Bad CRE, Rotten Home Loans, and the End of US Banking Prominence?

Zero Hedge

It’s bound to happen if regulators don’t stop playing hide the sausage
and don’t start forcing banks to take their medicine. First, a quick
recap of the nonsense currently taking place. This post is designed to
convince banks that they are considerably better off taking their
medicine now than going on with the government endorsed plan of
pretending your not sick and risking major surgery, plus chemo and
radiation just a year or two later. My next post will be a selection of
REITs that didn’t make my shortlist, followed by a new REIT report for
subscribers that will explicitly show property values of each and every
property in said REITs portfolio (and potentially the lender or
CMBS/mortgagee pool collateralized by said properties – that’s right,
someone may be called out).

After dealing with European banks during my work with GGP,
I have come to the conclusion that most regional, community and even
global banks have no where near the capacity and/or expertise to
properly evaluate and value the projects/assets that they have invested
in. Well, if that is the case, this is your chance to rectify that
problem – on the cheap, at least on a relative basis. So if you are in
an appropriate position in your bank, fund or lender – read this
evidence that supports the proactive behavior of snatching the big
crumbs off the table before there is a mad dash for the micro-specs of
bread that may or may not be left if one were to wait it out while
playing “hide the sausage games”. I’ll give you the tools to make a
convincing argument, trust me. Here is the broader macro argument for
lenders pulling bad debt from under the REIT and CRE industry, thus
supporting a bearish thesis for said players.

First: A picture is worth a thousand words…

Instance asset gains and market value stemming from just a small tweak
of truth. Financial stocks fly, moving farther and farther from their
fundamental values.

Second: We have the obvious manipulation that is occurring in the REIT space (see Here’s a Big Company Bailout by the Taxpayer That Even the Taxpayer’s Missed!). Zerohedge speculates “Is Goldman Preparing To Upgrade The REIT Sector?” 

Third: We have government complicity in the purposeful opacity of the
values of the mortgage assets (see the FDIC “Prudent Commercial Real
Estate Loan Workouts” guidance issued Oct 30th, as reported by the WSJ:
Banks Hasten to Adopt New Loan Rules and the new FDIC guidance
that states performing loans “made to creditworthy borrowers” will not
require write downs “solely because the value of the underlying
collateral declined”).

Fouth: We have a false sense of security that nearly everybody believes
should make us insecure, yet somehow we have those long in the markets
feelng warm and fuzzy. See You’ve Been Bamboozled, Hoodwinked and Lied To! Here’s the Proof. What Are You Going to Do About It?.

Now, for those of you who believe that the government’s “pretend and
extend” policy has any chance in hell of working, or better yet, that
we are not following in the footsteps of Japan, let’s take a pictorial
trip through recent history. There are nearly no Japanese banks in the
top 20 bank category on  global basis by 2003 – NONE (save potentially
Nomura, which arguably survived in name, alone). As you can see, they
literally dominated 90% of the space in 1990!

Click to enlarge…

Source: Cap Gemini Banking M&A

I want the banks that read my upcoming real estate analysis to take
heed to history. It truly does tend to repeat itself. If you are an
officer in a bank with CRE exposure, reach out to me from your work email
and I will supply you with an abbreviated copy of one of the recent
reports, gratis. This should  whet your appetite to subscribe for
more. 

Well, are we following the Japanese “Lost Path”. Notwithstanding the
damning evidence of hide the truth and hide amongst lies linked to
above, ponder the following rather dated, but still quite poignant
data… 

Source: Nomura on Balance Sheet Recessions

Futures have corrected even farther since this graph was made. As excerpted from a previous guest post on “Animal Spirits”:

First consider this chart of Japanese home prices:

Their prices peaked in the middle of 1991 and have declined ever since. We have now seen 18 years of decline.

One may then counter that Japan is a one off case due to their poor monetary policy. Well, then what about Los Angeles?

Consider the following chart:
Note,
our bubble was bigger, stronger and longer than theirs. Ours has also
has considerably more stimulation than theirs. Yet periodically
throughout that bubble we saw seasonal upticks, and they were also
during the March-June/August time frame.

Our housing prices peaked in December 2005. Through June 2009, that’s
3.5 years. Even relative to this smaller bust, we are still in the
crash phase, which is then followed by a long tail of lower prices at a
diminished rate of decline. Given our bubble was much bigger and longer
in the making, I contend this will be longer if anything, not shorter.

Notice, in some ways as of 2008, US and Japanese bank losses have been
similar. I posit the US losses will end up being much worse. Notice how
the chart below references the subprime crisis. I have always alleged,
and apparently have been proven correct, in that this is an Asset Securitization Crisis. and by definition is much broader, deeper and more intense than any subprime crisis could ever be.

Source: IMF, Global Financial Stability Report (October 2008), p.16

Japanese asset prices literally collapsed after 1990, but several banks
remained in the Global top 20 for some years (reference the second
chart from the top of this blog post). Don’t be fooled, though. If the
value of your assets plunged significantly, your equity and enterprise
value are soon to follow.

 Here are a few quotes from others who have studied the situation:

•Japan financial minister Watanabe: “Unlike Japan’s 1990s
crisis, financial risk in the U.S. spread beyond the bank sector to the
rest of the financial system, i.e. hedge funds.”
•In the May/ April 2009 issue of Foreign Affairs, Robert
Madsen, a senior fellow at MIT, pointed out that “Japan’s illness
occurred in a relatively benign international environment,” with
overseas markets hungry for Japanese exports, the yen holding strong,
and the government posting a modest surplus. The U.S. is in a very
different place, Madsen writes. The U.S. deficit is skyrocketing, and
appetite for its exports is weak.
•Economist David Rosenberg at Merrill Lynch: “Japanese consumers had a
higher saving rate (13%) going into the 1990s crisis than Americans had
going into the present crisis. In the USA, there is no high savings
rate to wind down in support of consumption. It’s been more than 25
years since the U.S. savings rate was anywhere close to where it was in
Japan at the onset of its multi-year real estate deflation and credit
contraction.”
•Analyst Koyo Ozeki of PIMCO: “One factor that probably helped stem the
default rate on home mortgages in 1990s Japan despite the sluggishness
in the economy was the relative employment stability, thanks to the
system of lifetime employment.” [as opposed to 10%+ employment here in the states]

•Analyst Masamichi Adachi of JPMorgan: “Reliable
valuation is key to solving financial instability. A key underlying
issue through Japan’s lost decade was a distrust of valuations of land
prices and NPLs. This issue applies to the current global credit
situation too, i.e. valuations of structured finance products and of
likely losses at financial institutions.” [reference the first graph at the top of this post, and then wonder why no one trusts the banks, even the banks themselves!]

•Analyst Takehiro Sato of Morgan Stanley: “During a liquidity crunch,
market players retain cash regardless of the level of interest rates
and do not supply funds to external parties during a sharp rise in
credit risk. Monetary easing alone won’t expand credit or stop
collateral values from falling…However, unconventional measures (such
as nationalizing corporate debt) are still an option.” [reference the
chart below]

•Central Bank of Cyprus Governor Athanasios Orphanides: “Low or zero
interest rates alone do not indicate a liquidity trap as long as there
are assets in the economy that the central bank can purchase with
money.” [Bernanke read these notes!]
•Analyst David Rosenberg of Merrill Lynch: “Fiscal stimulus in 1990s
Japan was a band-aid, not a solution. All the stimulus did was prevent
an even greater decline in real GDP. As for monetary policy, aggressive
moves to boost the money supply are offset by the contraction of
private sector credit as money disappears into debt elimination.
Reflationary monetary policies are merely going to minimize
destabilizing deflation pressures.” 

So, how’s it looking across the Pacific over here in the good ‘ole US
of A? As excerpted from, and sourced with the assistance of RGE
Monitor…

• National Federation of Independent Business
  (NFIB): The NFIB Index of Small Business Optimism posted a modest gain
  of 0.3 points to reach 89.1 October 2009 after remaining largely flat
  in September. Small business owners reported weak sales as the biggest
  cause of concern and a net 40% of firms reported a negative profit
  trend. Plans to increase employment remained negative in October, but
  improved over September. Firms continued to liquidate inventories in
  October. Plans for capital expenditure over the coming months fell, and
  as of October, stood 1 point above the 35 year record low reached in
  August. (National Federation of Independent Business, 11/11/09)
• Demand
  for loans remains weak as a result of a delay in restocking and capital
  expansion plans. The net percentage of borrowers reporting tighter
  access to credit remained high at 14% in October, and firms reported
  high rejection rates. (National Federation of Independent Business,
  11/11/09)
• Melinda Pitts, Research Economist, Federal
  Reserve Bank of Atlanta: When national employment levels were expanding
  since 1992, small firms operating with under 50 employees accounted for
  one-third of the employment growth.  While in the 2001 recession, these
  firms accounted for only 9% of job losses, in the current recession,
  they have accounted for 45% of job losses. If the financial constraints
  are a major contributor to the disproportionately large employment
  contractions for very small firms, then the post recession employment
  boost these firms typically provide may be less robust than in previous
  recoveries. (Macroblog, 10/06/09) [which portends significantly longer
  lasting unemployment than I think many are even coming close to pricing
  in]
• According to a New York Times report on October 12,
  2009 many small businesses are struggling to get bank loans, which is
  constraining expansion plans.  While the credit squeeze from banks
  reflects risk aversion as lenders confront economic uncertainties, the
  banks say that the tight credit conditions stem from weak borrower
  performance rather than a reluctance of banks to make loans. (NYT,
  10/12/09) [exactly as experienced in Japan, seen via the chart above.
  This is exacerbated by major sources of small business loans going
  bankrupt - reference Retailers Fear Impact of a CIT Bankruptcy - washingtonpost.com and CIT Bankruptcy Filed: US Will Likely Lose $2.3 Billion, Goldman ...]
• Dennis
  Lockhart, President, Federal Reserve Bank of Atlanta: Banks with the
  highest exposure to commercial real estate loans also happen to account
  for 40% of all loans going to small businesses. The potential impact of
  the commercial real estate problem on the broader economy remains a
  concern. Commercial real estate could be a factor that suppresses the
  economic recovery by impairing the ability of small banks to support
  the small business sector, which is critical for job creation.
  (11/10/09) 
• William C Dunkelberg and Holly Wade:
  Financing is cited as the most important problem by only four percent
  of NFIB’s member firms. Enhancing SBA lending programs will not help as
  too many owners have no reason to borrow. “Record low percentages cite
  the current period as a good time to expand, more owners plan to reduce
  inventories than to add to them, and record low percentages plan any
  capital expenditures. In short, the demand for credit is in short
  supply and failing to understand the more major problems facing small
  business leads to bad policy.” (National Federation of Independent
  Business, 11/11/09)
• According to the October 2009
  Federal Reserve Senior Loan Officer Survey, lending standards for
  commercial and industrial loans for smaller firms (with annual sales
  less than US$50 million) continued to tighten, though at a slower pace
  as compared to July 2009. About 16% of the surveyed banks reporting
  tighter lending standards for loans to smaller businesses. 55% of
  respondent banks reported lower demand for commercial and industrial
  loans from small businesses. 44% of the surveyed banks reported weaker
  demand for commercial and industrial loans in Q3 2009, with 40% of the
  surveyed banks attributing the weakness to lower investment in plants
  or equipment.  (11/09/09)
• Jan Hatzius, Economist, GS:
  Indicators that reflect the performance of small businesses look
  significantly weaker, like the National Federation of Independent
  Business (NFIB) small business index. The household survey of
  employment, which does not contain a small business bias unlike the establishment survey, shows an average loss of 140,000 jobs per month over the establishment survey. Standard
  economic indicators such as nonfarm payrolls, factory orders, shipments
  and the ISM extrapolate from the behavior of larger firms to the
  behavior of the aggregate economy and may be overstating economic
  activity at present. “Although both the economy and
  the financial markets are in much better shape than they were earlier
  this year, we are far away from a V-shaped recovery.” (via the October
  13, 2009 Report: “The Small Business Slump, and Why It Matters”)
• Jan
  Hatzius, Economist, GS: The economy might have grown between 0.5 to 2
  percentage points more slowly than indicated by the advance Q3 2009
  estimate of 3.5% annualized real GDP growth, because of the inability
  of official estimates to capture the unusually poor performance of
  small firms.  Even if this is correct and shows up in the revision
  data, it could take several years.(via the November 11, 2009 Report:
  “Small Firms and GDP Measurement”)
• William C Dudley,
  President, Federal Reserve Bank of New York: “For small business
  borrowers, there are three problems. First, the fundamentals of their
  businesses have often deteriorated because of the length and severity
  of the recession—making many less creditworthy. Second, some sources of
  funding for small businesses—credit card borrowing and home equity
  loans—have dried up as banks have responded to rising credit losses in
  these areas by tightening credit standards. Third, small businesses
  have few alternative sources of funds. They are too small to borrow in
  the capital markets and the Small Business Administration programs are
  not large enough to accommodate more than a small fraction of the
  demand from this sector.” (10/05/09)
• Apart from the
  traditional interest rate channel of monetary policy transmission, the
  effects of monetary policy are argued to work through a separate “bank
  lending channel” – the effect of policy changes on the supply of credit
  by banks. Mark Thoma, Economist’s View Blog: While large firms can
  raise credit from non-bank sources such as the issuance bonds and
  commercial paper, small businesses are dependent on bank lending for
  credit. The effect of a credit or policy shock on borrowing by large
  and small firms is thus asymmetric, and can cause small firms to
  contract activity more sharply. Tight credit conditions for small
  businesses are suggestive that the bank lending channel has been
  important in this recession. (10/13/09)

This really calls into question the usefulness of broad GDP reports in
anticipating asset value recovery after a land bubble bust. See “#87b876;”>Who are ya gonna believe, the pundits or your lying eyes?”#000000;”> (for pictures), “Who are you going to believe, the pundits or your lying eyes, part 2″ (for numbers and a very shaky video), and Boo!!! Will Halloween Scare the Market into Respecting the Fundamentals? for an idea of what needs to be cleared up in this space before we move forward.

Hey read this - Treasury Sales Smash Record – WSJ.com: Oct 30, 2009 …
For all the concern over Washington’s deficits and its $12 trillion
debt load, the US demonstrated this week that it retains the capacity
to…

Now check out the chart below and tell me if this calls anything to mind… 

If we do follow the path of the Japanese (and thus far I see nothing
but similarities except for where Japan was in better shape than the
US, save sume structural rigidity) one can be rest assured that their
will not be a big future in lending and fixed income products…

If our situation is indeed more intense than the Japanese, then it can
easily be surmised that to exist stimulus before Midterm Elections next
year will push us back into recession. Who wants to take that bet????

 According to Nomura, although the US and Japan may be (have been)
successful in bolstering the money supply through government action,
that money acts very, very differently during a balance sheet
recession. Click to enlarge…

  The logic behind the debasement of the dollar? According to the most
popular school of thought amongst the academics, it is unavoidable…

I will suggest congress force the three main ratings agencies to post this disclaimer everywhere their name or logo appears!!!

The graphic comes from the Nomura report linked above. The last line was a Reggie Middleton touch-up job .

Bankers, if you are not yet convinced it is time to take the first
mover advantage on some of those rotting CRE assets, then I don’t think
you will be convinced at all. Next up, a peak at my short list of REIT
candidates rejects.

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