The Bubble Asks for a Bail Out

Last Monday the front page of the Wall Street Journal headlined a story  which outlined why the most powerful real estate developers in the U.S. have formally asked for a bailout loan from the Federal Government. A drop in asset values from to the real estate bubble, rising vacancies and dropping rents in the commercial markets have depressed cash flows so much that many of these large developers cannot meet their debt obligations.  These developers cannot look to banks for additional credit because they are already over leveraged; they are left to turn to the government for help. 

The depressed rents and a sudden depreciation in assets that the developers are describing should not be a surprise to anyone. When Bernanke and Paulson said the real estate market would be entering an adjustment period, this is exactly what they were talking about! 

To understand how dangerous it would be to extend government credit to real estate developers, it is important to first take a step back and restate the causes of the "real estate bubble" which is considered the impetus of the 2008 recession. The real estate market is like any other free market, driven by supply and demand forces. In its most simplistic and fundamental form, the real estate bubble was created by artificial demand side changes. An extremely lax credit environment created artificially¹ high demand for real estate, (more borrowers qualified for loans = more demand) which in turn led to an artificially high valuation for real estate. Credit was then extended based on this artificially high valuation of real estate assets.² The bubble "popping" was the realization that all the underlying assets were, in fact, overvalued, which meant many of the properties purchased within the bubble had mortgages based on a value higher than asset’s actual worth. The bubble was simply a difference between an artificial inflation and reality. This recession is an adjustment period for the credit markets, where all of the mortgages will somehow adjust or unwind to meet pre-bubble prices.

Offering government issued loans to developers would slow or reverse this market adjustment, which must happen for the real estate market to find a firm footing and for credit to start flowing again. If the government extends loans to real estate developers they could only do so by ignoring the deflated value of the underlining assets. (This is inherently true in the request to the Government. The market has deemed these assets unfit to extend additional credit, forcing developers to ask the Government for a loan.) To issue a new loan on these deflated assets the Government would have to repeat the mistakes of the past and secure a loan based on an inflated asset value. The Government would essentially be reinflating the bubble by allowing Real Estate Developers to continue to over leverage their depreciated assets. This will continue to fuel the artificial demand that caused this recession and prevent the market from finding a bottom from which to rebuild. 

The recovery of the credit markets is hinged on a return to a realistic (pre-bubble) valuation for real estate. Proper underwriting depends heavily on being able to comfortably assign an applicable risk premium within the interest rate, and this can only be done if the lender is comfortable with the stability of the securtized asset. If the Developers received a bail out their assets will not undergo the market adjustment, it would artificially keep real estate prices high, and prevent the market from finding a bottom.   

There is no solution that will help troubled Real Estate Developers, they are probably extremely over leveraged now that their assets have lost so much value. As the economy contracts real estate rents will need to come down to meet demand changes. It may also pose the scenario where an asset manager may need to offer space at a loss to cover at least a portion of fixed costs. The riskiest of the real estate developers, those who took on the most debt based on inflated values, will probably not survive the adjustment, but this is a necessary process. 

If left uninhibited, the market forces that are driving real estate values downward are the path to economic recovery. Inexpensive space decreases the barrier to entry for emerging businesses. New and more conservative Real Estate Developers will now have a greater opportunity to expand by capitalizing on the bad bets made by riskier developers. The worst over valued properties will be defaulted, and then resold at more realistic values at auction and lenders will be insulated by auction losses by Government backing already guaranteed through TARP. This process will eventually lead to the bottom of the market, where prices become stable. This stability will allow credit to start flowing again by solidifying confidence in the value of real estate, which will once again be used to leverage new loans.  

This new request will prove to be a real test for the Federal Government. The Developers' problems are a description of the natural market forces adjusting in the wake of a real estate bubble. Depressed rents, and depreciated assets are a necessary evil as our economy searches for a firm footing. I can only hope that congress has the sense not to hand out money to everyone that asks, and instead analyzes the impacts of their stimulus. This will be an opportunity to either show a true understanding of the causes of this recession by denying the developer loans, or show true ignorance by granting them. 

 

1.   Demand was "artificial" because borrowers received loans they should not have qualified for in a normal credit environment. This is a widely accepted cause of the real estate bubble. 

2.   To understand the crisis in more detail please see two articles I wrote in October, "Truly Understanding the Credit Crisis..." and "You Would Have Been an Idiot Not to Take a Teaser Rate..."

Money Does Grow on Trees! The Fed Goes to 0%.

In the past two weeks the Fed made a remarkable policy decision by moving the federal funds rate to zero, and the market made a remarkable move to push the U.S. treasury yield on a 4 week note below 0%. These stories are an important fear indicator. The Fed has taken the position that they are willing to flood the market with dollars. With not even a whisper of inflation the policy is to literally give money away for free. But instead of throwing money out the backs of armored cars, banks and a broad range of investors are giving it back by buying short term treasuries at a loss, saying thanks, but no thanks, the market risk just isn't worth it. 

The treasury yield story is history in the making. Both the Times and the Wall Street Journal have various economists weighing in, both suggesting that this has not happened since the Great Depression. The interesting nuance now is we supposedly have safety measures in place that would curb the kind of risk one assumed when keeping cash in a simple bank account during the Great Depression. This treasury yield signals that a bank/investor/hedge fund would rather give
their money to the federal government for safe keeping rather than holding it in cash. There is so little faith in the U.S. Banking system in the year 2008 that there are people making rational choices to have the Federal Government hold onto their money, at a loss, for the protection from a financial collapse over the next 4 weeks. If this all sounds very grim, it is because there is no
other rational explanation. Many of the articles site the fear of other riskier options like the broader stock market that have driven higher demand for these safe treasuries, but such a mounting demand that it actually pushed the yield negative is shocking.

The story on the federal funds rate seems to be a last stand, it is the Fed’s Alamo. What more can the Fed do to try to spur lending again? They have literally left the vault open and no one has shown up to take the money. There have been some early reports that this, along with moves by other major central banks to cut their benchmark rates, have helped curb some investor fears, but these are unchartered waters and no one really knows how long it will take for credit to flow again.

This all circles back to the uncertainty in the real estate market. I see the majority of lending in the U.S. as a house of cards with real estate as the base. Most loans are secured on a real estate asset. Small - medium businesses rely on the real estate market to leverage capital improvements and individuals rely on their real estate stability to access credit and build wealth. We are in a time where no one is really sure when the real estate trough will be. As a result, the base of the house of cards has collapsed. No one wants to take on additional risk lending or borrowing when the value of the securitizing is completely unknown. It creates the circumstance we see today, the Fed can offer money for free but with lenders and borrowers sitting on the sidelines there seems to be little interest to be the first one back into the pool. 

These two stories indicate that the recession still has a way to go to find its bottom. Even with the fund rate at 0% and the Fed pumping dollars into banks to sure up their balance sheets (See "Throw in the Kitchen Sink" for a description of all government infusion programs) lending continues to be sluggish and the market seems extremely risk adverse overall.

Because every story has a silver lining, these two represent a unique advantage to the President elect. The government now essentially has zero cost to capital. Even the 10 year treasury is at an all time low, settling just over 2% today. With such inexpensive borrowing this is an excellent time to make the kind of infrastructure investments Barack Obama has suggested. This approach will indirectly stabilize the housing market by putting dollars directly into the hands of consumers and our nations infrastructure will get a much needed face lift at the lowest possible cost. Maybe a massive government driven stimulus is exactly what this free market needs to get back on track.  

Homeowners Re-defaulting. I Told You So?

I read a report in Reuters today that was titled "Homeowners Redefaulting After Getting Aid" and I now have the unfortunate right to say to the FDIC, "I told you so." 

The FDIC plan to restructure mortgages seemed dangerously underdeveloped when I first analyzed it in my article "When a Government Becomes a Bank, Anyone Else Concerned with Moral Hazard (part 1 of 3)."  In this 3 part series I analyzed 2 proposals for readjusting troubled mortgages, the worst of the two being the FDIC's loan guarantee program. The basic argument I tried to convey is the loan guarantee does not address the essential problem troubled borrowers are facing: Troubled homeowners are over leveraged, at best they can afford their loan principle at a "teaser rate" which the current market cannot provide, even with a government guarantee. Without addressing this core issue the FDIC program is going to fail, miserably. This Reuters article reports that over half of all restructured mortgages have failed within the first 6 months; it is just proving my point. 

I am disappointed the FDIC program did not take into account some nice aspects of the second program I profiled in "When a Government Becomes a Bank," which extended the term of the loan. The term focused plan was part of the depression era Home Owners Loan Corporation program. It allowed principles to be extended over a longer period of time, thereby reducing the monthly debt service to a manageable level. This is still a viable solution if the market is willing to look at a much longer time horizon. If not, this may be the best government driven solution I have heard so far, and presumably would have significantly less risk to the taxpayer.

I see this recent statistic as the start of a colossal blunder by the FDIC and I am worried that it may shake congress' confidence in Henry Paulson and Ben Bernanke's (who were weary of the FDIC plan as I pointed out in "Nice to Know Henry Paulson Agrees a Loan Guarantee Will Not Work") economic recovery vision. The Reuters article is already showing signs of grandstanding by politicians, citing Rep. Barney Frank (D) who chairs the House Financial Services Committee as saying that he would agree to release the remaining $350 billion only if "they (the Bush administration) made it clear they were wrong in refusing (to use) it for foreclosure relief...Foreclosures are getting worse." The problem is not a resistance to help foreclosures, the problem is the FDIC plan is fundamentally flawed, and does not address the central over leveraged issue. Someone needs to either guide the private market to provide term extending debt packages, or seriously explore a government driven alternative in order to make any real change in foreclosure rates. 

In light of these new statistics I tried to find any FDIC projections for default rate, which were unavailable, but I did uncover a new shocking detail about the plan. From a press release from Nov. 20, 2008 which highlights a speech given by FDIC chairman Bair to the Johns Hopkins Cary Business School:  

"We'll accomplish this (the loan guarantee program) at no cost to the taxpayer or the deposit insurance fund. The TLPG is being offered under the systemic risk exception in our statute. Fees for the guarantee have been structured to cover our expected costs. However, in the unlikely event of a shortfall, the difference will be made up through a special assessment on all insured institutions, consistent with the procedure contained in our statute." 

A very relevant, yet not widely publicized detail. In this case the taxpayer is saved, new burden for default is put on the already distressed financial sector. So if I understand the reasoning:

1.    The banking sector cannot afford the losses they are taking on defaulting mortgages. Therefore: 

2.   The FDIC will "guarantee" the mortgages. But 

3.   The guarantee will be paid for by the banks that are FDIC members. Therefore:

4.   Banks are again guaranteeing themselves. 

Is this madness?! This is not a government guarantee at all, this is spreading the losses out among all banking institutions through a government created utility. I won't even begin to address the free market problems and backward incentive structure this creates, it will have to be put into its own installment. How did this plan get approved? 

 Everyone cross their fingers that Obama has someone a bit better for the FDIC, this plan is a fast sinking ship.

What if Housing Doesn't Come Back?!

I have been mulling around a simple concept over the past two weeks. Our housing market for many years has been driven primarily by easy access to credit. It allowed many home buyers to overextend, and even more suitable buyers access to extremely (relative to the 80s) inexpensive financing options. Much of this (putting aside much better Fed policies since the 80s) can be attributed to an extremely lucrative market for mortgage backed securities. It leads me to the simple question, what if the mortgage backed securities market doesn't come back...ever?  

 

Many economists, including Henry Paulson, are calling the real estate tumble a "market correction" which is an inherent acknowledgment that there was something wrong with the housing market that now needs correcting. There has been a lot of discussion about the need to make mortgage backed securities more transparent so investments carry the appropriate risk level to stem a future crisis from happening again (I have yet to hear of one viable option). But no one is really admitting that whatever new form these securities will take, it will never be the same. These new securities will have added cost due to new government oversight, and more importantly they will be sold in a market where investors now consider the security extremely risky, instead of extremely safe. 

 

Since most individuals purchase real estate with credit, cost of accessing credit is a strong contributing factor for the demand for real estate. Packaging mortgages and selling them in a bulk security greatly lowered the cost of borrowing. It opened the mortgage market up to a world (literally the entire world) of investors. A bank in Ohio no longer needed to hold the entire mortgage amount; they could sell these mortgages on the open market, possibly finding a buyer in an investment bank in India. The attraction for investors was a chance own what was considered a diversified (a wide range of underlying properties in a security), safe asset. The U.S. housing market was perceived as very strong through the 90s and could offer a lucrative return, thereby encouraging more investment. So what happens when the perception of mortgage backed securities moves from being the safest to the riskiest investments? There is the obvious response that credit immediately freezes, we have already seen that, but what happens 10 years from now?  

 

This may be the end of real estate based wealth building as we know it. For years housing prices were driven upward, I would argue primarily by easy credit. Securitizing mortgages brought borrowing costs down so low there was an influx of new demand into the market. Now, with more investors becoming extremely risk adverse to U.S. housing market investments, there will be an immediate capital drain from the market. Even as the credit markets begin to thaw it will take a significant amount of time before the fear towards the market subsides.  

 

Looking forward two years from now, after the global recession will begin to (hopefully) ease, and when consumer spending and Fed policy returns to normal; the mortgage market may look very different. With an additional fear factor, investors will be looking for a higher return to account for newly recognized (does not even need to be real, just perceived) risk in the U.S. market, this will translate into much higher interest rates for mortgages. Higher rates means a higher barrier to enter for new buyers, and demand will take a heavy hit. I would also predict this will effect all tiers of real estate in different ways. Those with good credit that remain in the market post-crisis will not be able to afford the principle they were able to pre-crisis because of higher debt service. This means even the luxury home market will take a significant hit. I also believe the overall skittish feeling toward the market will deter eager investors who purchase properties on spec for a short term reward. All of this translates into a long term national depression in demand for new housing. In the end I think this "correction" will adjust for more realistic risk, and once the adjustment is made home prices will appreciate again, but at a much slower pace then we may have become accustomed to over the past two decades. I would predict, after the adjustment is completed in about a year or two, the appreciation of most real estate will closely follow local income growth (which hasn't been too great on a nation scale the last 20 years) of the middle class or better, (those with good-to-great credit) rather than any other external factors. 

 

To end on a bright note. If you rent, this is great news! Wait out this adjustment period, build your credit now,  save up for a ridiculously high down payment to secure your loan, and hopefully the post-recession, post-crisis, interest rates won't be too far out of reach! Just don't count on your home being your nest egg unless you anticipate a sudden jump in U.S. income growth, similar to the growth we had post world war two, but have not seen since. Your home will just be your home, it will not generate income or make you a millionaire, but at least you get a tax credit on the mortgage and don't have to deal with a landlord!