A Double Dip Recession?

It is critical for investors & real estate professionals to know which cities to invest in and which to stay away from for the time being.

We are very pleased to announce that CoStar’s Watch List featured some of our May 2010 Analytics in their article, “Impact of CRE Distress Varies Widely Market to Market” receiving more than 10,000 reads within 24 hours. A sample report for All Properties is available at http://www.QuantumRisk.com/.  

Our July 2010 CMBS Property Risk Analytics** (CPRA) shows that CMBS defaults & losses vary across the US by city from 0.0% to 80.0% defaults & 0.0% to 78.0% loss severities. Defaults rates continue to increase but loss severities continue to decline. How?

July 2010 CMBS Default Rates

The July CMBS Property Risk Analytics shows that the CMBS default rates continue to increase, and is at 5.79%. Note the graph is a snap shot of the CMBS pipeline as of the end of July 2010.

July 2010 CMBS Severity of Loss 

The July CMBS Property Risk Analytics shows that the CMBS severity of loss (before recovery) continues to decline and is now at 5.51%. Note, the severity of loss numbers do not include loss due to appraised value reductions. Note the graph is a snap shot of the CMBS pipeline as of the end of July 2010.

FDIC’s Mixed Report on Banks
FDIC’s list of “problem banks” reached 829 in 2Q 2010, NY Times August 31 2010. Even so, bank earnings continue to rebound posting $21.6 billion industry profits. “Across nearly every category, troubled loans started falling for the first time in more than four years. The sole exception was commercial real estate loans, which continued to show increased weakness. Still, the nation’s 7,830 banks remain under pressure.”

 

“Without question, the industry still faces challenges,” Sheila Bair said in a news statement. “But the banking sector is gaining strength. Earnings have grown, and most asset quality indicators are moving in the right direction.” The agency expects a “recovery, sluggish and slow”.

The FDIC is cautioning that even though the outlook is becoming positive it may not be positive enough for a strong recoveery. On the other hand Russell Abrams of Titan Capital Group LLC, is betting the market is underestimating the likelihood of a crash (Bloomberg August 30, 2010)

So whose outcome is more likely, the FDIC’s small positive or Abrams’ second market crash leading to a double dip recession?

Will This Recession Be A Double Dip?
Our CMBS Property Risk Analytics shows that defaults are increasing but loss severities are declining. Apparently contradictory behaviors when you take into account that defaults and loss severities are usually positively correlated.

What is happening in the economy is that up to about a year ago CMBS defaults were dominated by newer loans that were backed by over priced (compared to today’s) valuations. Therefore, the large severity of losses late in the pipeline. The more recent defaults are from much older loans. Therefore smaller severity of losses early in the pipeline.

This tells us two things. First, industry losses that were primarily driven by over priced valuations have been fully absorbed by the industry – good news. Second, the industry losses has transitioned to a second stage, insufficient revenue. That is the more established older loans are defaulting due to insufficient business revenue.

It is this second stage that worries me. Our CMBS Property Risk Analytics shows that at the national level City DSCRs – a proxy for business revenue – are at 1.366 (April), 1.367 (May), 1.376 (June) and 1.397 (July). About constant between April, May, June and a 2.3% increase in July.

Could the July 2.3% increase be a one off ‘bump’ in the reported data?

Looking at the national level City Occupancies, our CMBS Property Risk Analytics show that City Occupancies were at 88.22%, 88.51%, 90.16% & 89.33% respectively. That is in the last 4 months there has been a general upward trend in CMBS City Occupancies of 0.5% increase per month – also good news – and if sustainable will reflect a general economic environment that will avert a second market crash & double dip.

Therefore, in my opinion a double dip recession is unlikely and I disagree with Russell Abrams opinion that a second market crash is likely to occur. I concur with Sheila Bair that even though a recovery is in place, at this point in time, a recovery is not likely to be as fast as we would like it to be.

Disclaimer: There is a certain amount of opacity in any business. For example the collapse of Lehman Brothers took us all by surprise. Therefore, if for example a major bank were to collapse that would alter this expected outcome.

CMBS Property Risk Analytics Pricing & Promotion
For Single Users, the CMBS Property Risk Analytics monthly reports are priced as follows:

Item Title	Monthly Price
QR CPRA Retail	$135.00
QR CPRA Office	$135.00
QR CPRA MultiFamily	$135.00
QR CPRA Hotels/Lodgings	$135.00
QR CPRA All Properties	$370.00

 

The prices shown do not include discounted annual price, sale tax for Colorado residents/companies or Multi User pricing. For more information on pricing visit our website http://www.QuantumRisk.com/.

The corresponding April, May, June & July reports will be provided free for all 12-month or annual subscriptions paid by September 10, 2010. For PayPal payment instructions, please contact Ben Solomon. Note, an email address is required for receipt of ftp user id, ftp password and decryption password for each monthly report.

A sample report is available at http://www.QuantumRisk.com/Subscriptions/QRCPRA/SampleReports/(00)CMBSPropertyRiskAnalytics(2010-04)01-AL-SampleReport.zip

How the CPRA Report is Generated?
Every month we analyze reported data on more than 85,000 properties backing more than 52,000 loans to identify default probability, loss severity before recovery, loan to value ratio (LTV), debt service coverage ratio (DSCR), occupancy rates & change in property appraisal value for more than 400 U.S. markets, by property type, by city, by SMSA/MSA by state across the US. Five property type reports are generated: All Properties, Lodgings/Hotels, MultiFamily, Office & Retail.

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** Property Risk Analytics is the registered trademakr of QuantumRIsk LLC.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk
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The Hard Data Shows that Sheila Bair is Correct

The New York Times article, Regulators Feud as Banking System Overhauled, presented an interesting insight into the regulatory world. In essence the opposing points of view are,

(1) John C. Dugan, the Comptroller of the Currency, blasted a proposal to impose stiff new insurance fees on banks as unfair to the largest banks, which he regulates.
(2) Sheila Bair, chair of the Federal Deposit Insurance Corporation, says that the large banks had wreaked havoc on the system, only to be bailed out by “hundreds of billions, if not trillions, in government assistance.” Sheila Bair regulates the smaller banks.

In my blog post, We Need a Non-Linear Risk Capital Scheme, I showed that the Obama Administration had indeed allocated TARP funds fairly uniformly at 2.69c of TARP per $1 of bank assets across the industry. However, the banking industry like many industries is relatively opaque. What the TARP allocation allowed us to infer was that professional bankers tend to underestimate their risk as these risk increase.

These inferences taken with my earlier blog post, TARP, a Post Event Risk Capital, shows that the 20 biggest TARP recipients received more TARP than the 20 smaller TARP recipients when normalized for risk capital or equity. The biggest recipients received on average $15.9 billion TARP each, or 54%.77 of their equity, while the smaller recipients recieved on average $0.12 billion or 24.94% of equity.

The hard data shows that Sheila Bair is correct, that big banks were undercapitalized for the risk they were taking compared to the smaller banks. This does not mean that the smaller banks were risk averse, just that the bigger banks were more risk seeking than the smaller banks. And this makes logical sense because the bigger banks could better afford to pay for resources to delve in and exploit exotic (with hindsight) high risk instruments.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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When to Expect a Recovery in the Mortgage Market

In my previous post Mortgage Spreads too High? I had used the formula: 

53% * 2,000,000 * $250,000 * (35% + 20%) = $145.75 billion

Let me explain. This is a standard expected loss formula adapted to our current situation. It takes the form:

Expected Loss = Prob of Default *  Severity of Loss

Given no reworking of loans, the probability of a default is 53%. The Severity of Loss is the average loss as a percentage of the loan, in this case 35%, multiplied by the average loan value. Depending on which paper you read, the average residential mortgage loss varies between 20+% to 60+%. The generally accepted figure is 35%. 

Given that a very large proportion of the loans are subprime, one can expect a Loan-to-Value (LTV) ratio of 100%, i.e. the average loan amout was the value of the property or $250,000.

I added an additional 20% to the loss as on a 100% LTV the unrecoverable loss needs to include the depreciation in house prices of 20%. This is appropriate as average losses are monotic and subadditive.

There is an important lesson here.

The formula tells us that if banks foreclose on a property they will have to realize the additional loss from the 20% house price depreciation. If banks have the capital to hold on to these foreclosed properties until the economy revives and house prices appreciate, then these banks do not require the government bailout funds, and should not be allowed access to the bailout funds.

This raises the question, how are banks using the bailout funds? If the bailout funds are being escrowed into reserve accounts for when a foreclosure is realized, then expect further deterioration in the mortgage markets in 2009; because the bailout funds are being used to stopgap bank losses but not to address the cause – the real economy.

If the funds are used to rework and rewrite mortgages so that 85% of the toxic mortgages are now viable, then we can expect a recovery in the mortgage market in 2009, because banks are addressing the problems in the real economy.

Now we know why Sheila Bair of the FDIC proposed a workout of 2,000,000 residential mortgages. In the long run it will actually help save the banks.

Unfortunately, as Paul Kruger pointed out in his New York Time’s blog, the spreads have increased to unprecedented highs. So don’t expect a recovery in the real economy of the mortgage markets until mortgage spreads come back down.

Benjamin T Solomon
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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Mortgage Spreads Too High?

Paul Krugman in his New York Times blog wrote,

“… there’s still a huge spread between mortgage rates and rates on federal debt … the spread between conventional 30-year mortgages and 10-year Treasuries  … was historically stable at about 150 basis points, but has been nearly double that lately.”

This market behavior is significant for what it portents. Investors, i.e. the market, voting with their dollars are saying that they do not have as much confidence in the mortgage industry as they did prior to 2008, despite efforts like TARP.

CNN reports in When mortgage rescues go bad, that U.S. Comptroller of the Currency (OCC) found that 53% of borrowers who had their mortgages modified in the first half of 2008 were already at least two months delinquent again.

Unfortunately this was not the whole story, there is some more to this story.

Michael Van Zalingen, director of home ownership services for Neighborhood Housing Services of Chicago, says that one-third of his clients modifications wound up with housing payments equal to a whopping 50% or more of their gross incomes. That is, many of these modifications are resulting in higher real dollar payments! 

A Credit Suisse study reported redefault rates of only 15% when modification results in lower real dollar payments.

Looking at these news items I have to agree with the FDIC Chairperson, Sheila Bair’s plan to modify more than two million loans. The only real way to resolve this mortgage mess is to go back in and rework all delinquent loans until acceptable outcomes are reached. 

Lets look at the consequences:

a. Interest Rate Reduction:
If, as some estimates put it, there are about $500 billion in toxic loans, then a 100 basis point reduction in loan rates results in $5 billion loss of income to investors per annum.

b. No Rate Adjustment:
If we don’t do anything than, at a default rate of 53%, a standard severity of loss of 35%, and an average house price ($250,000) depreciation of say, 20%, will result in total loss of 53% * 2,000,000 * $250,000 * (35% + 20%) = $145.75 billion.

Options (a.) and (b.) clearly explains what market spreads are showing. The undesireable consequenses of not reworking the ‘expensive’ mortgages, is in fact less expensive that not doing so.

I do hope banks figure out what the market is pointing to before it is too late, otherwise we may have a second mortgage/banking implosion in 2009. 

Benjamin T Solomon
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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