Banking and Real Estate: The Problems Are Still There

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 |  Includes: IYR, XLF
by: John M. Mason

Fed Chairman Ben Bernanke just informed Congress that people were not anxious to buy homes. He commented that “there’s no demand for construction to build homes and so the construction industry is quite reduced.”

As a consequence, the Fed will continue to purchase Treasury securities up to some $900 billion, $300 billion to replace maturing mortgage-backed securities that have rested in the Fed’s portfolio and an additional $600 billion to expand reserves in the banking system.

My feeling has been that this injection of reserves into the banking system has been to protect the banking system, especially the smaller banks, and keep failing institutions open for as long as possible so that the FDIC can close these insolvent banks in an orderly fashion.

This, of course, is different from what the Fed has been telling us. The Fed has argued that their reason for the injection of liquidity into the banking system has been to help spur on bank lending and help accelerate economic growth.

The data that continues to come in from the real estate sector does nothing to convince me that the Fed’s statement is the correct one.

Data coming in from the real estate sector, I believe, continues to support my contention that the loan portfolios of many smaller financial institutions remain seriously underwater.

The median sales price of a house sold in February, the Commerce Department has just reported, was $202,100, down from $221,900 a year earlier. This is a drop of almost 9%.

Just one added piece of information: last month’s price was at it lowest level since December 2003 when the median sales price stood at $196,000.

This just exacerbated the problem of “underwater” mortgages. CoreLogic, Inc., reported in early March that about 23%, or roughly one out of every four, mortgages in the United States had outstanding balances that were higher than the reported value of the secured properties.

In addition, a record 2.2 million homes were in foreclosure in January of this year. The number of homes in foreclosure had slowed down in the last half of 2010 because of all the fuss being made about how banks had not used proper methods to foreclose on many properties. This slowdown seems to have ended.

Furthermore, the purchases of new homes declined to the slowest pace on record.

Housing starts dropped in February to an annual rate of 479,000, the lowest level since April 2009.

And, construction permits slumped to a record low.

The commercial real estate sector is now getting hit with a new phenomenon…state governments and municipalities that are under tremendous budget pressures are downsizing and cutting back on office space. As a consequence, a lot of commercial office buildings are standing empty and their owners, who are not the states or municipalities, are faced with the task of trying to fill up the empty space.

The banking system holds the paper on a lot of this real estate.

The question is, how big a write-down is the commercial banking system going to have to take…and how fast is it going to have to take it.

The credit inflation the Federal Reserve is trying to create, I don’t believe, will cause housing prices to turn around any time soon in the magnitude needed to save their asset values.

Sooner or later these asset values are going to have to be written down.

Therefore, the efforts of the Fed are just allowing banks to stay liquid enough so that the assets do not have to be written down precipitously. In that way the regulators can control the situation and close the banks that must be closed in an orderly fashion.

But, this raises another question. This question pertains to the length of time the Fed will need to continue to provide liquidity to the financial markets? That is, how long will QE2 be maintained?

The original plans of the Federal Reserve were to call an end to QE2 in June. But, will we need to add on QE3?

My guess is that the Fed will need to continue some kind of program to maintain the “peace and quiet” on the banking front for an “extended period.”

This is a “good news” and “bad news” situation. The “good news” is that events in the banking sector are relatively quiet. The FDIC continues to close banks in an orderly fashion.

The “bad news” is that events in the banking sector are relatively quiet. The Fed must continue some kind of financial support to the banking industry because there are so many real estate related assets in the banking system that are troubled and are in need of a “write down.”

It would seem that as long as there are problems like the ones described above in the real estate sector, there will continue to be problems in the banking sector.

And, as long as there are problems in the real estate sector and the banking sector of this magnitude, the desired pickup in the economy will not be forthcoming.