From a small northwestern observatory…

Finance and economics generally focused on real estate

Archive for December 2011

@ Renaissance Weekend

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Renaissance Weekend is an invitation-only, off-the-record, no photographs, no minutes taken, intellectual jam-fest held in Charleston, SC, each year.  (There are smaller “off-season” conclaves held around the country in Aspen, Monterrey, and Santa Monica.)  Lynnda and I have been terrifically honored to be invited here for several years.

Following the no-quote rule is tough.  As you can see from this article on Yahoo Finance (click here), the quantity and quality of high-end consultation is enormous.  Meeting (usually about an hour in length) go from 8am until midnight, and hit basically all of the cutting edge topics of today.  Everyone is expected to participate, speak, and lead group sessions.  I heard a terrifically well organized, thoughtful, and detailed discussion about the problems with school curriculum and testing from an 8th grader (it’s frightening how bright the progeny of type-A’s can be).  What’s more interesting, she was arguing with a senior attorney from the U.S. Department of Education…. and winning.

I’ve been asked to sit on three panels — one one each on real estate, corporate governance, and the issues surrounding LEED buildings.  Being able to not only organize my own thoughts, but also engage in high-level discussions about these and other topics with Nobel laureates, Fortune-500 CEO’s, top scholars from academia, and celebrities is terrifically invigorating experience.  It is really the way intellectual enclaves should be organized.  (By the way — there’s one panel made up of nothing but astronauts.)

Of course, it ends with the mother-of-all New Years parties.  Nothing like dancing with Dr. Ruth Westheimer when the champagne starts flowing!  Again, no pictures….. sigh.

Anyway, this is totally off the subject, but I had to put this down in words.  I’ll be back to talking about business, real estate, and the economy next week.  Happy New Year, everyone!

Written by johnkilpatrick

December 31, 2011 at 10:59 am

Posted in Economy

Tagged with ,

Economy set to improve?

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Neat article in CNN Money this morning titled “Economists a Bit More Optimistic”.  To read in its entirety, click here.

In short, economists are a bit surprised — pleasantly so, I might add — at economic results thus-far in the 4th quarter.  CNN’s survey of 20 economic forecasters finds a consensus sentiment of GDP growth at 3.3% this quarter, substantially higher than where it’s been thus-far in the past several quarters, and with perhaps some momentum to carry forward into 2012.

Now, 3.3% isn’t quite as good as we’d like to see — 4% would be even better.  However, as I’ve been noting for some months, GDP growth in the 2% – 3% range would barely be enough to keep us at status-quo, much less get job growth to the levels needed to cure unemployment problems.  Hence, if this survey and forecast are correct, it is indeed very good news for the holidays.

Written by johnkilpatrick

December 28, 2011 at 7:48 am

Posted in Economy, Finance, Uncategorized

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FDIC — Supervisory Insights

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The latest issue of the FDIC’s Supervisory Insights (Winter, 2011) just hit my desk.  (If you really have plenty of time to kill, you’re welcomed to download your own copy, for free, from here.)

The focus of this issue is on appraisal problems, particularly re-inventing the review appraisal supervision role.  This issue — which is ongoing — is a matter of considerable discussion and debate within the appraisal community.  I’ll leave that matter to other pundits, but with the caveat no solution on the drawing board today will make everyone happy.

It may be a bit more interesting to examine the underlying arguments within the FDIC, to gain some insight in to where that agency is “coming from”.  First, Table Four from the publication really sets the stage with the overarching problems facing the FDIC.

graphic courtesy FDIC

Notably, while the non-current loan ratio is slightly down from two years ago (although, terrifically higher than before the current crisis began), the dollar figure of “other real estate” (FDIC code for “real estate owned” or REO) hovers about 10 times as high as in 2006, with no end in sight.

So, the FDIC is challenged not only with fixing the CURRENT problem, but laying blame — so as to presumably prevent the NEXT crisis. Peeling back the layers of the onion, Table Three from that same report give significant insight into their perspective on the problem.

Courtesy FDIC

This data comes from LexisNexis, and the percentages do not total to 100% because many cases have multiple sources of problems. Nonetheless, since 2006, the trends for all categories have been flat or trending positively except for appraisal problems, which are now significantly higher than at the beginning of the crisis. One might argue that the increasing percentage of cases with appraisal problems is a manifestation of increased investigation in that realm, but that would be damning with faint praise, since it implies that oversight was lacking in the past.

Written by johnkilpatrick

December 27, 2011 at 11:14 am

Musings about the real estate market — part 2

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A few days ago, I kicked off this series with some comments about the asset side of the residential market.  Today, I’ll discuss the finance side of that market.  Later on (parts 3 and 4) I’ll talk about the asset and financial side of the commercial market.  Keep in mind that these markets are all very different, albeit intertwined.

A quick caveat — don’t use ANY of this to answer Econ 101 exam questions.  I’ve over simplified nearly all of this to make it readable.

If you watched the really excellent HBO movie, Too Big to Fail, you saw and heard the actors talk about huge losses in “real estate”.  While many of these players actually owned real estate assets (see my commentary about Archstone), the real thing that brought them down was their ownership of real estate derivatives.  Now, this may sound like I’m side tracking, but it’s very helpful to understand how we got here, if we’re going to understand how to fix it.

Imagine John and Jane America go to Main Street Bank (MSB) and borrow $100,000 to buy a house.  In the course of a year, Main Street Bank may make 100 of such loans, totaling $10,000,000.  In a typical pool of 100 loans, two of them will go bust, resulting in $200,000 in “paper” losses to MSB.  Now, before you start feeling sorry for the depositors and shareholders of MSB, it’s important to note three things:

1.  This was a fairly predictable set of losses.  Hence, every borrower paid a slight premium on their loan to “share the burden” of everyone else.

2.  The bank has the house as collateral.  While foreclosure sales rarely fully compensate the bank for the losses, they really do cut the pain down to a small headache, and then #1 above kicks in.

3.  Many mortgages have private mortgage insurance, etc., to compensate even further.

Hence, in a normal year, a small number of foreclosures is expected and manageable.  However, the period leading into this recession was anything but normal.  House prices peaked, and actually started tumbling downward, meaning that #2 wasn’t working very well.  The losses started bankrupting the PMI companies, thus making #3 ineffective.  Finally, foreclosure rates got up to huge levels. 

Still, you might say, these numbers should have been reasonably manageable, right?  Well, not so quick, partner.  Now we need to introduce two new concepts:  the mortgage backed security (MBS) and the default swap.  An MBS is a really strange, hybrid, derivative instrument.  Fully explaining it here is nearly impossible, but let’s take a stab.  Remember the $10m in mortgages?  (In actuality, we were usually dealing with pots of loans that were ten times that big.)  Let’s say the average yield on that pool was 6%.  Now, I’ll chop and dice that pool three ways.  First, I’ll sell $5 million of it to widows and orphans, and promise them AAA safety by giving them first crack at the principal and interest.  However, their yield will only be, say, 4%.  Next, I’ll sell some speculators the next $2.5 million of AA rated paper, and give them the NEXT crack at the payments but only a 5% return.  The last $2.5 million will get all the residual returns, which should work out to an 11% yield if nothing goes wrong (see numbers 1 – 3 above).  However, everything went wrong, and these last slices of the pie went down the tubes.

Now, if you’re Lehman Brothers, you take that last slice, and sell IT off  in slices to investors.  However, you promise THEM AAA security by entering into a credit default swap.  Essentially, you’re getting Bear Stearns to guarantee YOUR pools, and you guarantee theirs.  To find out how that worked in reality, go see the movie.

Unfortunately, so much of our investment banking establishment was hinged on these derivatives, and the underlying asset values went so far down, that the system totally broke down.  It’s very close to broken today, which is why getting low-down-payment loans is nearly impossible now-a-days (in effect, the default rate on 80% LTV loans is nearly zero, so that’s the only part of the system that’s working fairly well now). 

Fannie-Mae and Freddie Mac had Congressional mandates to buy tons of these mortgages.  While they were not in the MBS and credit default swap business, they were in the business of borrowing money to invest in loans.  A default rate of 6% or more might have been manageable if the values of the underlying assets hadn’t fallen by 20% – 40% in some parts of the country.  Note that 6% of several trillion dollars is a lot of money when the short-sale only recovers 60 to 80 cents on the dollar.  There is also a huge shadow inventory of properties (by some estimates, 5 million homes with a potential loan overhang of a trillion dollars) that haven’t yet even been foreclosed on but the loans are either non-performing or in serious arrears.

How do we fix it?  The system depends on a complex network of institutional trust coupled with complex insurance and hedges (essentially, a credit default swap was an insurance policy).  Most of that system is irreparably broken.  Following the Savings and Loan Crisis of the late 1980’s, the nature of residential mortgage lending was significantly changed in the U.S. and many other countries.  This situation is far, far more complex than that one, and probably calls for the same level of overhaul we saw in the Great Depression, when the very nature of home mortgages was completely stood on its head.  Unfortunately, we’ve wasted several good years with no settlement in sight.  My guess is that the rest of this decade will be wasted, at the pace we’re currently seeing.

Any good news?  I think so.  There are some great private sector minds who are currently realizing that the Federal Government is NOT going to step up to the plate with a solution like it did in the 1930’s.  Hopefully, the pace will pick up as the market starts realizing that it needs to find new financing instruments to satisfy the demand for housing and restore health to this sector of the economy.

 

Mort Zuckerman in U.S. News

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Great article on jobs by Mort Zuckerman in U.S. News last Friday.  To read it yourself on-line, go here.

I’m in general agreement with everything he says.  Indeed, two of his points (about education and a national infrastructure bank) are things I’ve spoken about, and were on Austan Goolsbee’s agenda at the White House before he headed back to the warmth and safety of U. Chicago.

Your cheat sheet, if you don’t want to read the whole article:

1.  Focus on education.  Zuckerman posits this as a longer-term solution to a dire problem.  While I’d agree with the “dire problem”, I would instead suggest that a real focus on education in America — and I mean the sort of focus that we put on the space program after Sputnik — would pay dividends in a lot of ways (juvenile delinquency, neighborhood quality, housing values) sooner than you think.  By the way, you real estate guys and gals reading this, there is significant research linking the quality of neighborhood schools to home values.

2.  Change our visa policy.  We educate tens of thousands of the best and brightest from other countries, only to send them home after they earn their degree (often advanced degrees in hard sciences and engineering).  These people CREATE jobs, rather than take them away.  We should reverse our policies, and keep them here if they want to stay.

3.  Rationalize our patent process — I hadn’t thought of this one, but he’s dead right.

4.  Eliminate programmatic uncertainty in governance.  (Probably the most complex of his topics, and it goes to the heart of beltway gridlock and the current polarization of politics.)

5.  A national infrastructure investment bank (which would put hundreds of thousands of skilled workers on the payroll immediately).

Zuckerman characterizes these as “sure-fire” ways to create jobs, and I tend to agree with him.

Written by johnkilpatrick

December 13, 2011 at 9:00 am

Posted in Economy

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Niall Ferguson in Newsweek

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Absolutely riveting piece in Newsweek this week by Harvard Prof. Niall Ferguson titled “The Feds Critics are Wrong:  We Need to Avert Depression.”  He notes the significant parallels between the current financial crisis and the Great Depression.

In short — and I encourage you to read his piece and not just this synopsis — we often mistakenly think of the Great Depression as starting with the U.S. stock market crash in 1929.  Ferguson points out that there were really two depressions, the one that started in 1929 and the subsequent banking crisis that began in 1931 when European banks began to go bust.  This moved back across the pond to the U.S., and eventually led to our “bank holiday” in 1933.  This second crisis probably had longer and stronger impacts than the first, and wasn’t really ended until the arms buildup preceding WW-II.

It was this spector that Ben Bernake (who was a Depression-era scholar in academia) had in mind when he catalyzed the bank rescues in 2008, and Ferguson makes it clear that we are no where near out of the woods yet.  Ferguson encourages leaders to read Friedman and Schartz’s Monetary History of the United States, which he calls the “single most important book about American financial history ever written.  They note that the panic of 1929 turned into a depression because of avoidable errors by the FED.  Fortunately, Bernake is well aware of this history and is loathe to repeat those mistakes.  However, his views aren’t fully accepted — or politically acceptable — by our European allies, who are unfortunately in the driver’s seat right now.

Tim Geitner is in Europe this week, with an array of meetings in preparation for Thursday’s big soiree in Brussels.  (See David Jolly’s great article in this morning’s New York Times — click here for the article.)  Some good news — a German bond offering this week met with great success in the market, after problems with a similar bond offering back in November.  Markets seem to feel that European leaders (read:  Merkel and Sarkozy) understand what they need to do and are willing to impose the necessary discipline.  Nonetheless, one cannot understate the importance of Thursday’s meeting.

Written by johnkilpatrick

December 7, 2011 at 9:36 am

And a bit more about Archstone

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Private Equity Real Estate reports this morning that the Estate of Lehman is challenging Equity Residential’s proposed acquisition of BofA’s 26.5% stake with protests to the Securities Exchange Commissions.

PERE reports that Lehman, which owns 47% of Archstone and serves as manager (the remainder is owned by Barclays) had filed a plan to emerge from Chapter 11 by paying $65 Billion to pay creditors, who hold about $450 Billion in claims.  Selling Archstone (they actually proposed an IPO) would have helped raise this sum (Lehman currently only has about $23 Billion), but Sam Zell’s move has left this idea hanging out to dry.

It’s going to be fun to watch.  We’ll keep you posted.

Written by johnkilpatrick

December 7, 2011 at 8:27 am