Investors who are new to income-producing properties often ask: " How does a commercial lender underwrite a loan?"

It’s a good question, because if one understands how the commercial lender decides on the amount of money he will lend on a commercial property (multi-family properties greater than 4 units included ), a prospective borrower has a chance to assemble a loan package which is attractive to the  lender and thereby improve chances to obtain a good loan.

Loans on individual single family residences (SFR), condos and multi-family properties of 4 units or less, are generally obtained from savings and loan associations, local banks and credit unions. Private lenders, other than sellers, are rarely involved. Underwriters for these loans are interested in the answers to 4 important questions:

1. Does the prospective borrower have the financial capacity and stability of employment to repay the loan?
2. What is the fair market value (FMV) of the property which will serve as collateral for the loan?
3. What percent of the FMV is the requested loan amount?
4. Does the prospective borrower pay his bills on time?

In the case of the SFR loan (and others in this category) the first question is whether the prospective borrower(s) earns sufficient income and has a sufficient history of steady employment such that the required mortgage payment will not be an unmanageable percent of the gross monthly income.

The residential lender’s second and third concerns pertain to the value of the property which will act as security for the loan. Lenders always envision a scenario in which they become the owners of the property as a result of the borrower’s default. They ask themselves: "How long will it take for me following foreclosure to sell this property at a price which will cover my loan balance and expenses of sale?"

The last criterion judges the borrower’s credit history and pattern of paying debts. This is very important because the first line of defense against loss for the lender is not the amount of equity the borrower has in the property but rather the creditworthiness and credit character of the borrower.

So it is that SFR loan underwriter’s focuses on the borrower and his ability and demonstrated readiness to repay his loan. This is not the case, however, with income–producing properties. Rather than look to the borrower as the first source of repayment for the mortgage, the commercial underwriter looks first to the property and its income.

In order to verify the Gross Operating income from the property the lender will require copies of all leases which will survive the transfer of title. The lender is interested in the quality of the tenant(s), the amount of rent to be paid and the duration of the leases. In a word, he is interested in the quality and durability of the income stream.

In order to calculate the property’s Net Operating Income (NOI) the lender will request a current operating statement showing all operating expenses. The GOI less operating expenses yields the NOI.

The NOI is very important since it is the primary source of cash for servicing the loan. But the commercial underwriter will not lend so large a loan that it would require all the NOI to pay principal and interest. Instead, he will create a cushion for himself but applying a larger Debt Coverage Ratio (DCR), sometimes called the Debt Service Ratio (DSR).

For example, in order to provide a cushion of 25% over the actual cost of servicing the debt, the lender will use a DCR of 125% or 1.25. Therefore he will lend an amount of money such that the NOI of the property divided by annual cost of the loan is equal to 1.25. The reciprocal of 1.25 is 0.80 or 80%. Using a DCR of 1.25, this lender will permit 80% of the NOI to be devoted to debt service.

When the lender perceives a certain property to be riskier (for any number of factors), he will apply a larger DCR and thereby lower the amount of cash earmarked for loan payments. Highly specialized properties may call for a DCR of 1.5 indicating a smaller loan. If the lender judges the property to be very risky he may also charge a very high rate of interest to compensate for the added risk,  or simply refuse a loan.

In addition to the evaluation of operating income, the commercial lender usually follows a guideline which limits the amount of the loan to a percentage of its appraised value. The particular percentage applicable to a property varies according to a property’s use, location, age, degree of specialization and other factors which contribute to its saleability. Highly specialized improvements indicate greater difficulty in reselling or re-leasing, and are therefore subject to lower loan-to-value (LTV) limitations.

In either case, the lender will lend the lower amount as determined by the DCR and by the LTV.

Some commercial lenders are willing to accept the property as total security for the loan. In the event of a default by the borrower the lender would acquire title to the property, but would not have any recourse against the borrower for any monetary deficiencies suffered by the lender upon resale of the property. Other lenders, however, will look secondarily to the borrower to cure any deficiencies. These loans are known as recourse loans .

Most commercial loans are structured to completely amortize over a period of from 15 to 30 years, with 20 or 25 years being most common. Nevertheless the great majority of loans become all due and payable at the end of the 10^th year. Shorter due dates are common and are usually offered at slightly lower interest rates.

]]> http://www.TheDonohueCompany.net/?feed=rss2&p=244 0 http://www.TheDonohueCompany.net/?p=206 http://www.TheDonohueCompany.net/?p=206#comments Sat, 09 Aug 2008 23:39:21 +0000 Robert Donohue, CCIM http://www.TheDonohueCompany.net/?p=206 Commercial and multi-family real estate investors are finding it more and more difficult to obtain adequate financing at reasonable rates. As a result, a variety of data sources indicate a reduction of 65-80%  in 2008 vs. 2007 total transactions.

One of the most significant causes of the credit crunch has been  the near disappearance of new Collateralized Mortgage-Backed Securities (CMBS) securitized by commercial and multi-family mortgages. Until now CMBSs have provided a robust and much needed secondary market for loans on commercial and multi-family properties. But the volume of these bonds has declined from approximately $61.2B  in 1Q07 to less than $5.6B in 1Q08  (-90%). Conduit lenders in their peak quarter in 2Q07 issued approximately $75B. Insurance companies, local banks and thrifts have taken up only a small portion of the slack.

In addition to their problems with subprime and Alt-A loans, regional and investment banks are still working to rebuild required reserves. Although voices can be heard proclaiming that the end of the crisis is near at hand, the number of foreclosures in those markets  most affected by the subprime problem (CA, NV, AZ, NM and Fl) have tripled in the first 7 months of 2008 compared to the same period in 2007. So it is evident that a bottom is nowhere in sight. To top it off, the Financial Accounting Board of Standards at the urging of the Mortgage Banker’s Association has postponed the implementation of FAS 140 which would have required banks to bring onto their balance statements the total of debt held in off-balance sheet, Enron-like Qualified Special Investment Vehicles (QSIV). The postponement gives the investment banks another year of obfuscation to repair their damage.

We are also now beginning to learn of the size of the debt facing the institutions that were active in the Auction Rate Securities (ARS) market. ARS are bonds issued with a coupon rate that resets every 7, 14 or 35 days. ARSs have been  touted by the sellers as equivalent to cash but earning more than savings accounts. Most securities were rated AAA and were federal, state and local tax-exempt. They had special appeal to municipalities, pension funds and to those high net-worth individuals who could afford the $25,000 minimum investment.

When a holder of an ARS wanted to sell but could not find a buyer, the issuer stepped up to either acquire the security or guarantee a minimum interest rate for the next period. But all this stopped on Feb.13, 2008 when the investment banks, who have issued more than half the $330B in outstanding ARSs, withdrew their support. More than 80% of the auctions failed. Some banks (e.g. UBS) announced they were marking down the value of the ARS in  clients’ accounts from a few percentage points to more than 20%. As the result of the threat of legal action by the SEC and the N.Y. State Attorney General Cuomo, who charged that the issuers committed fraud by representing the securities as equivalent to cash, a number of major investment banks have announced that they will buy back ARS from private investors. UBS is committed to redeem $19B while Merril l Lynch and Citi have pledged to buy $17B from individuals. Institutional investors and student-loan organizations may not fare quite so well. This additional pressure on lenders further restricts available loan funds.

Those lenders still in the market have increased their interest rates and tightened up considerably on their underwriting standards. Rates for loans scheduled over 30 years but due in 10  years are now 250 – 275 basis points over the comparable Treasury yield (the 10-year Treasury is now ~ 4.0%). Loan amounts are restricted to 65% of appraised value or to an amount supported by a Debt Coverage Ratio of at least 1.25, whichever is lower .

Sellers have also made financing difficult by clinging to yesterday’s high prices. California multi-family properties in the $1-5M range are still offered at cap rates of 4.5-5.3%. At these low cap rates, properties do not deliver adequate Net Operating Income to offer a chance of reasonable (65%) leverage.  The higher down payment required places the hope of an adequate yield (IRR) over 5-10 years on the attainment of much higher rents. But despite higher foreclosure rates on single-family homes, vacancy rates in many markets are rising, not falling.

The investor’s life at this time is not a bowl of cherries.

— President Woodrow Wilson, in reference to the
Federal Reserve Act of 1913, which he signed into law.

When Bear Stearns got into difficulty in March of this year, a "bailout" was arranged by which JP Morgan Chase agreed to buy the investment bank provided that the Federal Reserve guarantee JPM against losses up to $29B. Until that moment, the Fed’s role – in part – was thought to be  as a lender of last resort for commercial banks only.  In April Paul Volcker, ex-Fed Chairman, was quoted saying:

"The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.”

Since then, the Fed has expanded its domain still further and devised novel means to funnel additional cash into the system in its effort to "bail out" investment banks. The Fannie-Freddie debacle is now another occasion for the Fed to extend its jurisdiction and oversight far beyond that originally contemplated in 1913 when the Fed was authorized to be the keeper of the financial keys.

The $173B Economic Stimulus Package passed by the Congress authorized FNMA to acquire residential loans up to $729,750 or 125% of the median home sales price in that particular MSA. This made room for FNMA to acquire existing loans far in excess of their previous maximum limit ($417,000). It is easy to understand Secretary Paulson’s dilemma; it is somewhat akin to that  of Chairman Bernanke. Fannie Mae is leveraged to an extraordinary degree. While most banks are required to maintain reserves in the order of 8-10% (~ 10:1 ratio) of their capital, Fannie maintains reserves of approximately $83 Billion to support loans of approximately $5.2 Trillion, a 60:1 ratio. It takes a relativity modest decline in the value of the loan and loan guarantee portfolio to declare the GSE bankrupt.

Officially, Fannie and Freddie are privately owned corporations, are not government agencies, and are not legally entitled to special financial treatment. Although voices continue to proclaim that the GSE’s debt is not guaranteed by the Fed, the GSEs enjoy the implicit support of the government allowing them to borrow money at rates substantially below that of other banks.  If the government failed to "bail out" Fannie and Freddie in a time of crisis it could reasonably be expected that foreign governments would  judge the U.S. unwilling to  honor its debts. The crash of the U.S. dollar would be deafening.

If, on the other hand, the government steps in to rescue this private enterprise under the "too big to fail" doctrine, then the  Fed will surely have exceeded Mr. Volcker’s "..very edge of its lawful and implied powers.."

The Congress has now seen fit to increase FNMA’s total lending limits by $300B until 12/31/08. Increasing the individual loan limit and the total value of loans that Fannie may acquire is designed to allow Fannie to refinance sub-prime loans and replace them with fixed-rate mortgages not greater than 90% of the property’s new assessed value – all of this provided the lender takes at least a 10% haircut on his loan.

Worse still, the newly passed legislation provides an additional $2.5B line of credit to Fannie-Freddie and a blank check to Secretary Paulson to buy equities in the GSEs "if necessary."

Although the U.S. government is not obligated to rescue Fannie and Freddie in an emergency, some deem it unthinkable it would not. Not to do so, they contend,  would transfer $5.2 Trillion in mortgage liabilities to the $9.5 Trillion of existing U.S. debt, sinking the value of the dollar.

But there are those who stoutly contest this assertion, pointing out that approximately $100M of the $5.2Trillion is at risk of default. These individuals feel that the U.S. could easily handle the $100M loss but would be rid of Fannie and Freddie forever.

What remains certain is that the Treasury and Federal Reserve have already injected a prodigious amount of capital into the banking system to shore up failing enterprises. This year’s trade deficit is likely to exceed $600B and an operating deficit of more than $500B, not including the costs of the Iraq and Afghanistan wars. The question is: "Where is the money to pay these deficits coming from?"

In the past we have relied on the kindness of strangers who recirculated our petrodollars by buying U.S. Treasuries. But with Treasuries paying rates far below the true inflation rate is it reasonable to expect that foreigners – however kind – will continue to invest in  U.S. securities ?

In the absence of a financial genie, we see the day soon approaching   when the U.S. will be unable to finance its entire debt and that the Treasury Department will begin to monetize the debt by issuing Treasury Notes which the Federal Reserve Bank will buy,  thereby inserting additional dollars into the system. The rescue of other "too big to fail" entities cannot be far behind.

"With what money, you ask?"
Why with fiat money, of course.

Apparently the attention of most Americans has finally been captured by the rising prices of gasoline, heating oil, food, natural gas, plastics, metals and most everyday commodities. Until now, the driving public has sucked up and paid up as gasoline prices rose through the $2.00 level, then through the $3.00 level and now through the $4.00 level, on the way to $5.00 per gallon; $6.00 gasoline no longer seems so distant or improbable.

The basic energy problem is that the world’s current supply of oil is approximately 87 million barrels per day (bpd) and the total global production of oil has peaked at about 85 million bpd. Of this amount the United States imports 10 million bpd against a domestic demand of 23 million bpd.

Brazil’s national oil company, Petrobras, has stirred hope that its new off-shore field discoveries, Tupi and Carioca, may be potential sources of enough new oil that  the U.S can be relieved of its dependency on mid-east oil. Estimated reserves from these two sources range from 8 to 33 billion barrels. These oil deposits, however, are 9,000 feet below the surface of the ocean. It will take many years and many dollars to retrieve this oil.

An often overlooked factor in the supply/demand equation is the increasing oil consumption by the mid- east companies themselves. The economies of Saudi Arabia, Oman, Egypt, Qatar, Bahrain, Kuwait and the United Arab Emirates have grown 7% annually since 2002. The average income for the citizens of these countries has reached $19,000, which is 3 times that of China.  Because all mid-east countries heavily subsidize the price of oil and gasoline, it is very likely that these countries with expanding economies and expanding personal income will consume much more – not less – oil in the future. A full one-third of oil their consumption now goes to produce electricity for air conditioning. Add this to the increased demand from China and India and there is no question that oil prices will continue to rise. The fundamental cause of higher energy prices is attributable to excess demand oversupply.
Look for $175/bbl by January 1, 2009.

Meanwhile, the United States has no coherent energy policy other than to:
>    shift 33% of its corn crop to ethanol production,
>    bar the importation of ethanol
>    subsidize domestic ethanol supply at the rate of 0.45¢ per gallon
>    prevent drilling in the Gulf of Mexico and coastal waters
>    prevent drilling in the Arctic National Wildlife Preserve (ANWR)
>    discourage the construction of new refinery faculties
>    block the construction of nuclear facilities
>    propose higher taxes on oil companies
>    propose "cap and swap" legislation which would add a tax to U.S. manufacturers based on carbon
emissions and redistribute the tax money to companies involved in alternative fuels as determined by
the federal government,
and, according to Rep. Maxine Waters (D-CA) threaten to nationalize the oil companies.

The other key factor that results in higher across-the-board prices is the debasement of the US dollar. The dollar has lost 7% of its value so far in 2008 alone and 40% of its value since 2001.

The root problem of the dollar’s decline is that the U.S. Treasury continues to print fiat currency at a rate 17%  greater than that of the same period in 2007. It is simply "no problem" to the U.S. Congress to issue a $170B "economic stimulus package" when all they need to do is to turn on the printing press. The estimated budget shortfall (overspending) in 2008 is $420B, excluding the $250B-$300B to support the Iraq and Afghanistan wars. The majority of Congress has "no problem" in passing a $350B Farm Bill which includes $35B in payments to farmers not to grow commodity crops – at a time when the world is experiencing a dire food shortage and US farmers’ profits are at an all-time high. Spend, spend, and spend.

Foreign holders of US petrodollars ($1.3 Trillion) now show signs of moving away from the dollar. Kuwait and Iran no longer accept dollars in payment for oil.  China, India, Saudi Arabia, Canada and other countries have now formed sovereign banks that will invest their petrodollars in assets other than US Treasury securities. The U.S. will be forced to raise taxes to cover budget deficits.

The government’s script is now to blame the problems on anything but the true cause:  the weather, hurricanes, terrorism, OPEC, Wall Street, etc., etc.  Voices in Congress even now are clamoring for a law to prevent the public from investing in commodity futures, as though investing in commodity futures is the cause of commodity inflation. Such a law will not prevent investors buying and selling commodity futures; it will drive this business offshore to London, Abu Dhabi,  Hong Kong, Tokyo and other financial centers around the world. Instead of trading in dollars, these transactions will be done in a replacement currency, and we could expect to see a greater decline in the value of the dollar.

The greatest problem the imperiled middle class now faces is to find a way to shelter what savings they may have left from forthcoming higher taxes and inflation which can only intensify until the breaking point – a depression – is reached.

I remain fascinated by the extraordinary parallel between Ayn Rand’s Atlas Shrugged and the path of the economic decline of the United States. Where is John Galt?

“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
John Maynard Keynes

But if you are his nephew and do make a risky investment and – lo and behold – your uncle comes to your rescue, then Hooray!! The problem will not be that you will dissolve into bankruptcy, but that all your uncle’s other nephews may come to expect the very same treatment.

Such is the problem of the Federal Reserve Bank.

Investors are generally aware that the Fed acts as a "lender of last resort" to commercial banks who are members of the Federal Reserve System. It does not similarly serve the investment banks (e.g. Citigroup, Merrill, Lehman Bros., Bear Stearns, J.P. Morgan Chase, etc…).

The difference is significant in many ways; very importantly, commercial banks are limited by the Fed in the amount of debt they may incur proportionate to their current equity. Reserve requirements of the central bank specify that (most) commercial banks maintain equity reserves not less than 10% of their total assets. The investment banks, however, unfettered by such a requirement, generally carry much higher – and riskier – debt:equity ratios. For example, Bear Stearns, a recent casualty of excessive debt, carried a debt:equity ratio of 32:1.

Some investment banks carry debt ratios much higher than they appear. Citigroup, for example, carries a ratio of approximately 8.2:1. But Citi has grown in the last few years by acquisitions and the value of the goodwill acquired in these transactions (value of the transaction over and above the market value) adds considerably to the total of assets on its balance sheet. In Citi’s case, subtracting these non-cash items from the asset total shows that Citi’s debt ratio is approximately 42:1.

Most investors know that leverage is the original two-edged sword. Leverage is a great equity multiplier when asset values are increasing, but it can also be a howling demon in periods of asset deflation. Demands for cash from investors and creditors cannot be met with amortization and depreciation allowances.

Bear Stearns found this out when counterparties made – for all practical cases – a run on the firm, demanding a liquidation of their accounts. We now know, as the result of the Fed’s subsequent bailout, that Bear Stearns carries at least $30B in mortgage debt. But in the current liquidity crunch which makes it extremely difficult, if not impossible, to sell assets for their fair market value, Bear Stearns was unable to meet withdrawal demands last Thursday and faced impending insolvency. If Bear Stearns had been allowed to proceed to bankruptcy, the cascading effect among other investment banks would likely have brought down the entire financial system.

Enter Uncle Sam. The rescue of the system was initiated over the weekend by Uncle Timothy F. Geithner, otherwise known as President and CEO of the NY Federal Reserve Bank. James (Jamie) Dimon, a Director of the NY Federal Reserve Bank and President and CEO of J.P. Morgan Chase, was conveniently at hand.

According to the bailout agreement, J.P. Morgan Chase agreed to buyout Bear Stearns for $2.00/share (vs. $84 in book value) in return for a guarantee by the Federal Reserve Bank of up to $30B in Bear Stearn’s debt. Later this week, in response to protests from Bear Stearns’ employees who hold approximately 1/3 of the shares and shareholders, such as Britain’s Joseph Lewis who holds approximately 8 % of Bear stock, Dimon upped his price to $10.00 per share. To placate the Fed, which is sensitive to criticism that it has bailed out a bank that is not a member of the Federal Reserve System, Dimon has agreed to assume the first $1B in losses, if any.

Alea Iacta Est: The Die is Cast.

In expanding its regulatory sphere, the Fed has now poked its nose under the traditional tent of the Securities Exchange Commission. The next financial emergency, which is very probable in view of the high leverage employed by most hedge funds and other investment banks, will raise the question of Uncle’s role. It remains to be seen whether the SEC will contest this regulatory expansion onto its turf or will acquiesce. Odds are that, lacking a means of financial rescue, the SEC will silently steal away. What we can expect, sooner or later, is another bailout by the Fed which will transfer more bad debt onto the Treasury’s books.

In the meantime, Mr. Bernanke’s lowering of interest rates has also severely lowered the returns from savings and CD accounts upon which so many people depend. It has also caused a drastic depreciation in the purchasing power of the earned US dollar spiking commodity prices, food and fuel for the average American. It is hard to overlook the fact that last January the top 5 investment banks (including Bear Stearns) paid out over $39B in annual bonuses.

Once again, Mr. Bernanke has averted a financial disaster, albeit having bent a few rules. The test will come when the next financial emergency arises. There is just so much debt that the Treasury can take onto its books and just so much debt that the U.S. economy and its taxpayers can withstand.

The issue is quite important since the language of the code specifies that only property held for investment or for use in a trade of business may be exchanged for “like-kind” property which is also to be held for investment or for use in a trade or business.

The I.R.S. has long held (Rev. Rul. 59-229, 1959-2 C.B. 180) that a residence is not eligible for an exchange since it is held neither for productive use in a trade or business nor for investment. This position was reconfirmed in 2007 in Moore v . Commissioner when the taxpayers exchanged one lakeside vacation home for another. Neither home was ever rented. Both properties were used by the taxpayers only for personal use. The taxpayers claimed that the properties were eligible since they were expected to appreciate in value and thus were held for investment. The tax court rejected this argument saying that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence . ”

Rev. Proc. 2008-16 is intended by the I.R.S to provide a “safe harbor” under which the Service “will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of §1031of the Internal Revenue Code.” By “safe harbor” the I.R.S means that it will not challenge the eligibility of the property for an exchange if certain conditions are met. The qualifying use standards for both relinquished property and for replacement property are quite similar.

In the case of the Relinquished Property . . .

The property will qualify if:

1. the dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the qualifying use period), and
2. within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange,
   • the taxpayer rents the dwelling unit to another person or persons at a fair market
     rental for 14 days or more, and
   • the period of the taxpayer’s personal use of the dwelling unit does not exceed the
     greater of 14 days or 10 percent of the number of days during the 12-month
     period that the dwelling is rented at a fair rental.

For purposes of defining the 12-month periods, the first period ends on the day before the date of the exchange; the second period ends on the day prior to the beginning of the first 12-month period.

In the case of the Replacement Property…

The rules are the same except that first 12-month period begins on the day following the date on which the exchange takes place, and the second 12-month period begins on the first day after the first 12-month period ends.

In both cases, all the other requirements for a valid §1031 exchange remain intact.

This Rev. Prod. suggests that property must be held as an investment or for trade use for 2 years before and after an exchange. But the Rev. Proc. is a safe harbor and does not necessarily apply to all circumstances. But it does emphasize that those who own an investment property and wish to exchange it for a residential property which they plan later to use as their residence are safer if they rent the acquired property for at least 2 years before occupying it.

Remember, too, that a residential property acquired via an exchange and later converted to a personal residence must be occupied for 2 years and held for a minimum of five (5) years before it will be eligible under §121 for the long-term capital gains exclusion of $500,000 (married, filing jointly) or $250,000 ( singe or married filing separately).

Consult your personal tax attorney or specialist before acting on this information .

”If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that grow up around them will deprive the people of their property until their children will wake up homeless on the continent their fathers conquered . ”

— President Thomas Jefferson

An oft-heard aphorism is that if you find yourself in a deep hole, the first thing to do is to stop digging . Chairman Bernanke may be beginning to get the message, but we seriously doubt it .

The basic, underlying problem with the U . S . economy is not a shortage of credit but rather an overabundance of credit resulting in excessive personal debt, excessive municipal debt, excessive federal debt, excessive housing debt, excessive credit card debt etc . etc An entire generation has come to believe that almost anything can be purchased on credit and paid for sometime in the distant future . Perhaps the worst offender is the U . S . Congress which finds no difficulty in authorizing, for example, a “rebate” of $160B to the American taxpayer . No one, no one mind you, asks where the money is coming from . But we know that the money will come from the printing presses of the U . S . Treasury . Mr . Bernanke’s Keynesian solution is to put additional cash in the hands of the consumer who can be depended on to spend nearly all for consumer purchases and thereby stimulate the economy . But this time around the consumer, knee-deep in debt, facing higher food costs and $4 . 00 gasoline, is much more likely to use the cash to pay down debt, which will leave the United States with little or no economic stimulus albeit deeper in debt .

Add to this the very significant dollars which the Fed continues to put into circulation in order to stimulate the economy . At last count, the Fed has overtly added more than $160B to the money supply by creation of the Treasury Auction Facility, The TAF makes loans available to banks at very low interest rates . Historically, banks which were short required reserves could borrow from the Fed’s Discount Window . But banks have always been reluctant to do this since it carried a certain stigma regarding the bank’s ability to manage its business . Now, through the TAF, the Fed puts money into circulation at low borrowing rates while accepting a wide variety of collateral, including mortgages . If the amount of unborrowed reserves now held by banks is totaled, we find that U . S . banks are lacking more than $20B in reserve requirements . In prior years, this would be cause for the closure of the bank .

We say overtly because the Fed continues to expand the supply of money at the rate of approximately 15% per year, but has made it difficult to track this fact by the discontinuance of the M3 money supply measurement stick . The
U . S . is not alone in printing money, however . There is no longer any major central bank whose currency is linked to gold or silver and which is not increasing its supply of fiat money at an alarming rate .

In the United States (now the world’s largest debtor nation) the result is the ever-deepening decline in the value of the dollar and the consequent increases in the price of oil, food, base metals, precious metals and agricultural products: wheat, corn and soybeans, etc . . The government allows John Q . Public to believe that the oil companies and large corporations are responsible for the increase in the cost of living; but the high cost of oil (and other goods) is the result of inflation, not its cause . The cause is the issuance by the Federal Reserve Bank of excessive amounts of fiat money unrestrained by any linkage to either gold or silver, or to any other collateral which has intrinsic value .

While almost everyone suffers as the dollar declines in value, the greatest harm is being done to the middle class, to the saver and to the individuals who struggle to meet their daily needs on pensions and fixed incomes . Indeed, inflation is the worst kind of tax, and the inflation created by the Federal Reserve Bank is decimating the purchasing power of the earned dollar, the saved dollar and the purchasing power of the social security and pension dollar . Unless a drastic change is made in the Fed’s strategy to address the mistakes made under Messrs . Greenspan and Bernanke, we can look forward only to a serious economic depression in the face of hyperinflation .

“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation . ”

—Lenin

At the bottom of the “liquidity” problem is a lack of financial transparency: the fact is that no one yet has a reliable estimate of the market value of these financial derivatives. So it is little wonder that banks are reluctant to lend each other when the true condition of their balance sheets remains unqualified and unquantified.

Nonetheless, Chairman Bernanke remains determined to solve the underlying problem by injecting still more and more liquidity into the system. In an action coordinated with European banks (

The goal is to make funds available to qualified lenders who otherwise may not be able to secure a loan, thereby providing additional liquidity to the system. The plan is, in effect, an attempt to jump-start lending and thereby provide credit where credit is scarce.

All of which is to say that the shutdown in lending is attributed by the Fed to a lack of liquidity rather than a question of credit worthiness. But the problem of the subprimes is a problem resulting from lending money to individuals with poor credit and diminished ability to repay the loans. It is not the result of a scarcity of cash. The low-credit loans which were created have been disseminated throughout the world and have thus become a global financial problem rather than just a local one.Many will recall the experience of

Meanwhile, the cost of commercial real estate loans is increasing and the number of transactions decreasing. For investors higher debt costs resulting from higher risk premiums will lower property prices despite lower short-term rates. In Southern California, capitalization rates are still below the cost of funds, resulting in negative leverage. It would be optimistic to say that rents will continue to increase in order to justify higher prices. But this does not appear to be in the offing.

For example: the Financial Accounting Standards Board had earlier ruled that a bank’s Tier 3 assets (those for which no ready market value can be determined) must be ”marked to market” (evaluated for what they are currently worth) and transferred to the lender’s balance statement. The day of reckoning was scheduled for Nov. 15, 2007.

But you will also recall that when two of the SIVs organized by Bears Sterns got in trouble in July ‘07, the SIVs began to sell the assets, thereby establishing a market value for the underlying collateral which consisted in large part of subprime mortgages and other collateralized debt obligations (CDOs) of less than AAA quality. The price obtained by BS in early sales was reported to be about 50¢ on the dollar.

Other major lenders, such as Citigroup, Lehman Brothers, JP Morgan Chase and B of A, rose to the occasion, prevailing on BS not to sell assets which would establish a market value for the less-than-sterling collateral carried by these large bank centers. BS relented and sales were curtailed.

Treasury Sec. Paulson arranged (but did not sponsor) the establishment of the Master-Liquidity Enhancement Conduit (M-LEC), an entity created to provide access to funds for major banks which could experience a “run on funds.” (Recall GB’s Northern Rock.) The idea is that by creating such a fund ($85B), banks under duress would have a ready source of re-financing short-term commercial paper rollovers rather than a sale of assets – and in so doing inadvertently establish a market value for these debt obligations. The final outcome of the M-LEC is still to be decided, but optimists anticipate full funding by 1Q08.

Which brings us back to FASB 157 which mandated a mark-to-market of Tier 3 assets by Nov. 15, 2007. Had this been done on schedule, the effect would have been the same – a drastic, if not calamitous, reduction in the value of collateral held by major banks. No wonder, then, that the relevant provisions of FASB 157 have been “postponed” for one year.

But the cascade of failing subprime mortgages continues unabated. The financial collapse of millions of these high-risk mortgages over the next 18 months could undermine the solvency of even our “strongest” bank centers. Consider, for example, that Citi (Citigroup) holds an estimated $64.7B in troubled mortgages. Citi just got outside help from the Abu Dhabi Investment Authority’s (the United Arab Emirates sovereign investment vehicle) $7.5B cash infusion in return for 4.9% convertible bonds bearing an 11% coupon.

Now Paulson’s Copper Bullet

Secretary Paulson has been careful to emphasize that the latest device to delay the recognition of big bank losses will not be a “silver bullet.” His effort is to obtain an agreement among loan servicers, loan investors and lenders to arrest the scheduled rise in Adjustable Rate Mortgage rates and impending defaults. This is a herculean task made more difficult by the fact that the investors who now own these less-that-desirable debt obligations are diffused throughout the world.

Sec. Paulson envisages dividing the subprime borrowers into three groups:

• Those who cannot sustain their mortgage payments even if the payments were frozen at the teaser    rate.
• Those who are well qualified and can sustain increased payments without help.
• Those who cannot sustain their payments at an increased interest level but who can make the payments at the lower teaser rate.

Since many of the subprime borrowers were Ninjas (No income, no job, no assets), this group (1) would be most likely not to receive help and would be allowed to proceed to foreclosure. But of the remaining two groups, Paulson’s plan would subsidize group (3) but not group (2.) All of which creates an advantage for one group at the expense of the other.

The Paulson Plan assumes no direct help using government funds but it does depend on the willingness of investors to absorb losses on mortgage contracts which they bought. Case in point: Florida’s state-run Retirement Pool which invested heavily in SIVs. A run on the Pool within the last 2 weeks reduced assets from $27B to $14B before the administration group (Fla’s Governor, CFO and Atty. Gen) halted withdrawals. The case has captured national attention since so many other pension plans are in the same financial soup.

But Rep. Charles Rangle’s (D. MA, Chairman of the House Financial Committee) pending bill would not only give federal judges the right to modify mortgage contracts (an action prohibited by Article 10 of the U.S. Constitution) but would also forgive any tax due from a borrower who sold his home for less than the balance of the mortgage (a “short sale”), thereby realizing (ala IRS) “taxable income.” It would also reset the Fannie Mae and Freddie Mac lending limit much higher than its current $417,000. Countrywide Financial’s CEO Mozilo likes this idea and has recommended a 50% increase in the limit to $650,000. This would allow the GSE’s to purchase mortgages from lenders thereby transferring the risk from owning entities (pension funds, banks, investors,) to agencies which have the implicit guarantee of the U.S. government. This would be a transfer of private debt to public debt.

There is no simple solution to the current subprime problem. If the subprime problem were left to market forces, the market would purge bad loans and bad borrowers in relatively short order. This would be painful and would undoubtedly accelerate the coming recession. But we would be through with it rather than prolong the inevitable, as did Japan for the decade of the ’90s.

And the millions of potential real estate buyers who are now waiting for the bottom of the market would become active buyers. And the nation would recover. And perhaps learn something about easy credit.

But come Dec. 11th, alas, we expect another rate cut, higher inflation, a weaker dollar and more kicking the can down the road. Our coming recession is likely to be deeper and more protracted that just a few quarters. We don’t expect a ‘silver bullet’ from the government; we just wish that it would get out of the business of trying to manage the economy. They do a lousy job of it.

Everyone of voting age should read Daniel Yergin’s "The Commanding Heights."

It ought to come as no surprise to observers of the scene that the peak of the subprime fallout still lies ahead. The greatest number of adjustable rate mortgages were scheduled to reset a month ago, in October ’07, although the total number scheduled to reset through 1Q08 remains very high. If we assume that it takes about 90 days for a mortgage in default to enter into the foreclosure process, and 3-4 months to complete, then we can expect the money center banks, some hedge funds and other investors to continue to post substantial losses on loan portfolios and affiliated Scheduled Investment Vehicles (SIVs) through 1Q08 -2Q08.

Jan Hatzius, Chief Economist at Goldman Sachs, estimates that total subprime losses will be close to $400B. To put that in perspective, $400B is about 2x the loss experienced by the Resolution Trust Corporation in cleaning up the S&L crisis of the 80’s.

That problem can be regarded as the near-term issue. The more immediate problem is the credit crunch which makes rolling over the SIVs’ short-term (270 day) loans very difficult. The nub of that problem is the uncertain quality of the collateral held by the SIVs and other holders of interests in these derivatives. Some collateral may indeed be rated AAA, but others may be CDOs that contain less than investment-grade obligations. Many institutional investors and pension funds are barred from investing in less than AAA investment-rated situations.

Until that collateral can be picked apart, analyzed and evaluated, many investors prefer to stand down. As well they should, since the rating agencies whose job it is to perform those tasks, have lost substantial credibility.

Meanwhile, the Fed, under Dr. Bernanke’s leadership, continues to follow its Keynesian nose by lowering interest rates and adding liquidity to stimulate the economy. The Fed added $41B in new funds (read: fiat money) during the first week of November and an additional $49B in funny money just last week. The value of the US dollar continued its decline [35% since 2001 (thank you Mr. Greenspan) and 6.7% since 1-01-07 (thank you Mr. Bernanke)]. In light of a flagging US economy expect that – despite all protestations by the Fed and by Secretary Paulson’s jawboning to have China allow the Renimbi to float (fat chance) – the Fed will again lower the Fed Funds Rate in December by 0.25%. Expect, also, the predictable result: a continued slide in the US dollar and a continuing rise in prices due to inflation.

Quo Vadis, Commercial Real Estate in CA?

There is an important distinction between loans secured by residential (single-family) real estate and those secured by commercial properties. The former loans, originated by local lenders – have been readily salable to Fannie Mae/Freddie Mac which returned proceeds for additional lending. But commercial loans – until a few years ago – had no such secondary market until Wall Street dreamed up the securitization of these loans using REMICs (real estate mortgage investments conduits).

There were many loose loans issued by commercial lenders during the 2006-2007 hay-day of easy financing, but the total is nowhere near the volume and value of residential subprimes. Nevertheless, investors seem to make little distinction between the two since many SIVs, hedge finds and other entities hold loans securitized by an assortment of collateral types: residential loans, commercial loans, auto loans, credit card loans etc. As a result, the dollar value of CMBS (collateralized mortgage-backed securities) has declined 40% in 3Q07.

Commercial loans are now available under tighter underwriting criteria: lower Loan-to-Value (LTV) ratios, higher debt-coverage ratios (DCR) and higher interest rates. Buyers in this market must pony-up larger down payments and demonstrate the stability of the property’s future income stream.

This reality has not yet settled in with some sellers and some buyers of investment real estate. This is especially true in California (and on the East coast) where capitalization rates for commercial properties remain in the low 5-6% range while interest rates have climbed to 6-7% range. The only rationale for buying a low cap-rate property ( in light of real inflation rates substantially above those reported by the gov’t’s CPI) is the reasonable expectation that rents can be raised sufficiently to deliver an acceptable yield on the investment over the entire holding period. This expectation is called “risk.”

Although California is forecasted to enjoy a substantial increase in population, we do not believe that the demographic profile of this increase presages increased per capita net spending power. We believe that better real estate investment opportunities lie beyond California’s borders, in so-called “secondary markets,” and even in foreign countries.