The timing of this recession could not have been worse. The National Bureau of Economic Research puts the start at January 2008. This coincides with the final leg of the lame-duck Bush Presidency. Regardless of your politics, it is clear that the Bush administration a) lacked the political power to produce an all-encompassing response, and b) realized after Lehman’s demise that the complex, global recession developing was going to require a long-term solution. They correctly assumed it was not proper for an exiting administration to “buy the groceries” for a “meal someone else would have to cook.” In other words, the election all but guaranteed an extended recession.
On a broader scale, the monetary, fiscal, and administrative reactions to the combined credit crisis/recession have had a more dramatic effect in extending the downturn. That said, this writing suggests no opinion on the actions of the central authorities, let’s leave that to the generations to follow. One must note however, there is much evidence that the U.S.—indeed the entire global economic system—was steps away from a systemic failure.
We should all appreciate the fact that due to the unprecedented nature of so many events to which they had to react, Messrs Bernake and Paulson were in many ways “making it up as they went along.” After the February, 2008 Bush $170 million stimulus was muted by the Bear Sterns rescue the following month, one could easily win a sleepless night by playing out several, very real doomsday scenarios. That fear was exacerbated as the Lehman failure was followed by weeks of contagion events. This writing is directed at identifying the policies that are limiting a real estate recovery specifically—policies that may have been prudent in saving our system, but now impede progress.
A well-intended ruling
One of the more interesting “actors” in this recession is “FASB 157.” This is the well-intended ruling by the Accounting Standards Board that mandates “mark-to-market” treatment of all assets quarterly. It was intended to provide better balance sheet transparency for markets. In practice, however, its implementation becomes very tricky.
To be fair, many purported victims of 157 enjoyed enhanced “earnings” when the markets were rising. However, the authors of 157 clearly never envisioned a period where there was no market. Most estimates put the number of 1998 U.S. real estate transactions (sales between bona fide third parties) down 70-90 percent from year earlier. In other words, there was no market. The few transactions completed were dominated by distress sales, and thus vastly distorted results. In addition, certain assets are very difficult to value mid-stream, such as real estate construction and bridge loans that are held to maturity. Such assets are in-process and reach stabilized value only when fully funded. There has never been a market for in-process and construction-type loans due to intervening lien issues and other complications. While then SEC Chairman Cox had the power to suspend 157, he was torn by the message this might send to transparency efforts and declined any action.
Some have suggested that Lehman’s failure was entirely based on mark-to-market adjustments that would not have pushed them into bankruptcy absent 157. The fact that FASB greatly relaxed this rule shortly after the demise of Lehman is further evidence of its impact. While the merits of 157 will be debated for years, certain outcomes of 157 are undeniable:
• Lenders were forced to arbitrarily assign depressed values to assets leading to reduced capital ratios and a curtailment of new lending.
• CMBS lenders were especially impacted. When the entire secondary market seized up, lenders holding assets had to either mark to a non-existent market or move the assets to their balance sheet. This allowed slightly better treatment since they were not held for sale but now held for investment. The outcome of this was to crowd out the lender’s balance sheet and further curtail new lending.
• The most insidious impact of 157 has been the unintended impact on selling assets. Since there is no market, a lender has some flexibility in assessing value-to-portfolio assets. However, if they do sell a similar asset at a distressed number, there is an argument that 157 requires the lender to adjust its entire portfolio downward thereby incurring a major loss, versus a loss associated only with the certain asset sold. Result: lenders are not selling anything.
• Other Central Policy breaks on recovery include the various actions (inactions) from Washington. After a burst of opportunity in late 2007, and early 2008, the market for secondary whole loans evaporated. Some loans-for-sale started to emerge mid 2008, and then this dried up as well. In discussions with would-be sellers, it became clear the lost market can be traced to Central actions.
In early 2008, the Fed expanded its Term Auction Facility (TAF) and created the Term Securities Lending Facility (TALF) which allowed banks to post loan collateral for Fed advances other than the traditional treasuries. Banks jumped at the opportunity to move “loans held for sale” to “loans held for investment” with its more relaxed mark-to-market requirements, then achieve liquidity via the new Fed loan program.
This also provided the chance to gradually mark down the assets over multiple quarters versus take a big one-time hit on a sale. The mid- to late-2008 secondary loan sale market was again stymied by rumors of a “bad bank” emerging from Washington that might pay “par” for these assets.
Early reports this time of Troubled Assets Relief Program (TARP) seemed to suggest the same. This all had the effect of portfolio lenders pulling back from selling loans, thereby delaying recovery. In addition, the relaxation of 157 at this time, meant that banks could hold off marking assets until they had income to absorb the write-downs. All these had the effect of slowing the sale of bad loans of lender’s balance sheets.
Finally, as the new administration worked to put forth its recovery plan, again portfolio lenders pulled back from selling loans because of some poorly placed belief that Washington will pay more than their loans are worth. The Public Private Investment Program (PPIP)’s announcement was actually good news, in that finally portfolio lenders can no longer sit back and wait.
After review of PPIP, most in our business immediately saw the Legacy Loan component as unworkable. Its shortcomings include a bifurcated structure with both the selling bank and the FDIC in charge. Further, the buyer partnership with Treasury left most would-be bidders rightly skeptical. However, an unwanted PPIP is not all bad news.
The good news is that the market can now go about clearing itself, and we no longer have this cloud of a fantasy buyer paying above market. Since early April we have seen bid/asks come in substantially, and sellers began to offer financing. The market is far from robust, but these are very positive trends. We believe that by the fourth quarter, and into 2010, we should be well along with the necessary process of moving these assets off bank balance sheets.
These collective “negative incentives” to sell assets are the most significant Central Power induced detriment to this recovery. History has shown that banking recovery typically occurs when losses are recognized and assets are moved to parties capable of managing their nuances. Banks need to free their staff and balance sheet of troubled assets to get busy making new credit available. All of this intervention has led to a delayed recovery. This recession is shaping up unlike any other recession.
Due to the massive intervention, this recession will likely not be as deep at it potentially could have been, but the trade off is that it will be significantly longer due to the massive intervention. This recession is shaping up to be a “frying pan recession” which got its name from both the look of the curve, as well as its metaphoric inference of economic pain. How long will this downturn last? That answer certainly lies in just how much additional Central Power inference is coming!
(Daniel Owen Mee is Executive Director in Tremont Realty Capital’s Boston, MA office.)