October 1st, 2009 8:56 AM by Lehel Szucs
There is broad agreement that we have seen the worst of the recession, and that GDP will show a positive gain for the 3Q when we get the first government estimate in late October. Most pre-report GDP estimates I have seen are in the +2 to +3% range for the 3Q. The actual number remains to be seen, of course.
There is also a growing agreement that we have seen the worst of the housing bust, as sales of new and existing homes rose briskly for the four months ended in July; however sales of existing homes unexpectedly fell slightly in August as reported last week.
Yet while the economy appears to be on the mend, at least for a while, and the housing market seems to be recovering, there is another serious threat to the economy and the credit markets just ahead - the continuing commercial real estate bust which is still getting worse.
This week, we will take a brief look at the latest economic reports, most of which are encouraging, and then I will summarize the very troubling situation in US commercial real estate. This problem has led numerous analysts to predict that the commercial real estate may well be the next shoe to drop in the credit crunch.
The Economy Continues to Improve Slowly
As noted above, most forecasters believe the US economy has expanded at healthy rate in the 3Q which officially ends tomorrow. If so, that will be a welcome relief following GDP declines of -6.4% in the 1Q and -1.0% (annual rates) in the 2Q.
The Index of Leading Economic Indicators (LEI) rose 0.6% in August, marketing the sixth consecutive monthly increase. This is perhaps our best indication that growth in the 3Q and the 4Q will be positive and could surprise on the upside, which is not surprising following the worst recession since the Great Depression.
Most analysts that I follow closely believe, however, that the economic recovery in 2010 will be rather anemic with GDP growth at or below 3% on average. Such estimates could prove too rosy, depending on what happens in the huge commercial real estate sector (details to follow).
Consumer confidence improved significantly in August after falling slightly in June and July. The Consumer Confidence Index rose to its highest level (54.1) since the recession began. The improvement continued into September with the University of Michigan Consumer Sentiment Index climbing to a new recent high of 70.2.
Higher confidence resulted in a nice rise in retail sales in August, up 2.7%. Unfortunately, durable goods orders, which were expected to have risen in August, fell 2.7% last month, following the big increase of 4.8% in July.
On the manufacturing front, the ISM Index rose to 54.1 in August, up from a revised 47.4 in July. Industrial production rose 0.8% in August, following a 1.3% gain in July. Factory orders were up 1.3% in July (latest data available). The factory operating rate rose to 69.6% in August.
As noted above, existing home sales dipped slightly in August following four consecutive monthly increases. New home sales in August were up fractionally (0.7%), well below expectations, following the 9.6% jump in July, the highest in almost a year.
Of course, any analysis of the overall economy would be remiss not to point out that, while things are improving on most fronts, the unemployment rate continues to rise - up to 9.7% in August from 9.4% in July - and will almost certainly continue higher for several more months at least.
Overall, it appears clear that the recession will end this year, and it is quite possible that we will see positive growth in GDP in the 3Q and 4Q. Most of the estimates I read for the 2Q are in the +2-3% range; most of the guesses I read for the 4Q are in the +3-4% range, which remains to be seen, especially in light of the potentially dangerous situation in the commercial real estate markets.
Plunge in Commercial Real Estate Values
US commercial real estate, valued at some $3.5 trillion, has experienced a 39% decline in prices on average from the peak in late 2007, according to the MITCenter for Real Estate.
This current drop is considerably worse than the 27% commercial real estate decline associated with the savings and loan crisis of the late '80s and early '90s. You will recall that the S&L crisis precipitated the government-run Resolution Trust Corporation and the resulting seizures and auctions of hundreds S&Ls around the country.
The same conditions that caused the residential housing bubble, including the Fed's easy credit, lax lending standards and booming mortgage-backed securities underwriting on Wall Street, also drove commercial real estate overvaluation.
Recently, MIT reported that commercial real estate prices plunged 18% in the second quarter, which was the largest quarterly drop in the 25 years since MIT first published its Commercial Real Estate Price Index. MIT also reports that most commercial properties bought or refinanced in the last five years are now upside down on their loans, with current property prices having fallen below the finance or purchase price. Real Capital Analytics reports that owners have lost their entire down payments on about $1.3 trillion worth of property.
According to several sources, nearly half of all the commercial real estate mortgage loans in the US are coming due within the next five years. Deutsche Bank, for example, believes that 65% or more of these loans will fail to qualify for refinancing. Existing high vacancy rates will continue or worsen as long as the unemployment rate continues to rise.
We are hearing more and more talk about the plunge in commercial real estate values these days because commercial real estate value trends tend to lag the overall economy. There are many reasons for this - too many in fact that it is impossible to cover them in this short space.
Susan Smith, who is the director of PricewaterhouseCoopers' real estate advisory practice notes: "The biggest problem is that commercial real estate lags what happens in the economy. Companies are looking for ways to cut costs, many are continuing to reduce workers and are continuing to reduce their space needs." As a result, commercial rental rates have taken a nosedive in most markets.
Ms. Smith and her team at PricewaterhouseCoopers conduct surveys each year of the commercial real estate market, and their latest survey concludes that the rise in vacancy rates and the plunge in rental rate are far from over and may well extend into 2011. Office rents in New York and San Francisco may drop 20% in 2010 alone, the survey found.
The National Association of Realtors projects that retail vacancy rates will increase from 11.7% in the 2Q of 2009 to at least 12.9% in the same period of 2010, the highest vacancy rates since 1991. Likewise, NAR projects that office building vacancy rates will rise from 15.5% to at least 18.8% by this time next year.
Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc. are not affiliated with nor do they endorse, sponsor or recommend the following product or service.
More Trouble Ahead for the Banks
All of the above suggests the following: many of the banks that made commercial real estate have only realized a fraction of their losses. And as those losses continue to mount, we're likely to see more and more bank failures. Commercial real estate loans are not just concentrated among the nations largest banks; these loans are widely made by regional banks and even smaller banks.
Of the largest banks, San Francisco-based Wells Fargo has the largest share of the apprx. $3.5 trillion commercial debt securities, reportedly with 16.5% of its $821 billion loan portfolio invested. JPMorgan Chase is reportedly a distant second with 5.4% of its portfolio invested in commercial loans, followed by Citigroup with 3.4%.
However, smaller banks - 92 of which have already folded this year as of mid-September, according to the FDIC, compared to 25 last year - are even more at risk because they will likely have a harder time accessing the crucial capital to offset rising defaults on commercial real estate loans, according to the TARP-inspired Congressional Oversight Panel's August Oversight Report. The Oversight Panel noted:
"Unlike large banks that can sustain a certain number of defaults, even of large commercial loans, smaller banks may have far more difficulty in absorbing more than a few large loan losses. The FDIC's statement that ‘banks have been able to raise capital without having to sell bad assets through the LLP' may not reflect the reality for these banks."
Indeed, the number of smaller banks expected to be seized by the FDIC is forecast to accelerate later this year and next year. The FDIC's "problem list," of banks that run a higher risk of failure, grew to 416 in the 2Q, up from 305 in the 1Q. That's the highest number since the 2Q of 1994, following the S&L crisis, when there were 434 banks on the list.
As noted above, the S&L crisis resulted in a 27% decline in commercial real estate around the country. This time around the losses are even greater (39% so far) because the apprx. $3.5 trillion is over three times what it was during the early 1990s - meaning the potential for losses is steeper than ever before.
Glut of Commercial Mortgage-Backed Securities
Federal Reserve and Treasury officials are scrambling to prevent the commercial real estate sector from delivering another knockout punch to the US economy just as it struggles to get up off the mat. Yet their efforts could be undermined by a surge in foreclosures of commercial property carrying mortgages that were packaged and sold by Wall Street as bonds. These loans are known as Commercial Mortgage-Backed Securities (CMBS).
As discussed above, many US banks have high exposure to commercial real estate debt that they initiated through their own internal loans. In addition, many banks also bought CMBS and now have additional default risks that I will discuss in more detail as we go along.
Similar mortgage-backed securities (Sub-prime, Alt A, etc.) created out of home loans played a huge role in undoing that sector and triggering the global economic recession and credit crisis. Most sources estimate that there is around $700-$900 billion of CMBS outstanding at this time. These complicated products are being tested for the first time by the massive downturn real estate values discussed above, and so far the outcome so far hasn't been pretty.
A typical CMBS is stuffed with mortgages on a diverse group of properties, often fewer than 100, with loans ranging from a couple of million dollars to more than $100 million. A CMBS servicer, which is usually a large financial institution like Wells Fargo or JPMorgan Chase, collects monthly payments from the borrowers and passes the money on to the institutional investors that buy the securities.
The CMBS sector is suffering from two major problems, which, according to credit rater Realpoint LLC, sent its delinquency rate to 3.14% in July, more than six times the level a year earlier. One is major problem is that many of these mortgages were simply poorly underwritten. In the era of looser credit in recent years, Wall Street's CMBS machine lent owners money on the assumption that occupancy and rents of their office buildings, hotels, stores or other commercial property would keep rising. In fact, the opposite has happened. The result is that a growing number of properties aren't generating enough cash to make principal and interest payments.
The other major problem is the growing inability of property owners to refinance loans bundled into CMBS when these loans mature. By the end of 2012, some $153 billion in loans that make up CMBS are coming due, and close to $100 billion of that will face difficulty getting refinanced, according to Deutsche Bank. Unfortunately, other sources estimate that twice that many CMBS loans will come due between now and 2012; and double the amount that will be difficult or impossible to refinance.
Even though the cash flows of many of these properties are enough to pay interest and principal on the debt, their values have fallen so far that borrowers won't be able to extend existing mortgages or replace them with new debt. That means losses not only to the property owners but also to those who bought CMBS - including hedge funds, pension funds, mutual funds and other financial institutions - thus exacerbating the economic downturn.
Many banks that hold traditional commercial real estate loans have chosen to extend the maturities and/or renegotiate the terms (this is one reason we haven't heard too much about it until recently). Banks have had a strong incentive to refinance because relaxed accounting standards have enabled them to avoid marking the value of the loans down.
Until now, banks have been able to keep a lid on commercial-real-estate losses by extending debt when it has matured as long as the underlying properties are generating enough cash to pay debt service. Unfortunately, CMBS are held by scores of investors, and the servicers of CMBS loans have limited flexibility to extend or restructure troubled loans like banks do.
Mounting foreclosures in the CMBS sector will likely depress values even further as property is dumped on the market. And this, in turn, will likely put pressure on banks to write down the myriad of commercial loans on their books, thereby exacerbating the problem.
The $64 Question: Why Are Bank Stocks Soaring?
At this point, the logical question to ask is, how is it that we have this enormous commercial debt problem, yet bank stocks have been on a tear for the last couple of months? Frankly, I think most bank shares are wildly overbought at this point, but then I'm not a stock picker.
Some of the largest US-based multinational banks saw their share prices plunge to the level of "penny stocks" over the last year. CitiGroup at one point fell to below $1 per share (97¢) on March 5. Yet shares of these mega-banks have rebounded significantly in recent months, albeit from the lowest levels ever recorded for many of the largest banks. In other words, they were due for a significant rebound.
Another reason the large money center banks have seen their shares soar is the widespread belief that President Obama will not allow any of the major financial institutions fail on his watch. The turmoil that erupted after the Lehman failure will not be allowed to happen again, so investors have more confidence in the large bank stocks. The recent spike in bank stocks has also helped the regional bank stocks which, in most cases have seen their share prices rise as well.
None of this, however, makes the commercial real estate debt problem go away, and it will get worse before it gets better. There is virtually no market for CMBS. Potentially hundreds of billions in commercial mortgage loans will not be able to be refinanced over the next couple of years. I fully expect this to weigh heavily on the banks - small and large - in the weeks and months ahead.
If I had very large profits in banks stocks over the last 2-3 months, I would be taking money off the table. But again, I'm not a stock picker.
Thinking Wrong, But Getting It Right
If you have been reading this E-Letter all year, you know that my calls on the economy and the stock market have been off the mark for the most part. Earlier this year, I expected the economy would remain in negative GDP territory all year and not recover until sometime next year. I expected consumer confidence to stay in the dumps pretty much all year.
Despite my forecast, the economy did begin to rebound during the summer, and it now looks reasonable to expect positive growth in the 3Q and 4Q, assuming there are no more big negative surprises. Just how negative the commercial real estate debt problem will be remains to be seen.
In a similar vein, I did not see the recent surge in the stock markets coming. Of course, I don't know anyone else who predicted stocks would spike 50% higher back in March either. Back in early March when the Dow had literally collapsed to 6500, I did feel that the panic was probably over. Yet I never would have imagined that the Dow and other major market indexes would soar over 50% in relatively short order. But they have.
I openly admit to those misgivings to make the following point. I don't manage any of my own money that is in the stock market or in bonds. I haven't made a personal trade in years. I figured out a long time ago that I am too emotional to do it myself.
If I had been managing my own money in stocks or mutual funds, I would probably have bailed out sometime late last year or early this year, as millions of investors did. Given my views of the economy and the stock markets earlier this year, I can all but assure you I would not have jumped back in when the markets turned up in late March and April.
I would still be on the sidelines like millions of other investors, and I would have missed out on the huge gains that followed. By the way, estimates are that there is still $3-$4 trillion in money that bailed out that is still sitting on the sidelines in money market funds, T-bills, etc.
But since almost all of the money I have in the stock markets is managed by professionals, I have been able to participate in this recovery.
If you have read these letters for long, you know that my firm is in the business of finding successful professional money managers to recommend to our clients. As a long-time critic of Wall Street's "buy-and-hold" mantra, I have always preferred "active" or "tactical" money management strategies that have the ability to move to cash (money market) or "hedge" long positions during down periods.
The reality is that my equity managers lost far less than the market during the bear market that began in late 2007, and they have been able to participate in the bull market that began earlier this year. (As always, past performance is no guarantee of future returns.)
My goal has always been to avoid the 40-50% losses that often occur during bear markets. Remember, if you lose 50%, you must make 100% just to get back to breakeven.
If avoiding big losses is a big concern to you, then maybe it's time to checkout some of the active managers I recommend. Hopefully, you read my E-Letter two weeks ago on the Columbus High-Yield Bond Program.
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Very best regards,
Gary D. Halbert