Seven Notes, Primarily on the Financial Sector
1) I have been arguing for a while that commercial mortgages are an unresolved issue with most banks, who still hold their loans at par. Contrast that with the pricing on Commercial Mortgage Backed Securities [CMBS] or REIT stock prices, which show commercial real estate pricing in the dumps. Look at these articles: (one, two, three). How many commercial properties are inverted? Who knows, but when properties sell for significantly less than replacement costs, it is not a good scene.
Regarding CMBS, as the loss estimates ratchet up, the credit ratings ratchet down. Securities sold in 2005 and after will suffer, as well as marginal CMBS from earlier vintages.
2) Outside of conforming mortgages, losses in residential mortgages are considerable. Consider how S&P is raising its loss assumptions on alt-A loans. Or consider how being underwater, or close to underwater affects the willingness of people to default.
3) That last article helps point out a truth that is neglected. Defaults predominantly happen when borrowers are underwater, or nearly so. Changing the mortgage interest rate is cheaper in the short run, but does not cure the situation as well as reducing the principal (forgiving part of the loan). Why less loan forgiveness? Two reasons: Accounting would require a bigger short-term loss, and the government prefers subidizing a piece at a time, so it prefers smaller annual subsidies, rather than a once-and-for-all cure. They would rather pay over time, and overcommit future budgets, than pay the full freight now, even if it is cheaper in the long run to do so.
4) But many defaults are strategic. The owners know which side their bread is buttered on, and they default when their properties are too far underwater (one, two).
5) The states can’t print money like the Federal government can. Excluding California, of course, which has its new currency, the IOU. (We are still waiting for a secondary market to arise. Perhaps some enterprising bank will offer to buy IOUs at a discount. As it is, banks either honor in full or refuse to honor the IOUs.) The states represent the current troubles better than the Federal government does, because they must meet the challenge through expense cuts and tax increases, both of which are painful.
All that said, next year may be more painful, because of greater unemployment, and lower taxes from real property.
6) Beware junior debt. I know that at other times I have used trust preferred securities offensively to make money as the credit cycle turned in 2002, but that is a very hard game to play, and we aren’t there yet for this cycle.
7) I’ve had many people writing me for investment advice, and in the near term, I will try to write a piece that summarizes my views of what to do now. In broad, I lean toward reducing risk exposure, and sitting on high quality short term debt. For those that hedge, quality will be rewarded, and structure penalized over the next 6-12 months. And, avoid financials, aside from exchanges and insurers with clean assets.
July 7th, 20097:46 am at
Thanks as always for the comments, David. Regarding Point 5: CA is running a real-time experiment in the workings of Gresham’s Law. It should provide some fascinating data for a study a few years hence.
Another interesting development to observe would be the speed at which counterfeit IOU’s appear and develop, especially if the banks refuse to redeem them and a private market emerges.
CA at this point reminds me of a guy who gets into a bar fight thinking that the bouncers/bystanders are going to break it up before it gets too bad. . .
July 7th, 20095:50 pm at
How can you have a secondary market with this:
“California’s treasurer is telling recipients of the IOUs that if they sell them to third parties, they will be redeemed by the state treasurer’s office only if accompanied by a notarized bill of sale signed by their listed payee.”
July 8th, 200912:47 am at
You can’t have a secondary market then. Thanks for telling me about this; I hadn’t heard about it.
July 9th, 20097:27 pm at
It’s not just banks with commercial mortgage exposure carried on the books at par that we need to be concerned about. Insurance companies have large exposures to the commercial mortgage market, perhaps in larger numbers than the banks. How much exposure and to what extent are those mortgages underwater? Again, who knows, because they are certainly not being forthcoming about it to investors or regulators (at least in public filings).
July 9th, 200911:09 pm at
Insurance company underwriting standards on commercial mortgages have generally been higher than those of the banks, but yes, this is an issue. The insurance companies have greater transparency, though. Every loan is listed in their statutory annual statements, which are usually available to the public.