Monday, November 23, 2009

The Next Real Estate Bubble Prepares to Burst

Not all real estate is created equally. We all felt the pain when the housing mortgage bubble burst last year. Lately the chatter in certain financial circles about the situation in the commercial real estate market has been heating up.

The word is that the commercial real estate market today is “eerily similar to the subprime crisis” (see 10/22/09 IBD article) before the bubble burst. Regulators are trying to prevent the inevitable (see 11/2/09 Minyanville article) by “encouraging banks to modify loans, rather than foreclose and repossess property, even if the value of the building has fallen below the amount of the loan.”

Regulators are also allowing big banks to put off recognizing commercial real estate loan losses. This strategy only pushes the pain into the future. The only way this could diminish the problem would be if real estate prices rebounded to their previous unrealistic levels before the write downs were to become unavoidable. Nobody thinks that’s going to happen.

SmartMoney author James B. Stewart paints a bleak picture of the affair. He refutes claims by optimists that “the sector’s problems are likely to be contained because they’re valuation-driven, a result of easy credit and the inflated prices it encouraged.”

When it comes to “apartments, retail and industrial space,” vacancies are “rising sharply” and rents are falling at the highest rate ever recorded. “Goldman Sachs now predicts that asset prices will fall 40 to 42 percent on average. Private-equity firm Blackstone has marked down its commercial real estate portfolios by 45 percent.” The number of commercial real estate loans with a debt-service-coverage ratio of less than one (meaning the loan is technically in default), “will rise from a negligible level as of 2008 to 49 percent of all loans by mid-2010.” Forty-nine percent!

From his analysis of this year’s market rally, Stewart believes that most investors have failed to adequately factor in the risk in the commercial real estate market. In other words, he is saying that the market, similar to its condition before the subprime crisis took hold, has not yet considered the developing crisis, although, the information is available for anyone to see. Drawing parallels between the two crises, he writes:
“Stocks in general, and bank stocks in particular, kept hitting new highs in 2007 even after rising default rates in subprime mortgages were the subject of widespread press coverage. Only when banks started taking multibillion-dollar write-downs did investors finally wake up to the scope of the problem, and then they overreacted.”
So as we giddily watch the Dow press past 10,400, we are apparently oblivious to the fact that another crisis as severe as the last is coming. It is close to impossible to accurately predict the timing of the bursting of this next bubble. But I think it is safe to make some forecasts regarding it.
  • Politicians will use the crisis to increase the grasp of the federal government as well as to increase their own political stock.
  • Financial firms will successfully apply to the federal government for hundreds of billions (or even trillions) of dollars in aid.
  • The Fed will seek to expand its power while continuing to insist that it is doing a fine job of stabilizing the money supply and that it needs ‘independence’ to do so.
  • Regular American investors will lose a lot of money again.
While investors may be ignoring the impending calamity, I guarantee that politicians are not. Even as I write this, some politicians are scheming about ways to use the crisis to achieve their desired goals. Will we allow ourselves to be taken in again?


RD said...

"Financial firms will successfully apply to the federal government for hundreds of billions (or even trillions) of dollars in aid."

The Fed's deposits are empty, the FDIC is running on a credit line from the Fed and won't go positive until 2012 at the soonest.

If this prediction is correct(I can buy it) then the banks are in real trouble, The Fed doesn't have the reserve funds anymore, and FDIC is empty and the discretionary spending funds are gone.

Sure the Fed could just go and print a bunch of money, but that has problems of its own and would make the bank failure problem worse. Also this can be tracked easily and has nasty political consequences.

Given the state of the Fed&friends Congress would have to pass a bill containing the entire cost of the bailout, they can't use Fed&friends to hide the scope of the bailout in the next round. I don't buy that this would happen, The political backlash from this would be incredible.

Ron Paul's Audit the fed bill got attached to the wider democrat bill, so it will pass. Even as much as Ron Paul hates the regulations in the wider Democrat bill it sounds like the wider bill will have his vote.

The democrats are talking about a 0.025% transaction tax on derivative trades larger then $100,000 to make the banks and speculators pay for the current bailout and would generate $150-$200 billion per year. It may have a larger return however, as derivatives market may exceed $1.8 quadrillion dollars in trading this year(yes you heard that right $1.8 quadrillion or $1,800 trillion). Democrats are hoping the tax will deter short term speculative derivative trading and encourage a bit of stability into that market.

Charles D said...

Reining in the Fed and imposing taxes that will discourage high-risk speculation go part of the way, but ultimately we need to stop the bubble-burst cycle. The housing bubble, the gas price bubble in the summer of 2008, the dot-com bubble, and the savings and loan bubble all result from bad tax and fiscal policy. We need more than a quick fix to get us back on the bubble/burst merry-go-round, we need a systemic fix that will keep us within normal business cycle limits.

America no longer has a manufacturing base. America is no longer producing the worlds most highly educated work force. America's economy rests on the continuing encouragement and gullibility of its consumers to buy every more stuff that they do not need. This is not sustainable, even if the central bank is under control.

Scott Hinrichs said...

As noted here by Don Boudreaux, it is a myth that the U.S. no longer has any manufacturing base. He provides backup for his claim that "the real value of U.S. manufacturing output today is four times what it was during the alleged golden years of American manufacturing might, the 1950s, and more than twice what it was in 1980."

It is true that we have fewer direct manufacturing jobs than we had in the past because we have found far more efficient ways to manufacture goods than with direct human labor. It is also true that we don't manufacture the same kinds of products we produced in the past. But it is incorrect to claim that our manufacturing base has diminished.

I welcome more transparency in our nation's monetary policy. I am, however, dubious about the idea that we can tax ourselves out of this mess.

CharlesD is right about needing to get off the bubble cycle. Since the Fed was created in 1913, ostensibly to prevent intolerable bubbles, we have experienced bubble after bubble after bubble. If anything, the cycle rate is both tightening and increasing in intensity.

RD makes a good case that the next bubble burst won't be able to be swept under the rug. But it is also noted that all of the Fed's options are unpleasant.

The conspiracists claim that all of this is a deliberate strategy undertaken to collapse the dollar and force a one-world currency, which would result in a one-world government.

Regardless, it looks like we're in for a bumpy ride.

Charles D said...

Forrester Research estimates that 4 million American manufacturing jobs have moved offshore since 1983, so while automation has been a factor, it is not the only one.

America needs good jobs - jobs that pay a salary adequate to support a family, provide a decent retirement, good health care benefits, and reasonable job security. Those jobs need to be available not just for the minority with advanced degrees, but for workers with high school diplomas and community college degrees as well. For many decades unionized manufacturing provided those jobs and the wealth generated by them fueled our economy through its greatest period of sustained growth.

We cannot return to those days and those jobs, but somehow we need to return to that economic model. Ultimately if ordinary Americans who are willing to work hard cannot feed their families (on one salary, not two or three) and are not secure in their jobs and their retirement, we cannot truly recover. I don't see any politicians talking sensibly about how we can get back those high-paying jobs, except perhaps in the defense industry. Unfortunately that industry simply cannot fuel broad growth in the economy.