Agora Financial’s Rude Awakening

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Laguna Beach, California

• The looming option-ARM crisis and acid rain on Manhattan’s elite,
• Dissecting the mess over in the commercial real estate market,
• Following your pig through the sausage machine and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Continuing our recent series of religio-economic analyses, we shift our attention from the Gospel of Mark to the Gospel of Matthew. In the fifth chapter of Matthew, which details the Sermon on the Mount, the writer observes that rain falls on both “the righteous and the unrighteous.”

“The rain [also] falls on the rich and the poor,” as we observed in the January 8, 2007 edition of the Rude Awakening, “Bonus Envy.” But the story does not end there. Many of the rich are pretty good at siphoning rain away from the poor, or at drilling horizontal water wells under the poor’s property. That’s just the way of the world.

But if it is any comfort to the poor of the earth, acid rain also falls on the rich and poor alike. Of course, the rich possess better defenses against acid rain than the poor. But these defenses are not always foolproof.

Sometimes the acid rain of economic adversity burns a hole right through these defenses and erodes some or all of the wealth that the rich have amassed for themselves. The housing bust, for example, has victimized nearly every home-owning individual in the country, even those individuals who own homes in the Hamptons – the posh summertime playground of Manhattan’s rich (or formerly rich) Wall Streeters.

High-end homes everywhere are taking a beating. As home prices slide, many high-end homeowners – like so many of their subprime counterparts – find themselves hopelessly upside down in their mortgages.

Once the value of a home falls well below the size of the mortgage against it, the homeowner loses the incentive to continue making payments. The calculus is approximately the same, no matter whether the mortgage be $100,000 or $1,000,000.

That said, the truly rich would not go into foreclosure, no matter how disadvantageous that mortgage math might become. The truly rich possess other assets that could be liquidated to satisfy their mortgages.

But many, many of the theoretically rich individuals of the late great housing bubble were never really very rich at all. They were simply “credit-worthy.” They earned enough money to qualify for a monster mortgage. As long as nothing changed, paying the mortgage was doable. But if anything changed – anything at all – paying the mortgage was absolutely non-doable.

Something changed.

Lots of big-ticket employees lost their jobs; home prices tanked and credit disappeared. When you add all this up, you get lots of pain and suffering, even in “rich” households. And you also get an alarming rise in delinquencies and foreclosures within the “prime” and “near-prime” loan categories. Big-ticket mortgages are the new sub-prime. For three straight months, option adjustable-rate mortgages (“option-ARMs”) – a preferred product of many formerly rich homeowners – have generated proportionally more delinquencies and foreclosures than subprime mortgages.

“Wells Fargo ‘acquired’ $115 billion of these things (i.e., Option-ARMs) when it bought Wachovia,” blogger Karl Denninger observes. “[Wells] claims they’re worth $93 billion. Oh really? A bunch of loans that were mostly at or near 100% loan-to-value (that is, near zero equity) when originally written, in markets where prices have declined by half? Oh, and in May, [Wells] said 51% of the balances out [on these loans] were being paid only on the minimum due. That is, [these loans] were still negatively amortizing even as house prices fell! Talk about double-screwed!”

In other words, the housing-bust-cum-credit-crisis might not be over just yet. Meanwhile, the commercial-real-estate-bust-cum-credit-crisis is just getting started. Dan Amoss, the mind behind the Strategic Short Alert provides the details below…

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Sell REITs
By Dan Amoss

Like bank stocks one year ago, REITs look cheap on paper…but very expensive on pavement.

Out in the real world of plummeting demand for commercial space and constricting access to credit, commercial real estate is facing a very tough time. And that means the seemingly inexpensive shares of many REITs are not cheap at all.

REITs are still in the early stages of a huge deleveraging cycle that will last for years, which means that the REITs that concentrate on commercial real estate may be a deceptively dangerous asset class.

Our story begins with the massive credit bubble – and related housing bubble – of the last several years. These twin bubbles powered a dramatic rise in consumer spending. Some significant portion of commercial real estate sprouted up to serve and satisfy this artificial demand. From the top to bottom of the U.S. economy, easy access to credit during the last several years powered excess consumption – and a frenzy of knock-on commercial ventures.

Accordingly, shopping boutiques popped up everywhere, along with restaurants, real estate offices, home-furnishing stores, art galleries, etc. All of these enterprises unwittingly relied on credit-fueled demand, and believed that this demand was “normal.”

But now that credit has disappeared from the U.S. economy, thousands of businesses are discovering that they cannot survive the new normal – the one that relies on actual paychecks and savings, NOT credit. And so, one by one, business doors are closing and the empty commercial spaces are piling up.

“The severity of the recession is turning some malls that were once viewed as viable into potential casualties,” the Wall Street Journal recently observed. “‘Any mall that’s sitting on life support is probably going to get its plug pulled as the economy stalls,’ says Michael Glimcher, chairman and CEO of Glimcher Realty Trust, which owns 23 U.S. properties, including Eastland Mall in Charlotte.”

The distress in the commercial real estate market would be serious, even if credit were still flowing freely. But credit is contracting, which means that commercial real estate is in especially dire circumstances. Refinancing commercial properties has become an extremely difficult task. Without the ability to refinance – or to sell at a profitable level – properties will continue to stumble into foreclosure and liquidation, which will put continuous pressure on property values.

Owners of underwater properties will have to either default and hand the title over to the lender, or they’ll have to inject an impractically large amount of new equity into the property to qualify for refinancing. And in these cases, we are talking about face-to-face negotiations between borrowers and lenders. In the modern “securitized” economy, face-to-face negotiations have become as rare and quaint a concept as the corner malt shop. In the modern economy, most mortgages are sliced and diced into unrecognizable portions of various mortgage-backed securities (MBS).

Think of securitization this way: Image your pet pig ran away from home and stumbled into a sausage factory. If you searched for your pig at the end of the sausage production line, you probably couldn’t find him. He’d be there alright, but not in a form you would recognize. He is there; but he is now everywhere. So is your mortgage.

Securitization is, therefore, a very toxic aspect of this particular commercial real estate bust. Simply stated, securitized mortgage structures are not designed to function in our current environment — one with falling collateral values and soaring defaults. Let me highlight the loan restructuring challenge ahead for troubled commercial property owners and their lenders.

Take just one example of evaporating equity in commercial properties. It shows why stressed property owners cannot easily renegotiate terms with their lenders. A few weeks ago, Sunstone Hotel Investors Inc. defaulted on its mortgage on W San Diego hotel. Sunstone bought the W for $96 million in 2006. The transaction was financed by a $65 million mortgage that was sliced, diced, and sold into the commercial mortgage-backed security (CMBS) market. The W’s value is now below the face amount of the mortgage, so Sunstone will likely write its equity down to zero and turn the deed for the W (i.e., the mortgage collateral) over to creditors in order to eliminate its mortgage obligation.

Sunstone defaulted when it skipped its June 1 payment on the W hotel’s mortgage. Thus, Sunstone basically invited its servicer, Centerline Servicing, to foreclose on the hotel. Centerline represents the interests of the lenders, who are spread throughout the ownership structure of CMBS. Without the chance to renegotiate, the only real option is for lenders to foreclose and auction off collateral. Even worse, if Centerline were to approach the lenders about restructuring the mortgage, the lenders would have different objectives — some would want to liquidate collateral to get paid, while others would prefer to renegotiate and hope for a rebound in collateral value. This is known in the securitization business as “tranche warfare.”

From a legal standpoint, borrowers are too far away from ultimate lenders. The complex legal structure of CMBS practically guarantees that sensible loan restructurings, including debt-for-equity swaps, are very difficult.

Now apply this situation to hundreds of other properties around the U.S., and you can see how securitization (CMBS) practically eliminates the potential for property owners to meet with their creditors and renegotiate. Private sector creditors who want to participate in fire sales and in very attractive loans are waiting for property to fall to more reasonable levels first. Banks are not going to refinance commercial mortgages coming due on properties that are down 50% from peak values, and no equity is left. This means that the foreclosure market will dominate the overall market, pushing values for every comparable property down even more.

There will not be any legitimate bottom in the REIT market until there is a bottom in the prices of commercial real estate mortgages. The smart institutional money will initiate its investment in real estate by buying the distressed mortgages of attractive properties, NOT by buying REIT shares. These investors will want to buy claims on commercial property market that are high up in the capital structure, not gamble on equity in properties, which may be worth a fraction of peak values — or zero. That’s why I’m monitoring transactions in the commercial real estate debt markets, looking for signs of a true bottom.

The “bottom” we saw in early March was almost entirely due to the Fed’s extraordinary commitment to print money in an attempt to prop up old bubbles. This caused a temporary rally in CMBS and REITs. The most stressed REITs used this as an opportunity to de-lever their balance sheets just a smidge by flooding the market with new shares. With the window for REIT secondary offerings closing, by fall we should see another leg down in the Dow Jones U.S. Real Estate Index.

The real buyers for CMBS and commercial property are professional investors – not the Fed or taxpayers. By and large, these professionals are waiting for bargains, with bids far below the current market.

So should you.

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[Rude Endnote: Markets across Europe and Asia seemed to be squeezing the last bit of juice out of Wall Street’s fading rally overnight.

Here in Asia Hong Kong’s Hang Seng managed to stack on another 2.1% by today’s close after earlier in the week falling to a near two-month low. The Aussies too rallied 1.5%. Japan’s Nikkei 225, however, remained relatively unchanged on the day.

Last we checked Europe’s major measures were all up around the 1% mark with Germany’s DAX leading the way with around 1.2% gains for the session. France’s CAC and London’s FTSE were higher by around 0.9 and 0.8% respectively.

Over in the commodity pits, crude jumped a buck overnight to reclaim the $60 per barrel threshold. Gold, marching higher in recent days, added another couple of dollars and was sitting around $927 per ounce last we looked.

We’ll be back with more Rude views tomorrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com