Borrowers and Lenders Need To Get Real to Heal

The FDIC recently announced that it will auction off about $1 billion in residential and commercial real estate. Sadly, the reaction was predictable. Among the banks and borrowers the refrain was all too common: “We can’t sell those assets. If we do, we’ll take a loss.” Another familiar line: “If they sell those assets the banks will be weaker than before the sale.”

These views came not only from the holders of the loans and properties, but third-party analysts. Even the press lost its objectivity. One reporter’s headline even questioned if the FDIC thinks, “Does FDIC Think About The Impact It’s Having On Commercial Real Estate…” This is the same extend-and-pretend crowd that created the commercial real estate mess and whose policy prescriptions continue to keep us from starting the healing process.

The banks are going to take losses whether it is today or tomorrow. Waiting any longer isn’t going to make the situation better. To the contrary, it will only make the situation worse.

Industry faces headwinds

As the number of loans that need to be refinanced continues to rise each year, the supply/demand imbalance between the capital available and the capital needed will only worsen.

Waiting to take losses will result in even more defaults and foreclosures as properties exhaust interest reserves and can no longer extend loans.

Whether the economy continues its modest improvement, or remains stagnant, delaying write-downs will make the situation worse. If the current stimulus-driven economy becomes sustainable, the Federal Reserve will become concerned about inflation and act accordingly.

An improving economy will hasten the inevitable inflationary effects of the money supply and deficits that were necessary to forestall a depression. Collectively these factors will lead to rising interest rates and put additional pressure on already precarious floating-rate loans and the very banks that are protesting the FDIC sales.

Alternately, if the current economic activity turns out to be unsustainable, many properties living off of leases signed three to five years ago will be up for renewal in a significantly weaker economy, driving rates, occupancy, cash flows, and property values down further.

Don’t blame the FDIC

The FDIC is trying to clean up a mess that occurred when banks originated loans on properties that should have never been built or acquired at exorbitant, speculative pricing. The losses were exacerbated when banks increased their real estate loan concentration levels.

For example, by Sept. 30, 2008 approximately 96% of Silverton Bank’s loan portfolio consisted of loans secured by real estate. The FDIC didn’t do that, Silverton did. The banks alone created the problems they have today.

Borrowers need to shoulder some of the blame as well. They weren’t forced to accept mortgages with extremely high loan-to-values (LTV), based on ridiculously high values. Just as blaming the FDIC is incorrect, believing that liquidity will drive pricing is incorrect.

At this point in the cycle liquidity doesn’t drive pricing — pricing drives liquidity. The residential real estate market is proof. Liquidity increased when prices dropped sufficiently to stimulate residential sales volume. This has yet to happen in commercial real estate.

The extend-and-pretend crowd believes if we just wait for CMBS to get going and then auction off the FDIC assets, it will cut the losses. Unfortunately, the amount of new CMBS issuance will be a pittance compared with the $230 billion of domestic issuance in 2007 that helped inflate prices.

The CMBS loans made this year will be for properties that are cash flowing. Currently, many of the FDIC assets aren’t cash flowing. And the FDIC loans will have far higher LTVs and be based on far higher property values than what any new CMBS loan. So no, CMBS won’t make the banks’ mistakes go away.

We are at a crossroads. In order to create the liquidity necessary for recovery in commercial real estate, banks need to aggressively market and price their underwater assets. Let’s get real to heal.

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