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Pathfinder Partners' e-Newsletter

January, 2009

In This Issue

Thanks for Writing In

Charting the Course: 1929-2009 - An 80-Year Chronology in Ten Easy Steps; Auld Lang Syne - 9 Forecasts for 2009

Finding your Path: The High Cost of Learning

Snippets: Truth is Stranger Than Fiction

Why Banks Aren't Making Many Commercial Property Loans

Notables and Quotables

Pathfinder e-news is a complimentary quarterly publication published by Pathfinder Partners, LLC for lenders, loan servicers and commercial real estate professionals dealing with commercial non-performing loans and real estate. Our focus is on trends and specific issues relating to the commercial lending environment. If you have colleagues who may benefit from Pathfinder's e-news, please add their email address in "Subscribe."

Thanks For Writing In!
Thanks to those of you who have written in - please keep those cards and letters coming - we welcome your feedback, questions and comments. Several of you have asked about guest-writing features for upcoming newsletters. If you have expertise in an area that could be of interest to our subscribers, please email us at info@pathfinderpartnersllc.com with information about your proposed subject matter - we will be happy to consider it for a future edition.

CHARTING THE COURSE
1929-2009 - An 80-Year Chronology in Ten Easy Steps

Auld Lang Syne - 9 Forecasts for 2009

By Mitch Siegler, Senior Managing Director

In late November, Merriam-Webster named "bailout" its word of the year, thanks to the "highest intensity of lookups" at its online dictionary. We were a bit surprised, since the word "recession" seems to dominate news headlines. In fact, the "D" word is being bandied about and comparisons to the Great Depression are increasingly frequent.

Treasury Secretary Paulson and Fed Chairman Bernanke (Hank and Ben to their close friends) are said to be students of the Great Depression - though we're guessing they dozed off a bit during a couple of the more important lectures. They have a long list of "lessons learned" and are seeking to avoid the sequel on their watch.

There's enough blame to go around for turning a fairly ordinary recession of 1929 into the Great One. Historians point to the Fed keeping interest rates high after the stock market crash, Herbert Hoover signing the Smoot-Hawley tariff into law in 1930 and Congress hiking taxes in 1932 to cut the Federal budget deficit as being high on the list.

Now, while history generally doesn't repeat itself exactly, it does often rhyme. Today, interest rates are at rock bottom levels, though when our foreign friends wake up to the fact that we're running our currency printing presses 24/7, rates have only one place to go. Agora Financial reports that the U.S. monetary base is now growing at an annual rate of 75.5%. Their colorful prose: "In the battle against 'deflation', we're expecting the government's excessive bailout strategy to be akin to setting a match to tinder."

Since the good ol' US of A seems headed for some sort of financial socialism, we thought it would be instructive to see how we got into this mess. We've condensed the past 80 years of American financial history into ten brief contributors (a nearly pocket-sized guide):

1.      Glass Steagall Act - After the Depression, Congress built a wall between commercial and investment banking when it passed the Banking Act of 1933 (commonly known as the Glass-Steagall Act). The FDIC was created to insure commercial bank deposits and commercial banks were prohibited from underwriting securities or acting as stockbrokers/dealers.

2.      FSMA - Glass-Steagall remained in force until 1999 when the Financial Services Modernization Act ("FSMA" - try saying that five times really fast) was enacted, paving the way for consolidation in the banking industry.

3.      Securitization - Maybe somebody should have read FSMA a little more closely, because buried in some footnote was language that let commercial bankers turn mundane loans into sexy investment products - think CMBS, CDOs, SIVs and other fabulous three and four-letter acronyms. Voila, Wall Street investment banks were in the mortgage business.

4.      Unregulated Futures Trading - Just a year later, in 2000, the Commodities Futures Modernization Act morphed these new mortgage-backed securities into commodities, which could be traded on futures exchanges with essentially no regulatory oversight.

5.      Dot-com Bust Leads to Recession - In 2001, the tech stock/dot-com bubble burst, bringing on a recession. In response, Fed Chairman Greenspan reduced interest rates to next to nothing and maintained them at artificially low levels for several years. A flood of cash was looking for a home.

6.      Excessive Leverage - Then, in 2004, the SEC waived its leverage rules. Five companies - Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns - could increase their debt-to-capital ratios from 12:1 to 20:1 or even 40:1. (Two of these five companies went kaput; a third, Merrill, is no longer operating independently. The stock prices of the two survivors have plummeted.)

7.      Homes as ATMs - At the beginning, things looked fabulous. Commercial banks and mortgage originators, drowning in cheap money, lent to anyone who could fog a mirror. The national homeownership rate, 62.1% in 1960, shot up to 68.9% by 2006. And, if you need a few bucks for that new big screen TV or the family vacation, just borrow on the home equity line. Why not - housing prices only go up, right?

8.      Housing Bubble Bursts - Well, from 1970 to 2006, there wasn't a single down year for housing - the median home price increased from $23,000 to $222,000 during that period. But, in 2006-2007, low affordability rates and overbuilding combined to prick the bubble. At the same time, those low-interest loans started to reset.

9.      Declining Lender Accountability - In keeping with their stodgy nature, bankers are a conservative breed. As the more aggressive lenders pushed the limits of loan underwriting standards by scaling back down-payment, income and loan documentation requirements, the rest of the lenders fought to hang onto market share. One technique: bundling their loans into pools they could sell to investment banks. What had been a business grounded in local community banks was now the domain of Wall Street, which had far looser capital requirements and considerably less regulatory oversight.

10. Gordon Gecko was Wrong - Gecko, from the '80s film Wall Street popularized the saying "Greed is good." It just ain't so. When the game began, Wall Street wasn't looking to own millions of single family homes and oodles of commercial real estate. But, birds gotta fly and fish gotta swim - the investment bankers just wanted some product to sell to the widows, orphans and Dutch pension funds. Now, millions of homeowners, shareholders and most of all, taxpayers, will pay the piper.

9 Forecasts for 2009

When the National Bureau of Economic Research (NBER) came out a few weeks back and declared that the recession had actually begun in January, '08, we were slightly amused. You see, we made that call at Thanksgiving, '07. Now that Auld Lang Syne has been sung and the last bit o' bubbly has been quaffed, our New Year's Resolution is to look forward, not back. So, we'll ignore Mark Twain's sage advice (never predict anything, especially the future) and serve up our top nine forecasts for 2009.

1.                   Thrift is in - After years of tapping home equity lines to fuel spending, Americans are beginning to do the unthinkable - scale back consumption and ratchet up saving. History will mark '09 as the year the U.S. consumer didn't just have indigestion - he had a massive coronary. This paradigm shift will impact everything from economic growth and unemployment rates to the long-term health of manufacturers, retailers and financial institutions. Just like banks ratcheting back lending to repair their battered balance sheets, American consumers will slash their spending and increase their savings rates - perhaps back up toward 10% - over the next decade. While saving is exactly what we need to do, this type of savings rate means spending falls by an estimated $1.3 trillion per year. That giant sucking sound you'll hear will be sales coming out of retailers' cash registers.

2.                  Massive retail consolidation and loads of bankruptcies - The consumption boom has left the American retail landscape dramatically overstored. A big retail slowdown wouldn't surprise Allan Mottus, who publishes the Informationist, a newsletter that tracks retail trends. Median household income hasn't budged since 2000 while the retail store base has grown 4% per year, he says. The American retail landscape, as a result, has dramatic excess capacity. The inevitable consolidation in this space has begun to occur and will accelerate next year. Next year, look for proud moms to say "My son, the bankruptcy attorney."

3.                  Being #2 is no longer enough - GE's former CEO, Jack Welch, admonished managers that if GE couldn't be #1 or #2, the company should exit that business. In '09, we'll see more examples of duopolistic categories becoming monopolies. Last year brought massive consolidation in financial services. For '09, the Big Three will likely become the Big Two. In retail, CircuitCity can't compete with Best Buy and Linens and Things can't do battle with Bed Bath and Beyond. We'll see far more failures in numerous retail categories (think Borders in books and Pier One in home d�cor). There's probably a weak sister in other big box categories, like auto parts, pet supplies and home improvement as well.

4.                  We're shifting from a market economy to a political economy - In the olden days, a few months back, companies made pilgrimage to Wall Street for capital. Now, companies (and Wall Street firms) visit Washington when they need money. Look for an acceleration of this financial socialism - bailouts for auto companies, insurers, consumer credit firms and maybe even the homebuilders that got us into this mess in the first place.

5.                  Capital markets will remain frozen - Banks will continue to take their new capital from Washington and use it to patch up their battered balance sheets rather than lending it to businesses. Venture capitalists will remain stingy with their equity capital. Public offerings and leveraged buyouts - fugggedaboutit. Now more than ever, cash will be king.

6.                  Bankers will want to be extra nice to their bank regulator - Look for dramatic power shifting to mid-level bank regulators. Bank takeovers are expensive. We expect the FDIC and OTS muckety-mucks to finally empower the working stiffs so they can impact financial institutions, when there's still time. This year, we'll see regulators slap more sanctions on lenders and take early steps to save, merge or sell far more financial institutions than we've seen in the past year. (Through Thanksgiving, there were just 22 regulatory takeovers of banks. Our '09 forecast - 200-300.)

7.                  Your first markdown is your best markdown - This truism - whether about bank loan portfolios or retail inventories - will take on new meaning in '09.

8.                  The next shoe to drop is commercial real estate - And it's going to be a doozy. We're seeing lots of commercial real estate loans made just 18 months ago that are already way under water. Many projects acquired or refinanced in early '07 are now worth half of previous values. More half-empty office buildings will be sold for prices that will shock and awe. Industrial vacancies will rise and REITs will be forced to liquidate properties at surprisingly low prices. And retail properties - it's gonna be a bloodbath. Retailers simply won't be able to pay the rents previously commanded.

9.                  The banking system will survive but will likely look different - Treasury has already brought JP Morgan, Wells Fargo, Bank of America, Goldman Sachs, Morgan Stanley and Citicorp into the fort. They're survivors. We wouldn't be surprised to see partial or complete nationalization of these and other large financial institutions over the next year.

We wish you and yours a very happy new year. We'll report back in 12 months to let you know how we did.

Mitch Siegler is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Mitch was a partner with a management consulting firm, founded and served as CEO of several businesses and was a partner with a boutique investment banking and venture capital firm.

FINDING YOUR PATH
The High Cost of Learning
By Lorne Polger, Managing Director

I recently received a letter from the President of my undergraduate college, informing me that notwithstanding significant losses within the college's endowment, all was relatively safe. Students who were receiving various types of financial aid would continue to do so and parents who now required such aid because of their own financial losses should contact the college's financial office.

Two things struck me upon reading the letter. First, that the financial ruin of 2008 has provided very little immunity in its wake. Within the endowment and pension fund communities, some of the statistics are staggering. In the four month period of August through November, 2008, Harvard lost $8 billion of its $37 billion endowment, a 22% loss. Yale's endowment? $22.9 billion fell to $17 billion, a 25% loss, in the 6 month period beginning in July, 2008. CalPERS, the California State retirement system? Over $70 billion of losses in 2008, representing over 25% of its fund. Traditionally conservative pension funds drank from the Kool-Aid� of irrational real estate exuberance and started bulking up on the toxic elixir of speculative land plays, mezzanine financing and unsustainable development.

You see, this time around it's not just the lower middle class family with the overreaching mortgage that ran into trouble. It's almost every sector of the economy, every sector of the real estate market and every financial class. You hear it at this year's holiday cocktail parties, feel it at non-profit board meetings and see it in your 401(k) monthly statements (if you can bear to open them).

The second thought was how completely out of whack our system of higher education has become. When I began my private, liberal arts undergraduate education in 1980, the annual tuition was just under $7,000. A fair amount of money back then, but not impossible for middle class parents to pull it off. Today? About $50,000, including room and board, a 600% increase in 28 years. In 1985, my first semester of in-state tuition at UCLA law school cost this starving student a whopping $650. In hindsight, I was pretty lucky. First year law students for the 2009 class will have to come up with $41,000 for the year, a 3,100% increase in 23 years. If we end up sending our two kids to private colleges, my wife and I would need to budget $500,000 for the privilege. That's crazy. But more importantly, what are Harvard and Yale and all the others private schools doing with these massive endowments? Why isn't more of the money trickling down to the students? Why does a higher education now cost more than the median U.S. annual income ?

In the current environment and for the foreseeable future, who can really afford to pick up that kind of tab? And what does that mean for our country, when perhaps our most precious resource, our future generations, will not be able to afford a quality education? The system's broken and it's hard to see repairs in sight.

What a monumental shift in such a very short period of time. We spent and spent and spent and credit was as free as the air around us. I joked to some friends awhile back that I had been provided with almost $400,000 in credit card balances, without having, at any time, to apply for the lines. (I cancelled all those cards over three years ago.) While I know I'm not the only one in that position, I suspect that I wasn't in the majority in exercising restraint on personal spending and borrowing.

So what happens next? It's difficult to foresee emerging from this mess other than with a "save not spend" mentality. Hunker down, eat in, build up a savings account, buy used cars, shop at discount stores, etc. Some of the recently published earnings reports back this up. WalMart and Target are the only retailers showing signs of profitability. Walk into a Macy's or Nordstrom's, even in the pre-Christmas rush, and salespeople outnumber customers on a regular basis. Look at the price of gas. Oil is back under $50/barrel. I filled up for $1.79/gallon last week. These are the lowest prices we've seen in years. Are the Chevy Tahoes and Ford Explorers flying off the shelves at today's discounted prices? Nope, just the opposite. They're lingering on showroom floors, taking up space and burning up dealer cash.

There's going to be a secondary ripple to the new consumer mentality, and I believe that it will start showing itself prominently in 2009 in the office and retail real estate sectors. Shrinking businesses will require less square footage; retailers will focus on cutting costs and shedding unprofitable locations. This will lead to tremendous downward pressure on office and retail rents. On top of this, the $500 billion of commercial real estate loans coming due in 2009 and 2010 will wreck havoc on the real estate industry.

Even assuming static revenues (a generous assumption), the change in loan to value, debt service coverage ratio and lender capitalization rate requirements will put a dagger through the heart of much of the commercial real estate sector. The resetting of values will be unprecedented. The saving grace? The strong will survive, the weak will not and we bounce back again (beginning in 2013?) learning a few lessons along the way until the irrational exuberance kicks in once again near the top of the next cycle.

Lorne Polger is Senior Managing Director of Pathfinder Partners, LLC. Prior to co-founding Pathfinder in 2006, Lorne was a partner with a leading San Diego law firm, where he headed the Real Estate, Land Use and Environmental Law group.

SNIPPETS: TRUTH IS STRANGER THAN FICTION
A Collection of Comical, Outlandish, Bizarre and Frightening True Stories

A compendium of notable news articles relating to commercial lending which we've edited and commented upon.

Financial Crisis Tag Already $7 Trillion and Counting

Source: CNBC.com

As each day brings a new announcement from the Administration or Congress, it's a bit challenging to keep track of how much is being spent on the various bailouts. Thanks to the folks at CNBC, we have our answer - $7.36 trillion through Thanksgiving. This amount includes the various spending programs, budgeted amounts, guarantees, loans, swaps and other schemes launched by the Federal Reserve, Treasury and other government agencies during the past year or so. That's more than double what was spent on WWII, if adjusted for inflation, based on CNBC's computations from a variety of estimates and sources.

The lion's share falls under the Federal Reserve's umbrella, while another good chunk ($700 billion) is the under the Troubled Asset Relief Program. (This program is called TARP, for short but forgive us for getting confused and referring to it as TRAP.) Toss in some $900 billion allocated to the Term Auction Credit Facility (TAF). Oh, and another $1.8 trillion for the commercial paper funding facility. And, let's not forget the hundreds of billions for Bear Stearns, AIG, Citicorp, Fannie Mae and Freddie Mac.

How much is $7.3 trillion anyway? The table below summarizes 13 of the largest infrastructure projects, land acquisitions, wars and other expenditures, adjusted for inflation. All told, they total $7.5 trillion.

Institutions Need to Reduce Real Estate Exposure
Because of "Denominator Effect"

Source: The Wall Street Journal

The slumping commercial real estate market, already hard hit by a seized up credit market and a soft economy depressing demand for office and retail space now has a third force to contend with - the "denominator effect". As stock values decline and because real estate is typically appraised only once a year and not daily like stocks, the relative size of the real estate portfolio has grown to a level that exceeds many funds' guidelines.

Pension funds, college endowments and insurance companies typically allocate most of their investment dollars to stocks and bonds and a smaller amount - less than 10% for pension funds and 20% to 30% for other institutions - to real estate. Falling stock prices are leaving these institutions overexposed to real estate, which could trigger further declines in values as some of the market's most active buyers move to the sidelines.

According to Stephen Hansen, a managing director at ING Clarion Partners, real estate demand "has been destroyed effectively by the unintended consequences of the total pie shrinking. Certainly, these institutions are less prone to making new real estate investments today than at any time in the past seven or eight years." Richard Peterson, a trustee of the San Francisco Employees' Retirement System, which had $18.8 billion in assets as of January, 2008, says "If the denominator doesn't come back into sync, our new investments would be curtailed."

Why Foreclosure Relief Worries Loan Servicers

Source: American Banker

With pressure mounting on Congress to enact a moratorium on home foreclosures, mortgage servicers are warning that the move could have the opposite effect - prolonging the housing downturn.

"A foreclosure moratorium would make a correction much longer and have unintended consequences on servicers who already have liquidity constraints," said Dennis Stowe, president of Residential Credit Solutions, a leading trader of distressed mortgages. Pooling and servicing agreements typically require that servicers advance all the principal and interest payments, as well as tax, insurance, maintenance, and foreclosure costs, to investors regardless of whether the borrower is paying.

Servicers are reimbursed for expenses incurred while a loan is delinquent but only after the property goes into foreclosure - so getting repaid can take nine to 12 months. A foreclosure moratorium would indefinitely extend the advances that servicers make and come as servicers' bank lines are strained by the credit crunch.

Independent servicers and special servicers that deal with defaulted borrowers are already cash-strapped, said Matt Stadler, a principal and CFO at National Asset Direct Inc., a New York buyer and servicer of distressed loans. Mr. Stadler likened the state of the servicing industry to the "I Love Lucy" episode in which Lucy is furiously grabbing chocolates off a fast-moving conveyor belt. "The borrowers are just piling up, and servicers are inundated and overwhelmed with calls they can't answer, short sales they can't complete, and not enough staff - they need more manpower," he said.

Mr. Stowe, the former president and chief executive of Saxon Capital Inc., which Morgan Stanley bought in December, 2006, said servicers are already being pinched by laws passed in California, Florida, and New York that require borrowers be contacted before default or foreclosure notices are filed. "The longer you stretch out foreclosures, the more advances build up," he said. "There's limited liquidity for servicer advances because everybody that provided liquidity is also having credit issues."

Fred Cannon, an associate director of research and the chief equity strategist at KBW Inc.'s Keefe, Bruyette & Woods Inc., said that as banks move REO off their books the housing market could find a bottom in the second or third quarter of 2009. A foreclosure moratorium could prolong the housing downturn by keeping those REO properties off the market, he said. Clay Cornett, the president of Fidelity National Default Solutions, agreed. "It will prolong the agony and keep us from finding a bottom in housing prices, which is what is required to stabilize the market," he said.

For more than a year now, lenders, investors, and servicers have all claimed that they were doing everything they could to avoid foreclosures largely because of the costs. A foreclosure can cost up to $50,000 per property. A crucial problem is that many loan modification agreements ultimately fail. "It's well known within the industry that modified loans have a recidivism rate of 50%," said KBW's Mr. Cannon. "What the borrowers really want is principal reductions, and the banks don't want to forgive debt because, if you start forgiving principal, what's fair? And where does it stop?"

A Rising Sea of Defaults

Source: Barron's

Capital IQ/S&P, in its "Market Observations" on November 19, 2008, conducted scenario analysis pointing to escalating loan default rates. In the baseline scenario, to which the firm has assigned a 60% probability, Capital IQ expects the U.S. speculative-grade default rate to escalate to a mean forecast of 7.6% in the 12 months through September, 2009, with a one-standard-deviation range of 6.5% to 8.7%. This compares with a 2.68% trailing 12-month default rate observed in September, 2008 and the 25-year low of 0.97% in December, 2007.

Capital IQ doesn't "think the baseline projection of 7.6% constitutes a peak in default rates for this cycle and foresees further defaults materializing beyond the one-year horizon. To reach 7.6%, 125 issuers must default in the next 12 months or an average 10.4 defaults per month, versus 6.7 in the first nine months of 2008. All our scenarios have rates greater than the 1981-2007 long-term 4.4% average, underscoring the expected severity of the downturn," says Capital IQ.

The Next Shoe to Drop - Commercial Real Estate

Source: Barron's

Gregory Weldon, proprietor of the eponymous Weldonline.com and author of the lively Weldon's Money Monitor sees lots of perils in commercial real estate. Weldon says a sure sign of trouble is that the cost of buying protection against default of commercial-mortgage-backed securities has skyrocketed. The tracking index has more than doubled, Weldon reports, since Secretary Paulson "changed gears on the use of TARP." The yield on the highest-rated CMBS paper has recently been a startling 12 percentage points above the yield on Treasury securities of comparable maturity.

Through the first half of 2008, as the economy started to crumble, commercial real estate had held up rather well, to the point, according to Weldon, that what he calls "pop-media-pundits" insisted it was immune to the credit crunch. The response of contrarians like Weldon (and us) - this makes it inevitable that things would collapse, which they did. The future prognosis is increasingly bleak. As Weldon explains, there are fewer tenants and those that remain have "impaired businesses" amid declining retail traffic, as consumers ratchet back their spending; even when they buy something, they tend to buy less of it than in the past.

Weldon continues: Impaired businesses need less space and are on the prowl for lower rents. Institutional investors who have been slaughtered in the stock market are actively "adjusting" their allocation models. A critical part of that adjustment is unloading real-estate assets. The wrinkle: Buyers are few and far between and, says Weldon, "even those brave enough to consider bidding for property, can't get financing."

CMBS Market Begins to Show Fissures

Source: Wall Street Journal

The market for debt used to finance hotels, offices and shopping malls has tumbled on worries that the long-feared rise in defaults for commercial mortgage-backed securities (CMBS) had begun, possibly ushering the next stage of the financial crisis. Credit Suisse analysts said two big commercial mortgages that had been packaged into securities in the past year were likely to default. The rapid deterioration of these loans fed worries that the weakening economy and higher unemployment rate would drag down the $800 million CMBS market, which has so far withstood the credit crisis with low delinquency rates.

"It's pretty unheard of for two large loans to go bad this early on - this has shaken up the market for CMBS," said Richard Parkus, head of CMBS research at Deutsche Bank Securities, Inc. According to a Citigroup, Inc. report, the overall number of commercial mortgages packaged into securities that are more than 30 days past due rose to .64% in October, '08 from .39% in December, '07, with most of the increase coming in October. While still relatively low by historic standards, these are the highest delinquency rates in two years.

The increase is due primarily to the financing drought and lack of buyers. Owners have been unable to refinance mortgages as they come due, forcing defaults. The two defaulted loans - one on a hotel in Tucson, AZ and the other on a shopping center in Corona, CA - were made by J.P. Morgan Chase & Co. at the top of the real estate market. It turns out both were underwritten based on assumptions that the cash generated by the properties would increase substantially. Oops.

Lord Abbett: Housing Declines Should Taper

Source: Barron's

In a December 9, 2008 report, investment firm Lord Abbett postulates that the bottom of the housing market could be close at hand. Quoting from their report, "Even as the housing market continues its decline, hints of future stabilization have emerged. Of course, builders continue to cut back sharply on production and will likely do so for some time to come. But, with existing-home sales up slightly during the past few months, the inventory of unsold homes has begun to inch downward. By spring, 2009, that inventory should drop enough to erase the need for any further cutbacks or real estate price declines. Even before matters reach that point, the intensity and severity of the declines should begin to moderate."

The report continues: "With this year's sharp real estate price declines and monetary policy at last stabilizing mortgage rates, housing affordability has improved dramatically. Today, home ownership is as affordable as it was in 2003 - at least for those who can get the credit - which is, of course, a much less diverse group than in 2003. Some buyers clearly have responded. The National Association of Realtors data show that sales of existing homes, after falling more than 30% between 2005 and mid-2008, have picked up during this second half of the year, rising by about 3% between June and October (the last month for which data are available)."

(Editor's note: While we're not quite as ebullient as Lord Abbett and are certainly not ready to break out the bubbly just yet, we also don't want to be accused of being unbalanced - in our views. You know what we mean.)

Panel: Recovery May Not Come Until 2014

Source: San Diego Daily Transcript

A panel of experts in San Diego offered a somewhat overcast economic outlook in mid-November for the next several months, with rising unemployment and spiraling residential real estate delaying a recovery as far back as 2014.

"Fasten your seatbelts," said UCSD finance and economics professor Allan Timmermann to an audience comprised of many former and current CEOs. "This is going to be very turbulent and it's going to last a long period." Timmermann was one of four featured speakers at a special meeting of the Chairmen's Roundtable, a nonprofit organization of former and current CEOs who mentor and advise San Diego companies.

Some glimpse a turnaround beginning as soon as the third quarter, but "personally, I think it's going to be pushed out," said moderator Michael Tedesco of The Tedesco Group at Morgan Stanley. He and other panelists put their optimistic estimates of a recovery beginning in 2010, looking to the housing market to regain its footing and capital markets to start moving again.

The U.S. may have to wait until 2013 or 2014 "to get back to where we are now," said Dennis MacDonald of TCW Investment Management Co. In the meantime, banks will continue to consolidate and slowly rid themselves of tangled debt, while stocks remain volatile, Timmermann said. Investors and companies will continue to sit on their short-term cash.

The panelists did offer some hope, however. The majority of housing-related problems are concentrated in subprime loans, MacDonald said. Although defaults in the housing industry are expected to increase "with the percentage of delinquent subprime borrowers increasing from 35% to 60-70% - more than 95% of prime borrowers are still able to pay their loans, he said, noting that prime remains the largest sector.

U.S. Household Wealth Plunges

Source: Barron's

According to the latest flow of funds data from the Fed, U.S. households' net worth plunged by $2.8 trillion in the third quarter, the fourth consecutive quarterly decline. During the past year, Americans' net worth has shrunk by a staggering $7 trillion. Adjusted for inflation, household net worth has plummeted by 15.3% from year-ago levels, surpassing the 10.9% decline during the 2001 dot-com bust and the 13.8% fall during the 1974 bear market, according to Michael Darda, chief economist at MKM Partners.

International Strategy & Investment estimates that household net worth fell at an 18% annual rate in the current quarter and, in total, likely cut 1.5% from 2008 gross domestic product. As the value of their assets shriveled, Americans actually reduced their debt, something they haven't done since 1952 (that's how long records have been kept on this point). In the third quarter, household borrowing, mortgage and consumer credit together fell at a $117.4 billion annual rate.

Why Banks Aren't Making Many Commercial Property Loans

This is an edited version of "Commercial Property Loans Start to Haunt the Banks", from John Mauldin's "Thoughts from the Frontline" on November 25, 2008.

There are two aspects to the current recession and financial crisis. The first is the effect of the subprime crisis, now a full-blown credit crisis. That's what is taking us into what looks like the worst recession in decades.

The second is the usual problem of increased loan losses for financial institutions during an economic downturn. All types of loans - credit cards, home equity, residential mortgages and especially commercial property mortgages - suffer during a recession. Default rates are skyrocketing on all types of consumer loans, what you would expect to happen in a recession. The problem is that many banks have already had their capital depleted dealing with the credit crisis. Now, they will need to raise even more capital (or reduce lending) to deal with the usual loan problems that come with a recession.

These charts from www.markit.com show the stress in commercial property lending. Markit shows the interest spreads on an index of commercial mortgage-backed securities, or CMBS. The index is based on 25 different commercial property trusts, created by a dozen investment banks - JPMorgan, Merrill Lynch, UBS and others. Institutions that own commercial mortgages can hedge their portfolio with this index; if you want to sell swaps (insurance protection), this index is also a handy tool for doing so. The price is determined by the spread between the coupon and the 10-year U.S. Treasury bond. As the chart below shows, this spread, 100 basis points (bps) in May and 200 bps in July, jumped to 850 recently before settling back to 667!

spread

Twice a year, the banks that helped create the index build a new index comprised of recently created trusts containing hundreds of individual mortgages. These trusts are divided into different tranches (slices), with the highest-rated tranche getting the lowest return but first priority on the return of principle and interest. Lower-rated tranches take on more risk.

Markit tracks seven different indexes, from AAA to BB. Each index is composed of the corresponding tranche in the 25 trusts within the index. Check out the recent performance of the lowest-rated tranche.

Spread2

Recently, this lowest tranche was trading at 4,750 bps or, if you add in the Treasury bond rate, at over 50%. Translation: an institution that wants to hedge the risk of this BB-rated CMBS piece defaulting would have to pay 50% annual interest!

And this is interesting: Markit notes that they have not created the new series planned for October 25 because not enough new commercial mortgages were created to actually build an index. The reason? There is no longer a secondary CMBS market for commercial mortgage loans issued by banks, so any new loans made will have to be kept on the books of those issuing banks, since the price to securitize the loans is prohibitive. That goes a long way in explaining the massive decline in large commercial property loans.

Notables and Quotables

"We are now morphing toward a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism and where corporate profits are no longer a function of leverage, cheap financing and rather mindless ability to make a deal with other people's money."

- Bill Gross, Managing Director, PIMCO

"National inventory levels for new homes (including finished vacant and under construction) continue to decline, but finished vacant homes have yet to fall significantly, indicating that demand is still weak and pricing pressure will continue. Finished vacant-lot inventories are still rising, and further price declines and additional demand are needed to cause declines. The areas with the lowest housing and lot inventory will recover first. Baltimore, San Antonio and Indianapolis have the lowest MOS [months of supply] for finished vacant homes, while Orlando, South Florida and Atlanta have the highest MOS. For housing prices to stabilize and have appreciation again, the finished vacant-home inventory needs to return to normal levels...The areas with the lowest vacant-developed-lot MOS include the San Francisco Bay Area, Baltimore and L.A. Coastal, while the highest include Orlando, St. Paul and Chicago. Based on this data, it seems like California should rebound faster than Florida, and we still have significant concerns about Atlanta."

- Albert Savastan/Bill Young, Fox-Pitt Cochran Zaronia Waller

"A series of market accidents and a series of policy mistakes led to market disequilibrium. We haven't finished deleveraging. We don't have a crisis in the system, we have a crisis of the system. In this stage, we have economic weakness leading to policy response. The policymaker's mindset is best summed up by U.K. Prime Minister Gordon Brown: 'Whatever it takes - not because we want to but because all alternatives are much worse.' We're lurching from one policy solution to another."

- From an interview on CNBC w/Mohamed El-Arian, CEO of PIMCO, the world's largest bond investor

"For 15 to 20 years, cheap credit was extended to a lot of people who were not worthy. Now, you've got to resize that business back to traditional, normalized credit. Home ownership rates that peaked at 69% probably have to drift back to 66% or 65%. Remember, they had been 64% prior to 1994 for as far back as the eye can see. There are a considerable number of Americans who were homeowners for a brief period of time who will not be homeowners anymore."

- Meredith Whitney, Housing Analyst, Oppenheimer & Co.

"I see nominal GDP being around 1% for a long time, five years for sure. One thing to consider is after the dot-com bubble burst, it took the corporate sector five years to get back to the 2000 peak for capital expenditures and employment never got back to that level. And the tech bubble was nothing as a share of total assets compared to housing on household balance sheets. This is so much larger. If it took the corporate sector five years to recover from the bursting of the dot-com bubble, to suggest that it would take five years for consumers to recover from this seems like a very conservative call."

- Stephanie Pomboy, Founder and President, MacroMavens

"The big issue is the accounting and regulatory changes on the horizon. A regulatory proposal already endorsed by three of the federal agencies that govern credit card issuers and scheduled to go into effect in 2010 seriously restricts a lender's ability to raise rates based on risks it sees. You have $800 billion in revolving credit lines today but $4.7 trillion of unused lines. Those unused lines represent potential real risk for the lenders. So, if they can't reprice, I believe you're going to see $2 trillion of those unused lines cut from the system. Say you have a $10,000 limit and you're only using $200 of it. You may think, "O.K., if I lose my job, if my kid needs braces, if my dog gets sick, I have all this unused credit at my disposal for a rainy day." A consumer's primary source of cash flow is his job. We argue that his secondary source of cash flow has become his credit card."

- Meredith Whitney, Housing Analyst, Oppenheimer & Co.

"Yet, I'm also optimistic that housing prices are reaching a bottom. The S&P/Case-Shiller indexes showed prices fell at an accelerating rate in August. However, since then, we've seen vulture buyers enter the market, removing some excess inventory. No doubt prices are still falling, but there's a good chance the rate of decline has already begun to slow and housing prices [could] find a bottom around March."

- Forbes Growth Investor

Credits: Agora Financial, Associated Press, Barron's, Business Week, CNBC.com, Forbes, Fortune, John Mauldin's Thoughts from the Frontline, Marc Faber's Doom, Boom & Gloom Report, Moody's Economy.com, Reuters, San Diego Daily Transcript and Wall Street Journal.