Plans to Hide Commercial Real Estate Losses Won't Avert a Double-Dip Downturn

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Sooner or later, mounting losses on commercial real estate could crash through the market's 2009 optimism and send the economy and stocks into a double-dip downturn.

The major problem is that lawmakers and regulators are setting up investors into believing that commercial real estate (CRE) losses are being effectively addressed. The truth is that escalating losses are being hidden as part of a campaign of optimism in a desperate gamble that a robustly reviving economy will save the day.

To protect yourself from another investment beating, here's what you need to know.

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hopefully you are not foolish enough to believe that everything's ok...are you? …

Accounting Gimmickry

Two weeks ago, a bipartisan group of 79 members from the U.S. House of Representatives sent a letter to U.S. Treasury Secretary Timothy F. Geithner and Federal Reserve Chairman Ben S. Bernanke. The lawmakers want the public to know that they are concerned that the "commercial-real-estate industry has the potential to infect our economy and slow a recovery," according to Rep. Paul E. Kanjorski, D-Pa.

Kanjorski, the chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises (GSEs) - which includes the likes of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) - says it's the administration's responsibility to make sure that happens.

"The Treasury and Federal Reserve now must take needed and urgent action to stave off a potentially devastating wave of commercial real estate foreclosures and bank losses," Kanjorski said.

So in keeping with how effectively overseen and transparent our capital markets, insurance industry and GSE institutions are, the lawmakers want more accounting gimmickry to be made available to banks that hold commercial-real-estate assets. The lawmakers are concerned that banks may be forced by some regulators to write down the value of performing loans, even when payments are current. And these elected officials want more latitude for banks to manipulate recently issued CRE loan-modification guidelines.

Just what recently issued CRE loan modification guidelines are we referring to?

When is a Bad Loan Not a Bad Loan?

The tooth fairy commeth. On Oct. 30, bank, thrift and credit-union regulators very quietly gave lenders flexibility in how they classify distressed commercial mortgages. Banks can now slice distressed loans into performing and non-performing loans, and institutions will magically be able to reduce the total reserves set aside for non-performing loans.

For example, let's assume that a developer borrowed to build a shopping mall, but only one tenant leased space in the finished project. Cash flow from the project would be insufficient to service the loan, meaning the lending bank would have to set aside reserves against the total loan. Under the new guidelines, however, the mall loan actually could be carved into two loans - a performing loan representing the rented space, and a non-performing loan that represents the empty space.

Theoretically, with fewer reserves having to be set aside, bank balance sheets would look better, leaving lenders with more cash available for loans. But the reality might be very different. Granted, this accounting hocus-pocus might well stave off some bank failures. But with the overhang of non-performing loans still on their books, will those banks really be eager to lend out their precious cash?

That's not the only concern, either. The fact that lawmakers don't want to force banks to write down "performing loans" should be a cause for concern among investors. It's like the riddle: If an airplane crashes exactly on the border of two states, where do you bury the survivors? Hint ... you don't bury survivors. And, you don't have to write down performing loans - unless, of course, they're not really "performing."

What's really happening with performing loans is a game called "extend and pretend." When most banks make commercial loans they include an "interest reserve." The reserve amount is part of the total loan, and it is there so that banks can pay themselves their interest until the project generates enough cash flow to start paying interest and principal.

The unvarnished truth is that innumerable commercial loans are in distress right now because projects aren't being finished. And if they are , tenants aren't leasing. So rather than write down the loans, banks are extending the terms of the debt with more interest reserves included so they can continue to classify the loans as "performing."

Hiding behind the extend-and-pretend game is the dark reality that property values have declined at an alarming rate - racing ahead of the rate at which banks are writing down these loans.

Nor is that the only concern. Because interest reserves do not repay any of the loan principal, there is no amortization on these debts. In other words, banks are extending loans that they would never make now, because borrowers are already grossly upside-down.

A Real Race Against Time

Lawmakers and regulators are desperately hoping that a strong economic rebound will stimulate job growth, consumption and demand for the commercial real estate that banks continue to hold.

But let's be real: There isn't enough time on any clock to ever win that race.

Why do I say that? Because, in order for the United States to rebound to a full-employment rate of at least 5%, the nation's economy would have to create 200,000 jobs per month - for seven years.

Although all the big banks hold significant amounts of underperforming-commercial-real-estate loans, this exposure as a percentage of total-balance-sheet assets averages only 10% to 20%. And these banks have other income streams, such as proprietary-trading revenue, investment-banking fees, and credit-card fees and charges to bolster their bottom lines.

Regional and local community banks have as much as 80% of their balance sheets tied up in commercial real estate, and very few other sources of significant fee income to offset CRE losses.

It's not the too-big-to-fail banks that are lending to consumers; they're too busy catering to huge corporations, enslaving the credit card borrowers they pressed into servitude with low teaser rates, and pandering to lawmakers to preserve their monopolies and their outrageous executive compensation packages.

It's the regional and community banks that lend to individuals and small businesses that are sinking fast under the weight of CRE. How are they going to be the credit providers to consumers and the backers of the small businesses we are counting on to create jobs for the country's 18 million unemployed?

Lawmakers and regulators expect to buy time for the economy to grow in order to drive up commercial-real-estate prices and save the banks that are threatened. But their rescue vehicle of choice is the banking sector that is foundering because of the growing gale of commercial-real-estate losses. So please forgive me if I label these Washington insiders as grossly incompetent, self-serving and deluded.

The Only Way to Win

If we continue to chart this course, we're headed right for a double-dip downturn in the economy and in the stock market.

But there is a way out.

First, break up all the too-big-to-fail banks into "bad banks" by saddling them with all the bad bank loans. Don't worry: It won't take long for those institutions to discover how to make money from these non-performing loans.

Let these "new" institutions keep their proprietary trading desks so they can steal money from the big corporations and investment banking clients they front-run.

Cap all compensation for the top 25% of earners at those banks. And make these top-tier executives stay and work at their new employer for seven years, which is the same amount of time it takes to discharge a bankruptcy. That's only fair since bankruptcy is where these institutions force credit-card borrowers after ripping them off with hidden, retroactive fees and usurious interest rates. Phase out all taxpayer backing over the same seven years. Limit each bank's leverage and require them to add equity capital on a pre-set ratio relative to balance-sheet risk.

Spin off all big-bank credit-card operations into four regionally based trusts and make them operate as not-for-profit entities. Cap interest rates at some nationally set level above the prime rate, and make credit limits a function of income, assets and credit history. While we're at it, only charge merchants and credit-card users 50 cents each per any transaction.

Make community banks "good banks" by spreading the big banks performing loans across their balance sheets so banking is more "localized" and community-centric. Limit the size they can grow to - period. If there's additional business to be had in a particular locale, let another bank open up and help drive down the cost of services.

Create a compensation arrangement for bankers that rewards them generously for creating jobs, improving standards of living in their communities and running their banks profitably relative to standardized risk metrics.

As far as big loans and securitizing and selling asset-backed pools, make the banks syndicate and spread risks between themselves, all of them. They'll actually become experts in risk management as opposed to paying lip service to schemes like Value at Risk.

I'd like to say that I'm kidding, and that everything will work out just fine if we do nothing. But the reality is that only a comprehensive overhaul of banking regulations will save the U.S. economy and stock market from significant pain. Hiding behind accounting gimmickry is just another tarp being thrown over our problems by same special interests that got us into this mess in the first place.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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