Tuesday, June 30, 2009

Iceland's Program For a Fiscal Cure

June 30, 2009

At one end of Laugavegur, Reykjavik’s main shopping street, Icelanders jostle in the aisles of a Bonus discount grocery to fill their baskets with ham, dried codfish and other staples. A mile up the road, in an office tower that also houses the stock market, sits an Apple Store that is perhaps the only one of its kind: except for a salesman, it is completely empty.

This neatly illustrates the state of play in Iceland eight months after it essentially went bust. No country embraced the excesses of the credit bubble as zealously as this North Atlantic island nation of about 310,000 people. As a result, it’s hard to find a place that’s suffering the deprivations of the crisis to the same degree.

It’s not just that iPods are off the shopping list in favor of processed pork. The nation is deeply indebted, consumer spending is in free fall, its banks are ruined and capital controls restrict the flow of money outside the country.

As hard as Icelanders must toil to fulfill the demands of their financial rescuers — including $5 billion from the International Monetary Fund and a phalanx of Nordic neighbors — don’t cry for them. Iceland, unlike many other nations that went mad for credit, still has many things going for it: a low average age of 37, highly educated workers, a nearly positive birthrate, overfinanced pension funds and abundant natural resources.

That said, statistics paint the remarkable fiscal challenge Iceland faces. The central bank estimates four out of 10 households took out loans denominated in foreign currencies to buy cars. And 80 percent of Icelandic homes have mortgages with payments either directly linked to inflation or denominated in foreign currencies.

When the krona was soaring this might have seemed rational. The strong currency, buoyed by artificially high official interest rates, allowed hot money to flow over Iceland like the Gulf Stream that keeps the country temperate. Everyone from American hedge fund managers to Austrian dentists could borrow cheaply at home, or in low-rate currencies like the Japanese yen, and buy higher-yielding Icelandic paper.

When this vast “carry trade” ended, though, the currency crashed and the cost of servicing all those liabilities spiked. So did the prices of imports, which led to inflation. Because many Icelandic mortgages carry payments linked to consumer prices, one in six households now face mortgage payments equal to 60 percent or more of their take-home pay.

Iceland’s banks also got into this game, rolling in easy money they then lent to entrepreneurs known locally as “business Vikings.” Soaring stock prices also encouraged them to expand their businesses abroad. At its peak, the Reykjavik market’s capitalization rose to more than 250 percent of gross domestic product — making it the most highly valued in the world. Today it’s around 16 percent.

Now it’s up to the government, and the majority of its citizens, to avoid the bankruptcies suffered by Iceland’s banks and business borrowers. Fiscally speaking, this means Iceland must go back in time: under the agreement it reached with the I.M.F., it must gradually lift capital controls, tighten up its monetary policy and return to a current account surplus by 2013. This won’t be an easy task. Iceland is expected to have debt equal to 120 percent of its 14 billion euros of G.D.P. and a budget deficit of about 13 percent of output this year.

And that’s where the hard work comes in. The country’s leaders are fostering export-oriented businesses like fisheries, geothermal energy, tourism and technology. A few more British bachelor parties, cod exports and aluminum smelters will help bring in the hard currency the country needs to pay back its foreign debts.

But Iceland also seems to realize that sacrifice will be necessary to restore financial health. Indeed, on Monday, Iceland’s Parliament passed a bill so filled with tax increases it would make even the most spendthrift politician in Washington wince. Equally, the bill’s corresponding spending cuts were deep enough to embarrass the stingiest fiscal conservatives.

Creativity, hard work and belt-tightening should help Iceland emerge as a stronger economy. Other indebted developed nations, still stinging from the credit crisis, like the idea of innovation. But so far, few have shown themselves keen to adopt the tougher parts of a recovery plan like Iceland’s. They might do well to pay more attention.


For more independent financial commentary and analysis, visit www.breakingviews.com.

Monday, June 29, 2009

Wary Banks Hobble Toxic-Asset Plan


JUNE 30, 2009 Wall Street Journal

The government's plan to enable banks to dump troubled assets is facing troubles of its own.

Markets initially rallied when Treasury Secretary Timothy Geithner announced in March a two-pronged plan to offer favorable government financing to entice investors to buy bad loans and toxic securities from banks.

But that initiative -- called the Public-Private Investment Program, or PPIP -- has lost momentum. Big banks worried about having to sell at fire-sale prices while small banks feared they would be shut out. Potential buyers balked at the risk of doing business with the government, concerned that politicians might demonize them for making big profits.

The program's problems threaten to stymie efforts by struggling smaller banks, in particular, to clean up their balance sheets. That in turn could hinder efforts to revive the nation's economy.

A look at why the program has stumbled underscores how difficult it has been to solve one of the economy's biggest problems: Mountains of bad debt sitting on the books of the nation's banks. As those loans and securities lose value, they are saddling the banks with losses and constricting their ability to lend.

U.S. officials and investors are playing down expectations for the plan -- originally billed as a $1 trillion endeavor. Some federal officials say the banking environment has improved since the program was unveiled. They assert that because a dozen or so big banks recently succeeded in raising capital, they are under less pressure to sell bad assets.

Early this month, the Federal Deposit Insurance Corp. essentially shelved one arm of PPIP -- the government-financed buying of bad bank loans. Mr. Geithner recently said the other part -- to facilitate the buying from banks of troubled securities, many backed by real-estate loans -- could be scaled back because investors are "reluctant to participate." This week, the government is expected to name investment firms to manage this securities-buying portion.

"The fits and starts on all this stuff has added to the uncertainty that makes [investors] stay on the sidelines," says Trabo Reed, the deputy banking superintendent in Alabama, where many small and midsize banks are looking for cash infusions from investors.

Lee Sachs, counselor to the Treasury secretary, says the department remains committed to the program and has received more than 100 applications from would-be investment managers. "One of the goals of the PPIP program has been to help create liquidity in frozen markets," he says. "Some banks will sell assets. Even those that do not will benefit from the greater ability to value the assets they hold."

The slimmed-down program will focus not on bad loans, but on toxic securities, which are a problem for a relatively small fraction of the nation's banks. That is bad news for hundreds of smaller banks burdened with growing piles of defaulted loans. These banks are less able to tap capital markets than their larger rivals, so they have been eager for U.S. help unloading loans as a way to bolster their capital cushions. Many of them can face big problems if just one or two large loans go bad. Seventy banks, most of them community institutions, have failed since the start of last year. Analysts are bracing for hundreds of lenders to collapse in the next few years.

Because these lenders often play key roles supporting their local economies, taken together, they are important to the financial system and to a U.S. economic recovery, says Kenneth Segal, senior vice president at Howe Barnes Hoefer & Arnett Inc., an advisory firm for small and midsize lenders.

During the last banking crisis, nearly two decades ago, the government established the Resolution Trust Corp. to sell off the bad loans and securities of banks that had failed. Many experts credit the RTC with helping defuse that crisis.

This time around, efforts to rid banks of soured assets have sputtered repeatedly. In late 2007, federal officials helped cobble together a plan for a bank-financed fund to buy securities held by bank investment funds, but the effort was aborted. In 2008, the Bush administration established a $700 billion program to buy banks' soured assets. Partly because of the complexity of valuing those assets, the U.S. abandoned that plan, instead opting to directly pump taxpayer money into banks.

Scott Romanoff, a Goldman Sachs Group Inc. managing director, has referred to the current effort, PPIP, as "the greatest program that never occurred," because it "created confidence in the markets so banks can raise equity capital."

In recent weeks, markets have lost some vigor amid renewed concerns about the economy. That could make it more difficult for big banks to raise additional capital. Banks also could face further losses as bad assets decline more in value.

On March 23, when Mr. Geithner unveiled PPIP, the Dow Jones Industrial Average surged nearly 500 points, or 7%, its biggest gain since October, on hopes that the program would nurse the banking industry back to health.

Many bank executives were skeptical about whether the program could succeed. Even before it was announced, some had grumbled that federal officials weren't consulting them, and instead were crafting the initiative with input from would-be investors. Some banking executives say they warned that they would be loath to sell at the kind of prices investors were likely to demand.

Executives at Citigroup Inc. shared those concerns, according to people familiar with the matter. While the New York bank was sitting on at least $300 billion of risky loans and securities, selling them at discounted prices would require painful hits to its already thin capital ratios, these people say.

Some Citigroup executives had a different idea: Maybe they could turn a profit by bidding on their own toxic assets at discounted prices, using government financing, according to the people familiar with the talks. Other big banks also talked about setting up distressed-asset units to snap up troubled loans and securities, including from their parent companies, with taxpayer financing.

FDIC Chairman Sheila Bair later publicly shot down the idea. Citigroup declined to comment.

Meanwhile, many small-town bankers hoped the program would help them unload the bad assets -- generally loans to finance commercial real-estate projects -- that were hurting their balance sheets. Some potential buyers had surfaced before PPIP was announced, but they were offering such low prices that few banks could afford to sell the loans without severely denting their capital cushions.

The hope was that PPIP would help narrow the gap between buyers and sellers. Investors would be able to bid more because the government would offer buyers little-money-down financing, along with some downside protection.

"We have illiquid assets," says Patrick Patrick, chief executive of Towne Bancorp of Mesa, Ariz. "It would be helpful to have a vehicle where you could sell them at market and be able to restructure our balance sheet."

Like many small banks, Towne Bancorp has been hurt by a handful of loans to finance real-estate projects that went belly up. In the first quarter, the bank said two souring commercial real-estate loans caused its portfolio of loans at least 90 days past due to swell by 52%. Such loans represent more than 22% of Towne Bancorp's $143 million in assets. The company has been trying for months to sell 19 pieces of real estate -- including undeveloped land and a warehouse -- that it seized when loans went into default.

When PPIP was announced, big-name investors were intent on figuring out how to profit from it. Raymond Dalio of giant hedge-fund firm Bridgewater Associates, which oversees $72 billion in assets, initially expressed interest in participating. But within days, he was blasting it, saying buyers and sellers would have difficulty agreeing on pricing and fund managers that profited would be exposed to criticism from politicians. The way PPIP is set up "makes us not want to participate and it makes us question the breadth of interest that we will see in the program," he wrote to clients.

Lawyers for hedge funds and private-equity investors warned clients about the risks of doing business with the government. The industry was unnerved by the restrictions placed on banks participating in another federal bailout program, the Troubled Asset Relief Program. Fund managers were also bothered by President Barack Obama's criticism of the hedge funds holding Chrysler LLC debt who had refused the government's buyout offers.

In conference calls with bankers and investors, FDIC officials emphasized that PPIP was critically important to cleanse banks of their bad assets. "I think you know the stakes are very high with this," Ms. Bair, the FDIC chairman, said during a March 26 call, according to a transcript. "We need this program to work."

Ms. Bair and her deputies encountered skepticism. In an April 9 conference call with the FDIC, Mark Wolf of TRI Investments LLC, described his Carlsbad, Calif., firm as a potential PPIP bidder. "Unless you've got a process that either forces banks to sell or does a better job of encouraging them to sell, we're just going to see banks sitting back and dribbling these things out through an eyedropper over the course of time," he said.

FDIC Chairman Sheila Bair and her deputies encountered skepticism about the plan during conference calls with bankers and investors.

Some bankers were hesitant. "If these loans are bought at a discount, we create a hole in capital," Lou Akers, executive vice president of Adams National Bank in Washington, told FDIC officials on the March 26 call. He suggested that regulators consider changing the way they calculate banks' capital in order to cushion the blow. Government officials were noncommittal, a transcript of the call indicates.

FDIC officials emphasized on the conference calls that PPIP was intended to benefit all banks, not just industry giants. But smaller banks began to worry they'd be locked out.

To participate in PPIP, local lenders were told, they would have to pool their loans with other banks. The process, which the FDIC said it would facilitate, was designed to simplify the bidding process for government officials and prospective investors. The agency didn't want thousands of banks put their loan portfolios on the block separately.

But the FDIC planned to require participating banks to kick in a minimum amount of assets, and some small-town bankers worried they wouldn't have enough to qualify.

Too high a minimum "will virtually eliminate all community banks from being able to participate in this program," wrote Julian L. Fruhling, president of Legacy Bank in Scottsdale, Ariz., in a letter to the FDIC.

Still, some investment firms that were hoping to help manage the government's program were optimistic. Laurence Fink, chief executive of BlackRock Inc., said in mid-April during a trip to Japan that if his firm is selected as a manager, it was ready to raise $5 billion to $7 billion to buy securities through PPIP. He said he hoped to raise money from individual investors in Japan and the U.S., and that potential returns could be as high as 20%.

The FDIC and other regulatory agencies were planning to use their "stress tests" of the nation's top 19 banks to push them to sell assets via PPIP, according to people familiar with the matter. But in the weeks before the stress-test results were announced in May, market sentiment began to improve. A number of banks succeeded in raising capital by selling new shares to the public.

Once the stress tests were wrapped up in May, even more banks sold shares -- a total of roughly $65 billion within a month. The capital-raising removed regulators' leverage to encourage participation in PPIP, according to government officials.

Around the same time, BlackRock reduced its goal for the size of its potential PPIP investment fund to about $1 billion, say people familiar with the matter.

Earlier this month, the FDIC formally postponed the loan-buying portion of PPIP, called the Legacy Loan Program. "Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system," Ms. Bair said.

Next month, the FDIC intends to use PPIP for a far narrower purpose: to auction loans the agency has seized from failed banks. Eventually, it hopes to resuscitate the loan-buying program so that smaller banks can benefit from it.

But that could be tricky. The U.S. initially justified PPIP by invoking its "systemic risk" powers, which enable regulators to step in when the financial system is at risk. Regulators have debated whether such a justification would remain if the program were geared toward smaller banks. FDIC officials doubt they will muster the necessary consensus among regulators to invoke the special powers and keep the loan program alive, according to a person familiar with the matter.

Many banking experts contend that the financial system won't fully stabilize until banks get rid of their bad assets.

Mr. Segal, the bank adviser, complains that federal officials have cited recent capital raising by big banks as evidence that "the system is OK." That may be true "for the top 15 or 20 banks," he says. "But for everybody else, there really needs to be more attention paid."

—Deborah Solomon and Damian Paletta contributed to this article.

Write to David Enrich at david.enrich@wsj.com, Liz Rappaport at liz.rappaport@wsj.com and Jenny Strasburg at jenny.strasburg@wsj.com

Wednesday, June 24, 2009

CRE Indicators

At CRE Financial Advisors, we never stop underwriting. With countless years of Commercial Real Estate risk analysis between us, our firm’s “risk sensors” are never switched off as we monitor and assess rapidly changing Commercial Real Estate market conditions.

Some of the key CRE Indicators CRE Financial Advisors is watching closely:

Constrained CRE Capital Markets: there is nominal origination activity and most, if not all of the activity, is occurring by way of guarantees or funds issued by the government. The important market test will be if and when CRE capital markets can once again stand up without government support. We believe the reconstruction of the private CRE capital markets will take a long time and may not return to historical levels for at least 5-10 years.

Rapidly Rising CMBS Default Rates: The rise in default is occurring due both to the inability to refinance and the erosion of asset performance and quality. Looser underwriting based on aggressive growth assumptions in pre-2008 pools means these complex capital structures are unraveling rapidly. Addressing the interests of competing bondholders is new and treacherous territory for workout professionals.

CMBS Appraisal Reductions: Plunging values are prompting servicers to cut back on liquidity loans to securitization trust affecting interest payments to below investment grade bondholders. This trend is creeping up the credit curve. This downward trend (spiral) is self-reinforcing.

FDIC Sales Activity: The FDIC has conducted 1st Q 2009 of whole loan sales of bank assets totaling approximately $2Billion face value, selling at $.51 on average. A new FDIC portfolio, totaling $6 Billion in a structured loan offering, is expected to hit the market in July/August 2009.

CRE Asset Spot Market Sales Activity: We are hearing that in the private CRE asset sales market (mainly offered by banks), many deals are not closing. The bid/ask gap is still too wide and the prevailing approach by selling financial institutions may be that if price targets are not met via portfolio sales, it is better to wait for economic recovery to restore or shore up asset values.

CRE Financial Advisors’ Macro-market Monitoring and Micro-market Analysis

The New Normal Economic Utilization Rates:

One of our overriding concerns is that economic activity is going to run at a significantly lower level in the new, less leveraged economic environment both in the near and the long term. The core economy will keep working (at an 80-90% utilization rate) but the economy on the margin will continue to suffer. The government has been the major economic support and has financed the reconstruction of much of credit market and some productive capacity via credit enhancement and economic stimulus. The government support will not continue indefinitely. The devastation and destruction on Wall Street has eliminated many marginal players, allowing the strongest Wall Street institutions to gain share and recover quickly.

For us, one interesting example of the New Normal is the drop in US car sales from the “bubble” level of 17 million vehicles per year to possible sustainable sales of 10-12 million units in the more constrained credit environment. Lots of marginal human capital will need to be redeployed and relocated as production levels adjust to new, lower levels and production shifts to new locations thereby affecting many micro-markets. Production housing, a historically strong job-creating machine in many US markets, is also re-aligning itself to new demand levels in response to the still evolving economic and financial landscape.

The Inevitable CRE Value Reset to 1995 or 2005 Levels:

In CRE, cash flow is king. We believe that in many markets, CRE Net Operating Income will deteriorate slowly but surely. Due to the economic downturn, a significant rental rate reset is occurring and will flow to the commercial property bottom line, ultimately realigning commercial values over the near term. Just because it is occurring slowly does not mean it will not occur or can be avoided. As we have seen in the past year, there will be some spectacular failures and many more subtle, long term re-adjustments.

The banks have every reason to wait as long as they possibly can before unloading CRE assets. We believe, at minimum, we are facing a 10-30% commercial value downward adjustment. Some asset classes, such as raw residential land in outlying areas, may be hit much harder.

Some of the smartest people in the room are forecasting massive debt destruction (in fact, many are banking on it). According to some experts, the lack of true incremental productivity (not speculative financially engineered growth) of underlying assets is the force requiring the dramatic reset of debt levels. We believe that finding and valuing productive assets realistically is the key, where value is driven by solid and sustainable demand.

Debt destruction will eventually occur at banks and other financial institutions. An emerging strategy to access discounted bank debt is to simply buy the whole bank. Acquiring banks presents an “opaque trading opportunities” for various funds. In these transactions the government often assumes much of the downside risk.

The Old School Burnt Down but New School Fundamentals Have Yet to Emerge:

It has been reported that the rate of economic decline may be slowing. We firmly believe that new incremental demand and growth will be slow in coming and that we must be aware of false positive indicators in the CRE market. CRE is currently a lagging indicator and will not hit the floor for at least one to three years.

One of the questions we are asking ourselves is: what if consumer confidence is no longer an accurate indicator of the direction of the economy because the consumer demand algorithm (historically 70% of GDP) has shifted away from the consumer in a new, thriftier economic environment. Consumers may not get to call the next economic recovery. Loss of jobs, lack of savings and credit scarcity (for consumers and small businesses) means empty pocketbooks.

New demand can only derived from new incremental productivity. In this viscous cycle, credit providers are waiting for improved household productivity and stability. Households are waiting for job creation and the return of credit.