Friday, July 6, 2012

Real Estate, Especially Commercial Real Estate, is Still a Major Problem

Over the past two years or so, I have continually written about the problems that exist in commercial real estate lending, especially the problems faced by many commercial banks in the United States. 

Many commercial banks, especially the less than gigantic ones intent on growing and becoming more of a force in their local or regional areas, turned to the commercial real estate area over the past decade to “scale up” their organizations.  These larger loans allowed the “smaller” banks to increase their asset size quite rapidly and, given the means and the encouragement of the regulators, could finance this loan growth by “purchased” funds rather than rely upon “local” deposit growth. 

Of course, many of these organizations knew little or nothing about commercial real estate.  But, they could hire an “experienced” commercial real estate lender and then, with the support of their regulator, could write a policy document on their commercial real estate lending operations and forge bravely ahead to greater fame and glory.

Oh, and these “experienced” commercial real estate lenders could also begin a program of securitization of larger loans so as to create fees for the bank and sell some of the asset value off to other investors around the world. 

These commercial real estate loans still haunt the commercial banking system.  Since many of these loans, securitized or not, were “bullet” loans, the banks could continue to carry these loans at “book value” on their balance sheets and not have to deal with them until they matured…five years after they were originated…or seven years…or ten years. 

And, as has been typical of commercial bankers, the lenders could always justify carrying the loans at full value until maturity, even though the borrowers experienced problems, or, in some cases, were actually in trouble with the law.  Bank lenders are the most optimistic people in the world when it comes to explaining how a loan that doesn’t look so good…will be paid off…in full!

As many readers of this blog will attest, I have constantly argued that we still do not have a full understanding of the real value of bank assets…and one of the reasons that this is true is that commercial real estate lending has become such an important part of the balance sheets of US banks.  And, given the nature of these loans, they still remain at “book value” on the balance sheets, which in many cases, is nowhere near the “market value.”  And, in the case of “bullet” loans, will not be assessed a more realistic value until the loans reach their maturity.

I have supported this argument with two pieces of information.  First, commercial real estate lending at all commercial banks continue to decline…sometimes substantially.  Whereas there appears to be some leveling out of lending in other areas, even in the residential real estate area, commercial real estate lending continues to decline at all asset levels in the banking industry, but especially in the “smaller” banks.  Commercial banks are extremely reluctant to step up their commercial real estate lending…my argument being that there is so much trouble on balance sheets in this area that financial institutions just don’t want to introduce more complicated loans into their operations.

Second, I have argued that one of the major reasons that the Federal Reserve has pumped so many excess reserves into the banking system is to provide sufficient liquidity to the banks so that they have as much opportunity as possible to “work out” their problem loan portfolios, or, if this is impossible, to allow the FDIC to “close” banks in as orderly fashion as possible so as to avoid a disruptive, cumulative problem for the banking industry. 

So far, this latter effort has been extremely successful.  The FDIC has only been closing about one bank a week over the past year and another one-to-two banks are leaving the banking industry per week over this time due to being acquired.

The problem in the commercial real estate area is highlighted in a recent article by Floyd Norris in the New York Times, titled “Commercial Mortgages Show How Bad It Got.”  Although Norris focuses on commercial mortgage-backed securities, the problem experienced by the commercial banking industry is similar.

“Now the first of the mortgages that were securitized in 2007 have started to come due, and it is becoming clear just how bad many of the loans were.  The time when investors were most eager to buy turns out to have been the worst time to do so.

Commercial mortgages—unlike residential ones—are seldom issued for periods of longer than 10 years, and often for as little as five.  Many require no principal repayments during that period but call for the entire amount to be repaid in a balloon payment at the end of the loan.  So it can be at maturity when the bad news arrives.”

It is estimated that of the loans from 2007 due to mature in 2012, less than 30 percent will be paid off in full.  And, other loans, maturing in seven or ten years can present problems in 2014 and in 2017.

Many of the loans originated in 2007 were justified…just like in the residential area…by expected, but very optimistic, increases in rental values.  Well, rental values in commercial properties, just like in the prices of homes, had been going up for years.  Obviously, they would continue to increase!

Now, Norris reports, “more than 10 percent of loans in commercial mortgage-backed securities portfolios are delinquent.”  The worst category?  “Apartment loans with a delinquency rate of 15 percent.”

Furthermore, “Borrowers are current on their payments on less than one-third of the $3.1 billion of loans still left in the securitizations, and more than 80 percent of the properties securing those loans are thought by Wells Fargo, the trustee for the securitization, to be worth less than the amount owed.”

The bottom line is that commercial banks…and other investors…are not “out-of-the-woods” yet in terms of finding out the value of their assets.  And, the worst of the worst are those banks that went heavily into this commercial real estate lending in the “boom” years, not really knowing what they were doing. 

I believe that this fact is one of the major reasons why commercial banks are not really lending much at this time and why the regulators…the Federal Reserve and the FDIC…are acting so gently with respect to the banking system.  These regulators do not want to precipitate any more problems in the banking system than they are dealing with at the present time. 

If my analysis is correct, then I believe that it will be very difficult at this time for the Federal Reserve to stimulate a faster rate of expansion of loan growth within the banking system and, consequently, it will be very difficult for monetary policy to stimulate a faster rate of economic growth.  A healthy banking system is needed for a healthy rate of economic growth. 

And, this conclusion also holds true for Europe.  Given the state of the banking system in Europe and the problems that exist there relative to past lending in the real estate area, central bank efforts to stimulate the economies of the eurozone will have very little success.  The lowering of interest rates by the ECB and others, to me, is more for show than anything else.          

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