We INTERRUPT this FORECLOSURE CRISIS for a COMMERCIAL Message

So… commercial real estate has been the next financial shoe to drop for some time now.

The best thing about the meltdown in commercial property, for me anyway, is that it’s just a variation on a now all too well-known theme: Underwater properties cannot be refinanced so when loans come due… it’s foreclosure time. And foreclosures on underwater properties result in losses for banks and other investor groups, which in turn lead to federal bailouts, at least in cases where the bank is deemed TBTF – too big to fail, which should really be renamed TPCTF – or “too politically connected to fail”. So, at least I don’t have to spend time explaining what’s causing the problem… capiche?

And although I don’t know how successful such efforts are, some are now offering to work with lenders to get these loans modified, and its been talked about for the last year by those claiming knowledge of the space.

To be entirely candid, I expected to be hearing more about the impact of commercial property defaults tearing into bank balance sheets by now. A few months back I read about the John Hancock building in downtown Chicago being bought by a new investor group for something like $600 million less than the amount of the last mortgage, and I thought to myself… ouch, that’s gotta’ smart.

The commercial property meltdown is also familiar territory in that, even though there are hundreds of billions of dollars in underwater loans that will likely end up blowing up on bank balance sheets, Treasury Secretary Tim Geithner says there’s nothing to worry about. According to Bloomberg, on October 29^th of this year, while Tim was speaking at the Chicago Economic Club, he was asked whether defaults on commercial real estate could lead to another banking meltdown, he responded by saying:

“I don’t think so. That’s a problem the economy can manage through even though it’s going to be still exceptionally difficult.”

I don’t care what anyone says… I love Tim. He’s really is the best, don’t you think? This is a guy that would have awoken on the morning that Katrina slammed into the Gulf Coast, looked out the window of his hotel, and said:

“It’s a bit damp, but I’m sure it will clear up by this afternoon.”

And, lest you think I exaggerate Tim’s propensity to view the future through only the rosiest of lenses, Tim said what he did about the commercial real estate market on October 29^th, just a few days AFTER Capmark Financial Group, one of the country’s largest commercial real estate lenders, filed for bankruptcy protection. According to Moody’s, Capmark has originated more than $10 billion in commercial property loans.

Capmark came into existence in 2006, when an obviously prescient group of investors, including KKR & Co., Goldman Sachs and Five Mile Capital Partners acquired GMAC’s commercial-real estate business, renaming it Capmark. The group ended up with about 75% of the company, with GMAC and its employees holding onto the rest.

Capmark reported a second quarter loss of $1.6 billion this year, and finally filed for bankruptcy around the 24^th of October. KK&R has already written down its investment in Capmark to… wait for it… zero. Maybe the guys at KK&R haven’t spent enough time hanging out with Tim, because they sound like real downers.

The FDIC has also notified Capmark that it must raise capital in order to increase liquidity at its Utah bank, which also has roughly $10 billion in assets, although the bank is not included in Capmark’s bankruptcy filing… don’t ask me why. That’s funny, isn’t it? The FDIC going around telling other financial institutions about their need to raise capital and increase liquidity. I’m not saying it’s wrong… that’s the FDIC’s job and all, but it’s still funny to me. Sort of like Bernie Madoff going around telling fund managers what they need to do to remain in compliance with SEC regulations. Not exactly, but sort of.

Predictably, Capmark was just another company that relied heavily on selling the loans it made into the now non-existent, secondary market. When that market froze solid, as a result of the fabulous rating system we’ve developed in this country, and property values fell as a result, poor Capmark found itself stuck owing more to lenders than its loans were worth.

Doesn’t that make you wonder why homeowners aren’t described in that light?

Why is it that when Capmark goes bankrupt as a result of owing more on real estate than it’s worth, as a result of the secondary (read: bond) market freezing solid, the company is described as being the victim of unfortunate circumstances beyond its control? But, when the same exact thing happens to a homeowner, that homeowner becomes an irresponsible individual who assumed real estate prices would go up forever, used his or her home as an ATM, and bit off more than he or she could chew.

The problem is that between now and 2013, more than $2 trillion in commercial mortgages will need to be refinanced, according to a Deutsche Bank report published last July. Commercial mortgages aren’t like their residential cousins, because they typically have 5-10 year terms, as opposed to thirty.

With Moody’s/REAL Commercial Property Price Index showing that commercial properties have declined in value by 40% since their peak in October of 2007, the owners of these properties are going to have a dickens of a time refinancing them, assuming they’d want to in the first place. Homes are all about emotion, but I’m not sure the guy who owns a strip mall center in Des Moines feels all that much of an emotional connection to his property. Maybe I’m wrong, we’ll soon see.

The Philadelphia Inquirer recently quoted a guy by the name of Paul Halpern, who is a partner at Versa Capital Management of Philadelphia. Paul’s view is that a lack of available financing for commercial real estate has prevented properties from trading at depressed values. He says that may help some lenders that would otherwise be facing huge write-offs. But then he got all Geithner-like when he said:

“By the time financing is available, asset prices will have recovered substantially, though not enough to save everybody.”

Where do these guys get their sense of humor… or rather “hubris”? Rock on, brother Paul, rock on.

Okay, so does anybody have any questions about what’s going on here? Commercial real estate, a couple of trillion worth, is now circling the drain and soon we’re all going to hear that loud flushing sound we’ve all come to know and love, coming from banks all over the country.

I can’t keep up with the number of banks that have closed their doors forever during this past year, the list grows too quickly, but I think we’re at something in the neighborhood of 126, give or take, and you know that many of these regional banks… the ones not TBTF… have gone down as a result of their commercial loan portfolios.

Wilbur Ross, the at least somewhat creepy looking Chairman & CEO of WL Ross & Co. told CNBC on September 15^th, that he sees perhaps 1,000 more regional banks going under in the months to come. But here’s the rub… his characterization of this catastrophic forecast is that it will “create opportunities for investors”. Oh, well in that case, let the rooting and cheering begin. Fail banks, fail! Fail banks, fail!

I’ll say: What do we want?

You say: Opportunity!

I’ll say: How will we get it?

And you say: By 1,000 banks failing in the next few months!

Ross also told CNBC that his company will be looking to pick up some of the smaller institutions that fail, but… and pay attention here… he said: “There will be opportunities, but we will need federal assistance in them, because what we’re mainly looking for is stable sources of deposits, not so much the loan portfolio.”

You might want to go back and read that last paragraph. What he just said, besides that he’s looking to buy banks in order to get “federal assistance,” which is a euphemism for you know what, but far more importantly in my view, he’s looking to pick up “stable sources of deposits” at a discount. “Stable sources of deposits?” That sounds suspiciously like the bank accounts of regular folk… homeowners, if you will.

Does that say anything important to you, because to me it speaks volumes. Maybe “the people” have more power than they think. I wonder what would happen to Mr. Ross’ interest if the stability of those coveted deposits was somehow lessened. I don’t know, it’s besides the point… just thinking out loud over here.

Okay, so there’s not a whole lot of question that the implosion of commercial real estate is upon us, and that its growth as a destructive force over the next several years is assured. So, what is our government doing about this clear and present danger, to borrow a line from Tom Clancy?

It’s simple, really. And predictable, too, I suppose. Just conjure up some new rules and regulations that allow banks to ignore the losses, what else? I mean, it’s working fabulously well in the residential real estate market, so why quit on a winner?

According to the Halloween issue of the Wall Street Journal, federal bank regulators, including the FDIC, the Federal Reserve, and the Office of the Comptroller of the Currency (“OCC”), have issued guidelines that allow banks to keep commercial property loans on their books as “performing,” regardless of the true value of the underlying properties. It seems that the new guidelines were provided because of the government’s concern about commercial property owners that are… are you ready for this…

“Experiencing diminished operating cash flows, depreciated collateral values, or prolonged delays in selling or renting commercial properties.”

Oh, poor babies… Now I’m worried about them too. How could I not be? You have to feel sorry for anyone that’s making less money, has property whose value has dropped quite a bit, and who’s having trouble selling or renting their property as a result, right? I mean… UNLESS THEY’RE JUST REGULAR OLD HOMEOWNERS, THAT IS! If you’re a homeowner in exactly that SAME position, for exactly the SAME reasons… well, excuse my French, but vous êtes baisé.

The guidelines also point out that “restructurings are often in the best interest of both lenders and borrowers,” so what do you know about that?

Up until now, it seems, banks have been suppressing losses on commercial real estate the traditional way, which is by using a methodology known in financial circles as “extending and pretending,” or as my mother would call it… “LYING”. Basically, when a loan on commercial property comes due, the bank just pretends it hasn’t come due yet. Analysts and investors criticize the practice of “extending and pretending” because they say that pretending the maturity date hasn’t arrived will only put the pain off into the future.

Ya’ think? You don’t mean to say that pretending that a certain date hasn’t yet arrived doesn’t permanently stop that date from arriving, do you? Heaven forefend. I pretend that my birthday hasn’t arrived every year, and I’m still not yet 24. Morons.

The Rush to Fabrication

I think “Mish” Shedlock said it best this past week when, commenting on the new rules that allow banks to ignore losses on commercial real estate, he said: “It should come as no surprise that the banks are rushing to adopt the new rules.” And the Wall Street Journal concurred:

Banks are moving quickly to restructure commercial mortgages under new U.S. guidelines that are more forgiving of battered property values and can help banks avoid bigger losses.”

Citigroup Inc., regional bank Whitney Holding Corp. and other lenders around the country are planning to review loans now considered nonperforming to determine if they can be reclassified under the guidelines announced Oct. 30 by bank, thrift and credit-union regulators, according to bank executives and people familiar with the matter. The moves could help the banks absorb fewer losses on troubled real-estate loans and preserve capital.

“It’s a positive all the way around,” said James Smith, chief credit officer for National Bank of South Carolina, a unit of Synovus Financial Corp.

“Regional and small banks are the most likely financial institutions to benefit from the guidelines because of their exposure to commercial real estate. 2,600 banks and thrifts have commercial real-estate-loan portfolios that exceed 300% of total risk-based capital and regulators ignored it every step of the way. Now that loan losses are soaring, regulators came up with new rules so that banks can pretend the losses are not real.”

Regulators consider the 300% threshold a red flag, though it doesn’t necessarily mean the banks are in danger of failing. Risk-based capital is a cushion that banks use to cover losses. Commercial real-estate woes contributed to 100 of the 120 bank failures this year, according to Foresight Analytics.

Responds “Mish”…

These kind of reporting games do not really help anyone. All the pretending does is prolong the agony. Banks know the true score even if investors don’t. Thus, such measures to free up capital for banks to lend will not work here anymore than the same shell games encouraged lending in Japan.

The fact that regulators are resorting to such shell games is just further proof as to how weak the financial system is. This is an effort by Bair to stem the tide of bank takeovers. However, the time to do that was before (not after) 2,600 banks accumulated commercial real-estate-loan portfolios exceeding 300% of total risk-based capital.

The Response to the Criticism…

I should not have been the least bit surprised to find out that banking regulators responded by saying that in their view, they are in fact, being “prudent,” and that any banks that misinterpret the new rules to mean that there is an opportunity for leniency will be in big trouble.

Exactly what I was thinking… I better not hear about any bankers that think just because the government is allowing them to not recognize billions in losses, that the government’s being in any way lenient with them. No leniency here, Boy-O… that’s the absolute last thing anyone should take away from these new rules. Strictness… that’s what the government’s trying to impart as far as any message goes… total strictness.

I do have one more thing to say: Why did I not become a banker? I don’t remember anyone telling me about any of the fringe benefits involved. I mean, had I understood that bankers get all the profits and the government picks up the losses, or at least doesn’t make the bankers recognize them, I might have said… “Well, alrighty then…”

Yeah, I’m pissed, but I’m also starting to envy these guys.