The U.S. Economy's Gordian Knot: Real Estate

The Legend of the Gordian Knot

If you’ve ever tried to untangle a “bird’s nest” of fishing line on a reel you can relate to trying to untie the “Gordian Knot”. The Gordian Knot is a reference to a Greek legend. The legend claimed the person who successfully undid the “Gordian Knot” would rule. Many tried to untie the knot to no avail until Alexander the Great took a different approach --- he cut the knot with his sword.


Real Estate Loan Outstanding Value
vs. Real Estate Market Value:
a Gordian Knot for the U.S. economy?

Successfully resolving the lingering effects of the burst U.S. real estate bubble could be described as one of the “Gordian Knots” of the U.S. economy. The issue is the amount of outstanding debt collateralized by real estate during the real estate bubble. The problem is that since the loans were issued the market value of the loans’ collateral has sunk, or the loans are "underwater".

This is creating problems for both lenders as well as borrowers. For example, last week the Financial Times reported there were growing tensions between banks and their auditors over the divergence in the value of their commercial real estate loan portfolios and the collateral market value of those properties under current market conditions. Also last week Bank of America announced a program to begin reducing the principal on residential loans meeting certain criteria. A few days after the Bank of America announcement the Obama administration proposed a new program (see here and here for descriptions) to incent lenders to reduce the principal loan value to unemployed borrowers that meet certain criteria.

To get a handle on the magnitude of the "underwater" issue we compared the decline in real estate market values to the decline in what the Federal Reserve reports as outstanding real estate loans at commercial banks. It’s important to realize that commercial bank real estate loans compose about 27 percent of the total U.S. mortgage debt outstanding ($3.8 trillion of $14.3 trillion as of year-end 2009; see "Loans" in graph below, gray shade in legend, right axis); however, the percentage decline in total U.S. mortgage debt outstanding and in real estate debt outstanding at commercial banks has been similar. Using Case-Shiller index as a guide for residential properties values and Moodys/MIT index as a guide for commercial property values we contrasted the decline from peak values for each market value index as well as the outstanding real estate loan value. To simplify comparisons between the changes in value for outstanding real estate loans ("Loans" in graph, red line, left axis), the residential market price index (CSHPI in graph, left axis), and the commercial real estate market price index (CPPI in graph, left axis) we re-indexed each series with the maximum point of each series = 100.

Case-Shiller stands about 30 percent below its peak as of January 2010. In the case of commercial real estate the drop is larger --- about 40 percent. Currently both indices are roughly at the levels seen in the latter half of 2003. While the commercial real estate market represents about one-quarter of the total U.S. mortgage market it comprises a higher percentage, closer to 40 percent, of the real estate loans at commercial banks according to the Federal Reserve’s March 2010 H9 report.

However, while market values currently stand between 30 to 40 percent below peak levels the outstanding loan value has dropped by less than 3 percent from its peak value through January 2010. By our rough calculation a reasonable estimate of $1.5 trillion in outstanding loan value that has been added since the latter portion of 2003 that is no longer collateralized due to the drop in the real estate market is a little more than $300 billion. We expect this same proportion of “loan value at risk” could be extrapolated to the broader mortgage market; while the balance of the mortgage market has a higher proportion of residential properties, which have seen relatively less loss in value than commercial property, we also expect the balance of the mortgage loan portfolio carries a greater proportion of higher risk residential mortgages and so compensates for the difference in residential/commercial mix in the portfolio. Thus, the roughly $300 billion in the commercial bank real estate loan portfolio would translate into $1.1 trillion for the entire mortgage market, or about a 8 percent of the entire portfolio.

A Sign Post toward Sustainable Recovery

Until this divergence between loan value and market value is substantially reduced it will be difficult for the housing market engage in sustainable recovery. Lenders are reluctant to lend when faced with the prospect of large capital losses on existing loans. For many prospective buyers they have to sell their current home before purchasing another home and if their current home is less than the loan value they are obligated to come up with the difference or declare bankruptcy. Declaring bankruptcy of course affects their ability to qualify for another loan for some time. Further, for lenders, if they begin foreclosing on delinquent loans and then trying to sell them they expand the supply of homes, dropping market values further and compounding their problem with other loans in their portfolio.

Cutting the Knot

We do believe there could be an analogous “Gordian” solution: rather than trying to untie the knot you cut it. As an example we sketch out one possibility that may work in some cases:

• If the borrower and lender agree to a modified foreclosure process, patterned to some degree after a short-sale, and then execute a leaseback by the borrower some progress could be made on cutting the knot. It will probably be necessary to involve some intermediary to facilitate the transaction who ends up actually owning the property and leasing it. The original borrower will lose whatever equity they have in the property and the lender will have to write off the difference between the outstanding loan value of the property and the sale price at the time of the short-sale (i.e. those who entered into the transaction each shoulder some of costs of it not turning out as they had originally expected).
• The leaseback is written at the value of the short-sale so presumably the monthly lease payment is less than the previous monthly mortgage payment, helping keep the original borrower and now lessee solvent.
• By keeping the house leased and off the market the market supply is not expanded, mitigating additional market value erosion.
• By making lease payments the lessee is able to repair at least some of the credit damage the short sale inflicts (the damage is probably less than a bankruptcy however).
• In our view this approach also has the advantage of not requiring further government intervention into the markets.

While such solutions are not painless they may represent a less painful way than the approaches undertaken to date. It can be argued the current methods have halted the decline in the housing market and allowed it to stabilize. However, they have failed to solve what seems an otherwise intractable problem and without a solution it is unlikely there is a sustainable recovery in real estate. Our concern is with continuing high unemployment, increasing public debt, and the prospect of higher taxes in the near future the economic recovery will stall and ultimately reverse itself, deferring a lasting solution anytime soon. Further, we believe there is a very real prospect the market, rather than the Federal Reserve, will begin dictating interest rates and should they begin to climb the knot will tighten even more.