After being informed by several experts that oil has peaked on a global scale and thus us folks should begin conditioning ourselves for a rolling series of recessions that spike along faster and faster, we here at The Placemaking Institute endeavored to find what the next one may be. According to the Federal Reserve, “While the overall U.S. financial system is showing signs of stability, a rapidly rising tide of troubled loans for commercial real estate threatens the survival of hundreds of the nation’s small and medium-sized banks. Recent financial reports from federal regulators and industry analysts detail a new cycle of uncertainty that they fear could cripple the economic recovery. Billions of dollars in commercial debt will have to be paid back or refinanced at a time when property values have plummeted. About $500 billion will come due in 2010 alone and an equal amount every year through at least 2012.”
With that said, in its Commercial Real Estate: Exorcising the Shoe, UBS concludes that “The CRE market did not experience nearly the same increase in capacity over the past 20 years compared to the residential real estate market. While high unemployment continues to weigh on demand for commercial property, supply growth never materially outstripped demand…CRE-related credit losses are likely to remain high at regional and community banks, (but) a repeat of the 2008/09 severe credit crunch is highly unlikely…In terms of the direct economic impact, the drag from commercial construction on real GDP should moderate by mid-2010. However, we do not expect any positive growth contribution through 2011.”
During the dot-com boom and bust, Our Most Dismal Fellow was paid cash money by entities similar to UBS (such as Bloomberg and Thomson), who do and seek to do business with companies covered in their research reports. And subsequently he believes UBS’ analyses may very well indeed be too rosy because their analysts are thinking far too rationally while the Market behaves irrationally via, if you will, pagan consumerists. Money itself and thus Banks are backed by nothing but Faith. And when CRE loans begin defaulting mid-year at the rate the Federal Reserve expects, right about the time UBS predicts the Government will take off the economies “training wheels,” many small- to mid-sized community banks (which UBS thinks “are not systemically important”) will start going under. Folks, who have already lost much Faith, will panic and lose more Faith (a process that will be irrationally facilitated by Mass Media), forcing the Government to bail out those small- to mid-sized banks, sending our economy farther down that proverbial creek because it could be better invested elsewhere – Like by providing actual jobs. UBS is continuing to underweight this and the fact that (according to Leo Hindery, Jr.):
- At least 50 million people are ill-fed — up from 37 million just a year ago — including 17 million children. Hunger in America is now at an all-time high.
- 30% of the nation’s 50 million homeowners own a home whose value is below its mortgage balance, and this number could rise to an almost unbelievable 50% by year-end 2011. It would cost about $745 billion, more than the size of the original 2008 bank bailout, to restore these borrowers to the point where they were breaking even, which there is no obvious political will to find right now.
- Despite the truly dismal ‘real unemployment’ figures with which most everyone now agrees — a staggering 30 million workers and 19% of the labor force — almost no one is acknowledging the sad reality that even the nation’s 130 million full-time workers have had an average economic loss of 15% just since December 2007 — an average effective work week of 34 hours rather than 40 — which means that the number of unemployed workers, measured economically, is actually as high as 50 million.
- And 100 million people, fully one-third of the entire U.S. population, are at or below “200% of the federal poverty line of $21,834 for a family of four”, which is a needs-measure made lame by the fact that no family of four can actually comfortably live on such a low annual income.
But while we are amidst this socioeconomic situation as well as a job-less economic recovery, “The economy is improving!” UBS extols before going on to say that “the prospect for a strong CRE recovery is unlikely given the sector’s sensitivity to the labor market and our expectation for the unemployment rate to remain elevated (above 9.5%) through the end of 2011. We continue to underweight small-cap stocks and the REIT industry – two market segments that have significant CRE exposure and high relative valuations.” And Our Most Dismal Fellow won’t even mention how states and municipalities are increasingly laying-off teachers, police officers and firefighters because of budget crunches that have them verging upon Chapter 9! Which UBS assures us “will not develop” while some folks are predicting a reality wherein 911 calls will soon be outsourced to Bangalore!
Is the economy really improving? Or are we once again being soft-shoed about this country’s state of affairs as well as what’s looming just over the horizon? These are the predictions for 2010 that UBS is predicating their analyses upon; if any don’t hold true then of course their opinions are subsequently devalued:
So which of these do or don’t or will or won’t hold any water?
Choice excerpts from Commercial Real Estate – Exorcising the shoe
- We conclude that while CRE-related credit losses are likely to remain high at regional and community banks, a repeat of the 2008/09 severe credit crunch is highly unlikely. This is consistent with the view that we first outlined one year ago in February 2009. We discuss nine reasons why we believe that CRE is not the “next shoe to drop”.
- In terms of the direct economic impact, the drag from commercial construction on real GDP should moderate by mid-2010. However, we do not expect any positive growth contribution through 2011.
- The CRE market is much smaller than residential real estate. As Figure 1 illustrates, the residential mortgage market is over three times the size of the commercial and multi-family residential (condos, co-ops) markets combined. The sheer size of the loans outstanding means that the likelihood that losses would be so great that it would materially impact bank capital is small.
- Banks have stronger capital positions than before the residential mortgage meltdown and are more adequately provisioned for further CRE losses (Figures 2 and 4).
- However, the prospect for a strong CRE recovery is unlikely given the sector’s sensitivity to the labor market and our expectation for the unemployment rate to remain elevated (above 9.5%) through the end of 2011. We continue to underweight small-cap stocks and the REIT industry – two market segments that have significant CRE exposure and high relative valuations.
- Two reasons form the basis of our view for further moderation in the contraction of CRE construction. First, the level of non-residential investment relative to GDP was not much higher than its long-term average before the bust (see Figure 7). Moreover, since then, this ratio has already clearly fallen below its long-term mean. While excess capacity in the CRE space is still high and rising, the fact that the investment-to-GDP ratio is historically low and falling suggests that the rate of construction retrenchment should further moderate. Second, the NAR Commercial Leading Indicator (CLI) edged up in 3Q09, after falling since 3Q07.
- Surprisingly, income producing CRE exposure has grown modestly since 2008. In contrast, construction lending comprised only 7% of total loans and has contracted significantly during 2009 due to charge-offs, pay downs, and a combination of lack of demand by potential borrowers and unwillingness by banks to lend in this area.
- Clearly, construction has been the biggest problem so far. While construction loans represented only 7% of all loans, they accounted for 14% of total net charge-offs. Through 3Q 2009, CRE and multi-family have not been a major problem. Going forward, we think CRE losses will increase. But two years into the cycle, CRE, construction and multi-family losses have tracked better than expectations, which we believe will continue.
- The relative slowdown in construction problem loan formation is an encouraging sign. However, the level of problem formation remains high, suggesting to us that losses over the next five quarters (through the end of 2010) could approach the 10-12% range as outlined in the Federal Reserve’s baseline scenario, which would be consistent with lower losses in 2010.
- Implicit in 2009’s conventional wisdom that CRE would be the next shoe to drop was the belief that the capital markets would remain closed. This implied REITs would be unable to refinance or issue debt and would be unwilling to raise equity at extremely depressed prices. In fact, 2009 proved to be anything but conventional – it was truly a tale of two markets. As can be seen in Figure 22, the MSCI US REIT index declined in excess of 40% between 1 January and 15 March 2009. However, between 16 March and 31 December 2009, the index registered a total return in excess of 110% (see Figure 23).
Choice excerpts from Investment Strategy Guide: 2010 Outlook
- While there will be no shortage of opportunities or challenges in the year ahead, the sort of extreme directional moves that have characterized the past two years appear far less likely. Instead, we believe the normalization of financial markets and an unfolding economic recovery—albeit a tepid and shallow one—will prompt more moderate and less uniform performance across market sectors. After two years up on the high wire, 2010 will likely be the year of living less dangerously for most investors. (Quick note: What about those who are not investors?)
- So where does this leave us for 2010? The acute dislocations that existed within most risk assets back in March have now largely been unwound as a result of the extraordinary actions taken by policymakers.
- The economy is caught between two seemingly diametrically opposed forces—the tailwinds that typically accompany a post-recession recovery process and the headwinds generated from a structural deleveraging within the consumer and financial sectors. As our senior U.S. economist Thomas Berner points out, there is always a certain level of pent-up demand that accumulates at the end of any recession from consumers who have refrained from nonessential purchases, merchants who have pared down their inventories and businesses who have foregone capital investment spending. But as the recession draws to a close and business conditions begin to improve, these drivers start to reverse and contribute to both the breadth and depth of the recovery. The current recovery is no different. (Quick Note: Yes, these drivers may start to reverse. But for how long and to what degree?)
- The U.S. consumer is now engaged in the process of deleveraging, following a massive build-up in household debt (see figure 8). While savings rates may have rebounded in the immediate aftermath of the crisis, consumer debt burdens remain near all-time highs. The ongoing repair of personal balance sheets is apt to take several years and will therefore limit the extent to which the consumer re-engages in spending. At the same time, financial institutions are undergoing their own purging process. Faced with hundreds of billions of dollars in bad loans and troubled assets, banks and other financial intermediaries are taking steps to shrink their own balance sheets, pare back lending activity and restore their capital base.
- What this also means is that policymakers will likely opt to retain a decidedly supportive policy stance through at least the first half of 2010. Given the structural challenges that lie ahead, Fed officials will be reluctant to shift away from the near-zero rate policy that has been in place since the most acute phase of the crisis following the Lehman failure (see figure 10).
- This will be a recovery with “training wheels” as government fills the void created by the continued retrenchment on the part of the private sector… While actual rate hikes are unlikely to materialize until June at the earliest, market participants will begin to discount some tightening moves before the Fed has ever actually lifted the target funds rate… The first of these measures—the program to provide support to the housing market through the purchase of mortgage-backed securities—is set to expire in the first quarter. In the absence of any additional stimulus measures, fiscal policy will also begin to be less supportive for growth by the fourth quarter (see figure 11). This does not even reflect the impact from any changes in the tax code resulting from either the expiration of the Bush-era tax cuts and/or any additional tax hikes planned by the Obama administration. So while policy will remain supportive during the first half of the year, things could get a bit more wobbly by year-end when the training wheels are gradually removed. (Quick note: And so right about when things are going to be getting wobbly in the second half of the year, the ramifications of defaulting CRE loans is also going to be felt…this does not portend well.)
- Commercial real estate may reach crisis levels. The bursting of the bubble in residential real estate triggered massive losses at U.S. and global financial institutions and led to the credit crunch that essentially froze lending of all types. While early-cycle residential mortgage, home equity and consumer credit trends have shown signs of stabilization, late-cycle commercial real estate (CRE) credit trends continue to deteriorate. Considering that the size of the CRE market is far smaller than the residential market, even greater-than anticipated losses do not carry the same systemic implications. That said, unlike residential loans, commercial loan defaults are predominately recession-related—not the result of subprime lending or exotic lending products—and thus a weaker-than-expected economic recovery could have contagion effects and spark another “mini” credit crunch. (Quick note: Which, if based on past precedent, is probably going to be exacerbated into a more “maxi” one.)
- Sustainable but sub-par recovery We have grown more optimistic on the sustainability of a near-potential growth rate in 2010. In October, we raised our 2010 real GDP forecast from 2.2%to 2.6%, with growth hovering around 2.75%q/q annualized each quarter of 2010. Thus, our prior fear of a visible growth moderation throughout 2010 has taken a back seat. First, we raised our consumption growth forecast to reflect a pretty flat instead of a rising savings rate. The recent gyrations of the savings rate suggest that U.S. households have probably done most of the adjustments needed regarding their savings behavior. If so, real consumption will likely rise in tandem with real disposable income, which we expect to grow moderately. Second, while we are acutely aware of the need for the government to put its fiscal house back in order, we doubt that government spending will turn negative at any point in 2010. Therefore, we now expect a moderation in government spending, rather than an outright drag. (Quick note: why are they equating sustainable with sub-par? The past sixty some odd years of greed-driven avaricious growth is exactly what has led us to where we are today.)
- Housing construction is bottoming out, but inventory remains excessive
- House prices show tentative signs of bottoming