The Idaho Group Blog

Economic Double Bubble, Toil and Trouble

By Chris Volk, Guest Writer, 11-03-09

With slow but steady improvement in the economy’s vital signs, two questions are gnawing at analysts’ brain pans.  First, is this a sustainable recovery with the power to fuel substantial job growth?  Second, what will happen when the “double bubble” ruptures and some $1.7 trillion in commercial real estate notes come due over the next few years?

Most economic prognosticators portend a sluggish recovery with continued job losses throughout 2010.  New job growth will be slow, they say.  Too many businesses are changing fast or forever gone, like GM’s Saturn Division.  We can’t expect the same jobs to reappear and be filled by the same folks who were laid off.  Plus, globalization and the Internet have changed the game.  Look for new jobs to develop in health care, education, government and within new or fast-changing industries.

As for the double bubble effect, commercial real estate values are down about 35 percent since the peak in 2007, according to Moody’s.  Unlike residential mortgages, commercial loans are much shorter term—usually five to 10 years.  The first $300 billion in commercial-backed securities will come due in 2010.  Obviously, many businesses are on their knees due to the slowdown.  So there is a shortage of cash to payoff real estate loans, especially where property values have fallen far below contract values, which would cause buyers to bring even more cash to the closing table to accomplish a refinancing.  Meantime, lenders have locked down their underwriting guidelines and all but stopped making commercial loans, despite claims that they are open for business.

Lots of commercial real estate loans were made by smaller local and regional banks with total assets under $1 billion.  FDIC research reveals that there are about 6,500 banks of this size, representing 90 percent of all banks in the US.  Plus, some 74 percent of ALL loans held by local banks are secured by commercial real estate.

When these banks absorb commercial loan losses, there is less money available for home mortgages, car loans and credit cards.  Small businesses have an even harder time getting credit for business purchases.  The result is a negative, downward spiral.  Analysts predict many more small-fry banks will fail and be absorbed by bigger banking fish.

So far this year, 106 banks have failed.  The last time 100 banks failed in one year was during the 1992 savings-and-loan crisis when regulators shuttered 172 institutions.  CreditSights, a leading independent credit research provider with offices in New York and London, predicts that 1,100 banks will succumb to the one-two combination punches of residential then commercial loan losses.  They say that 13.4 percent of all US banks will stumble and fall, placing 7 percent of all US banking assets at risk.

The FDIC insures bank deposits up to $250,000.  The collapse of more than 120 banks over the past two years has depleted the agency’s deposit insurance fund, according to an Oct. 23 article from Bloomberg.com.

Quoting Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine, the Bloomberg article states:

The number of bank closings would likely be higher this year if the FDIC’s fund wasn’t depleted and if the agency had more bank examiners.  The agency shrank under President George W. Bush before adding employees in the Obama administration. The FDIC has about 6,000 employees now, compared with 21,000 during the savings-and-loan crisis in 1991.

“We certainly know there are hundreds and hundreds of zombie banks out there,” Cassidy said. “The only alternative for them is to be seized and it’s only a matter of manpower and money before they get to it.”

So both foreclosures and bank failures are likely to accelerate as the FDIC funds are replenished.  But it will take years for troubled loans and properties to work though the system.

Fortunately, the total volume of commercial debt represents less than 10 percent of the US residential debt.  Therefore, some analysts, like Jeffery Lacker, president of the Federal Reserve Bank of Richmond, are not predicting catastrophic failure.

“The magnitude of the deterioration seems consistent with past recessions,” Lacker stated recently as quoted in the Oct. 21st edition of VirginiaBusiness.com.  “It looks like a manageable problem,” he added.

Here in Idaho, the small banks aren’t talking much about their double bubble troubles.  That’s not a good sign.  Most are quietly trying to find buyers for land, stalled development projects and other commercial properties.  Sometimes these are so-called REO—or Real Estate Owned—properties actually owned by the banks after buyers default.  Others are properties that are “circling the drain” as lenders anticipate defaults and attempt to sell their loans prior to formal foreclosure proceedings.

Inside our local banks, “special assets” teams are bracing for more fallout from the hissing commercial bubble.  The underlying problem relates to the way federal regulators monitor the health of banks.  Too much bank-owned real estate is a red flag.  So are falling property values, which would be viewed as losses, essentially red ink on balance sheets.

The banks are in a bind: they really don’t want to get deeper into the real estate business, but they don’t want to write off bad loans and take the losses.  So many are choosing to “extend and pretend.” They are working with borrowers to relax deadlines and reduce short-term payments in hopes of a long-term recovery.

“After all, a rolling loan gathers no loss,” said a prominent Atlanta-based real estate attorney recently.

It is expected that Ben Bernanke and the Federal Reserve will come up with a new bailout program for commercial real estate.  The Fed will also continue to hold the safety net for depositors in small banks through the FDIC loan guarantee program.  In the meantime, the market will be turbulent as buyers and sellers come to terms, the market seeks equilibrium, and our nation strives to deliver real value in the form of products and services with substance, not just the promise of equity through ownership.

No doubt there will be some incredible deals to be had by some, all at the expense of tough lessons learned by others from the school of hard knocks.  This capitalism is an imperfect system, but it beats most of the available alternatives.

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