Scattershooting ... While Wondering Whatever Happened to the Real Estate Development Industry, Dallas | Houston | Austin

Scattershooting ... While Wondering Whatever Happened to the Real Estate Development Industry

By: William (Chip) T. Cavanaugh, Jr.
Real Estate in the Changing World: Confronting the Crisis
October 2009

Those of you who are old enough to remember the last big real estate downturn (no, not the speed bump of 2001-2002, but rather, the debacle of the late '80s) may also remember Blackie Sherrod's Dallas Times Herald sports column: "Scattershooting ... While Wondering Whatever Happened to [insert name of a forgotten legendary or infamous sports personality]." Blackie has rightfully been described as perhaps the world's first blogger, mixing information and sarcasm into his brief observations of life in the sports world.

In homage to Blackie and the dearly departed newspaper he worked for, it somehow seems appropriate to offer some real estate scattershots of my own as we move toward the end of 2009 (a year most of us in the real estate business will want to forget):

Whatever Happened to the Public-Private Investment Program (PPIP)? The Dow-Jones Industrial Average jumped 497 points (almost seven percent) on the government's announcement of the PPIP on March 23, 2009. Investors apparently believed that PPIP was going to be the magic bullet solution to the balance sheet woes of America's banks. That seems kinda silly in hindsight now, doesn't it? As it turned out, the "Legacy Loans" component of the PPIP never got off the ground and the "Legacy Securities" component of the PPIP is only now getting started. Treasury has announced that five private investment funds have raised $12.27 billion to participate in the purchase of so-called "toxic" securities. That sounds like a lot, but it is only a fraction of the $1.64 trillion in outstanding MBS backed by non-government agency guaranteed mortgage loans.
Could this Time be Worse than Last Time? The real estate industry is finally coming to accept that the current commercial real estate crash might end up being worse than the one that occurred during the late ‘80s and early ‘90s. The MIT Center for Real Estate estimates that the $3.5 billion United States commercial real estate market has suffered a 39% decline in prices from the peak two years ago, which is substantially greater than the 27% decline during the late ‘80s and early ‘90s. Real Capital Analytics reports that over $2 trillion in commercial properties bought or refinanced in the last five years (i.e., almost 60% of all commercial properties in the United States) have values below their loan balances. Deutsche Bank echoes that, stating that 65% or more of existing commercial real estate loans will fail to qualify for refinancing. I hope all that’s not true, but I suspect it is.
The Plight of the Federal Deposit Insurance Corporation (FDIC). At the end of the second quarter, the FDIC’s already-depleted insurance fund (i.e., the fund that insures about $4.5 trillion in United States bank deposits), which contained $45.2 billion a year ago, was down to $10.4 billion (constituting 0.22% of insured deposits, well below the minimum of 1.15% mandated by Congress). That’s before the Guaranty Bank and Colonial Bank failures. The FDIC expects this fund to sink below $0 by the end of the third quarter, which has only happened once before (in the early ‘90s). The Wall Street Journal reports that, of the over 100 banks that have collapsed in the last two years, the FDIC’s estimated cost averaged 25% of assets, which is up from the average cost of 19% of assets incurred in connection with the closing of 747 financial institutions between 1989 and 1995. In other words, the banks that are collapsing today are in worse shape than those that collapsed during the last crisis. In fact, some of the banks that have failed during the last few months have cost the FDIC more than 50% of assets, reflecting the fact that the failing smaller regional and community banks are often in more trouble than larger banks (costing the FDIC more money, on a percentage basis, to close them). The banking industry’s ratio of reserves to bad loans is just 63.5%, the lowest level since 1991. There are still more than 400 banks on the FDIC’s list of problem institutions and the FDIC has also purportedly recently initiated a “stress test” review of commercial real estate loans at approximately 800 regional and community banks. The FDIC recently estimated that bank failures will cost the fund approximately $100 billion over the next five years (a 43% increase from the agency’s last estimate in May), but in a possible indication of what it really fears, the FDIC successfully petitioned Congress to authorize the FDIC to “temporarily” borrow up to $500 billion from Treasury if needed (a very significant increase from its current $100 billion line of credit with Treasury). Such funding by Treasury would, of course, smack out of another taxpayer bailout, which everyone in Washington, DC would really like to avoid, so a week or so ago the FDIC floated the idea of, ironically, borrowing funds from healthy banks instead. That didn’t go over too well, so this week the FDIC backed off that idea and instead proposed that banks prepay three years of deposit insurance fees. I would not want to have Sheila Bair’s job right now.
FDIC “Loss Sharing” Agreements. Speaking of failed banks and the FDIC, I’ve heard lots of people ask whether there is going to be “another Resolution Trust Corporation (RTC).” Perhaps so, since the volume of distressed assets in the banking system may overwhelm the resources currently in place to handle them. But the FDIC has thus far avoided needing such an agency to hold and liquidate the assets of failed institutions. Instead, the FDIC has resurrected a mechanism that was sometimes used during the early '90s, called “loss sharing.” The FDIC has entered into more than 50 loss sharing agreements during the current crisis, requiring it to assume most of the losses on over $80 billion in loans and other assets. In fact, the FDIC estimates that it will eventually have to cover about $14 billion in future losses under loss sharing agreements entered into so far. Such loss sharing agreements typically require the FDIC and the acquiring bank to share losses on the failed bank’s assets on an 80/20 basis up to a certain point, with the FDIC bearing 95% of the losses thereafter. By using such agreements, the servicing, collection and resolution of these loans is handled by the acquiring bank rather than by a government agency such as the FDIC or an RTC successor. The FDIC expects/hopes that the acquiring banks sharing of at least some of such losses will motivate them to diligently work the loans and will ultimately save the FDIC billions of dollars as compared to the cost of setting up another RTC to handle such loans. This seems like a pretty sweet deal for the acquiring banks, and it probably will be, but the FDIC didn’t do this to be nice; rather, it only began to offer loss sharing agreements in 2008 after it was unable to persuade acquiring banks to otherwise acquire failing banks’ assets. Frankly, loss sharing agreements may be helpful to borrowers as well, since the acquiring bank may be more amenable to a favorable resolution or settlement than the failed bank was willing (or, more accurately, able) to enter into.
FDIC “Structured Sales.” If the FDIC does start selling the assets of failed institutions more regularly (because it elects not to, or can’t, enter into a loss sharing agreement with the acquiring bank), it looks like the FDIC’s preferred disposition method is going to be to contribute the assets to newly-formed entities and then sell 20% to 50% interests in those entities to investors, who would be responsible for the work out and liquidation of the assets. The FDIC has done six of these “structured sales” so far this year and currently has a few big offerings on the market.
Loan Sales by Special Servicers. I read an article recently in which the author stated that “there needs to be another RTC-like vehicle” because “special servicers cannot keep up with the influx of distressed assets." Each statement may be truly independent, but putting these two statements together doesn’t make any sense to me. In other words, it is possible that the FDIC may find it necessary or desirable to create the “Son of RTC” in lieu of continuing to enter into the loss sharing agreements and “structured sales” described above; however, since the government does not (yet) have a material role in the CMBS industry, and since the commercial mortgage-backed securities (CMBS) industry is quite fragmented, I don’t see how an RTC-like vehicle can be utilized to resolve bad CMBS loans. Instead, I think the special servicers will just have to slog it out. That being said, however, I suspect that, just as the RTC did in the old days, special servicers may increasingly come to rely on loan sales rather than adding all the people and other resources necessary to foreclose the loans and then manage and sell the properties. Currently, the only special servicer I know that is actively selling portfolios of loans is CWCapital (with approximately $400 million currently on the market). If they are successful, others will follow.
Memo: Don’t You Dare Make Another Real Estate Loan! The Wall Street Journal reports that the Federal Reserve and the Office of the Comptroller of the Currency (OCC) have issued so-called “Memorandums of Understanding” to 285 banks this year (presumably, to some of the same banks that are on the FDIC’s watch list described above) and are on track to issue more than 600 by year end. These Memorandums generally put the bank on “probation” and often require the bank to increase its total risk based capital and/or reduce its exposure to real estate. Although the motivations behind the regulators’ actions are understandable, needless to say this trend won’t make getting a real estate loan from a bank any easier.
The Lenders Don’t Always Win. On a more positive note for borrowers, there have been some recent victories for borrowers seeking to force lenders to continue to fund construction loans after the lenders have sought to stop funding due to weak leasing or other material adverse changes. For example, this summer a New York judge forced one of the major banks to keep funding advances on a $155 million construction loan on a shopping mall, agreeing with the borrower’s argument that the bank had manufactured a “contrived default.”
CMBS Structures Under Attack. As if the CMBS industry didn’t already have enough problems, creative and aggressive debtor lawyers are mounting increasing attacks on CMBS structures. Frankly, our firm’s bankruptcy lawyers have been telling us all along that this would happen. First, General Growth replaced the independent directors of over 100 of its single purpose entities (SPEs) with performing loans and included those SPEs in the bankruptcy filing of the parent company (which isn’t supposed to happen). Then, the Judge rejected the lenders’ impassioned efforts to have the SPEs dismissed from the bankruptcy. Needless to say, that created (and continues to create) a lot of anxiety in the CMBS industry. The Extended Stay case is also causing CMBS professionals to toss and turn at night. In that case, David Lichtenstein had signed a “bad boy” guaranty that provided that he’d have full recourse liability for Extended Stay’s CMBS debt if the company filed bankruptcy. The junior CMBS bondholders understandably felt that as long as Lichtenstein was in control, the company would never file bankruptcy ... but they didn’t foresee that some of the senior CMBS bondholders would offer to indemnify Lichenstein for as much as $100 million in liability incurred as a result of his filing bankruptcy and supporting a plan that would put the company in their hands. These cases may be only the beginning of a broad based attack on CMBS structures. If so, then it is going to take a lot more than Term Asset-Backed Securities Loan Facility (TALF) to restart CMBS lending ... and we really need that $230 billion or so in annual CMBS fundings that went “poof” last year ...
Real Estate Investment Trust (REIT) Shares Gone Wild. REIT shares have had a great run the last several months, with prices rallying almost 90% from their March lows and with at least 48 successful stock offerings by REITs this year. I initially thought this was crazy: REITs still own a lot of real estate and does anyone think that the financial picture for current owners of real estate is going to get better during the next few years? But, (a) REIT shares were arguably horribly oversold earlier this year (having been priced as if they were all just a step away from bankruptcy court), (b) REITs have lower leverage than other property owners, (c) REITs were net sellers of real estate during 2006 and 2007, (d) REITs will have better access to capital than private owners during the next several years (just as they did during the REIT explosion of the early ‘90s) so they should be able to make very favorable acquisitions during the next several years, and (e) despite the recent run up, REIT shares are still priced around 60 percent below their February 2007 highs (indicating that the coming decline in real estate values may already be priced in). So, maybe it's not so crazy after all.
Avoid Tax Surprises. Don’t forget about Cancellation of Indebtedness (COD) Income. If you are lucky enough to obtain the ability to pay off or purchase your loan at a discount, or convert any of the debt to equity, see your tax advisor first.
Ethan Penner. CBRE was nice enough to invite me to Ethan Penner’s presentation a few weeks ago. What a brilliant guy. He’s definitely mellowed since the go-go Nomura days, but his history — starting out at Drexel under Michael Miliken and moving on to Nomura, where he played a key role in development of the CMBS industry during the last real estate crash — gives him unique insight into what is going on today. A few points Ethan made seemed especially on target. For example, I’ve heard some players state that only the loans originated during the period from 2005 through 2007 are really in trouble, but Ethan pointed out that those vintages constitute 88% of the CMBS market (Duh-oh). Also, Ethan thinks that the securitization market will eventually come back in some form, although it will probably involve using CMBS to provide leverage to the originating lender (who will still own the loan) as opposed to a credit risk transfer, and will feature simpler structures with fewer tranches. But he cautions that the bond market, through CMBS, will not save the day for real estate as it did in the early ‘90s. I suspect he is right on all counts.
New Lenders to Fill the Void? When talking about the lack of available debt financing in the market today, one of the firm's finance attorneys likes to say that the problem “is not a liquidity issue, it’s a pricing issue.” He’s probably right. We all worry where the money is going to come from to replace the $230 billion per year in loan volume that the CMBS industry provided, not to mention the reduced loan capacity from the banks, insurance companies and other lenders. But, nature abhors a vacuum. So, at the right price (i.e., for a sufficiently attractive risk-adjusted return), capital will flow out of other asset classes and into real estate. This is already starting to happen. For example, (a) Starwood Property Trust recently raised over $1 billion to make real estate loans, (b) a dozen former Merrill Lynch bankers have recently formed a new mortgage company to originate up to $1 billion per year in commercial loans, stating it will use more aggressive underwriting criteria than that used by portfolio lenders such as insurance companies, (c) a leading pension consultant is urging public pension systems to become direct real estate lenders in light of the void left by the exit of CMBS and other lenders, (d) the Bank of China plans to increase its commercial real estate lending, and (e) rumors have surfaced that the $300 billion China Investment Corp. is in discussions with some of the nine PPIP fund managers and others to invest significant amounts of capital in, among other things, “toxic” (sorry, I mean “legacy”) CMBS. The money will show up if the price is right — the problem is that the “right price” seems very wrong if you are a current real estate owner or lender.
The Sad State of Transaction Volume. Jones Lang LaSalle reports in their United States Mid-Year Capital Markets bulletin that the $5.2 billion in commercial real estate investment sales volume during the second quarter of 2009 was down a whopping 95 percent from the $114.7 billion in the second quarter of 2007. If you are a service provider that needs transactions to survive (such as a title company, a broker, a mortgage banker or, like yours truly, a real estate lawyer) look on the bright side: it can’t really get any worse!