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!