Commentary

Investors Turn a Blind Eye to Commercial Real Estate Troubles

The Dow passes the 9,000 mark for the first time since January this week. The stock market’s big rally was fueled by optimistic Investors who are now firm in the belief that the worst financial crisis in 70 years is finally over and the recession that it spawned will soon fade away. The report of profits from once disgraced commercial and investment banks, as well as from technology giants, and signs of stabilization in the residential real estate market created the right environment for exuberance to take hold. Among the more rational set, outside of the trading pits, there are still fears about mounting losses on commercial real estate portfolios, causing Federal Reserve Chairman, Ben Bernanke, to voice concerns about this problem on Capitol Hill earlier this week.

The deterioration of the commercial property market poses a serious threat to a large number of regional banks, which do not have as many streams of income or adequate capital to absorb multi-billion dollar loses. Bad commercial real estate loans could cause many regional banks to shut their doors, because they are not deemed “too big too fail.” This could cause another collapse in confidence, setting the stage for another financial crisis. It will also contribute to further consolidation in the American banking industry, leaving consumers with fewer, yet more expensive options. The desperate condition of the commercial property market also shows just how bad things are in America, outside of the government-protected canyons of Wall Street.

Bloomberg.com’s article concerning Bernanke’s Senate testimony included his dire assessment of the commercial property market:

“As the recession’s gotten worse in the last six months or so, we’re seeing increased vacancy, declining rents, falling prices — and so, more pressure on commercial real estate.”

Bloomberg.com also noted that Christopher Dodd, Chairman of the Senate Banking Committee, said that some (I assume he refers to experts in the field) have suggested that the problems facing the commercial real estate market may be much greater than the well known difficulties plaguing the residential property market.

The massive credit bubble that fed an explosion in residential real estate prices also nourished an unsustainable rise in commercial real estate values. The agonizing front page stories of mounting foreclosures plaguing the housing market pushed the disaster that is looming in the commercial market off of the media’s radar screens.

The state of commercial real estate is very bad indeed; all one has to do to see the evidence is walk past an urban commercial district or drive along a suburban highway. The number of vacant storefronts across the nation is rising dramatically. Bloomberg.com provided a succinct, yet sobering summary of the situation this week:

U.S. commercial property prices fell 7.6 percent in May from a month earlier, bringing the total decline to 35 percent since the market’s peak, Moody’s Investors Service said in a report this week. Commercial properties in the U.S. valued at more than $108 billion are now in default, foreclosure or bankruptcy, almost double than at the start of the year, Real Capital Analytics Inc. said earlier this month.

Now those unpleasant numbers should provide ample reason for alarm. Bernanke stated in his Congressional testimony that the market for debt instruments backed by commercial mortgages “has completely shut down.” But on Wall Street, the former clowns of high finance are kings again (with a little help from a few trillion dollars in loan guarantees, equity infusions and ultra-low interest rates, of course). A rational soul would think the bad news from the commercial property market should shine a bright light on the truly sad state of the economy. While Wall Street basks in the glow of artificial profits from government-supported banking giants, the rest of the economy is suffering from continuing job losses, and weak demand for goods and services. The struggling economy is hitting the commercial property market hard, causing a rise in defaults among developers, and inflicting pain on the regional banks that supported them during the bubble years.

In order to avoid another potential financial calamity, Brenanke told lawmakers that the Fed’s Term Asset-Backed Securities Loan Facility, awkwardly known as “TALF,” which lends money to those willing to buy consumer and business loans, started accepting debt backed by commercial mortgages in June. He also wants lenders to modify troubled loans.

Bernanke’s recommendations may help ease some of the pain for regional banks that lent money to builders of unnecessary strip malls and office parks by offering these institutions credit in exchange for assets of dubious quality. But it will not make the problem disappear. Eventually, a substantial portion of these loans will have to be written off, or at best, sold at steep discounts. Until there is an open and honest accounting of souring commercial property loans, and the institution of an orderly disposal process, the banking sector and the economy will continue to suffer.

This week investors saw signs of life on the corporate profit front and some stabilization in the housing market, but the economy is still shedding many more jobs than its creating, and banks are still sitting on massive piles of non-performing loans, from credit cards to real estate. The deteriorating employment situation will only cause more defaults in both commercial and residential real estate markets, feeding a vicious cycle that will put further stress on the financial system, requiring more public funds in the form of loan guarantees and credit subsidies. It is way too early for investors to start celebrating. The mountain of bad loans that plague the commercial real estate market is causing the debt markets that deal in these products to seize up, and could easily cause a new panic that will lead to another financial crisis – possibly before the year is out. It may also force many regional lenders to merge with larger commercial banks, or shut to their doors permanently, which will limit consumer options and increase the cost of financial services for everyone.

I’ve provided links to some good articles on real estate and banking below:

Regional Banks’ Profits Are Hurt by Loan Losses

Subprime-Mortgage Loss Forecast Is Raised by Standard & Poor’s

Bailout Overseer Says Banks Misused TARP Funds

Bank of America Credit-Card Bond Ratings May Be Cut by Moody’s

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