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.

Ignoring E.F. Hutton

The New E.F. Hutton?

I grew up in the age of classic TV commercials. Who could forget Life cereal’s “Hey Mikey?” Or Wendy’s “Where’s the Beef?” And then there was the E.F. Hutton’s ad campaign with its slogan, “When E.F. Hutton talks, people listen."

E.F.Hutton -- its prestige tarnished by scandal -- is long gone, ultimately swallowed by other competitors. However, if there’s a firm that seems to have inherited the mantle of the slogan, “When E.F. Hutton talks, people listen” it may be PIMCO. When either of PIMCO’s co-leaders, either Bill Gross or Mohammed El-Erian, make public statements about their outlook, those comments are analyzed and dissected by the financial and investing media, searching for clues about what PIMCO may be thinking.

"Don't Care." What did he mean?

Gross posts a monthly newsletter on PIMCO’s site that provides plenty of fodder for the investing media but March 2010’s issue, titled “Don’t Care,” left people scratching their heads. The WSJ’s Marketbeat blog was indicative of the common reaction:

PIMCO bond guru’s monthly letter is usually good for a tidbit/modicum of insight into the mind of the one of the world’s most influential fixed income investors.

Well, this month’s edition from Bill Gross entitled “Don’t Care,” offers a little less insight and a little more drivel than usual.

“Don’t Care”? What’s this all about? Well, if we take a look at his closing paragraph it’s pretty clear: he doesn’t care about mere talk; he wants to see action on the part of governments that promise to deal with their debt load before he lends money to them (emphasis in excerpt below was in the original):

PIMCO’s “Ring of Fire” remains white hot and action, as opposed to cocktail blather, is required to maintain or regain trust in sovereign credits approaching the rocks. Just last week Bank of England Governor Mervyn King said that it would be difficult to cut government spending quickly, but that there needs to be a clear plan for doing so. Not good enough, Mr. King. Don’t care. Show investors the money, not vice-versa. An investor’s motto should be, “Don’t trust any government and verify before you invest.”

However, I speculate there’s a message in “Don’t Care” other than the one laid out plainly in the article. I don’t know for a fact, but suspect it may have something to do with the economic and investing community’s reaction to what Gross wrote in his February 2010 issue, entitled “The Ring of Fire.” In it Gross laid PIMCO’s take on sovereign debt risk around the globe. Being a fixed fund manager, assessing risk relative to return on debt is of paramount importance to PIMCO. Gross presented PIMCO’s concept of the Ring of Fire: countries with debt levels high enough there are heightened risks of seeing diminished economic growth. The countries in “the Ring” were most of the usual suspects: Greece, Italy, Spain, Ireland, France, Japan, and the U.K. Perhaps the shocker was who else was included in the Ring of Fire: the U.S.

Can't happen here!!
Reaction in the financial MSM was swift and generally dismissive --- some by name, some not. A NY Times Op-Ed entitled “Fiscal Scare Tactics” by Nobel laureate economist Paul Krugman captures the heartbeat of this sentiment. The column was posted on February 4, 2010, shortly after Gross’s February issue was posted on PIMCO’s website; although he doesn’t name Gross, Krugman dismissed assessments of the U.S.’s fiscal condition like Gross’ as “scare tactics”:

These days it’s hard to pick up a newspaper or turn on a news program without encountering stern warnings about the federal budget deficit. The deficit threatens economic recovery, we’re told; it puts American economic stability at risk; it will undermine our influence in the world. These claims generally aren’t stated as opinions, as views held by some analysts but disputed by others. Instead, they’re reported as if they were facts, plain and simple.

Yet they aren’t facts. Many economists take a much calmer view of budget deficits than anything you’ll see on TV. Nor do investors seem unduly concerned: U.S. government bonds continue to find ready buyers, even at historically low interest rates. The long-run budget outlook is problematic, but short-term deficits aren’t — and even the long-term outlook is much less frightening than the public is being led to believe.

Krugman was not alone in this dismissal. But, then, neither was Gross alone in his assessment. And so, I suspect at least in part, Gross wrote March’s news issue, because it was obvious many didn’t care to hear what he had to say, and he didn’t care what they were offering in response.

In the March issue Gross spelled out what he felt were some of the implications for countries continuing not to care about their debt (emphasis in excerpt below was in the original):

There has even been a developing debate in the press (and here at PIMCO) as to whether a highly-rated corporation could ever consistently trade at lower yields compared to its home country’s debt. I suspect not, but the narrowing in spreads since late November solicits an interesting proposition: Government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous “unicredit” type of bond market. If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee.

So what does this have to do with the U.S. forest products industry?
There are at least three areas in which the prospect of sovereign risk, and particularly U.S. sovereign risk, could affect the U.S. forest products industry.

• There is a direct linkage between sovereign debt risk and U.S. mortgage rates. Mortgage rates of course are a key ingredient in housing affordability and thus an important component to any lasting housing recovery. Mortgage rates are more closely aligned with longer-term treasury rates than the short-term rates that generally grab the headlines. The perception of heightened risk on U.S. long-term debt will ultimately drive mortgage rates higher. Higher mortgage rates could stall the near-term housing recovery; longer term they could adversely affect the sustainable level of housing start activity.
• Higher long-term rates will dampen economic activity, slowing the pace of recovery, keeping unemployment high, and potentially threatening the U.S. economy with a double-dip recession. A double-dip recession will add to housing inventory through foreclosure (foreclosure and unemployment are correlated; see March 2010 Macro Pulse), creating additional headwinds to eventual recovery in housing and reducing general demand for wood-pulp based products.
• Higher interest rates could mitigate further U.S. dollar weakness and so make U.S. wood-based exports less competitive globally. Early in the current economic downturn exports were an important source of demand for pulp and paper manufacturers to mitigate in part the loss of demand in the U.S. For wood products manufacturers the weaker greenback reduced the share of limited domestic demand met by imports into the US.

Our view for the past 18 months has been that the global debt onslaught the world is facing over the next several years will force U.S. interest rates higher, particularly longer-term rates. That will happen either as a result of:

• Capital rationing between various countries’ public debt, private debt, and equities;
• Central banks expanding the money supply and prompting lenders to demand an inflation-risk, (or in extreme cases default) premium on their debt;
• Both of the above.

And, it will happen, whether the Federal Reserve moves to increase short-term interest rates or not. We believe an increase in interest rates given the fragile condition of the U.S. economy trigger the double-dip recession.
Epilogue
As a post script to all of this we found a Bloomberg news article from this past weekend (March 22, 2010) interesting, particularly as what it described occurred within a month of Gross questioning whether such a thing could occur. The headline and lead paragraphs are shown below, emphasis added:

Obama Pays More Than Buffett as U.S. Risks AAA RatingThe bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

The new E.F. Hutton is talking. Are you listening?