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Pathfinder Partners' e-Newsletter

May 2008

 

Thanks For Writing In!
Thanks to those of you who wrote in following our inaugural edition of Pathfinder e-news. Among your comments: "A breath of fresh air," "Straight-up articles," and "Refreshing". Keep those cards and letters coming - we welcome your feedback, questions and comments.

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.

 

 

In This Issue

Charting Your Course: Look Out Below!

Finding Your Path: Chaper 11 Bankruptcy: It Ain't What it Used To Be

Snippets: Truth is Stranger Than Fiction

Feature Article: Whither Goes Housing, So Goes the Economy

Notables and Quotables

 

Charting Your Course
Look Out Below!
By Mitch Siegler, Managing Director

Will mortgage defaults force banks to cut back lending?  Have housing prices hit bottom? Have we seen the worst of the foreclosures? Will unemployment head north from here? Will Americans keep shopping or be forced to scale back? The answers to these questions will determine whether the "R" word is as common at cocktail parties in a few months as "dot com" was back in 1999.

Many banks are watching their revenues and earnings decline as borrowers default and the value of their collateral declines. Rising defaults, higher loan losses and the credit crunch are causing many financial institutions to slash new lending to shrink their balance sheets and improve capital ratios. 

An estimated 30% of subprime mortgages written in 2005 and 2006 are already under water. The banks face "challenging conditions," says Fed governor Donald Kohn. Delinquencies in Alt-A mortgages, a notch above subprime, are heading north as well. Durable goods orders have been falling. Vehicle sales were down 10% in February; both Ford and GM responded by slashing production. Meanwhile, bankruptcy filings are on the rise - a "grim omen," reports the Los Angeles Times.

Economists at Goldman Sachs, Merrill Lynch and other Wall Street investment banks have been saying since January that the U.S. is on the brink of recession. Odds of 25%, 50% and more are being bandied about.  In March, Warren Buffett said the U.S. is already in a recession. (We said we were on the cusp at Thanksgiving.)

Whether the economy meets the technical definition of recession or not doesn't much matter. Cause it's sure starting to feel like one. Probably time to stop talking about whether or not we're in a recession but about how long it will go and how ugly will it get.

The truly frightening aspect of all this - official government statistics aside - is that we appear to be heading into a recession at a time when consumer spending and the overall economy remain "strong." Net mortgage equity withdrawals had been running $800 million per year during 2005 and 2006. These withdrawals are quickly moving to zero, helped along by banks' recent "now you see them, now you don't" approach to previously issued home equity lines of credit. The implications for consumer spending are obvious.

Unemployment, reported by the federal government at 5.1% on April 4, is still low by historical standards. Notwithstanding the headlines about the problems in financial services, construction and retail, relatively few jobs have been shed by these industries. The decline in residential construction shaved a full percentage point off the economy's growth rate during the third quarter of 2007. While the economy showed a smidgen of growth in the fourth quarter, the 0.6% increase was the worst rate since 2002. Job losses by realtors, mortgage brokers, flooring manufacturers, home furnishings retailers and the like are now starting to contribute to higher unemployment. And, the inevitable slowdown in retail spending threatens to make matters worse.

Since loan write-offs, stalled construction projects and store closings likely precede job losses, it's virtually inevitable that unemployment heads north from here. Ditto the housing crisis. Since the bulk of mortgage resets aren't forecast to occur until fall, there's likely more pain ahead for homeowners upside down on their mortgages, especially in the hardest hit markets.

Furthermore, the relatively small decline to date in home prices has already driven home-loan delinquencies to their highest level in 20 years. And, with $440 billion of adjustable mortgages scheduled to reset this year, the economy appears to be weakening.

A new report by credit bureau Equifax and Moody's Economy.com shows that 4.46% of mortgages were at least 30 days past due at the end of the first quarter, up from 3.98% at the end of the fourth quarter and 2.92% a year earlier. Delinquencies varied widely by state, but were 7.03% in Florida and 6.59% in Nevada. At the same time, the foreclosure rate jumped to 1.39% from 1.08% at year-end and .58% a year ago. A report issued in April by investment bank UBS suggests foreclosures won't peak until mid-2009. 

Here's a staggering statistic: one-quarter of all mortgages are subprime (meaning the borrowers had FICO scores below 650) or Alt-A (to credit-challenged people who took out liar, er, "no documentation" loans). Foreclosures and mortgage delinquencies began in 2006, when consumer spending was robust and the labor market was tight. Now that we seem to be tipping into a recession, watch out. In some of the harder hit areas in California, foreclosures are skyrocketing. During the fourth quarter, they were 1.0% in Riverside and 1.7% in Sacramento - multiply that by four quarters and we're talking annualized rates of 4% to 6%. And ARM resets don't peak until the third quarter of 2008.

Meanwhile, 8.8 million borrowers had mortgages exceeding the value of their homes at the end of the first quarter, with the number projected to grow to 10.6 million at the end of the second quarter, according to Economy.com. "It's an incredibly bad mix that is causing foreclosures to go skyward," says Mark Zandy, Chief Economist of Economy.com. At the same time, consumer debt is also skyrocketing, with $715 billion in delinquency or default, up from less than $300 billion in 2005, according to Equifax and Economy.com.

Many wrongly cling to the fallacy that rising foreclosures are the cause of falling housing prices. The simple reason prices are declining is they're just too high relative to incomes. Falling home values cause borrowers to stop making payments because they conclude that they have no equity. That leads to foreclosures and foreclosed homes falling into disrepair. Lenders sell the homes at reduced prices, exacerbating the cycle. Foreclosures, though, are the tail of the dog.

Of course, where housing prices go from here will impact foreclosure and loan delinquency rates and have a considerable impact on consumer confidence and spending. Collectively, these forces will impact employment levels.

Optimists say the worst is over - there's a floor under home prices because:

  • Sellers will take their homes off the market rather than sell too cheaply;
  • Securitization of mortgages has led to lower rates (at their lowest level since mid-2005) and increased demand for housing;
  • Lower rates mean lower payments - the monthly payment is really what prospective home-buyers care about; and
  • A growing population, including immigrants, will increase demand for homes.

Pessimists say fasten your seat belts - housing is destined to fall further because:

  • Econ 101 - supply and demand - always carries the day. Reluctant sellers will be forced to capitulate, dragged along by the weakest sellers, including banks facing increasing regulatory pressure and wrestling with mounting foreclosures;
  • Mortgage securitization volumes have dwindled to a tiny fraction of peak levels, making mortgages especially tough to come by;
  • Demand from two major buyer segments - "investor buyers" and second home owners - has plummeted; and
  • Interest rates are declining for just one reason - a weak economy. As the recession unfolds, unemployment will increase and consumer spending will decline, hammering housing.

As we read the tea leaves, we find ourselves squarely in the "glass half empty" crowd. As we see it, it's all about supply and demand and affordability: The time to sell the average home has tripled from three years ago. It now takes 9.5 months to sell the average house, 13.5 months to move a typical condo, according to CB Richard Ellis/Torto Wheaton Research. If you're trying to sell a condo today in south Florida, you'd better be really patient: there's a six-year supply, with tens of thousands of additional units under construction and almost ready to hit the market. And, we're hearing about 60% walk-away rates on new condo construction projects; there's a shoe that has yet to drop.

What about the banks, which made the loans on real estate projects which are now troubled? Many are caught between a rock and a hard place. The "F" word for bankers last year seems to have been forbearance, not foreclosure. Many banks have been in denial, fearful that major write-offs would decimate their balance sheets and capital ratios. As we've seen, balance sheet strength can be fleeting. Exhibit "A" is Bear Stearns, which purportedly had adequate capital on a Tuesday and was insolvent by the weekend.

For many leveraged real estate projects, there are simply no viable exit strategies in 2008 and probably not a whole lot more in 2009. Asset values are continuing to fall so it doesn't do banks much good to extend the loan for another six months. But, we've seen exactly that ostrich strategy employed repeatedly.

Bank regulators are now starting to get into the act. After several years with no bank closures, regulators issued a stern warning to Fremont Investment & Loan: find a buyer in the next 60 days or face closure. Two weeks later, Fremont announced the sale of a big chunk of its business. A knowledgeable source tells us the FDIC is reviewing recent real estate appraisals and instructing banks to cut 30% off the appraised values in order to calculate required loan loss reserves. In 2008, very few buyers can obtain financing and it's a short list of folks who are buyers at appraised value.

Take the twin housing and credit crunches, add a dollop of rising foreclosures and mortgage delinquencies and a pinch of declining consumer confidence and it looks like a sure-fire recipe for an economic slowdown. Look out below.

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

 

 

 

Finding Your Path
Chapter 11 Bankruptcy: It Ain't What It Used To Be
By Lorne Polger, Managing Director

Having ridden through the real estate cycle in the early '90s as a commercial real estate lawyer, I recall with no great affection the three year period where I did not handle a single "normal" real estate transaction between an investment seller and an investment buyer.  Instead, we worked on bank-related dispositions (the few that were left in those wayward days), RTC dispositions and acquisitions, and a whole bunch of sales coming out of real estate bankruptcies.

Back then, it was not uncommon for a developer/investor to file a Chapter 11 proceeding when things went sour with a project.  At that time, the Chapter 11 process was viewed as a rest stop on the road to recovery, a place where, with a few bucks and a decent lawyer, you could find some time to get the creditors off your back. Meanwhile, you could enjoy the luxury of a court approved debtor in possession asset management fee, albeit having to deal with the hassles of the monthly reporting requirements. And who can forget that always surprisingly large monthly legal bill?

In the good ol' days for debtors, hope sprung eternal.  Judges typically did not mind having you in their courtroom if the end result was a successful reorganization. Cram downs of existing secured loans were possible. New lenders could be counted on for new financing to take out those bad overpriced loans from those mean secured lenders. And the real estate markets, although skidding along sideways for a while, seemed to eventually hit a slow but encouraging uptick.

By 1995, the good old days for debtors in commercial real estate bankruptcies had ended. Time had healed the wounds of the bad investments made in the late '80s and early '90s.  Flash forward to 2008.  The national markets are in a tail spin in virtually all commercial real estate sectors because so many bad deals were done in 2005 and 2006.  Many of these loans are in default.  Why haven't we seen the same number of Chapter 11 bankruptcy filings we saw 15 years ago?  Why are bankruptcy lawyers still playing cards with each other all day instead of slaving over their hot computers cranking out the billable hours?  What's changed?

There are multiple business factors which explain the difference.  First, rising values cure a lot of ills, falling ones put the sick patient into the ICU.  Nearly every economic prediction I've read during the last 90 days suggests that real estate values are still falling and have a ways to go before hitting bottom (much less, before we see any meaningful rebound).  Second, for all intents and purposes, banks have stopped lending.  Sure, a deal or two is getting done here and there. But, whether it's due to burgeoning loan loss reserves, growing REO portfolios, or reluctance to lend in markets trending down, the take-out lenders have basically closed up shop. 

Third, the lending community has taken a very different approach this time around in enforcing their rights.  When I represented a number of banks in the early to mid '90s, we had a pretty strict regimen. We raced down to State Court within a week or so after an event of monetary default and asked the judge to have a receiver appointed to oversee the asset. Then, in California, we pursued parallel paths of foreclosure: judicial (to preserve the lender's rights to a deficiency judgment against the borrower or guarantor) and non-judicial. 

What a different world it is this time around.  These days, we're seeing significant delays in the filing of Notices of Default, relatively few receivers appointed and few foreclosures.  We're seeing a number of circumstances where the developer/investor has been kept in the deal by the bank to essentially act as asset manager for a fee. And, we're seeing a number of deals where banks have taken deeds in lieu in exchange for wiping out the obligations under the personal guarantees (suggesting, or course, that the financial statements of the guarantors perhaps were not quite what they appeared to be when the loans were underwritten).  Finally, we have virtually every real estate asset titled in a single purpose or special purpose entity, with little cross collateralization across multiple assets.  This has allowed some debtors to walk from bad deals and preserve their equity in good ones.

There have also been a number of legal changes over the last 15 years.  Most notably, the costs of running through a successful or even an unsuccessful Chapter 11 single asset real estate bankruptcy have gone through the roof.  There's a reason profits per partner (the economic metric that law firms live by) exceed seven figures at many law firms. First, it's increasing hourly rates.  I can recall only a handful of lawyers in the stratospheric $300/hour range back in the early '90s.  Today, many of my former contemporaries are pushing $800/hour and higher; $500/hour is almost de rigeur. 

Successful law firms have also taken a page from manufacturers: separation of function. You don't have one lawyer on a bankruptcy: you have a "team."  (Who said lawyers weren't good business people?) In big firms, that usually means a senior partner to quarterback matters, a junior partner to review/edit, one or two up and coming young lawyers, still eager to work until 2:00 a.m. to crank out those critical points and authorities on the objection to the cash collateral motion and, for good measure, a paralegal or two.  With so many parties circling around the carcass of the bankruptcy estate (the debtor, secured creditors, unsecured creditors, creditor committees, trustees, etc.), the costs quickly get out of hand. 

Even in "successful" bankruptcies (from a creditor's point of view, meaning obtaining relief from stay to permit a foreclosure to move forward or some other settlement whereby the debtor hands the keys to the creditor), we are still seeing legal fees approaching $500,000.  This with minimal discovery work and no trial work.  Ouch.  That's a big hit to the bottom line on a typical $25,000,000 loan. 

Substantively, the laws have changed, making it more difficult for single purpose borrowers to successfully reorganize. Bankruptcy Code section 362(d)(3) provided that, in a single asset case, the court, upon request by a secured creditor, had to grant relief from the stay unless, within 90 days, the debtor had begun making reasonable payments or filed a confirmable plan.

The revised statute also included provisions that are not favorable to secured creditors.  First, the borrower can use the rents from the property to make payments to stave off relief from stay. Second, the interest rate for such payments will now be the non-default contract rate, not the current market rate. Third, the deadline for making payments or filing a confirmable plan has been delayed. While a single asset debtor can no longer linger in Chapter 11 without a confirmable plan in sight and without making substantial payments to the mortgagee, there are also increased risks to secured creditors that did not exist during the last real estate downturn.

So what lies ahead?  Burgeoning defaults in lending portfolios mean bankruptcy will continue to be a real risk for lenders.  Currently overburdened REO teams will be faced with the daunting task of committing manpower and money toward battles with debtors. While I don't believe we will see the same volume of filings we saw in the last cycle and the same percentage of confirmed reorganization plans, bankruptcy remains a time consuming, costly and uncertain process for creditors.

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

 

Snippets: Truth is Stranger Than Fiction
A Collection of Comical, Outlandish and Bizarre True Stories 

Foreclosures reach all time high.
About 6% of U.S. homeowners were in some form of mortgage delinquency at the end of 2007, according to an April report by the Mortgage Bankers Association. This is the highest level since the MBA began keeping these stats in 1985. Now, here's a shocker: adjustable-rate mortgages (ARMs) led the parade. Foreclosure rates have doubled during the past year in both prime and subprime ARMs.

Free falling.
U.S. home prices lost 8.9% in the fourth quarter of 2007, according to the S&P/Case Shiller Home Price Index.  This marks the biggest drop in the 20-year history of the index. "We reached a somber year-end for the housing market in 2007," said Robert Shiller, co-creator of the index. "Home prices across the nation and in most metro areas are significantly lower than where they were a year ago. Wherever you look things look bleak."

The S&P/Case-Shiller 20-city home index set a record annual decline of 9.1% in December with declines in 17 metro areas and double-digit declines in eight of them.

Miami was the weakest market, posting a 17.5% annual decline. Las Vegas and Phoenix followed with a 15.3% drops. Los Angeles, San Diego, San Francisco, Detroit and Washington, D.C. all recorded double-digit annual declines. Just three metro areas -  Charlotte, NC, Portland, OR, and Seattle, WA - showed year-over-year increases in prices, but Seattle's growth was up a slim 0.5%.

Bid ask gap
Source: CoStar's survey of its Watch List e-newsletter subscribers

Much has been made of the impact of the credit crunch on the commercial real estate slowdown. While the lack of credit plays a role, another disconnect is that buyers and sellers have not yet come to terms with the "new reality" and remain at odds on pricing.

"There is a lot of product for sale, most of which is not going to trade, either from unrealistic pricing or inability of the seller to sell at a realistic price, said Evan Kristol, Senior VP for Marcus & Millichap in Ft. Lauderdale.

Don't ask, don't tell.
Source: New York Times

We're awash in news about those greedy borrowers who duped poor lenders by falsifying incomes on loan documents. As New York Times writer Gretchen Morgenson points out, folks who make these claims overlook a key fact. Experts say that over 90% of mortgage applicants - even those who applied for stated income loans (aka "liar's loans") - signed an I.R.S. Form 4506T, which authorizes lenders to verify the applicant's income. So, while borrowers misrepresented their incomes, lenders could have detected these discrepancies before closing loans simply by checking with the I.R.S.

Veri-tax, Inc. handles the filing of these I.R.S. verification forms for lenders and loan originators. Mike Summers, the firm's VP of Sales and Marketing, began calling on lenders in 1999 but was met with a cool reception. "In 2001, I was going around the subprime world trying to get them to sign up," says Mr. Summers. "Ameriquest, and others I don't want to name, just didn't want to know because it would kill the deals. The attitude was 'don't ask, don't tell." (Subprime lender Ameriquest closed its 229 branches and laid off 3,800 employees in May, 2006 and no longer exists.) 

According to Summers, Ameriquest and its subprime brethren had weak excuses for saying no to Veri-tax's services. At $20 a pop, submitting the forms was just too expensive, they said. And, with a one business day turnaround time, too time-consuming. According to Summers, "It was greed on a few different levels.  I don't think $20 to protect your interest in a $500,000 loan is that big an investment. My estimate was between 3% and 5% of all loans funded in 2006 had a filed 4506. They just turned a blind eye, saying, 'Everything is going to be fine.'"

The ripple effect.
Source: MarketWatch

Major brokerage firms, including Goldman Sachs, Morgan Stanley and Lehman Brothers, are reining in lending and other activities that help financial markets function smoothly because they're facing funding problems of their own, say experts. "Fearful lenders are tightening credit standards. It is not a happy period on Wall Street," says analyst Brad Hintz of Bernstein Research. He continues, "The logical risk takers - hedge funds - are finding their sources of financing being pulled on them. These are the most willing traders to step into troubled markets. But if you don't provide them leverage, they can't do it. All these things are tied together seemingly with bungee cords. When you pull on one cord, it takes a little time, but all the other parts of the system get pulled down, too."

"The subprime mess has damaged the balance sheets of investment banks and brokerage firms," said Vladimir Belinsky, president of Hermitage Advisors Ltd. "These firms are at the core of our financial system and the extent of this is a lot worse than people thought."

$460 billion here. $600 billion over there. Pretty soon, we're talkin' real money.
Financial institutions will write down some $600 billion when all is said and done on the subprime and credit crisis, estimated UBS analysts on Feb. 29. $460 billion is the "when all is said and done" estimate from Goldman Sachs. Even the lower estimate means we're only halfway through.

UBS might have a pretty good idea how bad it could be...
The Swiss Bank's report comes just weeks after it admitted to a hefty $14 billion write-down of its own. With UBS' April Fool's Day announcement that it will have another $19 billion in mortgage-related write-downs, the total damage from the mortgage crisis has reached $232 billion. And, that's only for write-offs announced so far from the world's 45 largest banks. Since we're nowhere near done and we've seen very few announcements from regional and community banks - which have the same type of toxic loans in their portfolios - this number will only grow.

The chart below provides the ugly details. Before we go to the chart, we thought this might be a good time to recall Fed Chairman Bernanke's testimony on July 19, 2007 before the Senate Banking Committee: "Some estimates are in the order of between $50 billion and $100 billion of losses associated with subprime credit problems." While we give the Fed Chairman high marks for leadership in the recent credit crunch, the fact that someone in his position, with unlimited access and information, could miss it so badly tells you that it's virtually impossible to predict where this will end.

Asset Write-Downs and Credit Losses

From January, 2007 to March, 2008

(In Billions)

 

 

 

 

 

 

Firm

Write Down

 

Credit Loss

 

Total

 

 

 

 

 

 

UBS

$ 38.0

 

 

 

$ 38.0

Merrill Lynch

25.1

 

 

 

25.1

Citigroup

21.4

 

2.5

 

23.9

HSBC

3.0

 

9.4

 

12.4

Morgan Stanley

11.7

 

 

 

11.7

IKB Deutsche

9.0

 

 

 

9.0

Bank of America

7.3

 

0.9

 

8.2

Deutsche Bank

7.4

 

 

 

7.4

Credit Agricole

6.5

 

 

 

6.5

Credit Suisse

6.3

 

 

 

6.3

Washington Mutual

0.3

 

5.5

 

5.8

JPMorgan Chase

2.9

 

2.1

 

5.0

Wachovia

2.9

 

2.0

 

4.9

Canadian Imperial (CIBC)

4.0

 

 

 

4.0

Societe Generale

3.8

 

 

 

3.8

Mizuho Financial Group

3.4

 

 

 

3.4

Lehman Brothers

3.3

 

 

 

3.3

Barclays

3.2

 

 

 

3.2

Royal Bank of Scotland

3.1

 

 

 

3.1

Goldman Sachs

3.0

 

 

 

3.0

Dresdner

2.7

 

 

 

2.7

Bear Stearns

2.6

 

 

 

2.6

ABN Amro

2.4

 

 

 

2.4

Fortis

2.3

 

 

 

2.3

Natixis

1.9

 

 

 

1.9

HSH Nordbank

1.7

 

 

 

1.7

Wells Fargo

0.3

 

1.4

 

1.7

BNP Paribas

1.3

 

0.3

 

1.6

DZ Bank

1.5

 

 

 

1.5

National City

0.4

 

1.0

 

1.4

Bank of China

1.3

 

 

 

1.3

Bayerische Landesbank

1.3

 

 

 

1.3

Caisse d'Epargne

1.3

 

 

 

1.3

LB Baden-Wuerttemberg

1.3

 

 

 

1.3

Nomura Holdings

1.0

 

 

 

1.0

Sumitomo Mitsui

1.0

 

 

 

1.0

Gulf International

1.0

 

 

 

1.0

European banks not listed above

8.4

 

 

 

8.4

Asian banks not listed above

4.0

 

0.7

 

4.7

Canadian banks excluding CIBC

2.4

 

0.1

 

2.5

Totals

205.7

 

25.9

 

231.6



A CDO Post-mortem: Unraveling Parapet.

In the Jan. 25 issue of Grant's Interest Rate Observer, analyst Dan Gertner dissects a Collateralized Debt Obligation (CDO) named Parapet 2006 Ltd. As linguists and architects will tell you, a "parapet" is a low wall along the edge of a roof or balcony or a low wall which serves as a fortification. Like much else on Wall Street, the word means something a little different in practice.

Parapet and other CDOs simply don't lend themselves to the kind of detailed analysis a careful distressed buyer can place more than a nominal bid. Without more solid information, Gertner says, "You've got to buy it when the blood is up to your ears, at pennies. In Parapet, what, exactly, would one be buying? In each of the structure's 37 discrete assets is a myriad of bank loans, CDO tranches, collateralized loan obligation (CLO) tranches, and residential mortgage-backed security (RMBS) tranches. I examined three of the 37. Assuming all 37 contain the same number of loans or securities (which, of course, they don't), the overall entity would hold over 14,000 individual loans and over 1,000 CDO/CLO tranches, details of which are recorded on offering documents that generally run 200 or 300 pages. Those 1,000 CDO/CLO tranches would also hold more loans and more CDO/CLO tranches, supported by still more documents."

Gertner continues "Our investor source spent a full week kicking the Parapet tires. At the end of the exercise, our source chose to sit on his checkbook." The message is that these markets are incredibly incestuous. As Gertner explains, "so many CLOs and CDOs are all tranches of each other. It's like a sweater - you pull on a thread and once it starts going, the whole thing goes, because one triggers the next. And then we started looking into the trustee reports. It turned out that, if you really wanted to analyze it, you have 15, 20 tranches of potential value here and each one has a dozen or 20 or 50 tranches of other CDOs. How do you value that?"

Loads of this stuff is sitting on balance sheets of investment banks, commercial banks and hedge funds. We don't see how financial stocks will bottom and those markets will stabilize until CDO exposures are a bit clearer.

Implications from closing the home equity ATM.

Per the overused cliché, Americans used their homes as ATMs during the boom times. According to an analysis conducted for Business Week by real estate website Zillow.com, a further 20% decline in nationwide home prices would mean that fully two-thirds of Americans who purchased homes during the past year would owe more than their homes are worth - meaning the home equity ATM would be closed to them.

Dear Homeowner: Your home equity line of credit has been suspended.

As the San Francisco Chronicle reports, the credit crunch is hitting high income homeowners. Brent Meyers began his landscaping project in January, expecting to draw on his home equity loan to pay the landscaper $75,000 for the project. When Meyers took out the credit line last November, his home was valued at nearly $1.5 million. With less than $1 million in outstanding principal, he had a comfortable equity cushion.

In March, Meyers received a letter from Bank of America informing him that the line had been suspended. When he called to ask why the home ATM was being closed, he was told that his house had dropped to an estimated $1.09 million in value, leaving insufficient equity to cover the line.

Unlike some who have had their credit cut off, Meyers has other resources to fall back on; he intends to sell stock to pay for his landscaping project. Still, losing the credit line is prompting him to retrench. "I'm going to change my spending behavior because I lost access to $180,000," he said. "We're going to be deferring other expenditures to build a pot of money to replace what B of A took away."  (Editor's note: Since the Chronicle article appeared, we've heard similar stories about three other major money center banks.)

In search of the "Black Swan."
Former trader turned London Business School professor and novelist Nassim Nicholas Taleb has analyzed the way people misunderstand randomness and risk with his notion of Black Swan Theory.

A "Black Swan" is an unlikely but not impossible event beyond the realm of normal expectations. An example: the September 11th attacks. The origin of the theory: Until black swans were discovered in Australia in the 17th century, westerners thought all swans were white. Taleb believes almost all consequential events in history come from the unexpected.

The twin subprime mortgage and credit crunches could be characterized as Black Swan events. While the signs of excess abounded for several years, financial experts, pundits and their minions were "shocked" to learn of the widespread fraud and abuse surrounding the issuance and sale of mortgages.

Maybe it's normal - like a normal Heisman Trophy winner or a normal 7.2 earthquake. Or a normal, once in a lifetime credit bubble.

It's the house prices, stupid!
In an April 3 speech, San Francisco Fed President Janet Yellen points out that mortgage delinquency rates are more closely tied to falling house prices than interest rate resets.

Ms. Yellen says despite all the talk about interest rate resets causing delinquencies and foreclosures, this has not been a major factor so far. The vast majority of subprime loans are recent vintages, so only a fraction have reset so far. And, many initial, "teaser" rates were not set that far below the formula and some of the short-term rates that drive these formulas have declined since last summer. Moreover, variable-rate subprime loans are more likely to become delinquent because these borrowers had higher risk characteristics than fixed rate borrowers.

Since the subprime meltdown is tied more to declining house prices than interest rate resets, others, including prime borrowers, could also be affected. Indeed, while default rates for prime loans are lower than for subprime loans, delinquency rates among all categories are highly correlated with house price declines. According to Ms. Yellen, "More formal statistical analysis confirms that differences in house prices account for most of the regional differences in delinquency rates, whether borrowers are prime or nonprime, or whether loans have fixed or variable rates."

"This analysis drives home the importance of house-price movements both to future developments in the housing sector and also to the ultimate magnitude of credit losses likely to be realized by financial institutions on mortgage-backed securities and other housing-related loans, says Ms. Yellen. "Looking ahead, it seems likely that the period of house price declines will not be over very soon, since some models of the fundamental value of houses suggest that prices are still too high, and futures markets for house prices indicate further declines this year."

Fed Chairman sees challenges for banks; more bad news in housing market.
In a speech to commercial bankers on March 4th, Fed Chairman Ben Bernanke said there may be challenges facing the banking sector and more bad news ahead in the housing and mortgage markets. Helicopter Ben urged banks to write down principal balances of more loans to avoid foreclosures saying "there are substantial incentives for lenders to modify loans to avoid foreclosure." He cited statistics from the fourth quarter of 2007 that showed total losses exceeding 50% of the principal balance plus another 10% of capital loss for expenses in a typical foreclosure.

The Return of the regulators.
Source: Barron's

The FDIC is hiring over 100 new people because it anticipates more bank failures, according to Barron's. Yet, the bank deposits covered by the FDIC are at a 19-year low. Of the $7 trillion in deposits in 8,533 banks and thrifts, only $4.2 trillion, 61%, is covered by federal insurance. The rest is likely in accounts exceeding the $100,000 insurance limit. By way of perspective, in 1989, at the end of the S&L crisis, about 81% of bank deposits were insured.

In 1989, the FDIC was monitoring 1,500 troubled banks, about 10% of the total. Today the FDIC's list contains 76 institutions, less than 1% of all banks.

Thomas Michaud, President of Keefe, Bruyette & Woods, an investment bank that focuses exclusively on financial-services, expects the troubled list will grow, since we are just at the beginning of a recession. And, though bank failures will be higher than in recent years (there were just three in 2007 and none in 2005 and 2006), Michaud doesn't see a rash of bank failures, during the '90s when the FDIC closed nearly 1,000 institutions.

Michaud won't name names - there are laws against that. But, banks file "call reports" with the FDIC that detail their loan concentrations and these are published on the FDIC's website. The FDIC sometimes gives other clues. On March 26, the FDIC released a copy of a "supervisory letter" to Fremont Investment & Loan, demanding that Fremont raise capital or find a buyer.

 

Feature Article
Whither goes Housing, so goes the Economy.
By Mitch Siegler, Managing Director

The question on the mind of every economist: "Will the consumer continue propping up the economy?" We aren't economists, but it seems that the negative wealth effect from declining home prices, the reduced ability of homeowners to borrow money against home equity and higher unemployment resulting from fewer mortgage, construction, housing-related and retail jobs has to put a damper on consumer spending.

According to the RBC CASH Index - a measure of Consumer Attitudes and Spending by Households - confidence among consumers fell from 48 in February to 33 in March to 29.5 in April - its lowest level since inception in 2002. As a frame of reference, the index stood at 103 in January, 2007. Home re-sales have reached a nine-year low, according to the folks at Agora Financial. The housing boom of 1997-2007 raised the value of U.S. residential real estate by about $8 trillion. During the past five years, Americans took out an estimated $3 trillion in mortgage withdrawals, giving consumer spending a massive boost and driving a good chunk of GDP growth.

As housing prices plummet, American's residential housing wealth shrinks. And instead of encouraging homeowners to take money out of their homes, lenders are demanding that borrowers put some back in. Peter D. Schiff, president of brokerage Euro Pacific Capital in Darien, CT predicted a housing crash in 2005. According to Schiff, "Americans are going to have their credit cards taken away from them by the lenders. We're going to turn the American economy into a cash economy."

Of course, we Americans love our consumption lifestyle and will fight tooth and nail to keep it. So, during the past few quarters, when the housing boom no longer provided easy money, we reached for our credit cards and even our retirement savings accounts. Consumers have a few tricks up their sleeves for finding cash: Debt-to income ratios more than doubled between 1983 and 2004, according to a report issued in April by the Pew Research Center.

Now, the pendulum is swinging back. "Americans at all income levels tighten belts," is a recent headline in the Christian Science Monitor. "Looking at things differently is a theme running through conversations of Americans at all income levels these days as they review their spending habits," according to the periodical. And, a new survey by HSBC Bank says, "Nearly two out of three consumers intend to reduce indulgent spending in 2008." With millions of families already upside down on their mortgages and thousands more joining the club daily, it's not hard to see the beginning of a trend. 

The rich are feeling it, too. "Even at the top layers of luxury, there has been some softening in spending," says Milton Pedraza, CEO of The Luxury Institute in New York. That includes yachts, jets, cars and second homes. Fortune agrees, citing Anchor Yachts of Fort Lauderdale, which says sales of yachts in the $200,000 to $800,000 range have declined 50%, prompting price cuts of 20% from sellers. Bookings at Leading Hotels of the World are down 10% so far this year. Allen Brothers, a supplier of beef to fancy steakhouses like Del Frisco's, say it has seen restaurant-goers swap prime cuts for lower-grade meat. And golf retailer Golfsmith International saw same-store sales decline 4.6% in the recent quarter.

For the common folk, the first retail sector to feel it was home furnishings, which accounted for about a quarter of store closings in 2007. Bombay Co. went out of business and shuttered more than 500 stores last year. Linens and Things, taken private in a $1.3 billion dollar transaction in 2006, teeters on the brink of bankruptcy at press time. In just the first two months of 2008, more than 1,600 store closings were announced.

A host of other retailers, including Talbots, Pacific Sunwear, Ann Taylor and Zale Corp. are also closing stores. Others, like J.C. Penney, Coldwater Creek and Chico's, have said they will open fewer stores than planned. The International Center for Shopping Centers (ICSC) said in a recent report that the number of announcements about store closings so far this year "does not bode well for the industry in 2008." ICSC predicts full-year closings could reach 5,770 stores, the highest number since 2004.

And, even solid retailers are seeing same-store sales, a key health indicator, plummet. Kohl's said its March same store sales fell 15.5%. For J.C. Penney, the decline was 12%. Nordstrom saw a 5% fall. Thompson Financial says 17 of 23 retailers surveyed missed their sales estimates for March. If the economic slowdown accelerates, it's a safe bet that store openings will slow for many retailers and weaker companies may close stores.

Real estate investment/brokerage firm Grubb & Ellis said in a recent report that the weak housing market has already forced Wal-Mart to slow expansion. Wal-Mart has announced that it will expand retail square footage by 5%, down from 9%, over the next two years. In February, Wal-Mart also announced that gift card redemptions, which have made January one of the most important months for retailers, have stalled and many gift cards were being redeemed for food, gasoline and household products rather than gifts and discretionary items.

In a March conference call, David Helms, CEO of Discover Financial Services, told analysts that sales growth in the first quarter "generally became more concentrated in everyday categories such as groceries, gas or discount stores." In another survey released in April, Discover said 52% of consumers surveyed expect to spend more in April on household basics by cutting back on discretionary items, like vacations, or by putting aside less for savings and investing. That represents an increase of 12 percentage points from February.

"Record amounts of new retail supply came on line in 2007, just as the housing market began to fall and growth in consumer spending receded from lofty levels," said a Property & Portfolio Research report. "The consumer will continue to rein in purchasing, especially of housing-related goods while property owners will have a tougher time leasing space than they have since the last recession. The consumer appears to be faltering and may finally tap out in 2008." The same may be true for retailers.

 

Notables and Quotables

"The employment report is emitting recession signals." 

- Michael Gregory, Senior Economist of BMO Capital Markets Economics on the April employment report showing the economy shed 80,000 jobs, the most in five years, in March - the third consecutive month with shrinking U.S. employment.


"The country has slipped into a recession."

- Stuart Hoffman, Chief Economist for PNC Financial Services Group


"The latest job losses aren't a surprise to us. Finance and accounting, IT, engineering, scientific, legal - all have gone from very strong growth in 2007 to strong declines in the first quarter of 2008."  

- Tig Gilliam, CEO of temporary staffing company Adecco North America


"A recession is possible." 

- Ben Bernanke, Chairman of the U.S. Federal Reserve Bank   


"You have big credit losses that make it harder to get new credit, which means the economy starts to slow down and foreclosures go up. Then, you get even bigger credit losses, which makes banks even less willing to lend and you keep spiraling down. The debate should no longer be about whether there is or is not a recession, only about how deep it will be."           

- Nigel Gault, Senior Economist at forecasting firm Global Insight


"We are looking at the worst set of macroeconomic conditions since the Great Depression. I don't know where the bottom is. The federal government's going to have to do a lot more to contain what I think is the potential of a perfect storm. The most dangerous part in my judgment is what is going on in the housing world, where we're now running foreclosures at the rate of 2 million a year, where 9 million homes, according to the government, have either no equity or negative equity. That will go up to 15 million if housing prices continue to go down this year as they've done last year. We are clearly heading down."

- Mortimer Zuckerman, co-founder of Boston Properties Inc., the largest U.S. office REIT and Editor in Chief of U.S. News and World Report in a March 13, 2008 interview with Bloomberg Television


"Godot has arrived. I've been rooting for the muddling-through scenario. However, the credit crisis continues to worsen and has become a full-blown credit crunch, which is depressing the real economy."

- Edward Yardeni, Ph.D., who had been one of Wall Street's most upbeat forecasters, on March 8th


"We now see potential for another 25% to 30% downside over the next two years."

- David A. Rosenberg, North American economist for Merrill Lynch, who until recently had expected a much smaller slide in housing prices


"The real issue in today's housing markets is that prices currently sit at levels that are unaffordable given income levels in our state. Take Los Angeles County, where the median price of a house peaked higher than $530,000. With a 6% interest rate and assuming a 10% down payment, the total annual cost of owning such a house would be $35,000 for the mortgage alone and $43,000 if taxes and insurance are thrown in. This would eat up roughly 75% of gross annual income of your median homeowner in the county - much more than twice the maximum affordability rate used by Fannie Mae and Freddie Mac when making loan decisions. Prices are going to fall one way or another; it's only a function of time. They simply aren't sustainable at their current levels."

- Christopher Thornberg, Ph.D., one of California's best known economists


"A down market is getting baked into expectations. People say: 'I'm not buying until prices are lower."

- Chris Flanagan, head of Research in J.P. Morgan Chase's asset-backed securities group, who predicts prices will fall 25%, bottoming in 2010


"We've never been here before, so there's no road map."

- Ian Shepherdson of consulting firm High Frequency Economics, one of the first high-profile bears on housing, who is predicting a 20% decline in prices from their peak but says 40% wouldn't shock him.


"The banking system is facing the 21st-century equivalent of the wave of bank runs that swept America in the early 1930s. And your money is rushing in to help, with hundreds of billions from the taxpayer, and hundreds of billions more from tax-sponsored institutions like Fannie Mae, Freddie Mac and the Federal Home Loan Banks."

- Paul Krugman writing in the New York Times


"You only learn who has been swimming naked when the tide goes out - and what we are witnessing at some of our largest financial institutions is an ugly sight."

- Warren Buffett, Chairman of Berskhire Hathaway, Inc.


"Banking institutions will need to merge, raise more capital or potentially be put of business by their regulators. As many as 50 banks and thrifts likely will fail nationally over the next two years. We see the depth of the problem - We see first hand how deep the losses are." 

- Richard Hollowell, Partner in Charge of Real Estate Services Group of southern California accounting firm Squar, Milner, Peterson, Miranda & Williamson


"I've been telling anyone willing to listen that banks have a tendency to sit on time bombs while convincing themselves that they are conservative and nonvolatile. Anyone who knows anything about the history of banking or remembers the 1982 Latin America debt crisis or the 1990s savings and loan collapse will tell you that the subprime crisis was bound to happen. Banks are exposed to such blowups."

- Nassim Taleb, author of "Fooled by Randomness" and "The Black Swan"


"One of the worst since World War II. It will be a long time before we recover from the worst credit excesses in U.S. history."

- James B. Rogers, co-founder, with George Soros, of the Quantum Fund

 

Credits: Agora Financial, Associated Press, Barron's, Bloomberg, Business Week, CB Richard Ellis/Torto Wheaton Research, Christian Science Monitor, CoStar, DataQuick Information Systems, Fortune, Global Insight, Grant's Interest Rate Observer, John Mauldin's Investors Insight, Los Angeles Times, MarketWatch, Moody's Economy.com, New York Times, San Diego Union-Tribune, San Francisco Chronicle and Wall Street Journal.