CRE - Get Ready For The Next Down Leg

CRE - Commercial Real Estate is the most dangerous financial entity that will spark the next severe downdraft in the global markets.

From reading various earnings reports from JP, BOFA, C, and others, the alarm bells have already started, but the equity markets with Tim Geithner leading the cheers keep on hitting the snooze bottom. Give the banks some credit, they are very worried about severe blow back from commercial real estate, and have made it clear to investors that is the next major reason for concern. The partial reason for some gains recently is that the government is working on integrating CRE losses within TARP/TALF.

With General Growth Properties, the nations 2ND largest mall operator filling for bankruptcy protection last week, this is just a small portent of whats coming up for debt holders. Although GGP is still cash flow/EPS positive, it succumbed to the mounting debt that it could not refinance in 2009. All around the country default rates for small and medium sized businesses are under severe pressure.

The Federal Reserves most recent "beige book" survey of regional economic conditions, released last week, found that commercial real-estate conditions "continued to deteriorate over the past six weeks." Demand for space fell, the supply of sublease space rose and property values moved lower as reality "set in," the survey found. The slump in the commercial real-estate sector could be a drag on the economic recovery as well as recent market gains.

About $248 billion in commercial real-estate debt comes due this year, In 2010 and 2011, a total of $566 billion matures. Most cities have seen speculative office development, many are suffering from an oversupply of new condos and retail space. Other places are hurting as surplus office space is dumped by companies and from declining values of properties purchased when times were good. The current economic climate is bad, but the damage in commercial real estate has not completely been focused on, and who do you think is standing there holding the bag?

The delinquency rate on about $700 billion in securitized loans backed by office buildings, hotels, stores and other investment property has more than doubled since September to 1.8% this month, while that's low compared with the home mortgage delinquency rate, it's just short of the highest rate during the last downturn early this decade. My friend who is a real estate lawyer says... "it now looks as if the current commercial real-estate slump will rival or even exceed the one in the early 1990s, when bad commercial-property debt played a big role in dragging the economy into a recession. Then, close to 1,000 U.S. banks and savings institutions failed. Lenders took about $48.5 billion in charges on commercial real-estate debt between 1990 and 1995, representing 7.9% of such debt outstanding. Since late 2007, a total of 47 banks and savings institutions have failed, of which a dozen or so had unusually high commercial-mortgage exposure. The U.S. banking sector could suffer as much as $250 billion in commercial real-estate losses in this current downturn, as well as an additional 700-1000 banks could fail as a direct result of their exposure to CRE.

Commercial real estate debt is potentially more dangerous to the financial system than debt classes such as credit cards and student loans because of its size. Some estimate that commercial real estate in the U.S. is worth $6.5 trillion and financed by about $3.1 trillion in debt. Also, the commercial real-estate debt market is nearly three times as big now as in the early 1990s, potential losses in dollar terms loom larger.

Moody's and Fitch have already started to downgrade many CMBS backed securities underscoring the need for banks to start thinking about Real Estate Reserve exposure. The banks today are more leveraged to CRE then ever before via CMBS. The big danger is a repeat of what happened on the residential side, a complete choking up, foreclosure disasters and increased stress on the banking system.

Coming back to General Growth Properties, bankruptcy was the only avenue because the company just couldn't come to terms with restructuring or modifying their debt. Of $154.5 billion of securitized commercial mortgages coming due between now and 2012, about two-thirds likely won't qualify for refinancing. Most analysts estimates assumes declines in commercial-property values of 35% to 45% from the peak in 2007. That would exceed the price drops in the downturn of the early 1990s. The default rates on the $700 billion of commercial-mortgage-backed securities could hit at least 30%, and loss rates, which figure in the amounts recovered by lenders, could reach more than 10%, the peak seen in the early 1990s. Besides securities backed by commercial real-estate loans, about $524 billion of whole commercial mortgages held by U.S. banks and thrifts are expected to come due between this year and 2012. Nearly 50% of that wouldn't qualify for refinancing in a today's tight credit environment, as they exceed 90% of the property's value.

So what does this mean to the majority of the banks?

In contrast to home mortgages, the majority of which were made by only 10 or so giant institutions, hundreds of small and regional banks loaded up on commercial real estate. As of last year, more than 2,900 banks and savings institutions had more than 300% of their risk-based capital in commercial real-estate loans, including both commercial mortgages and construction loans.

All of this, plus a massive 30% move off of the lows tells me that the recent rally phase is over. The market when it was trading at 6500, was fore shadowing and pricing in a depression, currently the markets around the 8000 level is telling us that we are in a bad recession. But if CRE comes undone, we are headed towards the lows.

For years the entire market was obsessed with Alpha Risk (Performance), so they leveraged up the Beta (Risk). That entire trade had to be unwound and we are still in the 4Th or 5Th inning of that great unwinding. Perception always trumps reality, and the perception at the moment is that we are out of the woods. The current run up has exceeded the typical bear market rally of about 20%, but definite disappointment awaits. This is not the real thing, when $15 Trillion in global wealth has been destroyed, it takes more then 10 months to get back in gear.

The key reasons I feel this way is real simple:

-Recessions such as the current one we are experiencing, which was brought upon us by the financials typically take longer to resolve. The massive deleveraging of the 30 year credit cycle is not finished, and is about to get another round of losses.

-Government debt levels are huge, and will get exponentially bigger as the crisis heads on. Is this type of fiscal/monetary stimulus sustainable? What is the by product of such stimulus? Hyper INFLATION?

-After CRE losses, we got HELOC, auto, and credit card losses to suffer through.

-Corporate profits could fall by some 40% this year.

Bottom line, when you have a banking crisis combined with a cyclical downturn, you cant believe you can come out of it this quickly, no matter how much the government does.