Right now there are an awful lot of banks that do an awful lot of commercial real estate lending, and for about a year now you’ve been telling me that you saw the first and second quarter of 2010 as being particularly risky for commercial real estate. Why this year, and what do you see happening with these loans and the banks holding them?
MILLER: It’s an educated guess, and it hasn’t changed. I still think that it’s second quarter 2010.
The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there’s some alternative in place, it’s going to be a very hideous picture for the bond market and the banking system.
The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I’ll give you an example.
In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn’t have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.
That’s very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they’ll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that’s horribly destructive.
Just to be clear on this, let’s say I own an apartment building and I’ve been making my payments, but I’m having trouble and the value of the property has fallen by half. I go to the bank and say, “Look, I’ve got a problem,” and the bank says, “Okay, let’s work something out, and instead of you paying $10,000 a month, you pay us $5,000 a month and we’ll shake hands and smile.” Then, even though the property’s value has dropped, as long as we keep smiling and I’m still making payments, then the bank won’t have to reserve anything against the risk that I’ll give the building back and it will be worth a whole lot less than the mortgage.
MILLER: I think what you just described is accurate. And it’s exactly a Japanese-style solution. This is what Japan did in ’89 and ’90 because they didn’t want their banking system to implode, so they made it easier for their banks to sit on bad assets without owning up to the losses.
And what’s the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it’s not going to sell them.
Why is that bad? Well, the money tied up in the loans the bank is sitting on is idle. It is not being used for anything productive.
Wouldn’t banks know that ultimately the piper must be paid, and so they’d be trying to build cash – trying to build capital to deal with the problem when it comes home to roost?
MILLER: The more intelligent banks are doing exactly that, hoping they can weather the storm by building enough reserves, so when they do ultimately have to take the loss, it’s digestible. But in commercial real estate generally, the longer you delay realizing a loss, the more severe it’s going to be. I can tell you that because I’m out there servicing real estate all day long. Not facing the problems, and not writing down the values, and not allowing purchasers to come in and take these assets at discounted prices – all the foot-dragging allows the fundamental problem to get worse.
In the apartment business, people are under water, particularly if they got their loan through a conduit. When maintenance is required, a borrower with a property worth less than the loan is very reluctant to reach into his pocket. If you have a $10 million loan on a property now worth $5 million, you’re clearly not making any cash flow. So what do you do when you need new roofs? Are you going to dig into your pocket and spend $600,000 on roofing? Not likely. Why would you do that?
Or a borrower who is sitting on a suburban office property – he’s got two years left on the loan. He knows he has a loan-to-value problem. Well, a new tenant wants to lease from him, but it would cost $30 a square foot to put the tenant in. Is the borrower going to put the tenant in? I don’t think so. So the problems get bigger.
Why would the owner bother going through a workout with the bank if he knows he’s so deep underwater he’s below snorkel depth?
MILLER: It’s always in your interest to delay an inevitable default. For example, the minute you give the property back to the bank, you trigger a huge taxable gain. All of a sudden the forgiveness of debt on your loan becomes taxable income to you. Another reason is that many of these loans are either full recourse or part recourse. If you’re a borrower who’s guaranteed a loan, why would you want to hasten the call on your guarantee? You want to delay as long as possible because there’s always a little hope that values will turn around. So there is no reason to hurry into a default. None.
So that’s from the borrower’s standpoint. But wouldn’t the banks want to clear these loans off their balance sheets?
MILLER: No. The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against their capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. Remember, you suffer if the bank succumbs and turns around and liquidates that asset, then you really do have to take a write-down because then your capital is gone.
So here we are, we’ve got the federal government again, through its agencies and the FDIC, ready to support the commercial real estate market. They’ve taken one step, in allowing banks to use a very loose standard for loss reserves. What else can they do?
MILLER: Well, obviously nobody knows, but I can guess at what’s coming by extrapolating from what the federal government has already done. I believe that the Treasury and the Federal Reserve now see that commercial real estate is a huge problem.
I think they’re going to contrive something to help assist commercial real estate so that it doesn’t hurt the banks that lent on commercial real estate. It’ll resemble what they did with housing.
They created a nearly perfect political formula in dealing with housing, and they are going to follow that formula. The entire US residential mortgage market has in effect been nationalized, but there wasn’t any act of Congress, no screaming and shouting, no headlines in The Wall Street Journal or The New York Times about “Should we nationalize the home loan market in America.” No. It happened right under our noses and with no hue and cry. That’s a template for what they could do with the commercial loan market.
And how can they do that? By using federal guarantees much in the way they used federal guarantees for the FHA. FHA issues Ginnie Mae securities, which are sold to the public. Those proceeds are used to make the loans.
But it won’t really be a solution. In fact, it will make the problems much more intense.
Don’t these properties have to be allowed to go to their intrinsic value before the market can start working again?
MILLER: Yes. Of course, very few people agree with that, because if you let it all go today, there would be enormous losses and a tremendous amount of pain. We’re going to have some really terrible, terrible years ahead of us because letting it all go is the only way to be done with the problem.
Do you think the US will come out of this crisis? I mean, do you think the country, the institutions, the government, or the banking sector are going to look anything like they do today when this thing is over?
MILLER: I know this is going to make you laugh, but I’m actually an optimist about this. I’m not optimistic about the short run, and I’m not optimistic about the severity of the problem, but I’m totally optimistic as it relates to the United States of America.
This is a very resilient place. We have very resilient people. There is nothing like the American spirit. There is nothing like American ingenuity anywhere on Planet Earth, and while I certainly believe that we are headed for a catastrophe and a crisis, I also believe that ultimately we are going to come out better.
for The Daily Reckoning
David Galland is Managing Director of Casey Research. Over the course of his career he has worked on the Gold Newsletter, the Aden Analysis, Wealth Magazine and Outstanding Investments. He currently serves as Managing Editor for Doug Casey's International Speculator, Casey Investment Alert, and What We Now Know and was a founding partner and Executive Vice President of EverBank.
“There’s nothing like the American Spirit.”
Gees David, get a grip. There are dozens of Countries around the world that have bounced back from adversity, war, famine and all kinds of catastrophies far worse than the USA has ever experienced.
You love your Country, great. Try not to believe all the BS you hear about it from the Pollies and Hollywood.
It IS a great Country but it has a fat,lazy, overpaid, overfed and overconfident population who are on the road to ruin, by following currupt politians, bankers and the Money God to incredible excesses.
Most of the rest of the world is disgusted by the NEW USA and it’s decadence.
If we have huge inflation brewing in the future (from loose monetary policy and quantitative easing) why couldn’t it eventually even things out (2008 levels) with respect to real estate prices when the inflation takes root.
Ian, I think David is making a real effort to be optimistic. Your observations are correct, America the land will not disappear but the people that you so accurately described and the equally decadent government probably will not.
The survivors may then have earned back the respect of the rest of the world.
In that sense, America will be better in the long term. The short term does indeed look catastrophic (for the unprepared) and there will be blood in the streets.
What happens to the banks that hold these underwater and hopelessly in default commercial real property loans? They go under unless the “too big to fail” mantra has been squelched by recent experiences suffered by the markets. If so, why do B of A, Citigroup, et al keep defying financial gravity? Is this a case of gov’t intervention postponing the inevitable (but not permanently postponing the debacle to come)?
Peter, in a word, yes. And Miller is saying it is not a sound strategy, because the underwater debt remains, cloging the banks. The gov. hope was that the banks could earn their way to health, and GS, JPM might do it with their unfair advantages, but other banks will remain impaired (along with their customers). The collosal fleecing of the public is not over, and it will be anything like it was ever again in my lifetime.
Ian expressed sentiment exactly. All efforts re-inflate housing are doomed to fail. We just can’t print that much money. For the government to buy mortgages that are 90 days overdue is to buy toilet paper. Upping the FHA limit was insane. The government insured entities will sink us. God help us if they come up with similar plans for comercial real estate. Our creditors will shout,”Enough!” Then what?
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