negative-equity positions and make it more likely that more property gets pushed back to the lenders.

Nor do the builders dare to mention the bulk sales of inventory homes they are making to a new generation of giddy flippers with deeper pockets. This nonsense not only forces prices down further; it also creates a new competitor for the builders’ remaining inventories. The bulk buyers still have to sell these homes to end-users.

This twist is not all that new, but it is continuing to feed the overall problem of inventory glut. However, this is not what we should be focusing on as we enter the back half of this hurricane.

Almost nobody is reporting on how the inventory problem of 2006 has moved from builders to lenders, and how the lenders have no clue about what to do with the surge of defaults and foreclosures.

The reason the back half of the hurricane will be such a devastating wipeout: The failure of the lenders to address their issues with defaults is compounding the inventory problem to the point where we will see a tidal wave of inventory hit the market.

As a real-estate broker in Florida, I have first-hand experience with homeowners defaulting on mortgages and lenders who appear to be far too confused to develop a clear plan for avoiding foreclosure auctions.

Buyers now realize lenders are going to take weeks or months to review and respond to offers that often reflect market value but fall short of covering the balance on the mortgage. Such “short sales” should be the easiest way for lenders to move inventory at market prices—but the lenders have not faced reality. And now, most buyers who have had experience with short sales no longer want to look at short-sale properties because of the long and convoluted process. Instead of using this tool to realize market values, the lenders are dumping property into below-market foreclosure auctions, which then creates another new downward spiral for prices.

Lenders’ failure to address these issues has forced more defaults, which lead to skyrocketing foreclosure rates. Defaults and foreclosures mean huge expenses for the lender, and significantly lower values. And it gets worse for lenders. In the most extreme examples, lenders cannot foreclose because the documents have not followed the mortgage.

Lenders may be telling Wall Street and Capitol Hill that they are developing plans to keep owners in their homes, but we are seeing the exact opposite in the world of reality. Even when we try to work with lenders, most of the time there is no one at the helm with the authority to process a cup of coffee, let alone the sale of a property in default. The easy answer is to simply let the property flow through to the foreclosure auction, even when that means 30% to 50% less in sale price.

Commercial and retail property are also becoming casualties in the back half of the hurricane. Drive through just about any Florida market to see all the For Lease signs on commercial property. Real-estate agents, lawyers, builders, contractors, mortgage brokers, insurance companies, furniture stores and all the rest are going out of business and leaving a flood of office and commercial inventory vacant.

The condo market? Do you really want to hear anything about the devastation that the lenders and local municipalities are facing over the collapse of the condo market? That’s like adding a Class 5 tornado to the Category 5 hurricane over Florida.

————————————————————————————————

MIKE MORGAN is a real-estate broker in Stuart, Fla. and owner of Morgan Florida, which offers residential, commercial and investment real-estate services and research.

Related posts:

• Commercial Real Estate bust
• Commercial property hits the front page
• Why Real Estate Market Is Nowhere Near a Bottom: Caroline Baum
• Looking for a bottom in Manhattan real estate
• Commercial real estate is next

The Washington Post has a story on regional and healthy banks that I highly recommend. Essentially, we are past the first wave of writedowns and are moving into phase two where it won’t be about derivatives and RMBS’s as much as underlying loan losses and collateral damage in commercial property and construction loans. In the U.S., this puts the regionals front and center

The one and only reason I would support bailouts or nationalization of mortgage debt is because of systemic risk. I am very dubious on the bailout plans presented to date.

Ultimately, when good companies go down with the bad, as happens in a recession, it is a shame. But, there comes a point when systemic risk threatens to paralyze an economy. It is still early days. Nevertheless, we should keep this in mind as the credit crisis unfolds.

Increasing struggles by consumers and businesses to make payments on a variety of loans, not just mortgages, are setting off a new wave of trouble in the financial sector that is battering even institutions that had steered clear of the subprime-home-loan debacle.

Late payments on home-equity loans are at a record high, according to fresh data from the Federal Deposit Insurance Corp. The delinquency rates on loans for cars, small businesses and construction are spiking to levels not seen in a decade or more.

Unlike last year, when soaring mortgage defaults sparked a crisis of confidence in the financial system, the root of these problems is the downturn in the broader economy. Simply put, consumers and businesses are strapped for cash with job losses growing and retail sales falling, economists said.

“We are not finished with the mortgage problem, but you are starting to see increased delinquencies in other forms of consumer debt,” said Paul Kasriel, an economist at Northern Trust Securities. “We are in the eye of the hurricane. We had the first wave of the credit crisis, and it was quite damaging. But there’s another wave coming, and it’s likely to be as destructive.”

The institutions most at risk in this new phase of the credit crisis are regional and local banks, many of which stayed away from subprime mortgages. These firms are key drivers of economic activity in communities across the country. Without them, consumers would lose a source of personal loans. Small businesses would struggle to stay afloat. Construction companies often can’t finance local projects without these banks.

Because they have fewer options than big Wall Street firms for raising emergency funds, these regional and local banks tend to be more vulnerable in a crisis.

In the Washington area, the stock prices of several local banks have already plummeted, with shares of Virginia Commerce Bank falling nearly 50 percent and Alliance Bank dropping about 45 percent since the beginning of the year.

-Washington Post, 22 Jun 2008

See: Credit Crisis Timeline for a full list of writedowns and capital raising by institution and a timeline of the credit crunch.

Related posts:

• More warnings on regional banks
• Wave of regional bank write-offs?
• The regionals versus money center banks
• Regionals are exposed to credit crisis
• $35 billion in missing writedowns