ZAIO Chief Speaks - History Lesson is Relevant

RESOLVING THE SUB PRIME DILEMMA
Applying lessons from the S&L crisis will restore stability and market confidence

By Thomas Inserra, MAI, SRA, CEO, Zaio Inc.

History is repeating itself.
The conditions surrounding the current sub prime mortgage crisis and the 1980-95 savings and loan crisis are eerily similar: An oversupply of property for sale. A sharp drop in new home construction and mortgage lending volumes. Huge loan losses. Heightened foreclosure rates. Lenders going out of business. Turmoil in security markets, with global implications. Action from the Fed to stimulate the economy. Congressional hearings to assign blame and write new regulations.

During the S&L crisis, federally insured financial institutions with combined assets of $924 billion failed over a 15-year period. Like today’s sub prime mortgage problem, the root cause was a breakdown in credit and appraisal processes. To address the S&L issue, a government-funded corporation called the Resolution Trust Corp. (RTC) was created in 1989. The RTC managed 747 financial institutions with $402.6 billion in assets, making it one of the largest corporations in the world.

The RTC succeeded in resolving the S&L dilemma by revamping credit and appraisal processes, improving investor access to appraisal data, and revaluing mortgage assets to reflect current market values. Over time, restored confidence in credit and appraisal processes led to improved marketability and liquidity of mortgage assets.
Ironically, in 1994, at a time when the S&L crisis was still underway, lenders successfully lobbied for new regulatory loopholes, including an exemption from appraisal regulations for loans under $250,000. The $250,000 loophole, along with the failure to extend appraisal regulations to sub prime lenders, mortgage brokers and state-regulated institutions, sowed the seeds for the current sub prime crisis.

In some of the worst losses in the S&L breakdown, lenders bribed or coerced appraisers, partnerships flipped property back and forth to artificially increase value, and appraisers inflated values to help make more loans. It’s alarming to note that 90 percent of today’s appraisers have reported that lenders have attempted to influence their “independent” conclusions.

Lenders have also migrated away from appraisal reports. Some found that, instead of encouraging an appraiser to inflate values, they could avoid the appraiser altogether, and use less expensive broker price opinions (BPOs) from real estate agents or computer-generated AVMs (automated valuation models). The widespread use of BPOs and AVMs significantly increased sub prime loan losses, and represents yet another breakdown in the appraisal process.

Clearly, current issues will not be resolved until regulatory loopholes are closed and lenders take measures to improve credit and appraisal processes – essential steps in restoring market confidence, and preventing a future crisis.

Lenders and regulators need to re-engineer the appraisal process so that values cannot be manipulated, and so that pressure exerted by loan officers on appraisers is eliminated.
A very promising example of appraisal reform is a nationwide group of licensed appraisers who are beginning to draft reports in advance, prior to any transaction, and storing them in a secure database. Lenders are already benefiting from this approach, and are better able to meet the needs of borrowers because they can retrieve their pre-manufactured appraisals in seconds, instead of days or weeks.

Although regulatory loopholes have not yet been closed, many lenders have already strengthened their own credit and appraisal policies. Some have eliminated BPOs and AVMs, and reinstated mandatory appraisals on all mortgage loans. Lenders are also implementing new accounting regulations requiring assets to be based on current market value rather than historic costs. In addition, many lenders are now revaluing assets on a quarterly or even monthly basis. This improves transparency, while allowing lenders to react quickly to changing market conditions, establish appropriate loan loss reserves, and improve investor confidence.
Eventually, this mortgage dilemma, like the last one, will pass, and it will be resolved in the same manner: by restoring proven credit and appraisal procedures, by revaluating all mortgage assets to reflect realistic, current market values, and by restoring confidence.

Investors – then and now – demand proof of underlying market value before they will act. And it’s the investors, lenders and portfolio owners who have learned the lessons of the past who will lead the market recovery.

How the Residential Subprime Meltdown is Effecting the Commercial Market

State of CRE Financing Part I: Beyond What Was Expected CoStar.com

Written by Mark Heschmeyer

Residential Depression -- Not CRE Market Conditions -- Is the Main Force Constraining "Commercial Real Estate Lending"

"Beyond what we expected." That was how U.S. banks portrayed the first quarter in regards to their real estate lending - and they weren't being positive.

The amount of residential asset writedowns, the amount of reserves they have needed to set aside and the spillover of residential downturn into commercial real estate are going beyond what they expected just late last year.

For clarification purposes, the vast majority of banks treat residential construction loans as commercial real estate lending because that is how such loans are categorized by federal banking regulators. What's clear is that the vast majority of writedowns, reappraisals and delinquencies in the asset portfolios of U.S. banks are tied to residential construction. And without exception, the outlook for that segment of their business is still dismal.

While the owner- and non-owner-occupied commercial building loans segment of their portfolios remain stable, the chain reaction effect from the housing market collapse is beginning to show signs of creeping into these assets, according to banks' first-quarter results.

And, partly because of all the intermingled nature of loans and different real estate types, the outlook for lenders, the U.S. economy and commercial real estate is - in bankers' words - hard to predict, but is clearly going to be less robust for the time being.

John Allison, chairman and CEO of BB&T Corp. in Baltimore, MD, summed it up residential and commercial markets best in his quarterly conference call: "We expect real estate markets to remain slow and for prices to continue to fall, maybe another 5% to 10%, but it will vary a lot by market. We do think real estate will bottom this fall and be recovering in spring of 2009. Real estate price cycles typically run three years and in the spring of 2009, it will be three years."

"I think we're two-thirds [of the way through] recognizing the non-performers and maybe two-thirds, or probably more like a half, [the way through] recognizing the losses because we really didn't turn into losses until the fall. If you look at prices, [they] peaked two years ago in the spring of 2006, but because we've been on such a long run, it was really [the last part of] 2007 before we started really turning into losses. This is just a wild guess, I'm guessing we're probably halfway through the loss process as an industry."

(Editor's Note: This is the first of a two-part story examining the state of commercial real estate finance. CoStar Advisor has reviewed the first quarter results of more than 75 bank and bank holding companies, read through more than a 300,000 words in earnings call transcripts (the equivalent of more than 225 CoStar Advisor news stories) and culled through several federal regulatory surveys and banking reports. Part I looks at the current state of commercial real estate markets from the lenders' viewpoint. Part II of the story to be published next week looks at how lenders are and will be responding to market conditions and their outlooks for the coming year.)

It All Starts with Housing

To understand current commercial real estate market conditions, the housing market deflation cannot be ignored. It all started with the unexpected rapid implosion of the subprime mortgage market in February of last year. That was the event that wiped out an entire support base on which housing sales were based: the first-time and low-income homebuyer.

When that support cracked, so did a second column of support: the speculative investor that hoped to flip a property in a year or two. Then the whole housing market came tumbling down.

It triggered an immediate drop in value of hundreds of billions of dollars of mortgage-backed securities, which triggered the substantial write-off in values of assets at financial houses, closed the spigot on the issuance of new mortgage-backed securities and eventually shut down additional real estate lending. It was the proverbial house of cards collapse.

The chain reaction effect is important to understand because it explains in a lot of ways why banks, lenders and Wall Street have so far seemed to be caught off guard.

"The real problem today is what's happening 'around' our loans not so much what's happening 'with' our loans," said George L. Engelke, Jr., chairman and CEO of Astoria Financial Corp.

If you've got a community that's got 50 houses for sale and they are all in foreclosures or financial trouble, Engelke noted, "People can't get a transaction done."

No matter how well banks monitored the individual loans in their portfolio or the performance of their customers, it was not enough to see how they would be impacted from the chain reaction. Likewise, no matter how good customers' credit condition looks on paper, it is still hard to get a loan.

Because of that, it is not unusual now to see banks writing down the value of loans that they normally would not have and not making loans that normally would have. Bryan Jordan, CFO of First Horizon National Corp. gave this account of one loan that was current and in good standing.

"We observed the draw inactivity on construction projects in California City [in Kern County east of Bakersfield, CA]," Jordan said. "Our investigation identified that the local city had placed a stock order on construction by this customer due to past due real estate pattern and additional lengths placed on the property. Although the loan remained current due to interest reserves, the credit was classified substandard in a new appraisal order. Following receipt and review of the appraisal, the loan was charged down to the estimated current realizable value."

"Given the deteriorating market condition," Jordan said, "we continue to be proactive in identifying problem loans and in writing them down to realizable value, which includes disposition costs and adjustments for market declines since the last appraisal."

According to bankers, appraisers are also becoming more aggressive in writing down the value of real estate assets.

"What happened is that we are going through a very challenging time that when you have major developers like KB Homes and all of the big ones who are suddenly walking away from big developments in this kind of environment, appraisers are turning to extremely, extremely pessimistic views," said Dominic Ng, chairman, president and CEO of East West Bancorp.

Trickle Down into CRE

John D. Schwab, executive vice president and chief credit officer of Citizens Republic Bancorp Inc. said his bank saw 36 commercial real estate loans slip into the non-performing category.

"About half of them were what I’m going to call much smaller income producing properties where these are retail strips where there is vacancies where the cash flows are no longer supporting the currency of loans," Schwab said. "The chunkier ones happen to be, as I mentioned, both land development and income producing."

Harris H. Simmons, chairman, president and CEO of Zions Bancorporation, said his staff is seeing anecdotal evidence of a little bit of commercial deterioration in trades and businesses that are related to that market, for example, firms such as plumbers, electricians and so forth.

John Allison of BB&T said his banks are seeing the housing impact trickle into a host of other commercial businesses. "I think the impact in the automobiles business is pretty dramatic," Allison said. "I think the fact that people have less comfort in the equity in their homes, [and that lack of] security makes them less willing to do bigger purchases. It's impacting the furniture business pretty significantly. Obviously people buy furniture when they buy new homes and that's a deferrable purchase and so you have furniture retailers struggling."

Nonetheless, bankers are still generally comfortable with most aspects of their office, industrial and retail real estate portfolios and clients.

Whether you could translate auto dealer and furniture retailers' problems into shopping centers problems is an unknown, Allison said.

"I am in the process and every spring I get to visit all 33 of our community banks and I am having the opportunity to talk to lots of our small business, middle-sized business clients," he said. "And the story if you are in the residential construction development business is that you aren't having any fun."

That pessimism hasn't hit the commercial market yet, Allison added.

"If you are in the commercial end of the market, most everybody says things are fine, although they may not be fine going forward. I am not getting anybody on the commercial side that's not pretty optimistic," he said.

"One thing is that in the early '90s a lot of the downturn was commercial, not residential, because you had so much excess buildings," Allison said. "And this time around, you probably have some excess buildings, but it's nothing like the early '90s, where you had so much excess lot development in retrospect on the residential side. I think that's why you are having a much more serious correction on the residential versus commercial."

Gregory Smith, CFO and senior vice president of Marshall & Ilsley Corp., said, "fundamentals in the apartment, medical office, and warehousing segments are positive. Fundamentals in hospitality are currently good, however, we anticipate softening reflecting the economy in general and high gas prices. Retail and office demonstrates softening."

Dominic Ng of East West Bancorp, said the occupancy rates of shopping centers, hotels, industrial warehouses and office buildings in his Inland Empire market in Southern California are still holding up.

"Despite all of the concern about recession and so forth, we have not seen any kind of increase in vacancy rate in any substantial manner," Ng said. "There's a huge relief because interest rates have come down so much due to the Fed fund reduction. Now our customers used to pay about 7.5%, 8% to us and now they're paying, about 5.5%, 6% and they may be even lower but the rents are not dropping, so they're picking up even more cash flow."

On top of that, Ng said, unlike in the residential sector in which there is a huge glut of inventory, there is very little supply of commercial properties.

Fed Rate Cuts Have Produced Mixed Results

Not all banks agree that the rate cut has been a good thing or a stimulus. The escalating drop in interest rates over the winter occurred faster than the banks' could reprice their deposits. That prompted drops in net interest incomes for many banks.

Charles T. Canaday, Jr., president and CEO of MidCarolina Financial Corp., said, "The dramatic and rapid decreases in short-term interest rates during the first quarter, caused by the Federal Reserve's initiatives to stimulate our nation's economy which has been hampered by real estate related concerns, have negatively impacted our interest margin."

Hugh Potts, Jr., chairman and CEO First M&F Corp. also said, "First-quarter results are below last year's results and early expectations. The primary influence was the effect on the net interest margin brought about by the actions of the Federal Reserve in January and March to lower short-term rates," said. Potts added, "The Fed actions precipitated cuts in prime, which had an immediate negative impact on the margin. While we expect to recover margin as the year unfolds, its effect is evident."

That problem was particularly hard on banks that do a lot of commercial lending, said Ted Thomas Cecala, chairman and CEO of Wilmington Trust Corp. "Because we originate a larger number of commercial loans than any other type of loan, we tend to be access sensitive," Cecala said. "This means that when interest rates move, yields on our loan portfolio will adjust faster than our costs of deposits and national market funding. When the Fed moves interest rates, the effect on our floating rate assets is seen very quickly."

The Banker's Eye View of the Country

The Federal Reserve's latest monthly Beige Book lender survey issued in the past week concurs with what CoStar Advisor found in banks' first-quarter reports and comments.

Housing markets and home construction remained sluggish throughout most of the nation, but neither were there signs of any quickening in the pace of deterioration. New residential construction was reported to have remained at depressed levels, and none of the Federal Reserve districts reported any pickup since March.

Declines or downward pressures in residential selling prices were specifically reported in the Boston, New York, Philadelphia, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, and San Francisco regions.

In particular, New York and San Francisco noted some incipient price declines in areas that had previously shown resilience - respectively, New York City and the Pacific Northwest, as well as Utah.

On the other hand, the Cleveland region noted some stabilization in home prices.

Commercial real estate markets were generally reported to be steady or softening in most areas. Weaker conditions in the rental market were reported in eight regions: New York, Philadelphia, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, and San Francisco.

On the other hand, the leasing markets were said to be steady in the Boston, Kansas City and Dallas areas.

Reports on commercial development were mixed with activity having weakened in the Philadelphia, Atlanta, and San Francisco regions, but having increased in the Cleveland, Chicago, and Kansas City Districts. St. Louis characterized commercial construction as strong.

Sales of commercial properties were generally indicated to be sluggish, while prices were said to be under downward pressure. The Boston, Philadelphia, Minneapolis, Kansas City, Dallas, and San Francisco regions all reported weakness in commercial real estate sales and prices.

Banks reported mixed trends in lending activity, with fairly widespread slowing in the consumer segment but some stabilization, at low levels, in residential mortgage activity.

Overall lending activity was reported to have increased in the Philadelphia, Richmond and St. Louis regions, but to have declined in the New York, Chicago, Kansas City and San Francisco regions.

The Dallas region described lending activity as steady but soft.

Lending activity for new home mortgages, though generally characterized as sluggish, was reported to have stabilized in the New York, Cleveland, Chicago, and San Francisco areas.

Consumer loan demand, however, weakened in a number of areas: New York, Atlanta, Chicago and Kansas City. Credit quality was reported to have deteriorated, on balance, since March. Increased delinquency rates were noted by New York, Philadelphia, and Cleveland, while Kansas City reported that loan quality remained lower than a year ago.

Widespread tightening in credit standards was reported, especially on residential and commercial real estate loans. In general, banks were reported to be tightening credit standards in the New York, Cleveland, Atlanta, Chicago, Kansas City, Dallas and San Francisco regions.

In addition, Boston noted that standards remain tight on commercial mortgages, while Philadelphia indicated that banks are limiting lending in this category. Richmond indicated tighter standards on residential mortgages.

Pop the Champaigne and Savor This

The Housing Crisis Is Over
The Wall Street Journal

By CYRIL MOULLE-BERTEAUX
May 6, 2008; Page A23

The dire headlines coming fast and furious in the financial and popular press suggest that the housing crisis is intensifying. Yet it is very likely that April 2008 will mark the bottom of the U.S. housing market. Yes, the housing market is bottoming right now.
How can this be? For starters, a bottom does not mean that prices are about to return to the heady days of 2005. That probably won't happen for another 15 years. It just means that the trend is no longer getting worse, which is the critical factor.
Most people forget that the current housing bust is nearly three years old. Home sales peaked in July 2005. New home sales are down a staggering 63% from peak levels of 1.4 million. Housing starts have fallen more than 50% and, adjusted for population growth, are back to the trough levels of 1982.
Furthermore, residential construction is close to 15-year lows at 3.8% of GDP; by the fourth quarter of this year, it will probably hit the lowest level ever. So what's going to stop the housing decline? Very simply, the same thing that caused the bust: affordability.
The boom made housing unaffordable for many American families, especially first-time home buyers. During the 1990s and early 2000s, it took 19% of average monthly income to service a conforming mortgage on the average home purchased. By 2005 and 2006, it was absorbing 25% of monthly income. For first time buyers, it went from 29% of income to 37%. That just proved to be too much.
Prices got so high that people who intended to actually live in the houses they purchased (as opposed to speculators) stopped buying. This caused the bubble to burst.
Since then, house prices have fallen 10%-15%, while incomes have kept growing (albeit more slowly recently) and mortgage rates have come down 70 basis points from their highs. As a result, it now takes 19% of monthly income for the average home buyer, and 31% of monthly income for the first-time home buyer, to purchase a house. In other words, homes on average are back to being as affordable as during the best of times in the 1990s. Numerous households that had been priced out of the market can now afford to get in.
The next question is: Even if home sales pick up, how can home prices stop falling with so many houses vacant and unsold? The flip but true answer: because they always do.
In the past five major housing market corrections (and there were some big ones, such as in the early 1980s when home sales also fell by 50%-60% and prices fell 12%-15% in real terms), every time home sales bottomed, the pace of house-price declines halved within one or two months.
The explanation is that by the time home sales stop declining, inventories of unsold homes have usually already started falling in absolute terms and begin to peak out in "months of supply" terms. That's the case right now: New home inventories peaked at 598,000 homes in July 2006, and stand at 482,000 homes as of the end of March. This inventory is equivalent to 11 months of supply, a 25-year high – but it is similar to 1974, 1982 and 1991 levels, which saw a subsequent slowing in home-price declines within the next six months.
Inventories are declining because construction activity has been falling for such a long time that home completions are now just about undershooting new home sales. In a few months, completions of new homes for sale could be undershooting new home sales by 50,000-100,000 annually.
Inventories will drop even faster to 400,000 – or seven months of supply – by the end of 2008. This shift in inventories will have a significant impact on prices, although house prices won't stop falling entirely until inventories reach five months of supply sometime in 2009. A five-month supply has historically signaled tightness in the housing market.
Many pundits claim that house prices need to fall another 30% to bring them back in line with where they've been historically. This is usually based on an analysis of house prices adjusted for inflation: Real house prices are 30% above their 40-year, inflation-adjusted average, so they must fall 30%. This simplistic analysis is appealing on the surface, but is flawed for a variety of reasons.
Most importantly, it neglects the fact that a great majority of Americans buy their houses with mortgages. And if one buys a house with a mortgage, the most important factor in deciding what to pay for the house is how much of one's income is required to be able to make the mortgage payments on the house. Today the rate on a 30-year, fixed-rate mortgage is 5.7%. Back in 1981, the rate hit 18.5%. Comparing today's house prices to the 1970s or 1980s, when mortgage rates were stratospheric, is misguided and misleading.
This is all good news for the broader economy. The housing bust has been subtracting a full percentage point from GDP for almost two years now, which is very large for a sector that represents less than 5% of economic activity.
When the rate of house-price declines halves, there will be a wholesale shift in markets' perceptions. All of a sudden, the expected value of the collateral (i.e. houses) for much of the lending that went on for the past decade will change. Right now, when valuing the collateral, market participants including banks are extrapolating the current pace of house price declines for another two to three years; this has a significant impact on the amount of delinquencies, foreclosures and credit losses that lenders are expected to face.
More home sales and smaller price declines means fewer homeowners will be underwater on their mortgages. They will thus have less incentive to walk away and opt for foreclosure.
A milder house-price decline scenario could lead to increases in the market value of a lot of the securitized mortgages that have been responsible for $300 billion of write-downs in the past year. Even if write-backs do not occur, stabilizing collateral values will have a huge impact on the markets' perception of risk related to housing, the financial system, and the economy.
We are of course experiencing a serious housing bust, with serious economic consequences that are still unfolding. The odds are that the reverberations will lead to subtrend growth for a couple of years. Nonetheless, housing led us into this credit crisis and this recession. It is likely to lead us out. And that process is underway, right now.

Mr. Moulle-Berteaux is managing partner of Traxis Partners LP, a hedge fund firm based in New York.