Stock market bulls aren’t concerned about the inevitable acceleration in bank failures — at least for now. Even though deposits will be insured against loss, the loss of local banks will still have a depressing effect on hundreds of small communities. These communities are going to lose their only access to business credit when their local zombie banks — loaded with toxic construction or commercial real estate loans — are liquidated or merged into other weak banks.

Meanwhile, the latest monthly figures show that commercial bank balance sheets are shrinking at a fairly rapid rate, due to a combination of several factors: loan charge-offs, older loans are being paid back at a faster rate than new loans are being made, and regulators pressuring banks to build larger capital buffers.

So credit-fueled growth in consumption or investment is not occurring. Combine this with stagnant or declining wages and corporate profit margins and it becomes hard to imagine how GDP will rebound on a sustainable basis. GDP is the stat that every money manager fixates upon — despite the fact that GDP does not accurately measure true economic progress; it’s like evaluating a stock purely on sales growth, without thinking about what’s driving sales, and whether these sales are sustainable or accretive to wealth.

Nominal GDP is calculated as “consumption + investment + government spending + exports – imports.” Then, government statisticians subtract a highly doctored CPI figure from annualized changes in the above variables to get “real GDP growth.”

Note that all the variables in the GDP equation can be pumped up by excessive credit growth. As I mentioned in the Sept. 4 alert, if GDP is growing at the expense of degraded balance sheets, the end results are never happy. Japan’s GDP stayed higher than it otherwise would have been in the 1990s despite the incredibly wasteful spending on bridges to nowhere. Its policymakers reacted to a huge misallocation of capital into real estate in the 1980s by misallocating capital into government projects and subsidies to favored industries.

U.S. policymakers are following this playbook even faster, only without acknowledging one crucial difference: Japan had a high household savings rate to finance its government deficits, while the U.S. does not. Plus, the U.S. has already “dollarized” the rest of the world, and there are signs international demand for dollars has reached its saturation point.

The gold and commodities markets are reacting to this unpleasant reality. These markets are starting to discount the fact that the Fed will be the aggressive buyer of last resort for all types of debt securities. We’ve likely only seen the beginning of growth in the Federal Reserve’s balance sheet. As long as it can get away with it, the Fed will keep creating new money out of thin air to finance the U.S. federal deficit. Plus, via its liquidity facilities, the Fed and the megabanks will keep swapping Treasuries for legacy toxic securities marked at fantasy levels.

A few wild cards could disrupt this benign “reflationary” environment we’ve been in since the March stock market bottom, resulting in the stock market taking another nasty leg down:

1. If the “audit the Fed” bill were to pass and result in more handcuffs on the Fed, it would help to slow the reckless debasement of the U.S. dollar. But if it put an end to the Fed’s exotic lending facilities, which would force the owners of toxic securities to retain and mark them down sooner, then we could see a return to the January-early March 2009 stock market environment — only most of the damage would be contained to the financial sector as equity of insolvent institutions gets wiped out or diluted.
2. Contraction in the real economy and state governments could easily overwhelm expansion in the “federal government economy.”
3. International holders of trillions in paper U.S. assets could accelerate the rate at which they diversify into real assets. That’s how we could see a spike in “money velocity” that the deflationist camp says is a necessary condition for the CPI to rise. Most of the price pressure will be felt in oil prices, especially later in 2010 and 2011, when today’s underinvestment in new oil projects leads to tight international supplies.

I’d like to bring to your attention one more thing about today’s investing climate, because it’s being used so often lately in the media to justify today’s nosebleed stock valuations: the “money on the sidelines” fallacy. Growth or contraction in the current balance of $3.5 trillion in money market funds depends on how much companies look to borrow in the commercial paper market — not on the level of the stock market, as so many seem to believe.

Those who point to the $3.5 trillion in money market funds as if it’s a bucket that can be “poured” into the stock market bucket to keep the rally going do not understand that money does not go “into” or “out of” the market, but through the market. Trader A sells every share bought by Trader B. Once this transaction settles, cash goes one way and shares the other. The price at which the transaction takes place depends on how badly Trader B wants to own shares, not how many money market shares are in his account.

Also, money market fund balances represent very liquid short-term loans; they reflect an amount of money that’s already been spent in the economy and will be paid back over a very short time frame. John Hussman — one of the best mutual fund managers, in my view — refutes the “cash on the sidelines” fallacy best. It’s worth reading and remembering the next time you hear a talking head arguing that the rally can keep going because of liquidity.

Washington Federal Closes Offering; Now We Wait for Earnings

Yesterday, Washington Federal (WFSL) announced that its secondary stock offering would generate net proceeds of $333 million. This works out to a per share price of $13.79, including underwriting discounts and expenses and assuming full exercise of the underwriter’s overallotment. Here is an example of cash going “into” stocks, because these are newly issued, rather than existing, shares in the secondary market.

As I noted in Monday’s flash alert, I expect the offering will be necessary to absorb a mounting wave of net charge-offs in the future. It’s possible that this offering plan became a necessity after a friendly suggestion from regulators to raise more capital.

On Wednesday, WFSL stock rallied on high volume, but did not reflect organic demand for the stock. JP Morgan (NYSE:JPM) was the sole book-running manager for the Washington Federal offering. Knowing that it would likely receive a few million WFSL shares as a form of compensation in the underwriters’ overallotment, JPM’s trading desk probably established a short position that it plans to cover by delivering the shares it will receive upon the closing of the deal. This likely explains the bizarre trading moves in the stock this week: When institutions were more interested than expected, resulting in a higher offering price of $14.50, JPM likely covered some of their short position.

As for the analyst reaction to the offering, the two analyst notes I saw might as well be corporate press releases, because they expect this new capital to be deployed into an FDIC-assisted rollup of lots of zombie banks in the Pacific Northwest. Also, these analysts cite WFSL’s “strong” capital ratios without adjusting for future credit losses. One might suspect that these analysts have not even read the asset quality footnotes in Washington Federal’s SEC filings.

The big losses WFSL will take on construction loans are obvious, no matter how long management claims it will be able to sit on them. But what’s not obvious to the market — yet — is the rapid future loss formation in its $6.7 billion mortgage book. Management has set aside practically zero allowance for loan losses against its mortgage book. See the chart below for the allocation of WFSL’s allowance by loan type.

WFSL carries a mere $18.8 million loss allowance against its $6.7 billion book of mortgages — a ratio of just 0.28% of assets. The harsh reality of the mortgage crisis tells us that this $6.7 billion asset value is overstated, along with capital ratios (or equity); it should be marked down by far more than $18.8 million. Yet WFSL’s accounting translates as follows: Management does not expect more than $18.8 million in cumulative credit losses in mortgages (defaults, net of recoveries after foreclosure) through the rest of this credit cycle, despite the fact that the majority of these mortgages are now underwater and the job market remains weak.

As you can see in the chart, the ratio of loss allowance to nonperforming loans (by category) has shrunk dramatically. In December 2007, WFSL’s residential mortgage loss allowance was $13 million, and its nonperforming mortgages were also $13 million. As of June 30, this loss allowance had been built up to $18.8 million, but nonperforming mortgages had grown to $119 million (and will keep growing). This loss coverage ratio has shrunk from 100% to 16% over the past six quarters (as shown in the chart’s blue line) and needs to be built back up to a respectable level. And the only way for WFSL to build it up is to book large credit provision expenses in future income statements.

Washington Federal’s “strong” capital ratios are a function of hopeful accounting. I expect the market to come around to this view — not only for WFSL, but also for the entire banking sector. Ever since the loosening of mark-to-market accounting rules last April, the creators and users of financial statements have collectively chosen to deny reality and bury their head in the sand about the future direction of market values for collateral backing loans — and the value of the loans themselves.

Everyone is waiting and hoping for a miraculous rebound in housing prices and the labor market, when we have yet to see the bottom in either. When reality sets in, this will not end well for owners of bank stocks, REITs, and other financial stocks. These stocks are claims on assets that are marked to fantasy levels.

Mark-to-market suspension has slowed the rate at which losses are recognized, but this self-delusional accounting practice cannot make the losses disappear, and will likely make these cumulative, stretched-out losses even bigger in the future by rationing credit to the healthier parts of the economy.

Regards,
Dan Amoss

Source: GDP’s Debt to Credit

Here are a few:

1. The FDIC’s Deposit Insurance Fund is now promising to insure $6.2 trillion in deposits with just $10.4 billion in reserves. Expect to see another “special assessment” cutting a few billion dollars out of bank earnings later this year.

2. Credit card losses are at a record: 9.95%

3. 416 banks, or 5% of the nation’s banks, are on the ‘problem’ list.

4. FDIC-insured banks are sitting on $332 billion in loans more than 90 days past due, up from $290 billion in the first quarter.

5. Nonperforming loans now make up 2.77% of the entire banking industry’s assets. This is up from 1.4% in June 2008 and 0.47% in June 2006. As these loans get ‘worked out’ in today’s credit environment, the market will start to realize how severe net charge-offs will be.

In this new report, the FDIC published updated figures for the combined noncurrent loans and loan loss allowance at all FDIC-insured institutions. Here is an updated version of the chart we published in the Aug. 14 alert. The new figures – the moves from December 2008 to June 2009 – are highlighted in the dotted lines at the far right of this chart:

You can see how problem loans are increasing at a much faster rate than the rate at which the banking industry is adding to its loss allowance. This means that published capital ratios are misleadingly high.

Source: More Pain Ahead for US Banks

Consider this likely scenario: The heavy retail investor inflows into corporate bond funds last spring (far in advance of the peak in defaults, by the way) undoubtedly helped push corporate bond spreads down. The quant funds’ models detected this movement, concluded that the recession might be over, and proceeded to buy stocks that are highly sensitive to future U.S. consumer spending — including banks and REITs. This scenario likely explains some of the rally in bank and REIT shares, which occurred far in advance of the peak in credit losses.

This type of scenario could easily reverse this fall as experienced stock and bond fund managers start to question why they own barely solvent financial companies at valuations that imply 4-5% real GDP growth over the next two years. Huge swathes of the financial sector are insolvent (the mark-to-market value of assets is less than liabilities), and the debate over mark-to-market accounting boils down to whether losses should be recognized up front or over long periods of time. The losses are not going away, and were baked in the cake as soon as the bubble-era loans were made.

Last fall’s panic was not really a “black swan” event; it was the realization that much of the banking system was insolvent and at the mercy of electronic bank runs. Last fall, I thought that at the very least, the authorities had a plan to wind down Lehman in a controlled manner. Instead, Lehman went into forced liquidation and took the “shadow” banking system down with it. Our Lehman puts were huge winners, but even I was surprised at how quickly Lehman stock went to zero.

The issue facing REITs parallels that of the banks: an industry-wide solvency crisis. Only REITs lack access to enormous subsidies from the Federal Reserve, which include the manipulation of borrowing rates down to the range of 1%, resulting in a profitable spread on new lending.

If you carefully consider the combined statistics on commercial mortgage debt, equity, and future rental cash flows, you come to the conclusion that the value of many REITs is permanently impaired. Even if a core group of higher-quality REITs escapes bankruptcy, their equity will still be impaired because lenders will only refinance properties on very tight terms: strict covenants, high interest rates, and requirements of hefty equity infusions into upside-down properties. This is a transfer of wealth from REIT shareholders to creditors. This wealth transfer is occurring through many channels, but the most important one relates to claims on future rental cash flow, which will be bleak regardless of who owns it:

1. Creditors will take a higher share of those rental cash flows via higher interest rates
2. Of the cash flows that trickle down to shareholders, they will be divided up among more and more REIT shares as we see more and more dilutive secondary offerings

This unprecedented collapse in commercial real estate fundamentals means that for the next few years, you can throw out the analyses that rely on “cap rates” to value REITs. Distressed sellers and vulture buyers will make up the bulk of commercial real estate transactions for at least the next few years. Equity looking to invest will be scarce, so it will demand very low prices and high potential returns to invest.

Between now and 2013, $1.6 trillion in commercial real estate debt will mature. Bankers know this, so they’re going to keep conditions very tight for any refinancing that they grant. Plus, a hefty chunk of this debt is held by commercial mortgage-backed securities (CMBS), in which the lenders cannot sit across the table and renegotiate with stressed borrowers; owners of senior CMBS tranches will want to liquidate the collateral to get paid back, while owners of the junior tranches will want to refinance and pray for a recovery in value. I expect the motives of the senior lenders to win out, resulting in lots of property liquidations.

REITs Selling Must Compete to Dump Properties

Lots of REITs have plans to sell properties to pay down debts but… Sell to whom? And at what sort of price? Yet REIT investors seem unaware the hundreds of billions in new equity that creditors will require to refinance mortgages that were made during the 2006-2007 peak in values — and what that catalyst will do to the value of their equity.

On Wednesday, The Wall Street Journal ran a story that relates to this theme: “Tishman Faces Office Downturn.” Link in Web Version Only. The article describes the tough choices facing privately owned real estate investment partnership Tishman Speyer, which owns Manhattan landmarks like the Chrysler Building and Rockefeller Center.

Tishman also owns a levered portfolio of Washington, D.C., properties named CarrAmerica. You’d think that with all the crony capitalists flocking to Washington the lobbying business is booming. But apparently, even lobbying is not a strong enough business to justify CarrAmerica charging the pricey rents it needs to pay its mortgages. The WSJ describes the financing problem:

The Tishman partnership that bought the CarrAmerica portfolio has been in talks with its lenders, led by Lehman Brothers Holdings Inc., since late 2008 about modifying the credit agreement, according to S&P. But so far, nothing has happened and, until now, the talks have been kept quiet. “We have confidence in the long-term value of the properties,” Rob Speyer said.

S&P warned even if Tishman wins new covenants, its ability to refinance the loans in 2011 “will likely require additional capital investment or a recapitalization.” [emphasis added]

The Tishman mortgages were one of many credits that Lehman was marking at fantasy levels. As it turns out, the bears on Lehman were right: The loans that Lehman provided to Tishman to finance its acquisition of Archstone-Smith were impaired soon after they were underwritten.

What will the Tishman family do about its privately held portfolio? How much debt is carried against Tishman Speyer’s properties? I get the impression that it’s a lot, considering Tishman’s aggressive behavior at the market peak (as opposed to, say, Sam Zell, who unloaded a ton of properties onto Blackstone (NYSE:BX) and Maguire (NYSE:MPG), which will both wind up losing most or all of their equity). Tishman Speyer will probably hit a lot of low bids on its second-rate properties to raise the cash that banks will require as new injections in order to refinance — and keep to deeds to — its trophy properties.

The smart money in commercial real estate — including Sam Zell — certainly sees the mountain of debt maturities coming down the pike. Investors will certainly be looking for bargains in commercial real estate, and they will find the best deals in either foreclosure auctions or purchasing commercial mortgages from stressed banks at a discount.

Regards,
Dan Amoss

Source: REITs Racing to Bankruptcy

And I’m going to give you a chance to join them.

If you think Canada escaped the downward trend in U.S. banking, think again. While the country may not have plunged headfirst into subprime mortgages, it did dip heavily into risky derivatives. The leverage it took on generated impressive returns on equity in good times, but that same leverage is set to wipe out equity today.

Shareholders in one “safe” Canadian bank will have to rethink their loyalty. Its looming solvency crisis practically guarantees a dividend cut. And that’s our catalyst for this month’s short play action – offering us a chance for 200% profit potential.

Accounting secrets have not yet obliterated Canadian bank earnings – like those of U.S. banks – because the Canadians have not yet accounted for the coming tsunami of mortgage, consumer loan, and corporate loan losses.

Here’s how they loaded those loan books with hidden risk.

The Basics of Bank Accounting

Bank shareholders leverage their capital by borrowing short-term money, primarily from depositors. Your bank account is an asset for you, but it’s a liability for your bank. For every dollar of capital, bank shareholders borrow 15, 20, or even 30 dollars from senior creditors – otherwise, they could not afford to own their huge portfolios of loans and securities. Here’s the core problem: Bank shareholders and their agents (bank executives) are lending other people’s money. So bankers are looser with lending than if they were lending their own savings.

The accounting process to determine commercial bank profits is inherently speculative, as well. Banks book an upfront profit on every new loan they make, minus a small “provision” for loan losses – just in case some loans wind up going bad. These upfront profits have the habit of disappearing when loans “season,” and banks discover how many deadbeats owe them money. In case you’ve been wondering what has wiped out the majority of the S&P 500’s trailing earnings, here’s your answer: Banks and brokerages reversing most of the profits they booked on loans made and securities bought at the peak of the bubble.

Banks claimed to make good money loans to every borrower. But somebody sure was lying, since they’re taking charges against these older vintage loans and securities left and right. And the industrywide provision for loan losses, which is the single most important – and unpredictable – cost in a bank’s income statement, has been soaring. Once these provision expenses soared on the backs of delinquent loans, the banking sector’s earnings plunged deep into negative territory.

Throw in a few more explosive ingredients like deposit insurance, central bank lending facilities, loan syndication, and securitization and we’re left with a system for which sales volume – not risk management – is priority No. 1.

Those who claim the banking system is well capitalized – including those who designed the unstressful “stress test” – hold rosy assumptions about how many loans will go bad and how much banks will earn from existing loans to have a shot at outrunning their credit losses.

Lots of bank stocks remain in a fragile state. This month, we’re going to buy puts on the Canadian bank most ready to fall. And now’s your chance to join us. If you want the name of my latest play, just click here to learn more about Strategic Short Report.

Regards,
Dan Amoss

Source: Don’t Bet on Canada’s Banks

Yet the stocks of real estate investment trusts (REITs), which are popular among income-oriented retail investors, are still trading at high enough levels that discount just a garden-variety recession in commercial real estate. REITs were designed to invest in portfolios of rental properties, and generally pay no corporate income taxes if they distribute at least 90% of their profits as dividends to their shareholders.

REITs were designed to thrive in an environment of steadily rising property values and rents. But in this ice age for commercial real estate, the REIT business model will cease to function properly; a REIT’s tax-free status doesn’t allow it to retain much excess capital during lean times. Since REITs pay out all their earnings, they cannot grow without taking on more debt. During the boom, a REIT strategy encompassing growth, leverage, and acquisitions was a virtuous cycle that led to juicy dividends and soaring stocks. But in this bust phase, the REIT business model has morphed into a vicious cycle of dividend cuts, dilutive equity offerings, debt offerings at double-digit interest rates, and bankruptcies.

The REITs that levered up and grew too fast at the peak will go to zero in bankruptcy. Others could fall into the low single digits by year-end as the market anticipates that creditors will take title to many properties in 2009 and 2010. These developments would push the value of the REIT Index dramatically lower.

The REIT sector is woefully undercapitalized — just as the big banks were last year. If you mark the value of commercial real estate to market, it tells you that REIT debt in all its forms — commercial mortgages, unsecured notes, secured lines of credit – is much too burdensome. Equity cushions that seemed adequate at the commercial property market peak are now thin. REITs don’t have to mark their assets to market each quarter like investment banks. But you can be sure that before committing a single penny to a secondary offering of REIT stock, institutional investors will mark property portfolios to market.

Marking property to market will result in many underwater commercial properties. This is critically important because the combination of underwater properties (insolvency) and imminent debt maturities (illiquidity) tends to wipe out equity. The maturities over the next five years are staggering, and these debts were sloppily underwritten near the peak of the credit bubble. According to Goldman Sachs research, roughly $1.6 trillion in commercial real estate debt is coming due 2009-2013.

Lenders will not be willing to refinance mortgages in situations where mortgage debt exceeds the value of the property — so-called “underwater” properties. In order for all of these $1.6 trillion in loans to qualify for refinancing, hundreds of billions in new equity will need to be injected into properties. This much new equity capital dedicated to commercial property ownership will not exist in the investing environment of 2009-2013. So many of these loans will default.

In a scenario of paying off staggering debt loads under stress, the claims of common shareholders are either diluted or wiped out completely. This is the scenario facing General Growth Properties, for example, and shareholders will be lucky to recover anything. You can find shades of the General Growth saga throughout the REIT space.

Bulls argue that REIT stocks are cheap enough to buy. After all, they’ve declined to the point that you’d be buying ownership stakes in commercial real estate at prices well below peak values. Also, the high dividend yields already reflect plenty of pessimism.

What is the credit market’s response to REIT bulls? Creditors will take title to many properties in bankruptcy, and dividends will be paid mostly in new shares of REIT stock, rather than cash. I side with the credit markets.

A review of the aggregate REIT balance sheet — and the delusional commercial real estate purchases during the 2006-2007 peak — will tell you that this won’t be a garden-variety bear market in REITs. Supply of retail, office, hotel, and industrial space will greatly exceed demand for several years. In most cases, tenants will have the upper hand in lease renegotiations. This bear market, which is still in its early stages, will go down as the worst REIT bear market in history.

So will the TALF come to the rescue? Wasn’t the Federal Reserve’s “term asset-backed securities loan facility” (TALF) designed in part to mitigate the systemic damage from the time bombs ticking inside of CMBS? A primary reason for the recent rally in REIT shares is hope that the TALF will help restore value to equity of the most-indebted REITs by loosening up lending for commercial mortgages. The Dow Jones U.S. real estate index rallied from an intraday low of 80 in early March to a recent 130. But this REIT rally is based on hope, rather than strong fundamental evidence.

The Fed does not restore equity value to leveraged financial companies sitting on toxic assets; it merely tries to prevent stressed borrowers from unwinding positions too quickly. Look at how little equity value the Fed’s unprecedented lending facilities salvaged for Citigroup shareholders. TALF will do little to preserve equity value for highly indebted REITs. The Fed did not eat the losses on Lehman Bros.’ garbage securities, nor will the Fed or the Treasury eat losses that must be first absorbed by shareholders of overleveraged REITs.

Plus, potential limits on executive pay could limit interest in TALF participation. Special Inspector General Neil Barofsky said in a recently published report that executives involved with the TALF program “could be subject to the executive compensation restrictions.” Whether or not compensation restrictions are enacted as part of TALF, the mere threat of capricious rule changes and taxes imposed by Congress and the administration will scare many potential managers away from TALF.

While there are certainly opportunities to be had in this market, as I see it, REITs aren’t one of them.

Source: Sell REITs, Part II

REITs are still in the early stages of a huge deleveraging cycle that will last for years, which means that the REITs that concentrate on commercial real estate may be a deceptively dangerous asset class.

Our story begins with the massive credit bubble – and related housing bubble – of the last several years. These twin bubbles powered a dramatic rise in consumer spending. Some significant portion of commercial real estate sprouted up to serve and satisfy this artificial demand. From the top to bottom of the U.S. economy, easy access to credit during the last several years powered excess consumption – and a frenzy of knock-on commercial ventures.

Accordingly, shopping boutiques popped up everywhere, along with restaurants, real estate offices, home-furnishing stores, art galleries, etc. All of these enterprises unwittingly relied on credit-fueled demand, and believed that this demand was “normal.”

But now that credit has disappeared from the U.S. economy, thousands of businesses are discovering that they cannot survive the new normal – the one that relies on actual paychecks and savings, NOT credit. And so, one by one, business doors are closing and the empty commercial spaces are piling up.

“The severity of the recession is turning some malls that were once viewed as viable into potential casualties,” the Wall Street Journal recently observed. “‘Any mall that’s sitting on life support is probably going to get its plug pulled as the economy stalls,’ says Michael Glimcher, chairman and CEO of Glimcher Realty Trust, which owns 23 U.S. properties, including Eastland Mall in Charlotte.”

The distress in the commercial real estate market would be serious, even if credit were still flowing freely. But credit is contracting, which means that commercial real estate is in especially dire circumstances. Refinancing commercial properties has become an extremely difficult task. Without the ability to refinance – or to sell at a profitable level – properties will continue to stumble into foreclosure and liquidation, which will put continuous pressure on property values.

Owners of underwater properties will have to either default and hand the title over to the lender, or they’ll have to inject an impractically large amount of new equity into the property to qualify for refinancing. And in these cases, we are talking about face-to-face negotiations between borrowers and lenders. In the modern “securitized” economy, face-to-face negotiations have become as rare and quaint a concept as the corner malt shop. In the modern economy, most mortgages are sliced and diced into unrecognizable portions of various mortgage-backed securities (MBS).

Think of securitization this way: Image your pet pig ran away from home and stumbled into a sausage factory. If you searched for your pig at the end of the sausage production line, you probably couldn’t find him. He’d be there alright, but not in a form you would recognize. He is there; but he is now everywhere. So is your mortgage.

Securitization is, therefore, a very toxic aspect of this particular commercial real estate bust. Simply stated, securitized mortgage structures are not designed to function in our current environment — one with falling collateral values and soaring defaults. Let me highlight the loan restructuring challenge ahead for troubled commercial property owners and their lenders.

Take just one example of evaporating equity in commercial properties. It shows why stressed property owners cannot easily renegotiate terms with their lenders. A few weeks ago, Sunstone Hotel Investors Inc. defaulted on its mortgage on W San Diego hotel. Sunstone bought the W for $96 million in 2006. The transaction was financed by a $65 million mortgage that was sliced, diced, and sold into the commercial mortgage-backed security (CMBS) market. The W’s value is now below the face amount of the mortgage, so Sunstone will likely write its equity down to zero and turn the deed for the W (i.e., the mortgage collateral) over to creditors in order to eliminate its mortgage obligation.

Sunstone defaulted when it skipped its June 1 payment on the W hotel’s mortgage. Thus, Sunstone basically invited its servicer, Centerline Servicing, to foreclose on the hotel. Centerline represents the interests of the lenders, who are spread throughout the ownership structure of CMBS. Without the chance to renegotiate, the only real option is for lenders to foreclose and auction off collateral. Even worse, if Centerline were to approach the lenders about restructuring the mortgage, the lenders would have different objectives — some would want to liquidate collateral to get paid, while others would prefer to renegotiate and hope for a rebound in collateral value. This is known in the securitization business as “tranche warfare.”

From a legal standpoint, borrowers are too far away from ultimate lenders. The complex legal structure of CMBS practically guarantees that sensible loan restructurings, including debt-for-equity swaps, are very difficult.

Now apply this situation to hundreds of other properties around the U.S., and you can see how securitization (CMBS) practically eliminates the potential for property owners to meet with their creditors and renegotiate. Private sector creditors who want to participate in fire sales and in very attractive loans are waiting for property to fall to more reasonable levels first. Banks are not going to refinance commercial mortgages coming due on properties that are down 50% from peak values, and no equity is left. This means that the foreclosure market will dominate the overall market, pushing values for every comparable property down even more.

There will not be any legitimate bottom in the REIT market until there is a bottom in the prices of commercial real estate mortgages. The smart institutional money will initiate its investment in real estate by buying the distressed mortgages of attractive properties, NOT by buying REIT shares. These investors will want to buy claims on commercial property market that are high up in the capital structure, not gamble on equity in properties, which may be worth a fraction of peak values — or zero. That’s why I’m monitoring transactions in the commercial real estate debt markets, looking for signs of a true bottom.

The “bottom” we saw in early March was almost entirely due to the Fed’s extraordinary commitment to print money in an attempt to prop up old bubbles. This caused a temporary rally in CMBS and REITs. The most stressed REITs used this as an opportunity to de-lever their balance sheets just a smidge by flooding the market with new shares. With the window for REIT secondary offerings closing, by fall we should see another leg down in the Dow Jones U.S. Real Estate Index.

The real buyers for CMBS and commercial property are professional investors – not the Fed or taxpayers. By and large, these professionals are waiting for bargains, with bids far below the current market.

So should you.

Source: Sell REITs

Yet the stocks of real estate investment trusts (REITs), which are popular among income-oriented retail investors, are still trading at high enough levels that discount just a garden-variety recession in commercial real estate. REITs were designed to invest in portfolios of rental properties, and generally pay no corporate income taxes if they distribute at least 90% of their profits as dividends to their shareholders.

REITs were designed to thrive in an environment of steadily rising property values and rents. But in this ice age for commercial real estate, the REIT business model will cease to function properly; a REIT’s tax-free status doesn’t allow it to retain much excess capital during lean times. Since REITs pay out all their earnings, they cannot grow without taking on more debt. During the boom, a REIT strategy encompassing growth, leverage, and acquisitions was a virtuous cycle that led to juicy dividends and soaring stocks; in this bust, it’s morphed into a vicious cycle of dividend cuts, dilutive equity offerings, debt offerings at double-digit interest rates, and bankruptcies.

The REITs that levered up and grew too fast at the peak will go to zero in bankruptcy. Others could fall into the low single digits by year-end as the market anticipates that creditors will take title to many properties in 2009 and 2010. These developments would push the value of the REIT Index dramatically lower.

$1.6 Trillion in Commercial Real Estate Debt Needs to Be Refinanced

The REIT sector is undercapitalized – just as the big banks were last year. If you mark the value of commercial real estate to market, it tells you that REIT debt in all its forms – commercial mortgages, unsecured notes, secured lines of credit – is much too burdensome. Equity cushions that seemed adequate at the commercial property market peak are now thin. REITs don’t have to mark their assets to market each quarter like investment banks. But you can be sure that before committing a single penny to a secondary offering of REIT stock, institutional investors will mark property portfolios to market.

Marking property to market will result in many underwater commercial properties. This is critically important because the combination of underwater properties (insolvency) and imminent debt maturities (illiquidity) tends to wipe out equity. The maturities over the next five years are staggering, and these debts were sloppily underwritten near the peak of the credit bubble. According to Goldman Sachs research, roughly $1.6 trillion in commercial real estate debt is coming due 2009-2013.

Lenders will not be willing to refinance mortgages in situations where mortgage debt exceeds the value of the property – so-called “underwater” properties. In order for all of these $1.6 trillion in loans to qualify for refinancing, hundreds of billions in new equity will need to be injected into properties. This much new equity capital dedicated to commercial property ownership will not exist in the investing environment of 2009-2013, so many of these loans will default.

In a scenario of paying off staggering debt loads under stress, the claims of common shareholders are either diluted or wiped out completely. This is the scenario facing General Growth Properties, and shareholders will be lucky to recover anything. You can find shades of the General Growth saga throughout the REIT space.

The Credit Markets Are Signaling Danger for REITs

Bulls argue that REIT stocks are cheap enough to buy. After all, they’ve declined to the point that you’d be buying ownership stakes in commercial real estate at prices well below peak values. Also, the high dividend yields already reflect plenty of pessimism.

What is the credit market’s response to REIT bulls? Creditors will take title to many properties in bankruptcy, and dividends will be paid mostly in new shares of REIT stock, rather than cash. I side with the credit markets.

A review of the aggregate REIT balance sheet – and the delusional commercial real estate purchases during the 2006-2007 peak – will tell you that this won’t be a garden-variety bear market in REITs. Supply of retail, office, hotel, and industrial space will greatly exceed demand for several years. In most cases, tenants will have the upper hand in lease renegotiations. This bear market, which is still in its early stages, will go down as the worst REIT bear market in history.

Will the TALF Bail Out REIT Shareholders?

So will the TALF come to the rescue? Wasn’t the Federal Reserve’s “term asset-backed securities loan facility” (TALF) designed in part to mitigate the systemic damage from the time bombs ticking inside of CMBS? A primary reason for the recent rally in REIT shares is hope that the TALF will help restore value to equity of the most-indebted REITs by loosening up lending for commercial mortgages. The Dow Jones U.S. real estate index rallied from an intraday low of 80 in early March to a recent 130 (see chart below). But this REIT rally is based on hope, rather than strong fundamental evidence.

The Fed does not restore equity value to leveraged financial companies sitting on toxic assets; it merely tries to prevent stressed borrowers from unwinding positions too quickly. Look at how little equity value the Fed’s unprecedented lending facilities salvaged for Citigroup (NYSE:C) shareholders. TALF will do little to preserve equity value for highly indebted REITs. The Fed did not eat the losses on Lehman Bros.’ garbage securities, nor will the Fed or the Treasury eat losses that must be first absorbed by shareholders of overleveraged REITs.

Plus, potential limits on executive pay could limit interest in TALF participation. Special Inspector General Neil Barofsky said in a recently published report that executives involved with the TALF program “could be subject to the executive compensation restrictions.” Whether or not compensation restrictions are enacted as part of TALF, the mere threat of capricious rule changes and taxes imposed by Congress and the administration will scare many potential managers away from TALF.

While there are certainly opportunities to be had in this market, as I see it, REITs aren’t one of them. That said, after the closing bell today, I’m recommending an exciting new play to my Strategic Short Report readers that could generate as much as $200,000 in profits. If you want to be one of the first to act on this opportunity, visit the Strategic Short Report website for more details.

Regards,
Dan Amoss

Source: Beware of the REIT Reality

REITs may appear cheap, but they are very dangerous to hold right now. A basic tenet of corporate finance is that a company or a sector is only creating value for shareholders if its return on invested capital (ROIC) exceeds its weighted average cost of capital (WACC). If its WACC exceeds its ROIC, it is destroying value. This describes the situation facing the REIT sector for the next few years.

Most REITs cannot float unsecured debt at anything less than 10% or 12%, so their cost of capital is high and rising. At the same time, due to the glut of supply in commercial real estate supply, and waning demand from stressed tenants, the returns on incremental investment in new capacity are very low — possibly negative.

Summing it all up: REITs will be destroying shareholder value until supply and demand for commercial real estate reaches equilibrium. The free market is screaming as loudly as it can that millions of square feet of capacity need to be absorbed or eliminated over the next several years in order for the surviving REITs to have a chance at generating respectable returns on capital.

This process has barely even begun, after the biggest lending binge in the history of commercial real estate. It will last a long time. The lending binge ensured that a large swathe of REITs will not make it to see the next commercial real estate up-cycle, which is still several years away at minimum. The title to many properties will go back to creditors in bankruptcy, and auctions will bring down asset values across the sector until they are cheap enough to earn respectable returns in a weak rental environment.

Another example of stress surfaced earlier this week. The auction to settle credit default swaps related to the General Growth Properties bankruptcy indicates serious pain to come for mall REIT owners: GGP’s senior loans effectively liquidated for 44 cents on the dollar! This means that lenders are demanding extreme discounts and high yields to hold debts secured by mall collateral. This isn’t good news for peers like Kimco (NYSE: KIM) and Simon Property Group (NYSE: SPG).

Another argument I’ve seen lately is that REITs will be a good inflation hedge if you buy them at these prices. This is an overly simplistic view of Fed-created inflation and its ultimate symptoms.

Fed Chairman Bernanke can debase the dollar all he wants, but most of the new dollars will act to push up the prices of goods and services in sectors with relatively tight capacity. Mostly, this translates into lower living standards for the average American — an echo of the 1970s, only without the real estate appreciation.

The Fed’s inflation will find its way into tangible assets like gold and silver, oil and gas, uranium ore, farmland, potash mines, and any other commodity China needs to import. Conversely, the fed’s inflation will NOT find its way into the pricing of American shopping malls, which arre in a condition of extreme oversupply.

Over time, the capacity to supply light, sweet oil to the global economy will be far tighter than the capacity to supply American retailers with real estate in malls. Demand for oil will be far more resilient than the U.S.-centric consensus expects, while demand for discretionary items — like “Color Fiend Neon Green Hair Spray” at Hot Topic (this product actually exists) — will fluctuate up and down, but generally head lower. Rising prices for several necessary goods and services will crowd out discretionary spending in many family budgets.

Inflation does not re-inflate old bubbles — especially in the case of residential and commercial real estate. It will only slow the previously violent deleveraging process.

On a related note, it was a breath of fresh air to hear Howard Davidowitz of Davidowitz & Associates interviewed on Bloomberg Radio recently. (You can find a link to download an mp3 of the 17-minute interview here). Davidowitz has decades of in-the-trenches experience in retail consulting and analysis. Rarely do you find an industry analyst express an informed opinion so forcefully in the mainstream financial media. I highly recommend listening to the interview for an overview of how the retail and commercial real estate business will evolve in the coming quarters.

A preview: It ain’t good.

This from Eric Fry:

“Success is never final. But failure can be,” Bill Parcels, the former NFL coach, once observed. Investors in real estate investment rusts (REITs) might want to pay particular attention to this truism.

REITs, as the name suggests, invest in real estate of various types. But what the name does not suggest is that REITs usually utilize leverage in their pursuit of investment returns. Leverage, as many investors learned during the last 12 months, is fun on the way up, but potentially fatal on the way down (unless you happen to be one of America’s 19 largest financial institutions).

At the moment, the REIT industry finds itself squarely in the middle of the “way down” phase – both because asset values are plummeting and because interest rates are climbing. Just yesterday, the yield on 10-year Treasury notes kissed 4%, which means that the 10-year yield has nearly doubled since the start of this year!

When long-term interest rates rise this dramatically and rapidly, many different industries suffer. But few industries suffer as much as the commercial real estate industry. Even in the best of times, rising interest rates increases the cost of capital, while also undermining the value of commercial real estate assets. In the worst of times – or even in less-good times – rising rates can produce catastrophic consequences.

Today’s commercial real estate market was distressed, even before rates starting rising. The problem, in a nutshell, was excess capacity. During the last several years, America constructed shopping malls and office buildings to satisfy the excess, phony demand that easy credit produced. But now that home equity loans and other readily available forms of credit have disappeared, so has the phony demand.

The unfortunate result: a glut of shopping malls, office buildings and hotel/motel properties.

“Vacancies are definitely rising across the commercial real estate market,” observed hedge fund manager, Jason Stock, at last month’s Value Investing Congress in Pasadena, California. “You’ve got office vacancies well over 15%. We think those are going to approach 25% before this is over.”

Stock and his partner, Will Waller, oversee the M3 Fund, a hedge fund that invests solely in the banking sector. Stock and Waller claim they are finding a number of attractive stocks to buy. Nevertheless, they remain very anxious about the health of the overall banking sector. In particular, they fear that commercial loan defaults will skyrocket from current levels, causing a large number of banks to fail during the next two years.

“So far this year there’s been just over 30 bank failures,” Stock reported in early May. “We expect they’ll be roughly 150 bank failures by the end of the year. And we would actually expect that number should be significantly higher.

Stock continued:

“Every Friday night (we jokingly call it ‘death watch,’ because that’s when you get the notices of the banks that have failed [from the FDIC]), when we look at the banks that are coming across as failures, we’ll say to ourselves, ‘Geez, that bank is a lot better off than 20, 30, 40 banks that we can think of. The regulators right now are completely overwhelmed. You have to have people to close down banks. And it’s not a very quick and easy process. It takes a fair bit of manpower. So if the regulators had the staffing to do it, there are definitely 50 to 100 banks that you could say, ‘This Friday we are going to go in and close all these banks down.’ So it’ll just be a matter of time before that pace picks up.”

In last month’s letter to their investors, Stock and Waller reiterated their skeptical outlook:

“The Government’s release of the ‘stress test’ results on May 7th was a key driver of the rally in large bank stocks. The results indicated that nine of the 19 firms have adequate capital under the test’s most adverse scenario…In our opinion, this ‘stress test’ was in no way stressful and could more accurately be compared to a beach vacation in Hawaii where the weather forecast had a 10% chance of afternoon showers.

“The ‘worst case’ scenarios that the Government utilized in this test included unemployment reaching 8.9% in 2009 and 10.3% in 2010 (as of May 31, 2009 the unemployment rate was 9.4%), and GDP growth of .50% in 2010. We believe unemployment could easily exceed 10.3% and that it is absurd to use a positive number as a worst case scenario for GDP in 2010. This ‘stress test’ created a false sense of stability in the banking sector and created a historic opportunity for banks to raise capital at significantly inflated valuations…While extremely beneficial to the banks, we believe the investors who participated in these offerings will be choking on these investments over the upcoming months.”

Contradicting the sanguine conclusions of the stress tests, Stock and Waller point out, “The Federal Reserve chimed in with an alarming report on first quarter loan delinquency rates at commercial banks. Total loan and lease delinquencies increased by 96 basis points, a 20.7% increase in only one quarter (from 4.6% to 5.6%)…We maintain our bearish outlook…we believe this bear market rally is unsustainable and that fundamental trends for banks are negative…”

Your California editor concurs, which is why he does not hesitate to say that most bank stocks are better sold than bought at their new and improved “recovery prices.” Similarly, most REITs are better sold than bought.

Source: Real Estate Investment (Dis)Trusts

Editors Note: Dan Amoss appears courtesy of today’s Rude Awakening.

Forecasting loan losses at banks is an inexact science. In fact, it’s not a science at all. It’s more like a game of chance, like craps or roulette. Even if you know the odds, you still have no idea about the outcome. Forecasting future cash flow from existing loans is also a game of chance. Both of these unknowable forecasts lie at the core of last week’s stress test.

The market’s reaction to the stress test — in the form of soaring bank stocks — tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy.

Most of us do not have magic predictive powers — only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

For example, the stress test’s estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending.

The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much.

Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital).

Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that’s cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators prevent the water from falling to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels. There’s a risk that if the optimists are wrong about the amount of new water coming in, we’ll be stuck with a Japanese-style “zombie bank” situation.

After last week, I think the risk of the zombie bank scenario is much higher. We’ll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) — rather than write new commercial or consumer loans.

The big banks certainly will not be underwriting many commercial real estate loans (this is central to my thesis on buying the UltraShort Real Estate ETF (NYSE: SRS). Any commercial real estate lending that’s done will incorporate much lower loan-to-value ratios and higher interest rates. With property prices down 50%, the equity in levered deals done at the peak of the bubble has mostly vanished. REITs are a form of equity in leveraged commercial properties.

As you can see in the term sheet of the latest iteration of TALF lending for CMBS, the Fed is in no position to lower its lending standards (see link here). It is not willing to lend against commercial mortgage collateral that’s below investment grade or was created before July 2008 (“All mortgage loans must have been originated on or after July 1, 2008.”). These terms exclude virtually the entire pool of distressed commercial real estate assets. So even if the Fed lowers its collateral standards further, REIT equity will still not avoid massive dilution or elimination. Underwater commercial property owners (including REITs) are finding it nearly impossible to refinance maturing loans.

Certainly, the Federal Reserve will continue trying to cushion the deleveraging process underway in commercial real estate. The market’s expectation of Fed intervention in this sector has fueled much of the recent rally in REITs. But I think the market has it wrong here. The Fed may be able to slow the destruction of wealth in this sector, but it cannot preserve the equity value of overleveraged REITs, any more than the Fed’s 2007 lending programs could preserve equity value for Citigroup (NYSE:C) shareholders.

Source: Commercial Real Estate…The Crisis Begins

Many are valued like they are depleting assets (like energy trusts or master limited partnerships), when, in fact, they are growth companies.

Many of them have been expanding gas production too quickly until recently, because they were accessing outside capital in the form of debt. But ever since natural gas prices tanked, most have announced that they will “spend within cash flow,” or limit drilling activity to reinvesting the cash flow that they generate.

I’ve spent a lot of time in recent weeks reviewing E&P capital spending plans, and I think the market is underestimating just how quickly U.S. natural gas inventories could contract, given the recent collapse in drilling activity.

The Jan. 23 natural gas inventory report from the EIA revealed a 176 billion cubic foot inventory draw despite severely depressed industrial demand.

E&P companies were financing new drilling projects with debt in 2007 and early 2008, but it did not lead to an inventory glut. This reflects just how intensely the industry needs to drill to meet demand. Now that debt-financed projects are a thing of the past, we can expect to see a significant negative supply response.

For the most part, the E&P industry in the U.S. is very disciplined — perhaps more so than OPEC. E&P companies are responding to the lower natural gas price by slashing drilling and well completion activity in this depressed gas price environment. At $4.50 per thousand cubic feet, the spot price of gas is below marginal cost for most producing fields.

At today’s low prices, it makes economic sense for E&P companies to defer new projects. The U.S. natural gas supply originates from thousands of wells scattered all over the country.

Decline rates of these wells are very steep. Consider that most new production comes from shale plays — where production can decline 70% in the first year after well completion.

So low natural gas production should balance the market later in 2009 — prompting a rebound in natural gas prices. E&P stocks should rebound even faster than gas prices, since they are already discounting years of unattractive prices.

Source: Natural Gas E&P Stocks Should Rebound Quickly