Monday, January 31, 2011

Paying It Forward: Some Hopeful Signs for Failed Bank Borrowers

Tom Barrack appeared on Bloomberg Television last week to discuss Colony Capital's latest successful bid on two FDIC failed bank loan portfolios totaling $820 million in residential and commercial mortgages. Based on the FDIC's disclosure, the total amount Colony has purchased from FDIC through the structured sales program has reached nearly $3.7 billion:

Date Sold
Loan Type
No. of Loans
Book Value
Commercial Real Estate
Commercial Real Estate
Announced, Not Closed
Residential and Commercial Real Estate


In the interview Barrack manages investor expectations about just how tough these loan portfolios will be to work through:

"The reason that most people don't like these is that there's no income in
the meantime. It's not as though you're buying a loan and the loan is paying
you a coupon that just happens to be under-yielding. Just about everybody
stops paying, so every transaction is a workout."

"As a buyer, it's an ongoing business. You don't know. There's not a quick
spin here. You won't know how you really did until you resolve the last 10%
of that portfolio and that can either be 18 months or 36 months."

Barrack also identified Colony's possible approach to workouts that may give some hope to borrowers who have endured months of lender radio silence.  He seems to indicate that workouts and debt restructuring are at least a possibility.

Thursday, January 27, 2011

The 2 C’s of Lending: Credit and Character but what about Collateral (Asset Value)?

The news broke this week that the FASB has codified and made permanent temporary measures designed to go easier on banks using valuation measures instituted during the height of the 2008 financial crisis. The eased valuation rules give banks a great deal more discretion in the way asset values are established. To boil it down, the guidance says two of the C’s of lending are important, the third, not so much. Borrower credit and character will be weighted most heavily as summarized in Accounting Today:

“The “plain vanilla” assets that would be eligible for cost accounting would be “those instruments where the entity has a relationship with the borrower and the purpose is to be repaid with the collection of interest and fees,” said FASB chairman Leslie Seidman during a webcast Tuesday.”

“While mark-to-market can be very useful for a business that trades financial instruments, the most appropriate accounting measure for a loan portfolio is the loan balance minus impairment.”

“According to a summary of the board meeting, FASB decided that financial assets for which an entity’s business strategy is managing the assets for the collection of contractual cash flows through a lending or customer financing activity would be measured at amortized cost.”

(MICHAEL COHN, “FASB Reverses Course on Fair Value”,, JANUARY 25, 2011)

Mark-to-Model, Hold-to-Maturity

Fair values for loans will based on a discounted cash flow methodology (or a modeled approach) that is called a “level 3 valuation in the fair value hierarchy”. Put very simply, level 1 and 2 methods in determining fair value use actual asset sales in very active and somewhat less active markets, respectively.

Level 3 valuation was used in inactive markets or nonfunctioning loan markets like we have had since 2008; valuations are not solely based on asset sales or trades. Fair value requires the bank to make estimates about discount rates, market conditions, expected cash flows and other future events that are based on evaluation borrower credit and are highly subjective in nature and subject to change. Adverse changes in the model assumptions result in a loan impairment deducted from book value.

Investors most assuredly would like to know about the value of the underlying collateral backing the loan too, not rely on discretionary financial modeling alone. After all, if credit and character fail to support the loan, the collateral that is trade-able and liquid matters a lot. Whether the price data is found in the body of the financial statements or hidden in the footnotes, collateral values is what investors will want to focus on. And investors don't want to have been misled by overly smoothed value estimates only to find out it is too late to react.

CRE, The Worst is Over?

CRE may indeed be coming out of the woods as an increasing quantity of non-crisis CRE trading data is becoming available. Use of arms-length trading data as a valuation guide means many more eyes and extensive ‘at-risk’ due diligence that comes to bear on the determination of asset values. Discretionary internal models, as we have seen in events leading up to the crisis, may diverge from (and possibly overstate) values compared with those derived from true, 'at-risk' positions.

There is little to fear about current distressed debt pricing. Between loss sharing arrangements that have locked $200 Billion of failed bank loans away and out of view for many years to come and FDIC structured sales of distressed debt that have inflated prices through FDIC low cost financing, everything possible has been done to prop up distressed debt prices today.

Yes the markets for financial assets are volatile. Yes markets overreact in crisis. CMBS is an example of just such a vital, reactive, volatile and liquid arms-length market: investors trading in these securities are striving to get behind the façade and assess the collateral (cash flow) as well as the credit in order to price the securities.

We think too that de-emphasizing external data and valuation in favor of internally driven models will make the already impossible job of regulating and monitoring of the banks' condition even more difficult. Level 3 accounting is obscure, to say the least. Market-derived data points are a very necessary component of the valuation mix.

Wednesday, January 19, 2011

Telling Stories

How does one go about valuing development sites and selecting local economies (in which to invest) when some economists have made the dire, dismal predictions that some regions in California or Florida, for example, may not recover until 2030?

Where is true sustainable growth occurring or likely to occur in the US? And what places were never meant to be? The state of housing in the US is indicative of the true, sorry story about the economy and ultimately the sad financial state of the US Household:

“A new study released by the Mortgage Bankers Association's Research Institute for Housing America says the most recent recession may make many regions around the country -- especially in the South and West -- the Rust Belts of the 21st century. The burst housing bubble may mean the economy in those places never fully recovers."

(Will The Housing Bust Create New Rust Belts? by KAREN GRIGSBY BATES January 12, 2011 National Public Radio)


“Celia Chen, a housing economist with Moody's, predicts that a full recovery in parts of California, Nevada, Arizona and Florida won't occur until 2030.

"The housing boom elevated home prices in a number of areas far, far above what can be supported by the economic fundamentals, and so prices have fallen significantly, and they will remain below their previous peaks easily for a decade, or even two decades," Chen said.

Some experts contend that foreclosures, which have pierced neighborhoods of all income levels throughout the country, are quickly turning developments on the outskirts of metropolitan areas into the nation's newest slums. Complicating any recovery for these beaten-down areas is the difficulty in predicting which neighborhoods will fare worst. That uncertainty could lead to increasing skepticism by buyers and lenders looking to make loans on homes in these areas.”

Investors sift through assets looking for signs of life in communities that have withstood the financial firestorm. Some continue to grow (and even boom) benefiting from “Coastal Wealth” effects or "Global Resource Demand".

The search for positive indicators leads us to find healthier “community organisms”, signs or proxies of the US’ generally strong economic backbone and conversely in search of the economic medicine needed to heal damaged, salvageable places.

Monday, January 10, 2011

Rebuilding the US Economy: Don't Count on Housing

The housing industry, once a big part of the US economic growth machine, is now a much weaker contributor to US job growth and economic activity.

As NICK TIMIRAOS commented last month in the Wall Street Journal, “The U.S. has normally relied on an expanding housing market to help lift the economy as it exits a recession by fueling manufacturing, consumer spending and job growth. In the first year of all postwar recoveries, residential investment has accounted for nearly one percentage point of gross-domestic-product growth….But today, it has accounted for around 0.1 percentage point of GDP growth.”

The housing industry's anemia is being felt most acutely in large swathes of the former high growth, real estate dependent economies of California, Florida and Arizona; unfortunately speculative real estate construction activity itself fueled much of the economic activity in many parts of these states, not fundamental household demand-based growth.

The Los Angeles Times reported on August 16, 2010 that “Housing is a big business in California. Home builders employ hundreds of thousands of people, and other industries such as retail, manufacturing and restaurants benefit from the spending of those employees.

The slowdown in construction in California has muted those benefits. According to a report released Monday by the California Homebuilding Foundation and the Center for Strategic Economic Research, the economic output of the housing industry has fallen 80% since 2005.

In 2005, which the report says was near a peak in the housing industry, residential permit levels were around 205,000 units, generating 487,000 jobs and $67.7 billion in economic impact. By 2009, residential permit levels dropped to 35,000, employment hovered around 77,000. The economic benefits of housing dropped to around $13.8 billion, according to the report.”

The Long Slog

Rebuilding the housing industry will be long slog after housing's near apocalyptic self-destruction. The destruction was not only of basic housing demand (millions of US consumers were so severely hit by the meltdown and now are fighting to rebuild their credit and household net worth) but of the collapse of the entire system's infrastructure that once supported and processed all aspects the housing industry’s hyperactive (and some say slipshod) development, construction, sales and finance (bubble-making) machine.

All components of the US housing delivery system are still being questioned, probed, pounded, critiqued, dissected, dismantled, and above all litigated. Housing’s deconstruction is not yet complete. Commercial real estate too has suffered collateral damage from the direct relationship to it’s massive, ailing residential cousin.

No one yet knows what the housing and mortgage production will look like when reconstruction takes hold in earnest. There are too many unknowns. As always there is a naïve hope that the world will be the same as it ever was, an assumption that the rules will be as they were.

We don't think so.

Policy has yet to be written for the role of the surviving mortgage financing entities Fannie Mae and Freddie Mac. The smoldering remains of these two institutions are still too hot for politicians to touch. Will these sort of private but now blatantly public institutions, that have taken over for the private mortgage market, remain public agencies or become truly private this time? Neither side of the aisle wish to be labeled socialist nor put the final nail in the coffin of the housing industry left to pure and brutal market forces.

The new world order of mortgage finance will surely be one that is well underwritten and well documented. In other words it will not be as it ever was. It will be a much smaller, slower, more laborious and a less automated industry. It will take a long time for each loan to be underwritten and approved (to be measured in many months not the seconds of a phone call loan approval of times past) and it will be way more expensive (the current, temporarily and artificially low mortgage interest rates aside).

The Underwriting Pendulum Swings-More Questions than Answers

Lenders today, understandably, have a severe aversion to risk. How do they underwrite the US borrower today? How long before the millions of foreclosure casualties begin to heal their severely wounded balance sheets?

The mortgage origination business completely broke down. A permanent stable sustainable market has yet to emerge. Only massive government involvement has maintained what is left of the residential mortgage market’s faint pulse.

Fear now rules as “Lenders clamped down on the lax standards that fueled the housing bubble three years ago by requiring larger down payments, higher credit scores and greater documentation of borrowers' incomes and assets….private lenders have ceded the market to government entities Fannie Mae, Freddie Mac and the Federal Housing Administration. Those agencies, saddled with losses, are under heavy political pressure to avoid taking any new risks.” (Wall Street Journal DECEMBER 13, 2010)