Monday, 03 March 2008 00:00

As I was harping on relying on Name Brands...

I was just warning readers to beware of believing the hype behind financial name brands when I came across the following WSJ.com article. If you have followed this blog regularly, you would have been first warned of the CRE overvalution as early as September of last year, and had access to what I consider a fairly intensive amount of fundamental analysis and opinion on the topic, not to mention the banks that will suffer from it such as Bear Stearns, Lehman (contributed by a reader) and Morgan Stanley . Name brands issue the same warning 6 months later, in substantially less detail.

Wall Street Gears for Its New Pain

Commercial Real Estate
To Yield Write-Downs;
Defaults Slim So Far

After
suffering a beating from their exposure to home loans, banks and
securities firms are about to take their lumps from office towers,
hotels and other commercial real estate. And the losses could last
longer than those from the subprime shakeout.

As
the economy wobbles and financing costs rise because of the credit
crunch, commercial-real-estate values are starting to slide, with
analysts at Goldman Sachs Group
Inc. projecting a decline of 21% to 26% in the next two years. That
means misery for securities firms with exposure to
commercial-real-estate loans and commercial- mortgage-backed securities.

William Tanona, a Goldman analyst, expects total write-downs of $7.2 billion by Bear Stearns Cos., Citigroup Inc., J.P. Morgan Chase & Co., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Morgan Stanley
in the first quarter. Those firms had combined commercial-real-estate
exposure of $141 billion at the end of the fourth quarter.[Chart]

A team of Goldman analysts predicts the financial damage from commercial real estate could last as long as two years, which would mean "a significantly longer tail than subprime." That is because only 28% of commercial-real-estate loans have been packaged into securities since 1995, while about 80% of subprime loans have been securitized; the higher level of securitization subjects the subprime assets to more-immediate mark-to-market accounting, which is playing out in the form of the write-downs that are dominating headlines.

Wall Street has set itself up for a hard fall in commercial real estate. Banks and securities firms are facing exposure from loans and financing commitments made on commercial-real-estate projects, property they own directly and commercial-mortgage-backed securities that no one wants to buy.

How much worse the write-downs get likely depends on the economy. "If we go into a deep recession, as implied by the various indices looking at the fixed-income market, the write-downs could be bigger in coming quarters," says Richard Bove, an analyst at Punk Ziegel & Co.

If there is a silver lining, it is that the excesses that overtook the U.S. housing market aren't as prevalent in commercial real estate. Overbuilding of shopping malls, office parks and other commercial property hasn't been rampant, although vacancy rates are climbing in such markets as Orange County, Calif., and Las Vegas, which have been hit by the weak housing market.

Market values of commercial-mortgage-backed securities, which are pools of mortgages that are sliced up and sold to investors as bonds, are down about 5% since late last year, compared with declines of roughly 50% or more last year for some collateralized debt obligations. CDOs are debt pools of repackaged residential-mortgage bonds, and they have been brutally hit by losses on mortgage investments.

Overall, commercial-real-estate write-downs in the first quarter are expected to rival those for CDOs and leveraged loans. Mr. Tanona predicted write-downs of commercial-mortgage-backed securities should "intensify" in the first quarter to $7.2 billion from $1.8 billion in the fourth quarter. By comparison, he foresees first-quarter write-downs of $10 billion in CDOs and $5.8 billion in leveraged-loan commitments.

So far, default rates on commercial-mortgage-backed securities are a slim 0.4%. But that is likely to rise as loose lending standards on some commercial-real-estate loans come back to haunt lenders and investors. More than $50 billion of five-year, full-term interest-only loans written at aggressive loan-to-value ratios could turn into defaults "at a significant level" if the loans can't be refinanced this year, according to Jones Lang LaSalle, a real-estate brokerage and money-management firm in Chicago.

The sluggish economy will add more stress, because demand for office and retail space is likely to suffer. On the other hand, the commercial-property market hasn't seen the kind of excessive supply that caused property values to tumble in the last recession, which could help maintain real-estate prices.

Tough to Assess Impact

It isn't easy to size up the potential damage. Financial firms' public reports "don't paint a full picture," says Peter Nerby, a credit analyst at Moody's Investors Service. For example, Morgan Stanley reports commercial-mortgage exposure before and after the effect of offsetting transactions, or hedges, while Bear, Goldman and Lehman don't...

Problem With Leftovers

An even bigger problem is the firms' own holdings of leftover, unsold commercial-mortgage-backed securities. Because the market for these bonds has virtually shut down and made it hard to determine what they are worth, Wall Street firms are being forced to rely on the CMBX index, which tracks the performance of commercial-real-estate bonds with different credit ratings.

Portions of the index have more than tripled this year, indicating soaring perceptions of risk. The index's movement implies a 5% loss rate, pressuring banks to mark down the value of their bonds even though the underlying properties are still generating cash.

Morgan Stanley, last year's No. 1 underwriter of commercial-mortgage-backed securities, cut its exposure to such mortgages by 52% to $17.5 billion after hedges in the fourth quarter, compared with three months earlier. That might have pointed investors to the spot where Morgan Stanley expects the "next shoe will drop," Guy Moszkowski, an analyst at Merrill Lynch, said in a report.

Another trouble spot is the debt financing provided last year to facilitate leveraged buyouts of real-estate concerns. One of the biggest examples: A group led by Bear still is trying to sell the debt offered to Blackstone Group LP for its $20 billion takeover of Hilton Hotels Corp. In December, Moody's cut its ratings on Bear, partly blaming the firm's "concentrated risk" from the Hilton deal.

"You couldn't have been a player in this market without having legacy deals [that you're stuck with], because the market collapsed so quickly," said an executive at a large bank.

Last modified on Monday, 03 March 2008 00:00

4 comments

  • Comment Link Reggie Middleton Monday, 03 March 2008 11:34 posted by Reggie Middleton

    The problem with marking to market now is the velocity of the asset devaluation and lack of liquidity. Selling 2% of the portfolio is going to give a very different number than selling 25 or 50% of the portfolio. 2% will not give you a true liquidation value (thus, IMO an inaccurate carrying value), and in addition, it will give you a mere snapshot at a single point in time in a rapidly declining market. A true valuation is a number that you can sell the assets at any given time.

    The best way to do it is to mark the whole portfolio, which will yield very low prices, or take weekly marks with a smaller amount (say 2%) and report a rolling average - which will be rolling downward for quitesome time.
    Mar

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  • Comment Link Robert Cote Monday, 03 March 2008 10:55 posted by Robert Cote

    5 percent? 5 tiny little percent? Some single project failures in the portfolio are worth 5% by themselves. The problem is impairment to the rest from those "isolated and contained" failures. CRE doesn't go delinquent and then get foreclosed and then resold for 70¢ on the dollar like RRE. It goes bad, money lent disappears down a rathole consumed by operating costs and such then sits non-performing for quarters if not years then goes to the courts for years or longer. In short any CRE loans goes non-performing it is optimistic to mark it to zero and mark the rest down double digit percentages.
    I suggest any Wall Street firm holding CRE paper follow Buffett's advice; sell 2% of the portfolio for market price and then you have a defensible market-to-market model with less cost and risk than all these fancy spreadsheets-o-fantasy.

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  • Comment Link Reggie Middleton Monday, 03 March 2008 10:35 posted by Reggie Middleton

    The RMBS and mortgages alone are enough to continue write downs for a while. When adding CMBS, Leveraged loans, junk bonds, CLOs, CDOs, and consumer finance, these guys have quite a ways to go in terms of asset write downs. The steepening of the yield curve will come nowhere near compensating for the loss in asset value.

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  • Comment Link Liam Brady Monday, 03 March 2008 10:28 posted by Liam Brady

    Those writeoffs are in line with the decline in CRE values estimated by the MIT group, which come to some 7.5% in the last six months of 2007.

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