Kevin Hollins'  Instablog

On September 1, 2009, Lingling Wei wrote an article for the Wall Street Journal highlighting the “time bomb” looming in commercial banking.  More than $1 trillion of commercial property mortgages are losing value, and according to Deutsche Bank, total lifetime losses are expected to be between 11.6% and 15.3%.

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    In his recent speeches regarding health care reform, President Obama has been heard comparing a requirement that people obtain health insurance to states’ requirements that drivers obtain auto insurance.  The counterargument to this—that people can avoid having to buy auto insurance by simply not driving—ignores the hidden cost we already pay.

Whatever people’s feelings about the reform package itself, requiring everyone to have at least catastrophic health insurance should be something that both parties can agree on—Democrats for social reasons, and Republicans for economic ones.  There is no shortage of items on which to disagree (tort reform, anyone?), but it is irrational that this should be one of them.

    Shortly after the inauguration, I asked a friend (a very conservative fellow) if he thought that people should be required to buy health insurance.  The conversation that followed went something like this:

    “Absolutely not”, he said.

    “Why?” I asked.

    “Because it’s not the government’s place to force people to buy health insurance   if they don’t want it.”

    “But isn’t that sort of the point of insurance?  You don’t buy it because you want it today; you buy it because you might need it at some point in the future?”

    “Yes, but if a person wants to assume the risk, we should not be forcing them to buy insurance.  They should be allowed to take the risk and bear the consequences.”

    “Okay.  But what about auto insurance, do you think people should have to buy that?”

    “Oh, definitely.”

    “Why?”

    “Because if some uninsured driver smashes into my car and I can only look to my insurance company, my rates will go up through no fault of my own.  And if he doesn’t want to buy insurance, he doesn’t have to drive.  It’s his choice.”

    “Okay, so let’s go back to the person without health insurance.  If he gets injured and goes to the hospital, they are obligated to treat him.  If he doesn’t pay them, he may file bankruptcy, but the cost will still be recovered by increasing the cost of care for the rest of us.  In effect, you’re already paying for his poor choices.  Heads he wins and tails we all lose.”

    In college finance courses my classmates and I had it drilled into our heads that risk can only be managed in two ways: diversification and hedging. 

    Requiring the entire population to carry health insurance is a logical way to diversify; the problem is that it is counterintuitive.  The uninsured population is “driving without insurance” right now, and to the extent they are injured and cannot afford to pay directly, they have hedged the risk by offloading it to everyone else.  Further, because insurance programs typically pay discounted fees, when the risk becomes a problem the costs are even higher as the charges are full price.

    This is counterintuitive because although most insured people have seen their premiums skyrocket, no one has yet presented them with a statement that tells them what part of that increase was due to there being an insufficient number of healthy people on the insurance rolls and too many uninsureds requiring catastrophic care.  This is quite unlike the case where, after being hit by an uninsured driver, my friend can figure out with reasonable precision what the cost was to him of someone else not having insurance.

    Requiring people to have health insurance will not resolve all of the cost, structural, or political problems that flow from health care reform.  But attempting to reduce costs without truly diversifying the risk is simply untenable, and will not alleviate the hidden costs insured citizens and taxpayers already pay today.

An article in yesterday's Wall St. Journal discussed Maguire Properties' loss of several buildings that it had recently acquired from Equity Office/Blackstone.  The poor economy and job losses have raised vacancy rates, and backfilling space with costly capex and lower rents left the buildings unable to meet their debt service requirements.

We have only just begun to see stories such as this, and in order to address the next crisis we will need to acknowledge some painful truths. 

During the commercial real estate crisis in the late 80s and early 90s, thousands of buildings faced the same problem, but with a critical distinction.  The real estate crisis was not coupled with a banking crisis.  The two industries are, for better or worse, married to one another.  

During the last crisis, programs like the Resolution Trust Corp. (RTC) did what a good oncologist would do--they removed the tumorous cells (loans).  In some cases, banks failed, but depositors did not lose money and life went on.  Further, pools of capital that had not overextended during the boom were able to step in and acquire properties and mortgages at sensible valuations.  Indeed, some firms like JE Roberts built their fortunes during this time.  

At the moment, replicating the sucess of that outcome is not possible.  Unless there is a credit market available, there is simply not enough cash available to acquire what is coming back to the market, even at deep discounts.

While TALF can, if extended and properly managed, help restart the CMBS market for new loans, there is no realistic program in place to deal with the onslaught of "legacy" properties we can expect to see. 

Ostensibly, the PPIP regime was created for this purpose, but because the banks cannot sell at discounts without taking further hits to capital, there are two problems.  First, there are ready buyers, but few ready sellers.  Second, TALF is only applicable to investment grade loans, so again, there is no credit market for the acquisition of the kinds of properties we expect to see.

So how can we resolve this conundrum?  Perhaps it is worth considering allowing banks to provide seller financing for REO properties.  In exchange, any bank that did would be permitted to continue to carry the property at the book value it held at the time of sale.  That would encourage the banks to move the bad assets off of their balance sheets (albeit more slowly), and provide a form of credit for those acquirers who kept their noses clean during the bubble.

Disclosure: No positions.

Fox Business' Elizabeth MacDonald wrote an interesting article on the state of commercial real estate mortgages and the TALF and PPIP programs.  Some highlights:

• $1.4 trillion of CRE loans are maturing in the next 5 years.
• An estimated $165-$204 billion will mature this year.
• There isn't enough capital strength on banks and insurance companies' balance sheets to refi the loans.
• The CMBS market is, for the moment, virtually stalled.

Issues mentioned in the article include WFC, C, BAC, RF, STI, KEY, MI, ZION, CMA.

For the full article, click here.

Based on the recent experience of ours and similar organizations, it appears that the credit market for even the most conservatively underwritten, low leverage commercial real estate loans has virtually ground to a halt.  As recent newspaper columns have reported on the state of the credit markets for commercial real estate, two dominant narratives have emerged.  First, the market for large packages of CMBS may be beginning to show signs of life, as larger REITs look to TALF-backed investors to step into the void formerly occupied by the “shadow” banking system and their securitized brethren.  Second, the Federal Reserve and Congress are becoming increasingly concerned that commercial real estate is the next leg of the stool to fail, following the residential real estate market’s collapse in 2008.  As the government continues to work to restore confidence, some of their monetary policy actions risk creating long-term inflationary effects.  Meanwhile, there is one option available to policy makers that has been under-reported as part of the broader discussion, namely, modifying banks’ capital ratio requirements.  This gets at the core of the problem that goes beyond capital and to the heart of the Catch-22 decision facing bankers today.

    The financial soundness of a bank, for regulatory purposes, is interpreted by calculating a series of ratios.  These ratios, the product of an agreement known as the BASEL Accords, provide a rough snapshot of a bank’s health.  If there is one thing the current collapse has taught us, it is that no matter how much we might wish it otherwise, determining asset values is as much art as science. 

    It seems reasonable enough to say that liquid assets should be carried at “market value”; but that creates, for lack of a better term, an unsanctioned holiday problem.  For example, the stock exchanges are closed on the weekends, thus on the weekends there is no market.  Since one cannot readily sell a stock on Sundays, is the stock’s market value zero on those days?  If not, then what is the difference between the weekend and a day when the market is officially open, but for psychological or other reasons buyers have decided to take an extra long holiday?  This sort of unsanctioned market holiday is approximately what certain asset classes, including CMBS, experienced in 2008-09.

    In the case of an illiquid asset, it seems reasonable enough to carry it at its cost.  But what happens when the price for such illiquid assets, as a result of credit conditions, fear, or other causes, simply collapses?  Establishing a “fair” value becomes very difficult. In a market dominated by fear, price discovery will provide a greater reflection of the imbalance in the environment than an indication of an asset’s intrinsic value. 

    Thus the dilemma facing banks today.  Say a bank has made a loan for $100.  Since the collapse they have since marked it down to $60 and increased their reserve.  Maybe the loan is performing just fine, it is just that the latest appraisal reflects a fearful, discount demanding market.  This may well approach the intrinsic value of the loan.  But the impairment of the loan, unless backfilled by new capital, will do ongoing harm to the bank’s ability to meet capital ratio requirements.  And this is where the Catch-22 occurs.

    If a bank were to place the aforementioned loan into an auction, it could not accept less than $60 without doing further damage to its capital ratios.  But if auction pricing is being driven more by fear (of further depreciation) than greed, it is probable that an arms-length investor is going to demand an even deeper discount.  In another example, a bank may have a group of loans that it has modified or restructured.  The bank believes them to be good in their current state, and would like to continue to hold them.  But doing so damages their capital ratios, since any modification to a loan renders it impaired.  Again, this holds even if the loan is performing.  The same bank may have a portfolio of non-performing loans where it believes the intrinsic value of the underlying collateral is greater than the price it would receive in a panicked marketplace.  It would rather hold the collateral than sell into fear, but again, this harms its ratios today and exposes the bank to unknown future writedowns as the collateral is re-appraised in subsequent periods.  

Anyone who has spent even a small amount of time learning how banks operate comes to learn that the calculation of capital ratios is an algorithm with a series of dependent variables.  Touch one, and its knock-on effects appear elsewhere, the cumulative result of which is paralysis.  If they work out what they can and hold until a better day, their balance sheets get pulverized.  If they sell into fear, they get the same result, potentially worse.  So what do you do if you’re a bank in this position?  As it pertains to commercial real estate, nothing.  Nothing at all.

Of course, a bank with depositors and a staff of loan officers cannot signal to the market that the vaults are closed, so they must somehow punt without appearing to.  Say a borrower is looking to borrow $1 million to purchase a CRE asset worth $2 million.  Even with limited leverage and 200% or more debt coverage from cash flow, the loan committee’s conversation goes something like this:

 “You know, we have a lot of commercial real estate exposure already, and we can’t even get our hands around the residential side of our loan book.  We can’t sell a new loan into the CMBS market, since it is effectively closed.  We also can’t tell the customer that we’re not making new loans.  How can we make the loan terms so bullet-proof that if the customer really wants it, we’d be willing to do it?”

“Simple.  First, we value the actual property at zero for collateral purposes.  Second, we require the customer to post as collateral, cash or cash-equivalents equal to the amount of the loan.  That way, we have 100% liquid collateral coverage, and even more in property coverage.”

“But if the customer would be willing to post that amount of cash, why would they need a loan at all?”

“Exactly.  They wouldn’t.  They would be better off not doing the loan, but at least we made a loan available.”

    If you happen to meet a banker in a dark parking garage, you might even get one to admit to this practice.  Given the situation they are in, it is quite understandable.  Conservative underwriting is a good thing.  But when a bank will only effectively lend one dollar on a dollar of cash collateral, it’s not a lender anymore, and acting as though it is not happening does a disservice to capable bankers and their customers, and does nothing to help restore credit or confidence.  So how has the federal government addressed the situation so far?

    As everyone now knows, the taxpayers made capital available to banks under the Troubled Asset Relief Program (TARP).  But here we are some time later, and while the TARP has been used for many things, including cars, the one thing it has not done is provide relief for troubled assets.  And good intentions notwithstanding, it never could, for the same reason the auction model is unlikely to work under the current regime.  If a bank is carrying a marked-down asset for $50, and the market will only pay $40, the bank has to plug a $10 hole in its balance sheet.  Unless the bank believes it will never do better then $40, it is better off holding the asset, but doing so fails to solve the other problem created by its impact on their capital ratios.

    There are only two means we are aware of to truly address the conundrum and enable banks to make loans again.  One is to simply have the federal government push capital onto the banks’ balance sheets.  This has been the model followed thus far, and as it is fraught with risk.  First, the taxpayers have become, as in the case of Citi, bank owners, with all of the fiduciary risk and unavoidable politicization that entails.  Second, the current model fails to clear the assets that remain, as in the illustration above, a drag for banks to either hold or sell.  Third, the effect of the increase in money supply is temporarily not reflected by circulation, but this will not always be so, and the result may well be inflationary.  Finally, it requires picking winners and losers; a distinctly troubling notion when the specter of politics lurks nearby.

    The second method is to revise the capital ratio requirements to reflect the uniqueness of the situation the banks face today.  The capital ratios set forth under the BASEL Accords did not contemplate the current environment.  As John Meynard Keynes famously said, “When the facts change, I change my mind.  What do you do, sir?”  Since the capital ratio requirements are a legislative contrivance, they can be modified legislatively as well.  This provides cover for nervous bank examiners and takes the boot off the necks of those banks (particularly community banks) that can earn their way back to health.  As part of a multi-pronged strategy that includes TALF, PPIP, and a modification to the REMIC program, there is a better than even chance to improve credit flows to worthy, conservatively underwritten projects.  Further, the repaid TARP funds could be used to furnish a standby line of credit to the FDIC, providing greater security for depositors.

    The argument against relaxing the ratios is that it either forgives banks for prior sins or somehow creates an inaccurate reflection of banks’ health.  To which it should be noted that the ship of moral hazard has long since sailed, and the culpability flowchart for this mess, political demagoguery aside, includes lots of parties.  As to the banks’ health, do the results from the current regulatory regime provide satisfaction to anyone?  Both Fed Chairman Bernanke and FDIC Commissioner Bair make statements about getting banks to lend, but the message banks receive from their local examiners is precisely the opposite.  Why?  Because the examiners, a rather intelligent sort, have wagered that if something goes wrong it will be pinned on them, and if they loosen up, any credit for success will flow to the top.  The current regime discourages banks from making loans even as they have an opportunity to do so at some of the best returns they have seen in years.  Even Warren Buffett has stated his belief that banks have an opportunity to earn their way back to health.  He’s right, but only if the rules of the game don’t prevent them from doing so.

    None of this is to advocate a loosening of oversight or reporting requirements.  For as long as there has been accounting, divining the difference between carried values and market values has always been part art, part science, and vigorous oversight is surely needed.  Amongst the policy prescriptions for stabilizing the economy and restoring credit, adjustment of banks’ capital ratios surely merits a debate.  It remains, after all, one of the few remaining features designed for a “normal” environment, still being applied in an environment that is anything but.

Disclosure: No positions.