The Decade of the Living Dead

What happened? Everybody expected Commercial Real Estate (CRE) to follow housing down the drain this year, but it hasn't. Why not?

First let's take a trip down memory lane. We've been here before. I guess I'll just let it all hang out and date myself. Remember the Savings & Loan (S&L) bust? No? Bless you. Well, here it is in a nutshell. Johnson pulled the pin on inflation by waging a War on Poverty and a war in Vietnam at the same time without raising the taxes to pay for 'em. Yes, he did raid the Social Security fund, but that's a story for another day. Nixon tried (foolishly) to contain the problem with wage and price controls. The Saudis, using the Yom Kippur War for cover, decided to recoup their losses from the falling dollar by raising the price of oil. Gerald Ford might have had a chance, but there was no way he was going to get a full term and we got Carter instead who managed to compound the problem. Double digit inflation had become the new normal by the late 1970s.

Then, amazingly, along came Paul Volcker, certainly the best appointment of the Carter administration (1979). He got along fine with Ronald Reagan too, he restricted money supply and consequently raised interest rates astonishingly in order to stamp out inflation. At one point you could get a bank CD for 15% or more.

So what did that do to the S&Ls? They were toast. They were portfolio lenders for housing and their portfolios yielded under 10%. They were supposed to be funded by savings deposits at regulated (low) interest rates, but who wanted those? In the early 1980s they had a collective hole in their balance sheets on the order of $50 billion, which was regarded as big bucks at the time. So they went to Congress and said, "Hey, you can shut us down. Pay off our depositors. This is about what it will cost you." Congress replied, "Is there a Plan B?" The S&Ls said, "Of course you could let us do commercial development lending. It's so profitable we can earn our way out of our problem..." Congress said, "OK. Just don't come back crying during THIS Congress." There were those of us at the time who doubted there was enough good business out there to fill that hole, even if the S&Ls were smart enough to do it, but... Well, end of story, by the late 1980s S&Ls were failing in droves because of their bad CRE loans. The magnitude of the problem had become a quarter trillion, which is still regarded as a real number.

Naturally the hunt for scapegoats was in full cry when the scapegoat-in-chief, Charles Keating held a press conference. "Hey, we were only doing what Congress wanted..." That had enough truth in it to bring the hunt to a full stop. Yes Keating did time, but instead of trying to prosecute and/or recover from the perpetrators we got FIRREA. And the Resolution Trust Corporation (RTC) was assigned the task of burying the whole mess in a mass grave through rapid liquidation of the bad properties. At the end of the day, the official cost was about $100 billion, and John McCain, last of "The Keating Five" is still in office. Fortunes were made, of course, buying up those doggie properties at pennies on the dollar.

Enough history, but it sets the analogy; right now we're at about the 1987 stage of the present CRE meltdown. But we don't have as clear a definition of the problem. It is likely that local and regional banks which are failing by the hundred were major CRE lenders. If they weren't making SBA loans to their customers they were buying Commercial Mortgage Backed Securities (CMBS) from the "Too Big To Fail" (2B2F) institutions. Triple A rated at the time, they now are cheap, if not unmarketable. You might ask what distinguishes as 2B2F from an ordinary lender*. Probably the quickest answer is to look at Fannie whose "Friends", political "contractors" on Capitol Hill, account for a more reliable Congressional majority than either Pelosi or Reid can muster.

There is no doubt that the mass closure and liquidation that happened to the S&Ls hastened the clearance of the distressed commercial property markets. Is there an alternative? Yes. It's called "extend and pretend". The banks have bad loans, but while they're technically in default, or can't be refinanced, the loans' interest payments can, at least mostly, be kept current. The regulators, particularly FDIC which insures the deposits, are nervous that their resources are inadequate to cover all the problems, so they look the other way while the banks in question simply extend the problematic loans. One of the real arguments about "mark to market" accounting for assets is that if these extended loans were marked (down) to market, then the regulators would have no choice but to close down more banks. There are good theoretic arguments for and against marking to market, but the hard fact is that there would be a lot more failed banks if the rule was enforced rigorously.

Extend and pretend is the basis for a strategy which finds the real estate market both distressed and not being liquidated. The strategy of the decade seems to be 'Sell the best, if you have to. Liquidate the worst. Letting the bank have 'em is the easiest exit strategy. It also improves bargaining leverage for keeping the rest. So we have a trillion dollar problem. We have vultures hovering waiting for the carcasses to fall, but we have the borrowers, banks regulators and even Congress propping 'em up.

So, that's alright isn't it? Well, maybe, if we don't mind playing this mess out the way that Japan did in the 1990s (or FDR did in the 1930s). In Japan banks grew enormously in the 1980s, but a lot of their growth was loans to related companies in their keiretsu group which had little ability to repay them. After their bubble burst, however, that fact became pretty obvious. Interest payments on those loans were nominal, though, so they could easily be extended and even stay current. What's so wrong with that?

Well, part of the stagnation that Japan has suffered since 1990 has been because their banking system is stuffed with bad (but mostly current) loans. There isn't the capital to make new ones. In the United States that would mean, for instance, that new and small firms will pay more for borrowed capital if they can get it at all. As new and small firms are part of the American "engine of growth", that can't be all good. Another "bad" is that large firms which already are successful at extracting money from the political system will become more successful at it. They won't have to look over their shoulders at new competitors or teeny game-changers. Imagine if Bill Gates had been unable to get the capital he needed to fulfill his original IBM contract... "Extend and pretend" is the blindfold over the public's face as it wanders along the cliff.

Meanwhile, there's over a trillion dollars (face value) of loans out there that everybody expected to be liquidated which haven't. ("That parrot's not dead. It's only sleeping." "So why is it nailed to its perch?" - Monty Python) This is another flavor of shadow** inventory, isn't it?

* http://www.businessweek.com/news/2010-04-13/wamu-excluded-from-too-clubby-to-fail-group-killinger-says.html

** http://www.charlesbwarren.com/shadow.html

Charles B. Warren, MRICS,
ASA-urban real property
Pleasant Hill
925.609.7241
http://www.charlesbwarren.com/topics.html