The Commercial Real Estate Bust – “Extend and Pretend”

BusinessWeek’s cover story this week is “Why the Commercial Real Estate Bust Looks So Scary”.

Goldman Sachs has been receiving a lot of attention recently for their big profits and mammoth bonuses – don’t you wish you were on the receiving end of one?

Some of Goldman’s investors aren’t so fortunate. BW opens with a report on the Arizona Grand Resort, a deal which Goldman securitized and sold to investors in 2006. It turned out to be one of the largest busts of the recent economy: the resort defaulted on a $190 million loan.

There’s a great story about lending. If you owe the bank $100,000 and you can’t pay, then you have a problem. If you owe the bank $1 million or more and you can’t pay, then the bank has a problem.

In this case, Goldman sold the loan to investors. Goldman kept its fees, and seems to be in pretty good shape now. What if you are one of the investors in the bonds backed by this loan? Too bad.

$190 million is only a fraction of the whole commercial real estate market, measured at $6.4 trillion. But this scenario has played itself out over and over.

Unlike many housing loans backed by the FHA, there is no PMI or Federal guarantee for these commercial loans. Most of the big loans were securitized. Who loses when the big loans go south? Investors, not the underwriters.

The next scary story BW reports on is the bankruptcy of the Yellowstone club in Montana, It’s a sordid story, complete with a rags to riches owner, an acrimonious divorce, and wild spending. I’m sure some people may enjoy seeing the owner suffer a reduced state, but I’m more concerned about the investors and the multiplier effect on the economy.

The Yellowstone Club is another large resort where Bill Gates and Greg LeMond purchased homes (must have the celebrity factor!) In 2005 Tim Blixseth, the owner, borrowed $375 million from Credit Suisse, $209 million of which was for his personal use. That’s where the wild behavior and spending come in.

An entity can hold only so much debt given a reduced cash flow, which is why we hear so much about capital structure these days. Yellowstone Club went bankrupt and I’m glad I’m not holding one of those worthless bonds.

BW also reports on another deal which would be laughable if it weren’t true: Piazza Blanca, an upscale shopping complex in Galveston, TX. Prudential Financial lent $13.9 million. The standard operating procedure in commercial real estate deals is that the property owner needs to report on future cash flow so the lender knows the loan will be paid on schedule. In this case, the numbers were made up, exaggerated, and the dog probably ate the homework too.

Aren’t the lenders supposed to verify numbers? In 2007, apparently they had better things to do. I remember back in the 80’s Mikhail Gorbachev saying “Trust, but verify”. Commercial lenders seem to have heard only the first part of the saying.

2007 was the peak year for bad loan origination, and we will be hearing about this for years to come. Kenneth Riggs, CEO of Real Estate Research, says the market won’t fully recover until 2020. This is especially bad because of securitization. The ripple effect of a bad loan is huge, because so many people invested after the loan originated.

The stories go on. As I always like to ask, what’s in it for us? How does this affect the average person on the street?

This will be an enormous deadweight on the economy while the economy is struggling to recover. Banks now have weakened capital structures (their ratio of debt to equity) and they are holding on to their TARP money to strengthen the capital structure, not to lend out. In today’s New York Times there is a piece about how Tim Geitner is wringing his hands trying to get banks to lend. Well, they won’t lend until they can sell their securities on the secondary markets (which have dried up) and when they have stronger capital structures to please the regulators who have now woken up after being asleep at the wheel. Even banks which have always been careful about lending now have a shakier loan portfolio. Because the economy is weaker, by definition all outstanding loans have a slightly higher risk of default even if it is the same outstanding loan from years ago.

I am also concerned about who or what these securities were sold to. Institutions hold most of the securities in this country, and in the previous boom times pension plans were willing to invest in all sorts of fantastical products. That’s what happens when rates are low – investors must hunt everywhere for higher returns which are difficult to find. Taking on risk is the only way to get a higher rate in such an environment.

It sounds like the defaults are going to keep happening. Just when we hit 10.2% unemployment rate, this doesn’t give any boost to consumer confidence.

My favorite part of the article was the BW podcast. In the commercial real estate market, there is a rush to renegotiate debt. The new operating phrase is “Extend and Pretend”. In other words, extend the term of the loan and pretend it is okay.

“Extend and pretend”. Such wisdom from an industry that never bothered to check the numbers…

End note: The BusinessWeek reporter, Mara Der Hovanesian, wrote another cover story in mid-2006, “Toxic Mortgages”. I vaguely remember that issue, but who was paying attention back then? That woman is brilliant!

The stress test for banks did not include commercial real estate debt – why, I have no idea – and with a move to fair value accounting, these assets are on the banks’ balance sheets at their previous valuations. In other words, the other shoe has not yet dropped on this one. More later!