Is It Time To Break Up The Big Banks?

There is a growing, bi-partisan movement on Capitol Hill to pass legislation to break up the big banks.  When was the last time that Democrats and Republicans worked in a bi-partisan fashion on anything?  But I digress. 

Former Federal Reserve Chairman Alan Greenspan said recently, “if push comes to shove… I would be in favor breaking up the banks.”  Conservative columnist George Will recently wrote a persuasive editorial urging conservatives to support legislation proposed by Ohio U.S. Senator Sherrod Brown (D) to break up the big banks.  Before we look at this proposed legislation, let’s look at the facts.

How many financial institutions are there in the U.S?  As of 2010, there were about 7,700 financial institutions with insured deposits from the Federal Deposit Insurance Corporation (FDIC).   

How are assets distributed among these 7,700 banks?  The top 12 banks currently hold 69 percent of the total assets of the banking industry.  Community banks, which total about 5,500, have about 12 percent of the banking industry’s assets. 

What are the problems associated with large financial institutions?

1. They are too big to fail.  We cannot allow them to fail because of the negative consequences to our economy and to the world’s banking community.  So this means that we socialize the losses (taxpayers pay the bill) but when they are profitable, as they are now, the banks are allowed to keep their full share of the profits.
2.  They are too big to manage and too complex to regulate.    The recent bank scandals – LIBOR manipulation, money laundering, robo-signing, the “London Whale” – prove the megabanks are out of control.  Though there are a lot of good things in Dodd-Frank, it can only do so much to regulate bad behavior in the banking industry.
3. They are given preferential treatment.  The 20 largest banks pay between 50 to 80 basis points less when borrowing from The Federal Reserve than what community banks must pay.  
4. They are too big to prosecute.  Attorney General Holder stated in recent Senate testimony that “some of these institutions are so large that it becomes difficult for us to prosecute them.”  So in essence, they are too big to jail.  To prove this fact, no one all Wall Street was found guilty on any charges stemming from the 2008 financial meltdown.

So what would the SAFE Banking Act, co-authored by Senator Brown and Senator David Vitter (R-La), do to solve these problems?

1. It would provide sensible limits on the amount of debt that a single financial institution could hold.  No bank could have more debt than 2% of U.S. GDP; and no investment bank could have non-deposit liabilities exceeding 3% of GDP. 
2.  Their funding would be required to come from more stable sources, with about $3 of deposits for every $1 in volatile non-deposit funding.  
3. Banks in excess of this limit would be given three years to comply by drawing up their own proposals to meet this requirement.

Which banks would be affected?  Only six banks would be broken up: JP Morgan Chase, Goldman Sachs, Bank of America, Morgan Stanley, Wells Fargo and Citigroup. 

Now that the economy is improving and there are no immediate crises at hand, we need our legislators to push this bill through Congress on a bi-partisan basis for the president’s signature.  This is something that all of us should want to have enacted.  This is good legislation.  Let’s do it!

Sources: Is Fed Signaling Stance on Bank Break-Ups?, by Kayla Tausche, CNBC.com, March 15, 2013; Senator Sherrod Brown explains why he wants to break up the big banks, by Ezra Klein, The Washington Post, March 9, 2013; Time to break up the big banks, by George F. Will, The Washington Post, February 8, 2013.

Four Common Mistakes That Make Financing Your CRE Difficult, If Not Impossible

I’m surprised how often I am asked to find financing for a property that for one reason or another is obviously not financeable.  It’s as if the borrower wants the lender to forgo the use of common sense.  I’m going to let you in on a little secret: IT ISN’T GOING TO HAPPEN!!!  Anyone who is at all knowledgeable about commercial real estate lending realizes that lenders are risk averse.  They are not in business to take on any more risk than is absolutely necessary. 

So if you want to either refinance your property or to sell your property there things you must do a year or two before financing is needed to get the property to the point where I call it, “lender friendly.”  Not doing so will likely make it much more difficult, if not impossible, in getting a lender interested.  Here are four common mistakes:

1.   The property is in poor physical condition.  It’s a big turn off to lenders to see a property poorly maintained.  Why would a lender refinance a property for a borrower that is not willing to maintain his property?  If you want to refinance a property that has a lot of deferred maintenance you better have an excellent explanation as to why it’s in poor condition.  Better yet would be to get the big ticket items fixed prior to refinancing your property. 

2.   The occupancy rate for the property is below market calling into question the seller’s property management company’s ability to professionally manage the property.  If the property is self-managed you’re in deep trouble.  If the property is for sale some sellers or listing brokers think that providing a rent guarantee on the unoccupied space will satisfy a lender’s concern.  WRONG!!  It does just the opposite.  It’s a great big red flag that something is wrong with the property.  A better solution is to offer as much free rent as needed to get the vacant space occupied.  Offer the free rent at the beginning of the lease.  Once the free rent has burned off, then refinance or put the property up for sale.  You still need to disclose the free rent to the lender but it is much better to have your property at stabilized occupancy with free rent than to have a property with a high vacancy rate. 

3.   Operating expenses are well above normal for a property of that age and condition.  You need to investigate if there is a reason for this.  Is it an anomaly?  Are some ongoing maintenance expenses actually capital expenditures?  Can you explain why?  If you can determine that the additional expenses are costly one-time expenses then capitalize what you can identify and operate the property for a year to show what your operating expenses should be for a normal year.  If you rush to refinance the property with higher than normal operating expenses it will likely lower the loan amount because of the lender’s minimum debt coverage requirement.  And if you’re trying to sell the property, the value of the property will be adversely impacted because the NOI for the property will be lower than it should be.  Worst case scenario, the lower NOI could reduce the loan amount and thereby increase the equity required by the buyer beyond what he is willing to invest in the property killing your sale.      

4.   Most tenants are on a month-to-month basis (not a concern for apartment renters) or have only 1 or 2 years remaining on the term of their lease.  Most lenders will not accept rollover risk.  Again, proposing a rent guarantee on those tenants whose leases have expired or will expire shortly is a big turn off to lenders.  One way to mitigate risk is to identify when each tenant originally moved in.  If they have been a tenant at the property for 10 or more years then it is much less likely they plan to move once the lease expires.  But the best thing to do before you sell or refinance your property is to get as many tenants re-leased for as long as possible.  Once you’ve minimized the rollover risk then seek financing. 

Remember, it’s all about getting the lender as comfortable as possible with financing the property.  You’re asking the lender to lend you or your buyer lots of money.  Make sure to take some common sense steps prior to requesting a loan that makes it easy for the lender to say yes. 

Timing Is Everything When Financing CRE

They say that, "Timing is everything."  Right?  Well it certainly holds true when it comes to financing commercial real estate.  There are times during the year when trying to get a loan financed is pure misery and there are times when the financing "gods" are looking down benevolently on you.  But let me tell you a little secret: It's not rocket science to figure out when is the optimal time to get things financed.  It's plain common sense.  Shown below are the worst times and then the best times to get your property financed.

Worst Times to Finance CRE

1. June 10th through Labor Day - If you haven't signed your loan application before summer starts, good luck!  Summer is the time when kids are out of school and family's take long vacations.  Loan officers, underwriters, loan processors, real estate brokers, mortgage brokers, attorneys, appraisers, etc. all lose focus during the summer months and as a result the financing process slows down to a crawl, or so it seems.
2. November 1st through Year End - If your loan is not expected to close before year end, your deal will go to the bottom of the pile.  All the focus during the end of the year is to work on deals that will close before year end so loan officers can make their quotas and for those who have had a good year, to make their bonuses.

Best Times to Finance CRE

1. First Quarter - The best time of the year to start the financing process is during the first quarter.  Bankers are refreshed after the holidays and eager to start working on their annual quotas in order to acheive their year end bonuses.  Most insurance companies will be back in the market ready to lend.  As the year progresses, they become more and more selective on property type and quality of transaction.  
2. Labor Day through October 31st - People are back from vacations, kids are in school, and lenders are again eager to get their last round of deals started for the year so that they close before the holiday season. 
3. November 1st through the 15th - To paraphrase Charles Dickens, "These are the best of times and the worst of times."  No sane loan officer should commit to closing a loan in less than 60 days.  But those loan officers who haven't reached their quota, or have, but want to increase their bonuses even further go into "warp speed" trying to cram in the final deals for the year.  If the "moon and the stars" line up perfectly or they're just plain lucky they succeed.  I just found out late last week that I have a client that must close his commercial real estate purchase before the end of the year or he will experience adverse tax consequences.  There are less than 50 days to the end of the year and the deal is not yet under application.  I haven't closed a loan this year under 75 days, most have been considerably longer. And yet, I have four lenders who have committed to closing on this deal before year end. This just tells me there are a lot of hungry loan officers who want to get deals closed no matter what it takes. 

So when is the best time to finance commercial real estate?  It's plain common sense: Whenever your loan officer is highly motivated to get the deal done.

Source: The Importance of Luck and Timing in Real Estate, by Kevan McCormack, Metropolitan Capital Advisors

The 800 lb Gorilla in the Room

Whether Obama or Romney gets elected tonight, the next administration within the next four years will have two major crises that they will have to confront head on. One has been discussed frequently on the campaign trail – Iran getting a nuclear weapon, the other has been virtually ignored.  It's the 800 lb gorilla in the room.  We would prefer not to acknowledge that it even exists, which is, the inevitable financial collapse of Europe.

What most people don’t realize, or are unwilling to admit, there is no solution to the sovereign debt crisis in Europe. European leaders could assemble the brightest economist minds from all around the world together in one room, give them complete authority to act on the crisis as they see fit and it still would not change the ultimate outcome: Europe is going down. It’s inevitable. They are too far down the path to their own destruction to turn it around.

It’s only a matter of when, not if. True, they’ve done an excellent job “kicking the can down the road” these past three years and can continue to do so for some time to come but at some point the market is going to perceive their feeble attempts at a solution as putting a band aid on a gaping wound. When that occurs, market confidence will collapse taking down the European bond market and many of the European banks.

By now I suspect that many of you consider me a “nut job,” a “doom and gloom” type who thinks the world is coming to an end which I categorically deny. Humor me for a moment and for the sake of argument let’s assume my prediction is true. What then? How will this affect commercial real estate in the Pacific Northwest? To answer that question the following questions need to be answered:

• How will this affect trade with our largest trading partner, the European Union? We will see a substantial decline in our exports to Europe.
• How will this affect the U.S. economy? This will likely throw our economy into another recession.
• How will this affect our stock market? The stock market is affected by emotion. When things are good it soars far beyond any justification. When things are bad it plummets far lower than it should. In this case the stock market will initially plummet similar to what happened in 2008, maybe worse. At best it will be a roller coaster of a ride, soaring to new heights on good news and plummeting back down with any hiccup in economic news. This will not be a good time to be heavily invested in the stock market.
• How will this affect our bond market? It’s likely that Europeans will see our bond market as a safe haven and heavily invest in U.S. treasuries. If true, treasury yields, which are at historic lows, will likely go lower.
• How will this affect our financial institutions? This is where it gets ominous. The vast majority of our lending institutions should be unaffected. Only our five largest banks – Bank of America, JP Morgan Chase, Goldman Sachs, Citigroup and Morgan Stanley are heavily invested in credit default swaps on European sovereign debt. A credit default swap is a fancy term for bond insurance. Our five largest banks have insured a boat load of European sovereign bonds. When these European countries default on their bonds, these U.S. banks will be left holding the bag. Though these banks have confidently stated they have it under control, call me a cynic but I don’t believe them.  Between you and me, I hope they do. I truly hope they do because the alternative is these banks are going down.
• What response will the president (Obama or Romney) make to minimize the fallout on the American economy? This is where it gets interesting. The president has a very difficult decision to make: Does he let these five largest U.S. financial institutions go bankrupt? Or does he bail them out? Is the country in the mood to bail Wall Street out once again? Are these banks too big to fail? If he doesn’t bail them out will it not bring down the rest of the world’s financial system? Good luck Mr. President!
• So back to the original question: How will this affect commercial real estate in the Pacific Northwest? I think this can best be answered by looking back to the 2008 financial debacle. Four years ago some commercial real estate investors survived while others did not. The common denominator for survival was:
• Property type mattered. Apartments fared well. Office, raw land and single family subdivisions did poorly. Everything else was in between.
• Those properties that were modestly leveraged survived. Those that weren’t were taken over by the lender. 
• Those who have subsequently locked in long-term, low interest rate financing were the big winners.

When the Europe bond market collapses commercial real estate will be the investment that has the best chance to weather the economic storm. The stock market, on the other hand, will be a roller coaster basket case, the bond market will have incredibly low yields, and cash in the bank will yield no return. As long as investors invest in the right property type, leverage their properties modestly and lock in low interest rate, long-term fixed rate financing they will come out of this future economic crisis intact. And if inflation is the natural result of this disaster what better hedge against inflation than commercial real estate?

So am I a “nut job?” You decide.

CRE Delinquency Rates Continue to Plummet

The commercial real estate market is getting better.  What we've sensed was happening has numbers to prove our thinking.  There are two very insightful charts by SNL Financial that show the slow but steady decline in delinquency rates over time on commercial real estate loans.

U.S. commercial banks reported a delinquency rate of 5.28% on CRE loans compared to a high of 10.76% nine quarters ago.  Oregon has fared even better with a delinquency rate of only 3.04% on CRE loans. 

The asset quality of CRE loans has been improving at a faster pace than one-to-four-unit plexes (considered residential).  However, residential loan delinquencies have also declined by about 200 basis points to 12.66% as of the end of the 2nd quarter of this year. 

Looking at delinquency rates by state shows that the Northeast, the Plains states, Alaska and Hawaii have fared the best, while the Southeast and the state of Nevada have the highest overall delinquency rates.   

Source: CRE delinquencies continue to plummet; by Harish Mali and Robert Clark, SNL Financial, August 29, 2012

Surprise, Surprise, Surprise! Banks Downgraded

In my May 25th blog post I wrote:

"Are the U.S. financial institutions prepared for what is happening in Greece? The answer is, "It depends on which banks you're talking about."  The vast majority of the American banks have no exposure whatsoever to the Greek financial crisis with the exception of our very largest banks - Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley, Goldman Sachs and Wells Fargo.  These six banks have definite exposure to what's happening in Greece.  All reports say that their exposure to Greek insolvency is manageable.  If you want to believe what the banks are telling you then we have nothing to be concerned about.  Call me a cynic, call me a "glass half-empty type of guy, but I don't believe it."

Last Thursday, Moody's cut the credit ratings of 15 of the world's largest financial institutions including five out of the top six largest banks in the U.S. - Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley and Goldman Sachs.  As Gomer Pyle would say, "Surprise, surprise, surprise!" 

Why were they downgraded?  Reasons given were:

• Marginal liquidity
• Exposure to the European debt and banking crisis
• Unspecified volatility and risk management problems in their capital markets activities

How will a lower credit rating affect these banks?

• It will make it more expensive for them to borrow money.
• It will make it more difficult to sell their commercial paper to money market funds.
• It will likely require them to increase their capital requirements.
• It will likely have an adverse affect on the value of their publicly traded stock.

Did Moody's consider all 15 banks equally in trouble?  No.  Moody's grouped the 15 institutions into three categories based on their relative credit-worthiness.

• The strongest group had solid capital buffers and "contained" exposure to the European crisis.  J.P. Morgan Chase falls into this category.
• The second group had varying risk factors, ranging from high dependence on capital markets operations to limited liquidity and exposure to Europe.  Goldman Sachs was in this category.
• The weakest group had experienced problems with volatility and risk management, and in some cases had weaker buffers than their peers in the industry.  Bank of America, Citigroup & Morgan Stanley were in this category.

Bank of America and Citigroup's credit rating are now rated two notches about junk status, while Morgan Stanley is three notches above. 

Are the credit agencies done downgrading the world's largest financial institutions?  Not even close.  Most of the European banks have been downgraded on several occasions over the past few years and I suspect that further downgrading of our largest banks will continue unless drastic improvement occurs over the next couple of years. 

It is hard for me to believe that one or more of these major U.S. banks will not falter and eventually collapse of its own bad decision making.  The real question is not if it will happen, but when, and more importantly whether those in authority at The Federal Reserve and U.S. Treasury Department have a comprehensive plan to contain the fallout when this occurs.  I suspect that they do have a plan and I suspect that they hope that they don't have to implement it.  That and $1.65 will get you a tall cup of coffee at Starbucks.   

Sources: Major banks downgraded by Moody's, @CNNMoneyInvest, by James O'Toole, June 21, 2002; A Sober New Reality in Credit Downgrades for Banks, DealBook, NYTimes edited by Andrew Ross Sorkin, June 22, 2012.

Another Questionable Decision by The Federal Reserve

The Federal Reserve last Thursday released a proposal that would implement a global agreement known as Basel III. This agreement is a regulatory standard that proposes minimum capital requirements and liquidity standards for all financial institutions worldwide.

I know what you’re thinking as I was thinking it too: I’m tired of reading another boring article on banking regulations. But I would encourage you not to delete this blog post before you get a “view from 35,000 feet” on how Basel III is going to impact the commercial real estate industry. It could have an enormous adverse impact on our industry if not implemented gradually.

From our perspective the most egregious new implementation being proposed by Basel III is assigning a higher risk weight to commercial real estate loans of 150%, up from a current risk weight of 100%. How does that affect the bank? The more risk, the more capital that’s required by financial institutions to have on hand as a buffer. So the more they lend on commercial real estate the higher their capital requirement. If they lend on other assets, home loans or businesses for example, they will not be required to hold as much in reserve.

So what do you think the banks are going to do when this new rule is fully implemented? Do you think they will lend more or less on commercial real estate? Of course, the tendency will be to lend less. And how do you think in real terms that will be done? I think there will be fewer banks lending on commercial real estate and those that do will find a plethora of ways to make it that much more difficult to get a loan approved and closed (as if we need more banking regulations to slow down the loan approval process).

This isn’t me just “crying wolf.” Fitch Ratings estimated last week that the world’s 29 largest banks will need to raise another $566 billion by the end of 2018 to meet these new international liquidity requirements against risk. Where is that going to come from?

I wonder why they consider commercial real estate so risky? The Great Recession was brought about by a housing bubble and lax underwriting standards for qualifying borrowers of home loans, not because of excesses in the commercial real estate industry. So why pick on us? Why make commercial real estate the scapegoat? The Federal Reserve needs to think this through and figure out what the ramifications are to our economy if this is fully implemented. Basel III ultimately means less lending on commercial real estate which means a slower economy which means fewer people being employed.

I’m all in favor of reforming the banking industry (remember I’m in favor of Dodd Frank) but increasing the risk weight for commercial real estate may be over the top. There’s got to be someone on The Federal Reserve Board of Governors who has enough common sense to understand this and has the courage of his convictions to push back. Don’t you think?

Sources: Basel III, Wikipedia; Fitch Ratings: World's Biggest Banks May Need To Raise $566 to Comply With New International Rules, Huffington Post, June 7, 2012; Fed ups capital buffer for commercial real estate, Market Watch, The Wall Street Journal, June 7, 2012; Federal Reserve unveils Basel III bank capital proposal, The Economic Times, June 8, 2012.
 
 
 

What's the Rational Thing to Do in a Bank Run?

Something significant happened last week in Europe that I’m guessing most of my readers overlooked. Ever since the debt crisis hit Europe three years ago, Europe has fallen into very predictable cycle. The cycle goes like this:

• Phase 1 – A financial crisis emerges.

• Phase 2 – After dire public warnings that the world as we know it will come to an end if something isn’t done immediately a meeting of European leaders is held.

• Phase 3 – The meeting is met with hope and trepidation, followed by great relief that an agreement has been reached.

• Phase 4 – Within a few days of the meeting, possibly as long as month, the apparent solution is exposed for what it is: “a band aid for a gaping wound” and the solution unravels.

Last week this cycle was broken. O yes it began exactly the same way. A crisis loomed: What was to be done with Greece? And Phase 2 kicked in, European leaders met. But this is where the cycle stopped. No alternative was found to solve the crisis. And maybe this is a good thing. Maybe, finally, European leaders are realizing that there is no solution to Greece. It’s kind of like an alcoholic who finally admits to himself he has a drinking problem. Until that happens he has no chance whatsoever of living a life of sobriety.

And now that the European leaders admit that there is no solution to the Greek’s financial problems they can now move onto the next phase which is, “How do we allow Greece to leave the eurozone that will minimize the damage?” It is no longer a question of if the Greeks will leave the eurozone it is only a matter of how to do it so that it minimizes the negative consequences from such an event.

And negative consequences there will be. Even now there is a run on the Greek banks. It reminds me of what happened to Washington Mutual a couple of years ago. One moment it was a healthy going concern and within a couple of weeks depositors had electronically pulled out all their deposits from the bank. What is the rational thing to do in a bank run? The rational thing to do is to participate. And that is what’s happening right now with the Greek banks and there is nothing anyone can do about it. The Greek people aren’t stupid. They’re transferring their money into other currencies that have less risk. It’s way too late for the Greek banks to recover.

The really important question is, “Are U.S. financial institutions prepared for what is happening in Greece?” The answer is “It depends on which banks you’re talking about.”

The vast majority of the American banks have no exposure whatsoever to the Greek financial crisis with the exception of our very largest banks – Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley, Goldman Sachs and Wells Fargo. These six banks have definite exposure to what’s happening in Greece. All reports say that their exposure to Greek insolvency is manageable. If you want to believe what the banks are telling you then we have nothing to be concerned about. Call me a cynic, call me a “glass half-empty” type of guy if you like, but I don’t believe it.

Months ago I reported that American financial institutions had only modest amounts of European sovereign debt but they had significantly more risk with credit default swap exposure. A CDS is just a fancy way of saying that they are insuring those who own sovereign debt that it will not default. For a nice fee they are exposed to enormous risk if they are wrong. I believe this is what happened to J.P. Morgan Chase a couple of weeks ago. They bet wrong and voila, they lost $3 billion. Until Congress outlaws these risky forms of investments all bets are off that these six banks will come out of this crisis unscathed.

Sources: Greece and Banks by David Knox, Cumberland Advisors, May 23, 2012; The Rational Thing To Do In A Bank Run, GK Research, May 17, 2012; A Cycle of European Crisis Management, STRATFOR, May 25, 2012.

What the heck happened at JP Morgan Chase?

As you know by now JP Morgan Chase lost $2 billion last week by taking big bets on European bonds. Interesting to note (and telling) I found no article that explained what caused the loss. I scanned the internet and there are plenty of articles talking about whose heads would fly, articles supporting more regulation of the banks, articles about the political ramifications of the presidential race but no article that tried to explain what actually happened.  

Why not? I believe it’s because it’s too complicated for the lay person to understand. The investment that caused the loss is called a “synthetic credit portfolio.” Wow! What does that mean? I would guess that the average investment banker doesn’t fully understand the complexity of the investment vehicle either!  

Should we be concerned about this loss? Absolutely! As long as the American taxpayer has to bail out the banks when things go wrong we have every reason to be concerned. This $2 billion loss last week, although significant, is manageable. In comparison, last year JP Morgan Chase made a profit of $18 billion so a $2 billion loss is not the issue.  

The importance of last week’s loss shows us that we are just as vulnerable to a catastrophic event as we were four years ago when Lehman Brothers started the ball rolling. That’s the lesson we learned from this latest blunder by JP Morgan Chase. No legislation has been enacted, no common sense has been gained, that will prevent us from doing it all over again. How ominous is that.  

So if I were suddenly in charge how would I fix the problem? I would do the following:

1. As I stated in January in this blog I am in favor of the Dodd-Frank bill. Now I’m no expert on the bill but it has a number of common sense ideas that should be fully implemented. I know this is unpopular with many of my readers who believe in free markets but I believe that some regulation is necessary to save us from ourselves.

2. The deeper more penetrating question is, “Should banks in general be doing these types of trades?” I strongly believe the answer is a resounding “no” and agree with the Volker Rule (a section in the Dodd-Frank bill) which bans speculative trading on a bank’s own accounts.

3. I believe there needs to be a change in how investment bankers are compensated. Greed drives risky behavior. If they are on the right side of the bet they’re handsomely compensated. But what happens if they make poor choices? Do they give back some of their previous commissions and bonuses? Hardly! Instead reward employees for making sound investment decisions over time (perhaps over 2 or 3 years) and not on any one particular transaction.

4. The ultimate goal should be that banks should be allowed to fail if and when they make egregious errors in judgment. The federal government should not be in the business of bailing out the banks when things go wrong (though I do believe it was the right thing to do in 2008 to avoid a more catastrophic upheaval). This may mean that banks should be forced to downsize into several smaller financial institutions so that we can avoid the problem we had last time around when many of our bank were “too big to fail.”

Make me king for a day and I’ll solve all the world’s problems. But seriously, what occurred last week should be viewed as a wake-up call to everyone who is in charge of our financial institutions. How vulnerable are the American banks to the European debt crisis? What happens if a sovereign default does occur? Therein lies the great unknown.

 

1st Quarter 2012 Sales Activity - How Did We Do?

From a sales standpoint how well did we do in for the 1st quarter of 2012 compared to previous years? Shown below are the criteria we used to tabulate the results:

• Sales information is from the CoStar database as of March 31st. My guess is that it will take a few more weeks before CoStar has all the 1st quarter sales activity recorded but this is what they’ve recorded so far.
• Transactions closed between January 1st and March 31st, 2012
• Investment properties only (no owner user)
• Property types - flex, industrial, mixed use, multifamily, office & retail
• Transactions with sales prices of $1 million or larger
• Arms length transactions (no partial conveyance of ownership)
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on these criteria the chart below compares the sales activity for the first quarter of 2012 with each of the preceding five years:

As you can see 1st quarter sales activity was less than last year but more than in 2010.  It gives me the impression that that we've bottomed out but we are bouncing along the bottom, ie, it's not getting worse and it's not getting better.  For the past four years, the first quarter sales activity has been roughly the same.   

We then analyzed the 47 closed transactions by property type:

Not surprisingly, multi-family leads the way with the most sales transactions in the first quarter.  What is a bit surprising is the number of office transactions.  This is significantly up from the past few years.  Is this a trend or an anomaly?  We'll have to wait and see how the rest of the year develops. 

Of the 47 transactions, 16 had broker representation on both sides of the transaction.  Eleven had no broker representation.  The remaining 20 transactions had only one side of the transaction represented.

If you add it all up, there were a total of 52 paydays (2 x 16 + 20).  So if you want to know your personal market share of all the broker paydays divide your number of paydays by 52. 

Shown below are the lending sources for these transactions:

The banks continue to provide the bulk of the acquisition financing for Oregon and SW Washington.  There is almost a complete absence by the life companies, Freddie & Fannie, and the credit unions.  A big surprise is the lack of seller financing.  Over the past several years seller financing was the predominant way most non-apartment transactions were financed. 

Shown below are the top 6 real estate brokerage firms based on total broker representation of closed transactions for the 1st quarter of 2012: 

The real estate brokerage community is not dominated by any one firm.  In fact, Joseph Bernard Investment Real Estate, who is ranked #1 on the list with 5 broker representations, represents less than 10% of the total market.  The top 6 firms present only 42% of the total market.

So how do I summarize the first quarter?  It's been surprisingly quiet.  I was expecting more activity than last year, and so far that has not materialized.  That's not to say it won't but it needs to pick it up a few notches if the market is going to show a sustained improvement over the previous couple of years.  Here's hoping that the coming quarter shows improved strength over the one we've just finished! 

Should Dodd-Frank Be Repealed?

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama in 2010 is considered the most sweeping change in U.S. financial regulations since the Great Depression.

Many of those regulatory changes will become effective beginning January 1, 2012. If you’ve listened for any length of time to the Republican presidential debates one of the re-occurring themes that is bandied about by several of the candidates is that Dodd-Frank should be repealed. They consider this legislation a quintessential example of government red tape that is crippling our economy. Hmm… Is that really true?

I freely admit I’m no expert on the subject of the Dodd-Frank bill which totaled over 2,300 pages in length and most likely neither are you. So let’s begin by doing a quick overview of what was in the bill and how it impacts commercial real estate.

1. Banks are required to have 5% “skin in the game” for every loan that they approve. No longer can they approve a risky loan and then sell it to some unsuspecting investor by passing it off as a quality investment. This means that lenders are now scrutinizing and documenting real estate loans more carefully. Anyone in the mortgage lending business will tell you that it takes much longer and requires much more paperwork today than it did three years ago. You can thank this 5% rule for the reason why loan processing has become so much more cumbersome.

2. Banks are required to carry more capital reserves. They now have to prove they have the correct amount of reserves, and based on recent default rates and delinquencies, they have had to increase capital reserves significantly over what they were required only a few years ago. This has resulted in decreasing the overall amount of lending capacity in the market in addition to decreasing significantly the number of lenders lending. Pre-2008 lenders were tripping all over themselves competing for loans.

3. Rating agencies now bear more risk and liability under Dodd-Frank. Gone are the days when credit agencies were fearful of losing lucrative business if they came down too conservatively on risky loan pools. As a result CMBS issues today are much more conservative, with lower LTVs and higher debt coverage ratios. It is no surprise that the CMBS market is a shadow of its former self. In 2007 there was $228 billion in the CMBS market compared to a measly $12 billion in 2010. There are several reasons for this downturn but the rating agency reform in the Dodd-Frank bill is certainly one of them.

I would be the first to admit that the Dodd-Frank bill is having a huge adverse impact on the banking system in the short term. But would you prefer to go back to where the banking regulations were prior to the sub-prime loan debacle? I don’t think so. Yes it’s painful and it certainly makes a good sound bite on the campaign trail to rail against the Dodd Frank bill. But all three of these changes are just plain common sense. They are needed in order to slowly repair a battered banking system that has lost all the respect that it once had. If you disagree, I welcome your comments.

Source: Regulatory Reform: What Impact Will It Have On Commercial Real Estate?, CoStar Group Real Estate Information, Randyl Drummer, July 28, 2010.

What exactiy did The Fed do?

Last week the Dow Jones Industrial Average soared almost 500 points (4.2%) on the news that The Federal Reserve in a coordinated effort with five other central banks of the world came to the rescue of European banks. Specifically, The Fed’s action effectively gives these central banks access to a massive pool of new U.S. dollars that they can borrow at a very low rate of 0.5% to fund their banking sectors. Why should this action be viewed with euphoria by the world's stock markets?

To better understand what is going on you need to know why The Fed took this action. For European banks to lend money they have traditionally borrowed dollars from other banks, money market funds and institutional investors. As the European debt crisis has deepened, these lending sources have slowly pulled back because Europe’s banks are holding ever larger amounts of sovereign debt that is becoming increasingly more likely it will not get paid back.

Since May, U.S. money market funds have reduced their loans to European banks by 42 percent reports the Fitch rating agency. If we could know what the other lending sources for European banks were doing we would likely see the same response. Prudent lending sources seeing the increasing risk of sovereign debt are unwilling to risk their own money by lending it to the European banks. This is just plain common sense. You would do the exact same thing. Therefore the reason The Fed acted as it did last week is because the European banks were starting to experience a liquidity crunch.

It is the equivalent to what happened to Washington Mutual a few years ago. Recall what brought down WaMu was bank customers losing confidence in the long term viability of the bank quietly, but ever so quickly withdrawing their deposits. There was a run on the bank. In the period of a few weeks, WaMu went from being healthy to insolvent. The exact same thing is happening right now to European banks. The only difference is that it is happening across all the major banks in Europe, not just one particular lender like Washington Mutual. So I ask you? Is this something to be euphoric about? Does this justify a 500 point increase in the Dow? Only if you think bad news is good news.

We should be very concerned with what just happened and here’s why:

1. This did nothing to solve the European debt crisis. All it did was to delay the outcome.

2. The Federal Reserve has now become the lender of last resort. In other words when a European bank defaults, which will happen, we the American public will be picking up the tab.

How does that make you feel?  Euphoric?


Sources: What exactly did the Fed do?, by Robert J. Samuelson, The Oregonian, December 2, 2011; Fed Action in Europe Underscores Dollar Primacy, STRATFOR, November 30, 2011.

John Mitchell's Economic Forecast - Opportunities to Be Seized

I had the opportunity to hear John Mitchell’s economic forecast at the Sterling Savings Bank November 3^rd breakfast meeting.  John always does an excellent job making a boring topic interesting.  There were no surprises in his presentation about the current economic situation, the gist of which was, the U.S. economy is growing, albeit at a slower rate than one would hope.  

But I didn’t go to hear John Mitchell talk about our current economic situation.  I went there to hear what he thinks will happen going forward.  Accurately forecasting future economic trends splits the men from the boys, which reminds me of the Yogi Berra quote: “It’s tough to make predictions especially about the future.”

Not surprisingly, John Mitchell didn’t go out on a limb making any bold predictions about our economic future.  Economists as a rule are not known for being risk takers.  But in fairness to John, he did identify several issues that could influence the economy for good or for ill.  I would like to focus on two of these challenges.  If these issues are handled properly it would have a positive long-term impact on our economy. 

Opportunity #1 – The Housing Crisis

As John Mitchell pointed out, 17% of all homes in Oregon and 22% of all houses in the U.S. are underwater, i.e., homeowners owe more than their houses are worth.  Until this crisis is resolved, house prices will not bottom out, let alone begin to appreciate in value.  And until house prices begin going up most Americans will not have the confidence that the economy has turned the corner regardless of what the economic numbers may say.

One proposal that would go a long way to resolving the housing crisis is writing down some of the principal on these underwater mortgages.  It is estimated that 10 million out of 55 million mortgages are likely to default. The single best indicator of whether a homeowner will default is the size of the imbalance between what is owed and what the house is worth.  Reduce the size of the imbalance and there will be fewer defaults.  Fewer defaults would be a major step in stabilizing house prices.  

Banks hate this idea and would rather continue with the status quo.  The solution: Leaders in Congress should propose legislation that will allow banks to quickly write down mortgages in a manner that doesn’t punish the banks’ long-term viability.  The alternative is continued stagnation in the housing market. 

Opportunity #2 – The Congressional Supercommittee

As you already know, the congressional supercommittee has been given the task of proposing a combination of $1.2 trillion in spending cuts or revenue increases over the next 10 years.  Their deadline to make their proposal before Congress is November 23^rd which is fast approaching.  Most economists believe that anything less than a $3 trillion package will be perceived by the market as little more than putting a band aid on a gaping wound.  Failure to come to some agreement will likely increase our chances of a further downgrading of our nation’s credit rating. 

I hope that those on the committee are closely watching the debt crisis in Europe unfold.  Just in the last week both the Greek and Italian leaders have been forced from office.  Europe is in the throes of a financial crisis.  We could be next.  Compromise, a word that is now considered a pejorative by many, needs to happen between Republicans and Democrats in order to get anything through the supercommittee that has a chance of passing both houses of Congress.   

Both of these issues are at major crossroads.  And both of these are opportunities to be seized or to be squandered. If those in political power show some leadership they could help turn our economic ship around.

Sources: Aftershocks, Oil Shocks and the Long Good-Bye, by John Mitchell, November 3, 2011; A Good Idea in Principal, by Joe Nocera, The Oregonian, November 8, 2011. 

Why Greece Can't Default Just Yet

Greece has been on the verge of defaulting on its debt for more than a year.  Each time the crisis looms its ugly head, European leaders, led by Germany's Chancellor Angela Merkel, come through with another temporary bailout plan that enables the Greeks to survive a little while longer.  But the decision makers about the Greek crisis have to know that Greece at some point is going to default.  So why throw good money after bad with one more bailout? 

The reason is simple: the European market needs to have all its ducks in a row before it allows Greece to default.  If Greece were to default before they are ready, it could potentially have catastrophic financial consequences in Europe and in time to the rest of the world economy.  So while we watch the news showing the Europeans confidently handling the latest debt crisis, behind the scenes they are working as quickly as they can to make the necessary preparations for the eventual default.  It's like watching a duck traveling through water.  Above the surface it looks effortless but below the surface the duck is paddling furiously.  That's what's going on with the European leaders right now.  They are trying to put a "happy face" out to the public to reassure us that they have the crisis under control, but behind the scenes they are all wringing their hands making the hard decisions needed to weather this financial storm.

So what needs to be done to prepare for this eventual default?  Greece has to be kicked out of the eurozone if the euro is to survive, but for that to happen three things must occur: 1) 400 billion euros are needed to firebreak Greece off from the rest of the eurozone; 2) 800 billion euros are needed in order to prevent a wide-scale banking meltdown, because the day that Greece defaults on its debt, there is likely to be banking collapses in Portugal, Spain and France; and 3) the markets will go wild to say the least.  To avoid Italy being dragged down with Greece, it will need 800 billion euros to keep it solvent for the next three years.  So until the Europeans have two trillion euros in funding available for this crisis, they can't kick Greece out of the eurozone. 

So how does this affect commercial real estate in the Pacific Northwest?  For one, interest rates should remain low.  The Europeans will continue to pour their equity into U.S. treasuries (a flight to quality) which will keep treasury rates low.  Secondly, we are fortunate that our trading partners are situated along the Pacific rim.  Most of our exports are shipped to Canada, China, Japan, South Korea and other Asian nations.  If our export volume remains steady the Pacific Northwest should weather this storm without serious consequences.  I am not as bullish about our east coast which trades heavily with Europe.  I believe the Greek crisis will result in slower economic growth in Europe (likely prolonging the European recession) which will have an adverse impact on their buying U.S. exports.  This will eventually affect us on the west coast but not nearly as much as those states who trade significant volumes with Europe.  I still believe that commercial real estate in the Pacific Northwest is a sound long-term investment, and though it may sound like it, I'm not trying to put my own version of a "happy face" on the impact to us of the mounting crisis in Europe.  Stay positive, the world is not coming to an end, we'll get through this. 

Source: Portfolio: Preparing for Greece's Failure, STRATFOR, Peter Zeihan, September 29, 2011.

How Bill Gross Got It All Wrong

Earlier this year Bill Gross, the head of bond giant PIMCO, announced in grand fashion that he was getting out of U.S. Treasuries. His reasoning was quite rational: The end of the Fed's quantitative easing program, which ended in June, would be bad for bonds. Prices would fall causing yields (or interest rates) to rise. This would happen because the Fed was the number one buyer of U.S. debt. Without the Fed buying bonds one of two things would have to happen to prevent yields from rising:

1. Some other country would have to step in to buy the Fed's volume of U.S. Treasuries which was highly unlikely, or
2. The U.S. government would have to significantly moderate their borrowing to shrink the volume of U.S. Treasuries being sold on the market. At the present time for every $1 spent by the federal government about 40 cents of that amount is borrowed.

So what do you think are the chances of either #1 or #2 happening? Not likely is it? Looking at it from this perspective, it seemed quite unlikely that another country could purchase the enormous quantity of bonds that the Fed had been buying over the last two years. And it also seemed unlikely that the federal government would reduce its need to borrower.

This past week people were crowing about how Bill Gross got it all wrong and how he lost a lot of money for his bond fund investors. He even admitted sheepishly that it had been a "mistake" to get out of U.S. treasuries. Since Mr. Gross’s announcement in March the 10 year treasury rate has plummeted from 3.46% to 2.02% (Sep 2nd). So how does someone of Mr. Gross's caliber get it wrong? What did he miss?

Back in March when Mr. Gross made his announcement there was no way for anyone to predict:

1. That the sovereign debt crisis in Europe would reach critical mass this year. European leaders had been successful over the years in “kicking the can down the road” and it seemed likely this year would be no different. Wrong!
2. What the impact of the sovereign debt crisis would have on the U.S. treasury market. Fear of a default of sovereign debt by Greece and then by Italy has caused a panic among Europeans. And when panic ensues, investors take their money out of risky investments promising a return on their money and instead invest in less risky investments, in this case U.S. treasuries, where they focus on getting a return of their money.

What has happened is the law of supply and demand has kicked in. Concerned European investors have dramatically increased the demand for U.S. treasuries while the supply has stayed the same. When that happens, yields decline. It’s really that simple.

But the big question is, “How does this affect those of us in the commercial real estate market?” We are currently seeing historically low interest rates.  A lower interest rate means a lower mortgage payment which means better cash flows after debt service. If you own commercial real estate now is the time to lock in long term fixed rate financing.

I know I sound like the boy who cried wolf one too many times but some day we are all going to wake up and the world will be different. Some unpredictable catastrophic event will have occurred (a run on U.S. banks perhaps) causing interest rates to skyrocket and when that happens those who had the foresight to lock in the low rates will be the big winners.

Source: Bill Gross and the Case for Buy Low and Hold, Morgan Housel, The Motley Fool, August 31, 2011.

Why a Greek Default is Important to Us

I know that if I emphasize too strongly what is happening in Greece I will be accused of being another Chicken Little proclaiming that “the sky is falling.” But reality is that a default by Greece on its debt obligations will likely have a serious adverse impact on us in the United States. But before I explain why let me back up a bit and give you a brief overview of what’s going on.

The Greek sovereign debt crisis has grown to the point that it is no longer a question of if Greece will default on its debt it’s now only a matter of when. It’s going to happen. Last week Standard & Poors lowered the country’s debt rating to triple C – its worst rating for any country in the world. The Greek government is teetering on collapse as massive demonstrations express their rage and frustration in the streets.

A survey indicated that 85 percent of all Greeks would rather default on their country’s debt than institute the severe austerity measures that are being proposed for a temporary bailout. And make no mistake it is a temporary bailout. Barring an absolute miracle any bailout will only delay the inevitable. They have already tried “kicking the can down the road” too many times and at some point they will have to pay the piper.

There are three ways a default by Greece on their debt will affect us:

1. A small portion of their debt is borrowed from U.S. banks – $10 billion or about 5% of their total debt. It’s not pocket change but that amount is not a serious exposure to their debt. That can be absorbed by our banks.

2. However, U.S. banks through credit defaults swaps have indirect exposure to 56% of the total Greek debt. This represents $116 billion of the total $206 billion that Greece owes. That’s huge! Simply put, a credit default swap is default insurance. What has happened is European banks have lent money to Greece but insured their Greek loans with default insurance from U.S. banks.

So the big question is, which no one has an answer for, “Will the Greeks be able to restructure their debt (negotiate a lower interest rate, maybe a forgiveness on some of the debt, etc.) or will it be a complete default?” If it is a restructuring of debt (kind of a “soft landing”) the European banks will absorb the losses. It will not likely trigger the default insurance.  If it is a complete default, then it is likely that the American banks’ credit default swaps will take the hit. And because most of those American banks who issued the credit default swaps are “too big to fail” guess who will be footing the bill?

3. As tight as credit has been over the past three years, it’s going to get even tighter if $100+ billion is taken out of U.S. banks to pay off the credit default swaps on the defaulting European bank loans to Greece.  That money would better served lending to worthy businesses and individuals in the U.S.  That’s the real killer concern.

Here’s my thinking on this situation:

1. Banks are hoarding cash. They are reluctant to lend to businesses, to consumers and on commercial real estate which would help get this economy going again. The potential default by Greece and others – Portugal, Ireland, and Italy are next in line – will only make matters worse if American banks are picking up the tab through credit default swaps.

2. Congress needs to enact legislation regarding credit default swaps that either bans this financial product or greatly reduces the American taxpayers’ risk if something goes horribly wrong.

3. Finally, it’s time to get tough on banks that make stupid investment decisions. The federal government should not have to provide bailout money to keep these banks solvent. Let them fail!

Sources: Time to Get Outraged, Thoughts from the Frontline by John Mauldin, June 10, 2011; Greek Debt Tsunami Could Reach U.S. Shores, MSNBC.com by John W. Schoen, June 16, 2011; Greek Crisis May Put California Bank in Play, The Street, by Dan Freed, June 16, 2011; Global Markets Shaken by Greek Debt Crisis, AlJazeera.net, June 16, 2011.

Exposing the Soft Underbelly of the Beast

For those of us who believe the Federal Reserve, Wall Street and the major financial institutions in this country wield too much power, something recently happened that has me baffled. 

In March the US Securities and Exchange Commission requested a few of the regional banks to clarify their loan modification policies, what we call in the business "extend and pretend."  Last month the Financial Accounting Standards Board (better known as FASB) also got into the act by issuing new accounting guidelines for "troubled debt restructurings" (TDRs).

On the surface the new accounting guidelines for troubled assets seems quite reasonable.  FASB wants to standardize the definition of what constitutes a TDR so all financial institutions are operating under the same rules.  Right now that isn't happening.  In order to determine if the restructuring is a TDR, a lender must separately conclude that both the borrower is experiencing financial difficulties and the restructuring constitutes a concession.

Beginning June 15th lenders must re-examine their restructured debt to determine how much of it qualifies to be a TDR.  If so, the lender must classify it as such.  The end result is that for the very first time we will see how much of a lender's loan portfolio is deemed "troubled."  At the present time, lending institutions have been able to hide their TDRs with the hope that one day the market will turn around and the loans will be refinanced at market rates and terms, or better yet paid off in full. 

The new accounting rules could have enormous implications, most of which fall in the range between bad and catastrophic.  At the very least the number of loans classified as troubled debt will rise dramatically throughout the banking industry.  But the big question is, "Will the general public's confidence in a bank's solvency be adversely affected?"  Once the cat is out of the bag will the stronger financial institutions be reluctant to transact business with their weaker brothers?

Which leads me back to my original thought: Why did the SEC and the FASB do this?  If you believe like I do (most days) that the Federal Reserve, Wall Street and the major financial institutions wield way too much power, why would they allow these new TDR accounting guidelines to be implemented?  This is not in their best interests.  The change in these accounting rules has the potential of exposing the truth that they desperately want to keep hidden from the public - most banks are hopelessly insolvent.  This only helps to expose their true predicament.

The huge bank bailouts by both the Bush and Obama administrations, the extend and pretend lending policies of the banks, and the historically low interest rates by the Federal Reserve have all been implemented to directly benefit the financial institutions of this country.  So why are they now exposing the soft underbelly of the beast?  If you have an explanation, I'd like to hear it.

Sources: The Extend and Pretend Expose' - coming to a bank near you, ft.com/alphaville by Tracy Halloway, May 20, 2011; More Transparency Coming to Hidden Costs of 'Extend and Pretend' Strategies, CoStar Group by Mark Heschmeyer, May 18, 2011. 

1st Quarter 2011 Transaction Activity

The first quarter of 2011 is over.  From a sales standpoint how well did we do compared to previous years?  Shown below is the criteria we used to tabulate the results:

• Sales information from the CoStar Group database
• Transactions closed between January 1st and March 31st
• Investment transactions only (no owner occupied)
• Property types - apartments, office, flex, industrial, retail, mixed use & specialty use
• Transactions with sales prices of $1 million or larger
• Arms length transactions only
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on this criteria the chart shown below compares the sales activity for the 1st quarter for each of the last five years:

 
As you can see, the sale activity for the first quarter of 2011 increased significantly over 2010 but fell well below previous years.  The good news is that if this trend continues for the rest of this year, 2010 will have been the bottom of the market with a good possibility of improving sales activity going forward.   


We then analyzed the 45 sales transactions for the first quarter by property type.

As you can see apartments still are the most favored property type with 42 percent of the sales in the first quarter followed by retail.  Most of the retail sales were fast food franchises or single tenant buildings. 

Of the 45 sales transactions, only 35 identified the broker representation and only 38 identified the lending source used.  The remaining transactions did not provide sufficient information to determine the lender or if brokers were involved in the transactions.

Another way of looking at it, there were 45 paydays for all of the real estate brokers in the first quarter (17 x 2 = 34 + 7 +4 = 45).  So if you know how many of these transactions you were involved in, you can determine your market share. 

Shown below are the first quarter lending sources for the 38 sales transactions that a lender was identified.

Almost half of all sales transactions in the first quarter did not need new financing.  These results also explode the myth that life companies are back in the market.   After you take away the all cash buyers and assumed loans only 20 loans were placed in the first quarter, most of these from banks.  This paltry number of loans for the first quarter does not bode well for the mortgage brokerage community but hopefully we are on an improving trend.  I look forward to seeing how this quarter turns out.  Keep your fingers crossed.

Global Economic Issues Raise Their Ugly Head

Doug Marshall, CCIM
Market Assessment

I thought you would find the following article from Pacific Investment Management Company’s Chairman, Mohamed A. El-Erian interesting and informative.

This article was originally published on ftalphaville.ft.com on September 19, 2010. PIMCO is an investment company that manages the Total Return fund, the world’s largest mutual fund.

Shown below are Mr. El-Erian’s thoughts about two very important global economic issues.

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This coming week will be an interesting one. I am not just thinking of Tuesday’s FOMC meeting in Washington that will shed light on whether the Federal Reserve revises down its economic growth projections (it should and, I suspect, will) and expands non-conventional policies (it will, but probably not at this meeting).

I am also thinking of two other issues which were left to simmer quietly over the last few months when most of the focus was on America’s "recovery summer" — or, to be more exact, the lack thereof.

The first pertains to Europe. Solvency concerns are again on the rise there.

Last week’s catalyst was Ireland where banking issues are a serious worry. But the underlying problems are deeper and more complex.

Market measures of risk for peripheral European countries (Greece, Ireland, Portugal and Spain) are at or near danger levels… despite exceptional support from the European Central Bank, the European Union and the International Monetary Fund, and despite the implementation of adjustment measures on the part of some.

The failure to reduce risk spreads means that the public sector bailout is not working. Rather than provide assurances of better times ahead and, thus, encourage new investments, ECB/EU/IMF support funding is being used by existing investors to exit their exposures to the most vulnerable peripheral European countries.

This situation cannot be sustained forever. It undermines any chance that the most vulnerable countries (e.g., Greece) have of limiting the collapse in their GDP and maintaining social cohesion; it contaminates the balance sheet of the ECB; it exposes the revolving nature of IMF resources to considerable risk; and it raises the risk of renewed contagion.

The second issue is even more complex. It pertains to the global configuration of currencies.

Last week, Japan intervened massively to stop its currency from appreciating. It did so in a unilateral fashion and, immediately, faced criticisms from Europe and the U.S.

Meanwhile, in a sharply-worded testimony to Congress, Treasury Secretary Geithner provided lots of data to those that feel that the U.S should have already labeled China a currency manipulator.

And while China has recently accelerated the rate of its managed appreciation — 1% in the last week compared to just 1.6% since the country declared great "flexibility" back in June — this is proving insufficient to counter growing currency tensions.

These latest foreign exchange developments bring to the fore an inconvenient reality. While not all industrial countries wish to make it explicit, they are happy (indeed eager) to see their currencies depreciate.

They see this as helping them address the extremely difficult challenges associated with a protracted period of low growth, high unemployment, and limited policy effectiveness.

The list of industrial countries wishing to depreciate their currencies is not matched by a list of emerging economies happy to let their currencies appreciate significantly.

As a result, foreign exchange tensions are mounting, and the price of gold has been driven to a new record level.

This week will shed light on whether policymakers can do anything to deal with these two issues. If they continue to stumble and hesitate, what has been simmering may well come to a full boil in the next few months.

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You may ask, “Who cares about these global economic issues?” The reason to be concerned is that the global economy has a very real impact on the U.S. economy, for good or for ill.

The global community is now intertwined with each other in ways never before experienced. We’re all in it together.

Let’s hope that the power brokers, government bureaucrats and ivory tower economists know what they’re doing for the stakes are extremely high.