Jeffrey Bernstein's  Instablog

I was fortunate enough to attend Jamie Dimon's lunch presentation at the J.P. Morgan cyclicals conference the other day. I think it's worth re-capping here. I read Dimon's letter to shareholders in the J.P. Morgan annual report a few months back and was amazed by how well Dimon explained the financial crisis in plain English that even non-Wall Streeters could understand. You can find it here. I have always believed that the true measure of intelligence is the ability to explain complex concepts in simple terms. So I had great expectations of Dimon's lunch presentation at the conference and I wasn't disappointed. I will try to re-cap what I heard for you. My apologies to you and to Jamie if I miss anything or mischaracterize anything that was said.

Dimon began by taking the audience back in time to the Bear Stearns bankruptcy, when he got a phone call at a Greek restaurant asking if he could lend Bear Stearns $30 billion. He proceeded to walk through the incredible happening of the next nine months culminating with the Fannie/Freddie implosions, Wamu, Wachovia, Lehman, AIG et al. He noted that while he raised his hand to tell the powers that be that his bank did not need TARP, several other institutions said they would take the money before the Feds even finished making their offer. He averred that he agreed with the strategy of making all of the 19 large institutions take the TARP money, so as to avoid the risk of the strong refusing it because they didn't need it and the weak refusing it for fear of causing runs on their banks. Was TARP the perfect plan? No! But in hindsight it seems to have worked. Dimon averred that he didn't like how the Feds bailed out the auto companies by giving the unions 50% of the the business, but he told his bond guys he believed that it was fair that as secured creditors, his guys received just 30 cents on the dollar of debt, because in a liquidation they would have received even less. Not perfect, but the point was for the government to do something, not nothing.

Dimon asked the audience, which included a large number of management teams from cyclical companies that were presenting at the conference (many of these companies were large and small conglomerates serving many diverse end markets): Is your business stabilized or getting better? Many hands went up. Then he asked how many people's business is getting worse? One hand went up. Then he asked: What stock are you? Eliciting a well deserved roar of laughter. Not only is the guy straight as an arrow in telling it like he sees it....he's got a sense of humor too.

Dimon then discussed the kind of freeze he believed took place as a result of the markets going tilt last year. He asked, How many people moved money from riskier to lower risk assets in response to the crisis? Many hands went up. Dimon said that some $1 trillion of corporate assets were believed to have been moved into low risk, short maturity paper and was poised to move out on the risk curve. I don't believe he offered a quantification of the amount of consumer money that had done the same. He discussed the consumer pullback and some research by J.P. Morgan economists suggesting that if the current decline in consumer consumption was sustained, the consumer balance sheet would be de-levered back to 2003 levels within three years. Dimon's opinion was that this would not happen, as he expected consumer spending to pick up and de-levering to take place over a longer period of time.

On the subject of bank losses Dimon was less sanguine, saying. "Expect several bank failures each week," the reason for this being that local and regional banks are much more levered to commercial real estate. Dimon asserted that the commercial real estate shoe had already dropped and that the recognition of the consequences was merely a matter of accounting treatment. That said, he did not believe that these bank failures posed a systemic threat to the system. He noted that the 19 largest banks hold 50% of all loans. All 19 are now sound due to TARP, stress tests and required capital raises. He averred that these banks also had a margin of safety from their "well capitalized" status even if un-employment exceeds the "worst case" 10% level. Additionally, these banks have other levers to pull in terms of cost cutting and efficiency, as well as the ability to earn significant sums in short-order in the current environment.

In terms of the progress of the economy and capital markets, Dimon pointed out that the capital markets continue to open wider and wider, accommodating increasing lower rated credits' capital raising needs. He stated that stimulus money was only just beginning to flow and that the near-term economic outlook was increasingly positive. At this point Dimon threw the floor open to questions. His answers were concise and well reasoned, and addressed questions as diverse as what should bank regulations/capital requirements look like going forward? (Capital requirements will be higher) Should there be a "Too big to fail" policy? (No, it would invcentivize everyone to consolidate into giant banks status), Can J.P. Morgan make a 15% ROE in the future? (They can and are already at 10-12%).

Dimon opined on the status of the dollar by saying that China held only 65% of its assets in U.S. currency and could easily diversify by buying either yen or euros; he wasn't sure that either of those was a great alternative. He also said that if they did divest dollars in a big way, the yuan would appreciate significantly, killing their economy. I asked perhaps the most debated question of the current time: Are you more worried about inflation or deflation?

Dimon, in my opinion, showed his intelligence by saying, for planning purposes we look at those issues and I am equally concerned about both. It is possible that we could fail to get the economy going fast enough to become self reinforcing (I am paraphrasing here) and could have a double dip. At the same time there will come a time when the Fed has to remove the huge amounts of liquidity they have pumped into the market.

Bravo Jamie! I should mention that throughout, Dimon maintained a very composed and respectful demeanor even when he joked about writing a $25 billion (I think that's the number) TARP repayment check at a New York City J.P. Morgan branch while sending a note to Geithner reminding him that while the Fed had lent J.P. Morgan $25 billion, J.P. Morgan was still holding loans to Uncle Sam of $200 billion. He used some colorful language now and again to underscore a point and prove that not only is he one of us, but he's a real New Yorker.

GlobeSt.com recently published some quotes from a seminar they held in early June on the hospitality market. The outlook voiced was sobering to say the least. Richard Warnick of the eponymous Warnick + Co., a hospitality advisory company, said "Up until this point in time, most of the defaults have been technical defaults. We're now moving rapidly into significant monetary defaults on loans. The question is whether lenders take those properties back or try to work with borrowers."

According to a GlobeSt.com article from yesterday, "Last month, 13 hotel loans totaling $596 million defaulted. These included the $190-million Pointe South Mountain Resort in Phoenix, the $117-million Loews Lake Las Vegas in Las Vegas, and the $100-million Dream Hotel located in New York City."

I have noted several times in the past that the commercial real estate market decline is a continuing major challenge to the banking industry (especially regional and local banks) and, as a result, a continuing stumbling block for the economy as a whole. I have laughed along with you at the new industry maxim that "a rolling loan gathers no loss" and averred that pushing the problems out further in time is not a recovery strategy. I just read about a recent big metropolitan area distressed sale that got me thinking about how the constipation of the commercial real estate market may be beginning to ease...I won't take the analogy to it's logical conclusion, but suffice it to say that I think the market clearing adjustment to the downside is under way, and I believe I can put some logic behind my intuition that trying to hold onto properties that are marginally servicing debt and/or have no equity value in a refinancing scenario is a doomed strategy, even if the economy doesn't get a lot worse.

According to Globe Street, Realty Finance Corp. has sold an original $47 million loan on a Class A office building at 250 Montgomery Street in San Francisco for approximately $25MM. The building was reportedly only 55% occupied, so obviously debt service by the borrower, Lincoln Property Co., was an issue. What was really interesting was the reason given for why the lender, Realty Finance Corp. (who received the property back through a deed in lieu of foreclosure) turned around and sold the loan so quickly at a huge haircut. The article reports that according to SEC filings, Realty Finance's $1.2 billion investment portfolio, which has lost 26% of its value since the start of 2008, is encumbered by non-recourse long-term financing through two CDOs. It also noted that in February the company was notified that it failed the overcollateralization test for one of the CDOs and that payments were being diverted from the firm to pay down principal of senior bondholders. The firm also expected a similar result for the second CDO some time in 2009, resulting in minimal incoming cash flows to its primary business. So here we see a distressed property, being handed over by an owner to a leveraged lender, who immediately must sell the asset at a market clearing price. As I heard at the IMN Conference, fund level leverage exists up and down the real estate finance and investment business. This will be a significant catalyst of distressed sales as property owners start to default on their loans.

Okay you say, but this is only an example of a building that is distressed being puked up at a big discount, it's not just a property someone overpaid for.....like so many out there. Why should banks cough up the latter if they are not absolutely forced to? Why is their first sale likely to be their best sale?

What we have to do is look ahead at how the new owner of 250 Montgomery Street is likely to act. The new owner has not been disclosed in this case, but is said to have been another real estate private equity firm. This firm now has a great new basis cost in the building and lots of incentive to be aggressive in getting it leased up. This is the transmission mechanism whereby lower rents are enabled in a market due to distressed properties being turned over at a much lower prices. It just doesn't take a lot of this kind of activity in a soft market with high vacancy rates to crush rents.

So not only does the "new mark" caused by the transaction, in this case about $200 per square foot, versus a late 2006 purchase price of approximately $405 per square foot, hurt the valuation of banks' interests in loans on similar properties, it will eventually end up hurting cash flows across all their properties as the general rent level declines.

According to another Globe Street article, across the country in Florida, Ashkenazy & Agus Ventures recently foreclosed on a mortgage note they were said to have acquired on Downtown at the Gardens, a high-end mall in Palm Beach Gardens. Institutional Mall Investors, a joint venture between Miller Capital Advisory and Calpers, was said to have defaulted on the mortgage on the property, which they reportedly acquired in 2007 for $200 million. The mortgage note was said to have been acquired for $48 million, or about 35% of the original principal amount from TIAA CREF. It is speculated that Institutional Mall Investors will lose $60 to $90 million on the deal. With the mall, which has suffered the loss of several tenants, eventually landing in new hands at a lower basis cost, my guess is that rents will be lowered to get some tenants into the open space.

This situation certainly underscores the idea that your first sale may be your best sale, since Downtown at the Gardens is the second Palm Beach County mall to be foreclosed on recently after JP MorganChase foreclosed on the 1.2 million square foot Palm Beach Mall, suggesting yet another player in the market with a new lower basis cost and ability to discount to fill space.

The real estate financial market, like other financial markets, is like a permeable membrane: when the concentration of debt on one side gets too high, diffusion restores equilibrium. Fighting the restoration of equilibrium is a losing game, and it looks like the membrane is becoming quite porous in a few places.

Here in Manhattan we are seeing "distressed on distressed competition," but we may soon see (low basis cost) "blessed on distressed competition." In my recent piece I noted that the William Beaver House was doing some creative things to catalyze sales of units to investors. Nearby,

, a project that has suffered from significant construction delays, is said to be facing foreclosure by lender BayernLB. According to The Real Deal, because units in the building wouldn't start closing by July 1, 2009, buyers in contract would have rescission rights. I wonder how the already fragile downtown condominium and rental markets will react if any of the troubled projects there eventually fall into the hands of someone with a really low basis cost?

A rolling loan gathers no loss.

Unnamed Banker....as retold by Joe Sitt

I was fortunate enough to attend IMN's recent US Real Estate Opportunity & Private Fund Investing Forum held last Thursday and Friday. The conference was well attended, I don't have an actual count, but it was as big as the Wall Street equity conferences I used to attend at the Sheraton years ago in the bull market boom days and there were so many Masters of the Universe present it was hard to get a seat in the main ballroom. The mood was grim but energized. What does that mean? Attendees seemed every bit as pessimistic about the commercial real estate market as I could have expected, although there was a range of views extending from "it's bad" to "fuggedaboutit." But nearly everyone was excited about the opportunity to eventually find bargains in the market for the first time in years.

The following is a collection of quotes from the conference, which I hope will give Urban Digs some flavor for what professional money managers in the commercial real estate business are thinking about the banking system and New York City, without going into a lot of details on specific sectors or subjects, which would not serve Urban Digs readers' purposes.

The quote featured above by an unnamed banker was to my mind the most pithy of the conference. The length of this commercial real estate downturn and the "time to opportunity" is in part controlled by the banks and their regulators....as one could say it is for the economy as a whole. The fact is that banks are still pushing off the inevitable and hoping that the days of cap rates below financing rates will return and bail them out of loans made at the top of the cycle, that were clearly for overpriced transactions/projects and structured with way too much leverage.

One manager, Sush Torgalkar of Westbrook Partners, described the kinds of deals he is looking for going forward. "Good IRR on an unlevered basis, discount to construction cost less land and located in major markets." (For future reference, I don't write that fast, so quotes may not be verbatim, but generally capture what was said). I saw a lot of head nodding when Sush talked about deals that would get his attention and conclude that banks trying to peddle bad loans in secondary and tertiary markets for a premium to construction cost at small discounts to par may not be too successful.

One of the panels focused exclusively on the New York City market. It was averred that prior ideas that somehow the City would sidestep the problems in the rest of the country were not the case, with New York clearly suffering like everywhere else. However, Brad Klatt of property developer Roseland Property Company made the very good point that "Capital infusions and recovering equity markets with the ability to raise capital are an artificial catalyst to the New York market, keeping job attrition less than expected and less than in other geographies because the institutions being saved are either headquartered in New York or have substantial employment here." (Wall Street employment and its impact on the future of the New York City residential market will be featured in a piece on Urban Digs soon, as I previously promised - anyone with good stats send 'em in). That said, it was agreed that in office and hospitality markets, New York was doing its damndest to catch down to the rest of the country. It is said that retail in the City is being buffered by global retailers looking to enter the U.S. major metro areas with New York City being first choice - something we talked about here at Urban Digs a couple of months back in a piece on retail. There was even a mention of Chinese investor interest in New York City real estate....Ah, hope springs eternal! Investors agreed, though, that the recent benchmark set by the sale of Worldwide Plaza on Eighth Avenue for a reported 60% discount to its 2007 sale to Harry Macklowe was a good example of just how ugly the New York City commercial real estate market has become.

Besides his banker quote, Joe Sitt mentioned that land could be purchased in New York City for $30 - $50 per FAR (roughly buildable square foot for the uninitiated). I have to believe he was referring to the boroughs, though as at the peak asking prices in Manhattan's secondary markets like downtown and Harlem were as high as $500 to $600 per FAR (although I don't no how many unlucky souls actually paid them.) I am as bearish on New York City land prices as anyone, because in some cases partially built structures are not worth completing and fully constructed buildings are worth only a percentage of construction cost, both implying a theoretical negative value to the land, currently. Theory aside, a decent piece of land on Manhattan Island should still go for several hundred dollars per FAR even if it is going to be land banked for five years, as there was wide agreement that longer term New York City was underserved in a variety of asset classes (retail and housing come to mind). I have made note many times in the past that New York City is a demand-driven market, it can still get hit because of waning demand (particularly if property is over-priced and over-levered), but for the most part barriers to building and the City's huge scale make over-building very difficult.

Interestingly, one panelist asserted that you can make the numbers work on construction of a new rental building today in New York City, based on significantly lower land prices and lower construction costs, but you will be able to buy an 85% finished job for 30 cents on the dollar, so why take all the development risk?

Other interesting quotes:

"I have seen a big increase in activity in the last 2 months, workout teams are taking over the bad loan portfolios." - Jay Neveloff of Kramer Levin

"It takes time for the workout teams to be hired and ramped up, forebearance was mandated because the infrastructure to execute dispositions wasn't there." - Nick Bienstock of Savanna Funds

Other Voices:

"At some point the government will approach the banks to clear out their bad loans and take the hit, maybe before year-end."

"Regulators will facilitate write-offs through the annual examination process."

"The amount of equity ready to invest is small versus the amount of bad debt."

"The only assets the banks will sell are headed to foreclosure."

After the stunning swoon in treasuries - the 30 year has plunged over 20% year-to-date - it's only natural to ask, where the heck are bond yields going from here? Even more fundamental, what about the availability of credit? Just for a little historical perspective, let's take a look at where we have been.

As Urban Digs readers may know, Monday night my partner Jim Gannon and I gave a course entitled Real Estate Valuation Basics for Legal Professionals at the New York City Bar.   We managed to coral over 50 attendees, with the mere attraction of continuing education credits and some coffee and snacks.

Fortunately neither Jim nor I tripped on a banana peel and fell off the stage. The very comfortable, one might even say posh new auditorium at the City Bar (no more miniature desks with fold up arms) was, for all its multi-media splendor (we were taped and webcast live, had the benefit of flat panel monitors throughout the room displaying our powerpoint and a remote control with laser pointer that worked) way too hot. The fact that no audience members were snoring discernibly during the three hour program, we take not only as testament to the compelling subject matter of our presentation, but more so the talents of our distinguished guest panelists. Color and life was brought to our somewhat dry class materials, by the presence on two discussion panels of:

Martin Levine MAI - Chairman of Metropolitan Valuation Associates
Marc Shapiro - attorney with Orrick, Herrington & Sutcliffe LLP
Roger Roisman - attorney with Tannenbaum Helpern Syracuse & Hirschtritt LLP
Lee Spiegelman - Split Rock Group, New York real estate financier, investor and manager.

Our first panel discussion was Characteristics of the Current New York City Real Estate Market. Marty Levine discussed the commercial appraisers' role as a reporter of market trends and the extreme difficulty in valuing properties when there are hardly any data points to report on. What data points there are may not be reflective of "normally motivated" sales or may not have had sufficient "market exposure" because in all likelihood someone selling a commercial property in this environment needs to rather than chooses to do so. Not a lot of new news came out in terms of market data. Commercial office rents and retail rents are believed to be down as much as 30%, with occupancy down significantly. However, one important observation was Marty Levine's comment that over-supply was not at all the issue in New York in the residential and multi-family rental market. The issue driving price declines is affordability (Marty felt that this was an issue for retail as well).

Due to the bubble in land prices in New York (that I have commented on numerous times in the past - NY City Land: Will High Prices Cure High Prices? ) and the high cost of building anything in the city, affordability was sacrificed. New York is still a supply constrained market with fairly high occupancy, despite occupancy having recently taken a hit from the economic downturn. Levine's conclusion was that New York City multi-family would inevitably bounce back, but from lower pricing levels. When asked what the hardest areas to appraise in New York City were, he pointed to frontier areas like the far west side where prices had run-up during the upturn, for neighborhoods that may not have really "made it" yet. The most difficult asset class to appraise these days, in Marty's opinion mixed use residential with retail. Another interesting note for commercial real estate aficionado's, industrial/manufacturing space seems to be holding up best of all asset classes due to the relative dearth of remaining space in and around Manhattan.

Marc Shapiro confided that the bulk of his business now relates to restructuring of distressed loans. While his experience has been primarily assisting lenders, he has also been working with some owners and sponsors. He revealed that owners in some cases are still in denial about their predicaments, but less so about the reality that they have no equity in their properties at current market prices....whatever current market really is. As an example of the odd congruence of both these positions he noted a project sponsor for whom he helped negotiate one of the best restructurings for a client he can remember. Marc had insisted on the client being totally transparent with all of the financial and construction/construction management information the sponsor had, counter to his client's instincts. The bank had responded with the following (incredible) offer.

The client was actually released from all personal guarantees for the loan, the bank agreed to fund completion of the project, the sponsor was given flexibility to negotiate discounts on unit sales and was even given 6% of every sales dollar as an entrepreneurial incentive to stay on and finish out the project. Upon concluding the deal the client confided, "I think I got screwed."

The idea that the bigger the project's financial predicament the more likely that the bank will bargain, seems to be persuasive. Everyone thinks they're Donald Trump, but according to Shapiro the banks are nonplussed as the line of Donald Trumps is quickly stretching down the block and around the corner. Shapiro's advice to his bank clients, make a deal now or sell the loan. You don't want to own assets, you are going to own more than you know what to do with in due time.

Agreeing with the idea that the bottom has not yet been seen and cannot be predicted, Marty Levine commented, "until a more normal financing environment returns you can't even talk about seeing a bottom."

Our second panel was entitled Case Study: The Broken Condominium Development, during which Lee Spiegelman of Split Rock Group discussed his evaluation of a note purchase from a bank on a broken condo development, which I am proud to say my firm Guild Partners brought to his attention. Lee started off by talking about his family's position going into this downturn. His family's real estate construction, management and ownership business, PLP Companies, has been active in New York City for many years and learned a few things about downcycles managing properties for Freddie Mac in the late 80s and early 90s. At the time, Lee was working on Wall Street where he was taught "When the ducks are quacking feed them" and feed them he did, disposing of many of his family's properties in the city from 2005 to 2007, when he saw financial players buying at multiples he just couldn't rationalize.

Lee believes that the current cycle may play out like the prior one, with a long workout and then basing period before prices appreciate again (and a future peak coming around 2023). But he believes that it is time to start looking for opportunities selectively, with the best values to be found now, in messier situations. He ran through the evaluation of the partially built condo's economics as a rental, including assumptions on rents, rent up time, stabilized vacancy and collection loss and operating expense ratios. His conclusion; a reasonable bid to the bank on this note was about 50 - 60% of the value of the construction loan. This demonstrates the significant downside between value as a condo and value as a rental, a spread which most likely will converge towards the downside.

Spiegleman voiced some skepticism that TARP, TALF, PIPP TARPII, Son of TARP and TARP Wars: The Return of TARP would do much to aid the healing process in commercial real estate. Roger Roisman agreed, reporting that his advice to developers he deals with is to dispose of problem projects now, because things will get worse before they get better. He discussed some of the disconnects caused by the fee driven environment of the earlier part of the decade and the divorce of underwriting from ownership. Roger also discussed the many complications around the unwinding of complex capital stacks utilized, even in mid-sized deals in recent years. In the case of a simple disposition by a bank of a busted condo development, the acts of selling the note or foreclosing will in many cases trigger rights of rescission, which allow any buyers in the building to get out of their contracts, most likely relegating the project to rental status. Struggles between mezz lenders, preferred equity players and first lien lenders to preserve value and their potential equity in the deal follow. If a bank sells a note, which triggers the rights of rescission they may be wiping out the preferred equity or mezz lender's only hope for preserving value....that's what I call messy. Roger also noted that instituional real estate investors in many cases were using leverage, not just at the deal level, but at the partnership level as well, creating some serious balance sheet issues. He noted that other institutions like REITs, which have access to the capital markets have greater flexibility to deal in these uncertain times. He expected Simon Properties for one to be on the prowl for retail center cast offs from other REITs and investors. Roger also touched on the idea that quality of location would be coming back into vogue. In the prior decade the rule book was thrown out with regard to where new condominium projects could be successful, like Marty Levine, he believes that prime neighborhoods will endure the downturn and attract new development better than frontier areas.

It was muggy affair temperature wise, but we received a warm reception from members of the bar, to whom we are grateful, and especially so to our panel members who provided the most interesting material of the evening.