Coming Real Estate Crisis

For all intents and purposes, the US home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the US were made with federal assistance, either through Fannie Mac and the implied guarantee or Freddie Mac or through the FHA. If government support goes away, and it will go away, where will that leave the home market? Lenders are still lending but reverting to 75% to 80% loan to value. But that doesn’t help a homeowner whose property is worth less than the mortgage.

Then, commercial world has to follow suit. Because it is a normal progression. Obviously, when single-family homes decline in value, multifamily apartments decline in value too. And when consumers hit the wall with spending and debt, that is going to have an impact on retailers that pay for commercial space.

Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of the properties had been financed too aggressively and today it is clear that commercial properties are not performing and that values have gone down, although I have got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios.

The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point that I believe it will come sometime in 2010.

Key risk is that we might be heading to a Japanese-style solution. In 1989 and 1990, Japan didn’t want their banking system to implode so they made it easier for their banks to it on bad assets without owning up to the losses. And what’s the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it is not going to sell them. Well, the money tied up in the loans the bank is sitting on is idle and it is not being used for anything productive.

The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against the capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. I think the US government will contrive something to help commercial real estate so that it doesn’t hurt the banks that lent on commercial real estate. I will resemble what they did with housing. But it won’t really be solution. In fact, it will make the problems much more intense.