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July 16th, 2010
NEED TO KNOW
Profiles from the Recession
[VIDEO] Elizabeth Warren: The next real estate crisis

The value of nearly half of the commercial real estate loans across the country are worth less than the amount owed on their mortgages. And as these loans are set to come due between now and 2014, many of these properties are expected to end up in default or foreclosure. What will the American landscape look like when half of it is boarded up and abandoned?

Blueprint America –- on Need to Know –- with Elizabeth Warren, Harvard Law Professor and Chair of the Congressional Oversight Panel, on the impact of the looming commercial real estate crisis in our communities. Warren is the watchdog monitoring the federal government as it purchases these troubled assets and equities from financial institutions holding these loans — an effort to stabilize the economy, but, at the same time, potentially make the country into one big holding company.

Need to Know’s Alison Stewart talks to Professor Warren about the ways that commercial real estate loan defaults will affect the country. Already, in Atlanta, Georgia, vacancy rates are climbing, rents are falling, and small local banks are forced to turn away loans to small businesses in order to remain solvent.

Warren also weighs in on the financial reform bill that passed the Senate on Thursday and her hopes for its Consumer Financial Protection Bureau.

Watch the full episode. See more Need To Know.

Producer Justine Simonson and editor Leigh Anne Sides for Blueprint America

ALISON STEWART:
The big news of course is the passage of the Restoring American Financial Stability Act of 2010. The 2300 pages of financial reform legislation comes as home foreclosures have hit a historic high but another potential real estate crisis looms. Since the crisis began in 2007, nearly three million Americans have lost their homes, and a projected six million more could face the same fate.

And now alarms about commercial real estate have been growing louder. No matter where you go, vacant properties are hard to miss.

In Atlanta, the property problem is especially bad — strip malls, big box stores, offices and hotels are being offered at fire sale rates. It’s not just Atlanta. Nationwide, vacancies are at their highest levels in decades. But Atlanta is where Elizabeth Warren, Chair of the Congressional Oversight Panel, the watchdog for the $700 billion dollar Troubled Asset Relief Program, or TARP, chose to issue the panel’s first big warning about commercial real estate.

ELIZABETH WARREN:
These declines have severely threatened bank balance sheets, contributing to the failure of 30 Georgia banks since August of 2008, more than any other state in the nation … Many experts believe that Atlanta’s experience could foreshadow a problem that could echo across the country.

ALISON STEWART:
The panel found that “Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are …‘underwater’.”

Which means the borrowers owe more than the property is worth.

Warren worries that a tsunami of commercial foreclosures could swamp the fragile recovery that she and other economists say is underway.

At a panel hearing last month, Warren tried to draw out Treasury Secretary Timothy Geithner on the subject.

ELIZABETH WARREN:
Hundreds or even thousands more small banks could capsize. What is Treasury doing now to prepare for these coming problems? Do we need to be reworking any of our current programs? Mr. Secretary?

TREASURY SECRETARY TIMOTHY GEITHNER:
… I believe that this suite of programs that we have in TARP alongside the existing programs that the FDIC and the supervisors manage with this new small business lending initiatives that Congress is considering is the best mix of solutions that we’ve found.

ALISON STEWART:
And now Warren is believed to be the frontrunner to head up the new Consumer Protection Agency that is included in the new financial reform legislation. We thought this would be a good time to ask her, what we need to know…

Thank you for doing this–

ELIZABETH WARREN:
I’m glad to be here.

ALISON STEWART:
Is another agency with more regulation going to be really be able to make a change when there are so many lobbyists and so many people with money who are just going to pay lawyers and other people to figure a way around the regulation?

ELIZABETH WARREN:
You know, let’s start with the first part, and that is, the consumer agency is not more regulation. Right now, there are seven agencies in Washington, each of which has some piece of consumer financial regulation.

This agency’s very first step is to go through and scissor out the bureaucracy from all the other agencies. So they were going to consolidate in one place the responsibility for regulating what goes on with consumer credit.

We’re going to slim it down and listen to the central tenant. It’s not the stand up and make big pronouncements — don’t do that, you’re not allowed to do that, thou shalt not do this. It’s to say, “How do we make this market work better?” It’s how do we get credit card agreements that people can read and understand? How do we get mortgages people can read and understand? How do we get check overdraft that people can read and understand?

And either decide that they want it or that they don’t want it, because they see what it costs. Ultimately, that’s a sustainable market.

ALISON STEWART:
This Consumer Financial Protection agency, what’s an example of something that Americans might feel as a result of its existence. Immediately, in the immediate future.

ELIZABETH WARREN:
Well, remember, it takes a while to build an agency and to go through the rule making business. But credit cards. Credit card agreements run as long as 30 pages, and it’s 30 pages of largely incomprehensible text.

What this agency is designed to do is to push back to a smaller, cleaner, easier to read consumer credit card contract. And, I think that’s going to be a big difference for consumers. Consumers get used to reading and understanding their credit card contracts, their mortgages, their check overdraft agreements, those are good things. That puts power back in the hands of consumers.

ALISON STEWART:
Can you think of a big, bold move that would send a message that this is an agency that is robust, in your words, and strong, and to be contended with?

ELIZABETH WARREN:
That’s an interesting question. The best that this agency can do is to say to credit card companies, to mortgage companies, to banks “You can’t build a business model around tricking and trapping customers. That’s not going to work anymore.”

But to say at the same moment to consumers, “When we get these products to a level where you can read them, then you’re responsible for reading them.” So, we kind of want to re-introduce the buyer and the seller to each other on a way that says, “Make a good contract, but make a contract that both sides understand.” It’s a statement of where we are today, that that would be a bold move.

We have moved so far away from that model of interaction between borrowers and lenders, that’s a sea change.

ALISON STEWART:
I think that’s one of the reasons why people are willing to walk away from their mortgages. You would never not pay in my parent’s year and your parent’s year, you would do everything you can to make that mortgage payment because the local banker helped you get it, versus, “Hey, I think I’ve been tricked into this interest rate.”

ELIZABETH WARREN:
Uh huh. When people feel like, “Lenders weren’t fair with me, I don’t have any responsibility to be fair with them.” If we go far enough down that line, much of the fabric of our economy starts to unravel. You know, ultimately, I think that’s one of the reasons that if this consumer agency works the way it should, we dial back on that. And we put some trust back into the economic system overall.

ALISON STEWART:
I think a lot of people assume that you’re a Democrat. And for part of you’re life, you’re a registered Republican.

ELIZABETH WARREN:
Uh-huh.

ALISON STWEWART:
I’m interest in your take on how partisan it became as this legislation went forward, aside from some of the Republican Senators who are more moderate, it really went down party lines.

ELIZABETH WARREN:
It did, largely. But you know, I just stayed focused on the agency. I told the story as often as I could, about why we need an agency to repair a broken credit market, why this is ultimately about making contracts work, and making markets work. And I talked to as many people as would listen to me on the subject.

And at the end of the day, look, it’s a big bill, it’s got a lot of pieces in it, it’s got a lot of people who have a whole lot of things going on. It’s an historic step. And, I ultimately, I hope it’s good for everyone.

ALISON STEWART:
It’s interesting when something’s written about you, and there’s comments after. People say things like she rocks.” And not that you don’t rock, but it’s almost about the way you deliver your message.

ELIZABETH WARREN:
It’s about respect. I believe that the American people ought to be part of the conversation about what’s happening in our economy, and what’s happening in Washington and what’s happening on Wall Street.

I truly believe that if the insiders get together and rewrite all the rules, those will be rules that will benefit the insiders, and the rest of America will just be left out of it.

ALISON STEWART (VOICE OVER):
We also talked about what could be the second big dip of a double dip recession.

ELIZABETH WARREN:
By the end of this year commercial real estate will have dropped in value between 40 and 50 percent from its peak a few years back.

ALISON STEWART:
You first brought up the commercial loan issue back in, I think it was January. To Secretary Geithner, you did it again in June. Do you believe they’ve been playing enough attention, Geithner, and the administration, to this particular issue?

ELIZABETH WARREN:
We have not seen a strong response from Treasury.

ALISON STEWART:
He has said that TARP’s got it, TARP’s got the commercial loans. It’s going to be OK.

ELIZABETH WARREN:
I hope he is right. I would feel better if we saw more action, we saw some plans in place to deal with the 2,988 banks that are concentrated in commercial real estate.

ALISON STEWART:
Doesn’t sound like you think he’s right, though–

ELIZABETH WARREN:
It is our job in oversight not to say, “Oh good, let’s relax.” Our job in oversight is to push on the notions that these are problems, and show us what you’re doing here. We did it on behalf of the American people.

ALISON STEWART:
The Wall Street Journal last week echoed your concerns about commercial real estate loans. And they reported that nearly two thirds of the loans that are going to mature between now and 2014 are going to be under water.

ELIZABETH WARREN:
Well, unfortunately, the community banks are the ones who are more deeply concentrated in commercial real estate. It’s not the Wall Street banks. They got heavily concentrated, most of them during the peak, during the boom.

They look out there and they know what those loans are worth, what the odds are in many cases, that the owner of the commercial real estate will just walk away.

Just say, “I can’t refinance it, I’ll let it go. I can’t bring a million dollars to the table to do this.” And so they’re worried about saving the bank. And I can’t blame them. On the other hand, I can sure look at what the economic effect is on communities, on growth overall on our wider economy. And it is not good.

So what we’ve got is we’ve got a spiral that continues downward. Commercial real estate drags down the bank’s balance sheet, that means that banks are less likely to lend to small businesses, which means there are fewer tenants for the commercial real estate, I think you see how this one goes.

ALISON STEWART:
So are we going to see small cities with just giant skyscrapers that are empty?

ELIZABETH WARREN:
Well–

ALISON STEWART:
Store fronts that are empty?

ELIZABETH WARREN:
Quite frankly, we are going to see some of that. See-through buildings, where the building has already been built, but there are no tenants in it, so you can see from one set of windows all the way over to the other. There will be some of that. There will also be some other adjustments that will be made.

In some cases the mortgage lender will repossess the property and is able to sell it to someone else and get it off their books. Another possibility that in some ways is far more troubling is that the financial institution will say, “Oh, we think maybe that property is, um, maybe still worth $2 million. After all, you’re making your payments, and so how about if you, the borrower, and we, the lender, hold hands and pretend–”

ALISON STEWART:
Is this Extend and Pretend?

ELIZABETH WARREN:
This is Extend and Pretend, that’s exactly right. What it really means is we will pretend that this property is still valued where it was back in boom times, and we will simply extend your outstanding mortgage on this property so that you keep paying.

In other words, the loan appears to all the world on the books at a high value and fully performing, when the underlying economic reality is that it’s worth a whole lot less, and the odds that it will end up in collapse and default, ultimately in foreclosure, are very high.

ALISON STEWART:
Isn’t the idea, though, to give people more time? To give these institutions more time to come up with the money, perhaps hope against hope the economy gets better?

ELIZABETH WARREN:
Well, that’s the question. And you just put it in the right word, it’s hope against hope. Here’s a problem with it, the longer you pretend, the longer it takes to get the market back to where supply and demand match each other.

The longer it takes to get the right price back on the commercial real estate, attract in the businesses, get the rents in the right place, and get this economy back up and booming.

ELIZABETH WARREN:
Everyone would like the world always to be in bubble times. But that doesn’t happen. What we have to do to have a secure financial system and frankly an economy that functions well, is we’ve got to be right back down where supply meets demand. And then the role of finance is to come in and help people make purchases at that point.

That means there are a lot of losses in commercial real estate that just– I don’t know how else to say it except quite bluntly, they just have to be acknowledged. And you’ve got it write down, and that is where many banks are deeply resistant. Because if they write down enough of those mortgages, it will become apparent that they are no longer solvent.

ALISON STEWART:
From your experience, is it possible for someone who is not a D.C. insider, and not a Wall Street insider, to really help catalyze change?

ELIZABETH WARREN:
I don’t know. I don’t know anything except to try. And, it’s certainly the case that many, many people have told me that it is not possible. And if you’re not an insider in one of those two worlds of power, Wall Street, or Washington D.C. then don’t waste your time. I just refuse to give up.

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  • http://balancejunkie.com/2010/07/19/5-financial-bubbles-are-we-facing-a-bubble-of-bubbles/ 5 Financial Bubbles: Are We Facing a Bubble of Bubbles? | Balance Junkie

    [...] decade, given that it has already popped. Questions remain, however, about whether or not the U.S. commercial real estate market is the next real estate bubble to pop – or maybe it will be the Canadian housing market, or, [...]

  • Rod Stevens

    One investor group that I know calls a small city every Friday to see if the local hotels are booked. If they are, they know the FDIC is taking over a certain bank. But they haven’t come to town yet, and people think there are two reasons: 1) the FDIC doesn’t have enough staff and 2) the FDIC doesn’t have the money to take big write-downs. Follow the money up the food chain and the logical conclusion is that banks are extending loans, and the FDIC is letting them, because the FDIC doesn’t have the capacity to force shut-downs. Why? Because the federal government, in running up a big deficit, doesn’t want to make the deficit even bigger.

    The bigger question is whether we are entering a “Japanese decade” of denial, in which banks sit on their bad loans and don’t have the capacity to make new ones. Or call this the ‘zombie’ scenario, a time of the walking dead. And the zombie status will feed on itself. When there’s no investment in new ventures, there won’t the be tenants there for the space, so the rents and values will drop lower. How low? If net income drops from $10 to $7.5 per square foot, while cap rates increase from 5.5 to 8.0 percent, values per square foot will drop by 48 percent. A 25 percent drop in rents and a 20 percent increase in cap rates still leads to a 37 percent drop in values, so the swings in value are going to be big no matter almost regardless of your assumptions. Like the residential market several years ago, there will be an initial period when landlords and owners try to avoid cutting rents or sales prices, but when the market breaks, there may be a race for the bottom as owners seek liquidity on the sales they must make.

    Having worked in turn-arounds myself, I don’t think the financial institutions will recognize their problem loans unless they are so profitable, so liquid and so far-sighted that they can take these losses now and beat out the pack, by shifting away from real estate lending now. For investors, this means trying to buy from smart, well-managed banks that made bad loans but are moving on. They’ll deal honestly. This also means that the real problem loans, those that are not only bad real estate but also managed by bad bankers, will stay bottled up in that real estate. I often think of this as the “bottom of the refrigerator lettuce problem”. The longer it stays in the drawer, the more it rots, and the more reluctant you are to clean it out.

  • Ken

    The illusion is almost over. A nation in debt, a state in debt, a city and citizens in debt. Can you see where this is going? Let’s deal with reality. What possible outcomes can come of this?????? Ask yourself the question why and move backwards with the answer. History is a useful tool to those that have studied it. Logical thinking is also a requirement in setting a future direction. Good Luck!!!!!

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