The following is a guest post by John M. Walker, Jr., an attorney and business executive with over 30 years of experience in finance and real estate.
It’s been an interesting few days for those who follow commercial real estate and banking. Friday (October 30), Bloomberg quoted billionaire Wilbur L. Ross Jr. as saying that the U.S. is in the beginning of a “huge crash in commercial real estate.” He also said he’d use “extreme caution” before putting money in commercial real estate, and that, “All of the components of real estate value are going in the wrong direction simultaneously. Occupancy rates are going down. Rent rates are going down and the capitalization rate -- the return that investors are demanding to buy a property -- are going up.”
That same day, the Federal Reserve adopted a policy statement “supporting prudent commercial real estate (CRE) loan workouts,” which, according to the Fed’s press release, “provides guidance for examiners, and for financial institutions that are working with CRE borrowers who are experiencing diminished operating cash flows, depreciated collateral values, or prolonged delays in selling or renting commercial properties.”
The new loan modification guidelines prompted Henry Blodget to post a blog entitled “New Rules! Banks Can Lie About Commercial Real Estate Loans” on Sunday (November 1). Noting “there’s nothing wrong with encouraging modification,” Bloget expressed concern that with rents dropping, leases rolling into a declining rental rate market, and the possibility of interest rate increases, “the modifications will just kick the can down road. . . .In the meantime, moreover, we will be prolonging the illusion that the banks are healthy. The modified loans will still be classified as ‘performing’ and carried at par--even though the actual asset value is far lower.”
This all comes on the heels of an October 29th letter from Barney Frank and Walt Minnick to the heads of the Fed, FDIC, OCC, NCUA, and OTS exhorting the regulators “to show some temperance in their regulation of traditional banks” and identifying examples of problem areas, including “’unofficial’ capital requirements” that restrict lending activity and the valuation of assets “down to current ‘market’ value” that “now are making the banks’ capital crunch artificially and unnecessarily worse.”
So, are the new guidelines a lifeline for the banks or a license for them to lie? The answer is neither – and both – and when looking at the likely impact on the banking crisis, it really doesn’t matter which.
The Fed’s press release says the policy statement “details risk-management practices for loan workouts that support prudent and pragmatic credit and business decisionmaking within the framework of financial accuracy, transparency, and timely loss recognition.” The policy statement itself says, “In addition, renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.”
And, there lies (pardon the pun) the rub. If the collateral is declining in value – and has declined to an amount that is less than the loan balance - what really is financially accurate, transparent, and timely recognition of loss? Rather than constituting a concrete step toward softening the coming CRE blow and relieving some of the continuing pressure on the banks, the guidelines likely just will lead to sharper “Is too . . .Is not” babble between the banks and their regulators as they argue over value in workouts.
Let’s look at why that’s likely the result. The general consensus seems to be that commercial real estate values have fallen 35% to 45%. Except where there is substantial credit behind a CRE loan beyond just the real estate collateral alone, these loans today are worth no more than the underlying collateral. I don’t expect these values to snap back anytime soon. A September 2009 McKinsey Global Institute report, Global capital markets: Entering a new era, states, “From 1980 through 2007, the world’s financial assets – including equities, private and public debt, and bank deposits – nearly quadrupled in size relative to global GDP,” after having grown at about the same pace as GDP for most of the 1st eight decades of the 20th century. One of the report’s conclusions is that it is “likely that total financial assets will grow more in line with GDP in coming years.” A similar outlook for future asset value growth is expressed in the November 2009 Investment Outlook by Bill Gross. Gross notes that for a period of time, economic growth, not paper wealth, was king – but that, beginning in the 1980s, “the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate.” This in turn “produced a persistent increase in asset prices vs. nominal GDP.” And, according to Gross, “our ‘paper asset’ economy has driven not only stock prices, but all asset prices higher than the economic growth required to justify them.” Gross also notes “there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner’s platform.”
Now let’s stir in the massive maturity default risk facing the banks. Deutsche Bank, in its quarterly commercial real estate outlooks, has estimated that over $2 trillion in commercial real estate loans mature between now and 2013. According to Deutsche Bank’s outlooks, many of these loans likely do not qualify for a new loan large enough to pay off the existing debt.
Bloomberg, in an August 13, 2009 article (Next Bubble to Burst Is Banks' Big Loan Values), highlighted the conundrum faced by banks between the balance sheet value of their loans and what may be the loans’ estimated fair value, using Regions Financial Corp. as an example. On page 5 of Region’s 10Q for the period ending June 30, 2009, its loans (excluding leases and net of unearned income and its allowance for loan losses) were carried on its balance sheet at $90.85 billion. In note 11 on page 37 of the 10Q, the estimated fair value of those loans was shown as $68.05 billion, a negative difference of $22.8 billion that is greater than the $18.74 billion net worth reflected on Region’s balance sheet. Is it more financially accurate and transparent and does it reflect more timely loss recognition for the balance sheet loan portfolio value to be carried as $90.85 billion with a note reference to the estimated fair value of $68.05 billion, with the positive net worth of $18.74 billion; or is it more financially accurate and transparent, and does it reflect more timely loss recognition, to reverse the relative portfolio value positions and reflect the negative net worth?
What little I know about FAS 5, FAS 114, and FAS 157 could fit into the proverbial thimble. Varying degrees of managerial discretion and judgment are involved when recognizing impairment, measuring impairment, and measuring fair value – particularly when the “fair value” hierarchy and its 3 levels of inputs come into play. Level 1 inputs (quoted prices in active markets) generally are transparent. Level 2 inputs (not quoted prices, but “observable” inputs) and Level 3 inputs (“not observable”) involve managerial assumptions and are where the “mischief” can occur. Levels 2 and 3 can allow for what Warren Buffett has called “mark-to-model” or, in extreme cases, “mark-to-myth” accounting.
The CRE problem is real. We know serious de-leveraging has begun and will continue; but we don't know the extent of the de-leveraging nor do we know the timing of the de-leveraging period. I think that simply extending the term of troubled CRE loans in hopes of achieving higher occupancies, higher rents, and lower cap rates in the future will delay the inevitable losses – even more so if asset value future growth does track future GDP growth rates. Let’s assume a portfolio secured by collateral originally valued at $10 billion in 2007. At a 35% decrease in value today, that collateral now would be worth $6.5 billion. If GDP were to average 3.5% growth each year in the future and asset value growth were to track GDP growth, then it would take roughly 13 years for the collateral’s value to return to $10 billion. If you’re an optimist, though, it’ll only take about 3 years at a roughly 15.5 % annual growth rate.
Instead of providing the banks a lifeline or giving them license to lie, the guidelines only will give banks cover from under which to push back more strongly against (1) what has been reported as overzealous and heavy-handed examinations that both run counter to the pressure from Washington to “lend” and to “mitigate foreclosure,” and (2) what some have labeled as a “hidden” agenda to reduce the number of smaller or community banks in the U.S. (also known as “to small to save”). Activity is not achievement – while the Neros who oversee our banking system continue to fiddle by addressing only paper-like symptoms instead of the real disease affecting the banking system, that system continues its financial melt-down – unless your objective is to create a smaller banking system under greater government control by simultaneous pursuit of the twin policies of “too big to fail” and “too small to save.”
