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.


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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  1. Janice Clark | February 23, 2010

    i agree that 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. especially with a slow economy. it is hard to stimulate job growth

  2. Steverino | February 23, 2010

    What fascist world does Gilani live in? The rent must really be high in his dream world, hence the vitriolic and bitter tone of the article. After doing a fair job of describing the problem, he then goes on to slam, with inflammatory language, the evil big banks:

    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.
    …they can steal money…
    …these institutions force credit-card borrowers after ripping them off with hidden, retroactive fees and usurious interest rates…

    Jeez, dude, tell us how you really feel. Don't bother being an objective journalist.
    He then continues on to propose solutions suitable for communist countries:

    First, break up all the too-big-to-fail banks .
    Cap all compensation for the top 25% of earners at those banks.
    Create a compensation arrangement for bankers that rewards them generously for creating jobs, improving standards of living in their communities…
    Make community banks "good banks" by spreading the big banks performing loans across their balance sheets so banking is more "localized" and community-centric.

    Do those last two solutions sound like any community organizer turned president that we know of?
    Anyone wish to hazard a guess who Gilani voted for in the last election?

    • William | February 23, 2010

      When does the unadulterated GREED stop by these so-called masters of the universe who helped get us into this mess to begin with? Too big to fail must stop. They make bonuses while the taxpayer bails them out. Whats wrong with that picture?
      We already know about the cr card fiascos…basic thievery and enslavement hidden in lawyer 'devil in the details' mumbo jumbo small print…plain and simple.
      Nothing wrong with helping to create jobs and improving standards of living.
      Sometimes we need to help a neighbor up…rather than kick him further down the whole…like so many have and will do.
      Some of these 'masters' outta be hung for getting us into such a mess. Again…when does all the greed finally stop?

    • vxp | June 2, 2010

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

      are you a mutual fund guy? if so, then your adherence to the obvious lie makes sense.

      heil!

  3. Alexander Treutler | February 23, 2010

    Doing nothing is what the robber barons want us to do.

    Of course, it is for this goal that the new robber barons are spending huge amounts of money in bribing the "people's" representatives. If you believe our 3rd world style of corruption will change, I got a bridge for sale; it goes to Brooklyn. Very nice bridge.

    Nothing of value will get done. Money talks. Conscience walks.

  4. Jas Gill | February 23, 2010

    Mr. Shah Gilani your articles are logical, rational, based on reality as it exists. The wealth creation model in U.S. has shifted to financial gimmicks, so called consumers services or manipulations, borrowing from future generations and indebting by borrowing from other nations that are producing tangible goods and services. The role of elected officials have shifted to manage wealth transfer from those who may have to those who feel or have been made to believe they are entitled to it. We have to find a way to innovate, create, build tangible good and services economy as we did after world war II. We need policy direction and systamic solutions that take us in such direction. You offer very good ideas in your articles, I hope our elected officials are reading what you so thoughtfully write.

  5. Darryl Creighton | February 23, 2010

    Mr. Gilani:

    Your prescriptions for this country's ills are even worse than the disease. The disease is government mismanagement in markets, including banking. For example, it was the Federal Reserve's easy money policies of the early-mid 2000's, along with Congress's corruption of FNMA and Freddie Mac, that got the party started in the housing bubble. If you want to see something that will make your skin crawl, watch video of congressional hearings wherein some Congressional members tried to reign in the financial corruption that was rampant in these quasi-government entities, which had the implied backing of the US taxpayers, and the rebuke of any common sense by certain members of Congress with their own agendas (of course, putting the taxpayers at grave risk). http://www.youtube.com/watch?v=_MGT_cSi7Rs (you have to watch the whole thing, and kind of ignore the partisanship in the titles). GOVERNMENT BASED REGULATORS will always be subject to politics. That is why lots of regulations, or in your perfect world, a government run banking system, will never protect us in the long run. And Mr. Gilani, most of your "solutions" basically amount to complete government takeovers of our banking system, with the inevitable dislocations and inefficiencies that would naturally follow. I do think some regulations of our banking system are necessary, but I would look to more free market solutions–such as requiring banks to have private insurance to cover their default risks, and then having taxpayer backstopping of this insurance. Make the smart money lose a lot of money before the taxpayers are on the hook–that will price in risk and keep banks under control while not impeding full and free competition. Anyway, I definitely don't think a world where we have government run banks will lead us into prosperity!

    Darryl Creighton, Esq.

  6. HAPPY | February 23, 2010

    You are right on with your article. We have an impending collapse in commercial real-estate that would hurt alot of people involved either directly or indirectly. It's not a time to sugar-coat the problem. Unprepared Americans will get a jolting impact of the collapse, and will suffer great loss. I am, as my name shows, an optimistic person, but I speak the truth when I see one.
    We live in a reality that about to prop.

  7. Jeff Pluim | February 23, 2010

    Gilani"s article was well researched, and I am sure that he is not serious about most of his draconian cures for the banking system. But I am surprised to see that in all of the fixes that he suggests, he want to let the banks keep prop trading. Are you kidding? If the banks hadn't been able to do that kind of trading in the first place, the economy would not be in the mess it is in. Just look to the north to Canada's banking system and the great shape that Canada's economy is in. Canada now has some of, if not the strongest banks in the world. And the only thing that has slowed its economy is that Canada's largest trading partner is the albatros USA.

  8. Bruce L. Davies | February 23, 2010

    Wow!! I hope that you were kidding about the presented solutions. The problems are rooted in Free Market interference by government. The market distortions are incentivised by FED control over monetary policies to cover fiscal irresponsibility and socializing outcomes masked with untrue cries of unrequited meritocracy (deservings) by Congress. All the tweaks in the world will not unravel the great harm caused by socializing debt. For over 60 years, the USA has "socialized" our debt by exporting inflation to workers world-wide not only in the USA. Now, the jig is up. China and other creditor nations are evaluating our ability to make good on loans. And it doesn't look good. The mess we got into was caused by spending money we did not have; financed by money we can't repay. So, the answer government has come up with is to spend even more money we don't have ; financed by even more money we cannot repay. Does that sound like a plan for success or suicide? The role of government is to protect our rights not to usurp them. Government should trust the Free Market but be ready to verify the results as a legitimate exchange of values between buyer & seller. Instead, the suggestions made in this article mistrusts the market and asks government to create outcomes. They have already created outcomes as described in your article's complaints of what is wrong. We don't need more government "outcomes" but less. Are any of those authorities you suggest found in the Constitution? I think not! And you are an adviser of market investments? Shame on you.

  9. r4ds revolution for ds | February 23, 2010

    One crisis after another, when this gonna end?

  10. Jo Mueller | February 23, 2010

    Proposals sound like something I could write. Germany, for instance, caps interest at 15%. That way a runaway inflation (as experienced in the thirties) is prevented.

    I do not know why people defend banks. They got us into this mess with their greed though I am sure there are many good banks and bankers. Why did GS help Greece with their scheme? Pure greed, no conscience. The fact that banks and politicians are in bed with each other is the most destructive force because they feed each other at the expense of productive people and companies. A bank never creates or manufactures anything. The banks just take advantage of people who cannot properly handle their money (or lack thereof). So the banks are more powerful than the borrowers and therefor regulation is needed to level the field.

    I do not see why anyone needs an income in the millions when others do not even have a roof over their head. Don't tell me "get a job". There are no jobs, not even for qualified people! Many are being told they are over-qualified.

    In some markets which are free like cell phone businesses or entertainment through cable or satellite there is such an inefficiency that it hurts. Are these companies there to create employment or are they there to deliver fair value?

    Everyone tells you to diversify your portfolio. The banks didn't do what they preach and their bosses should pay the price. Don't ask the tax payer to help out. Just make regulations to protect the tax payer. May be there should be a felony for disregard of investor protection.

  11. Ted K | February 23, 2010

    Thanks for an informing article and exposing another side to this travisty we are in. Although the true reason of this crisis goes un-published. That is the mental illness of greed and its devistating bagggage of arrogance and corruption. Rampant throughout our nation, but none as evident as those in our governing body. This country will continue to sink into the abyss till greed is deminished to where it can be absorbed and yet prosper within our nations economy. The moral issue of greed cannot be regulated by governing policies or regulations. As infighting will insue and rightfully so. This countries mindset isn't there yet to concede to the errors of greed, may never? To impose any regulations at this time only covers the effects of greed, doesn't deal with it. So in turn will cause a bigger implosion down the road.

  12. Vada Hopkins | February 23, 2010

    Well some of your ideas on what to do are very good and some very interesting but all of them have a snowballs chance of happening. What will happen is that it will come to the wire and congress will have two days to save the world as we know it, give the banks bailout money and the taxpayers will pay. Instead of salary caps they will all get millions of dollars for figuring out how to bilk the taxpaying public.

  13. David | February 23, 2010

    I think everyone needs to read "Crashmaker, A Federal Affaire". We would all be better off.

  14. Richaed | February 24, 2010

    Per current and past policies and general mind set of the people, I am sorry to say, I do not see anything that would cause recovery and provide spendable money to get the economy going. NOW PEOPLE ARE BROKE, THE DOLLAR BUYS LITTLE. PEOPLE NOW HAVE HIGH NUMBERS IN THEIR PAYCHECK AND ARE BROKE. My grandfather in 20s being sole wage earner supported a family on about $15 a week; and

    that $15 a week THEN (early 1920s) = about $2300 a week today in purchasing power.

    Since I was child to now I have seen the American Standard of living just go down BIG TIME. Believe it or not, only way out is a step down from global economy to a TOTAL internal closed economy that protects and allows for the needs of both business and labor. Now the average American has been lowered to same pay scale as cheapest labor in the world. American business can not compete with foreign made goods to then pay proper wages too; and until labor realizes they need businesses on American soil to provide the jobs and turn around the restricted laws and allow for the costs of environmental issues on business America is in for BIG TIME trouble.

  15. VT | February 24, 2010

    I just snapped to a disaster. It's a little off subject, but not a lot.

    I've been studying foreclosure defense and reading case law regarding same. Due to the way loans are being sliced & diced and resold, there is no one with standing to foreclose. As if that weren't bad enough, what it also means is that there is no one with standing to deliver clear title.

    Do you realize the implications of this? Millions of homeowners are buying … nothing.

    And if this applies in the residential market, why doesn't it apply in the commercial market?

    If these commercial loans are sliced and diced, who is the developer paying his money to? The answer is beginning to look like … no one knows. So even if one were to pay off one's commercial mortgage (unheard of), there is no one who can deliver clear title.

    Don't look. As long as no one looks, we can keep playing this shell game.

  16. Commercial Notes | February 24, 2010

    As the baby boomer generation retires you will start to see more businesses start out of necessity from Generation Y. Generation Y will be using the internet and mobile applications to run businesses. With the reliance on the Internet, the necessity of an office seems to dissipate. Also, as the Internet grows and as does our dependence on oil, online retailers will continue to thrive. Retail stores will soon be going out of business at an alarming rate because people will want to save money from driving to the mall and people also enjoy the convenience of shopping online.

    The office and retail really is one of the biggest problems facing banks with these types of loans out there. They need to get these off their books asap.

  17. Damian | February 26, 2010

    How do you rationalize the irrational? This Ponzi Economy has been decades in the making.

    Managed by politicians who are all on the take in one form or another. Greased by professional bribers, er lobbyists who craft and kill legislation for self serving reasons. Plundered by Wall St hoods, insiders, lawyers and bailed out banksters.

    The world stands by awestruck as we amass more trillions in debt that can't possibly be repaid but there is next to nothing anyone can do about it.

    This is the new world order. Power will be held by whoever owes the most. Because the global economy can't afford to let them go broke.

    The Twilight Zone live daily from the USA.

  18. nohomehere | February 27, 2010

    Just annihilate all credit card debt payments and you will cause them(Bankers ) pain so as not to do it again ! you know loan sharking is illegal so disregard all theses loans up to a point and the balance do just like you said. Good idea, but by reducing the amount owed they are made to compensate the country for the previous bailouts by tax payers that never got compensated properly for their tax dollar . I guess the leader ship thought it was their money to give away , Again! . then enforce usury laws. and all the commercial real-estate ? what's the word? to cause them to eat their loses . treat them like the snakes they are . cause them pain . take the property and nationalize it , all the commercial property would belong to the citizens and the sales profits would pay back along with the money the bankers had to pay to the tax payer for misrepresenting the state of the economic system when pushing big inflated prices on unsuspecting Joe's ,You know the big pyramid scheme in real estate both commercial and residential not counting the compensation for trashing so many construction jobs and related industries which at one time reached 40% of the economy now gone disappeared kaput, adiosed ,86 'd, outa here, see ya later alligator after-while crocodile ! I don't see any body telling the truth even you where's your article on that 40% of the seventy % leaving 30% doing i don't know what , but the banks need to be made to pay compensation for all this suffering all the job loses all the foreclosures caused by them the bankers whether commercial or investment they were all in it together and they should all be made to pay ,BIG TIME! then we can talk restructuring . so you see forgiving debt is not asking to much just cool out your greedy jets and don't be so sure you are invisible as a mouth piece for the banking system consciously or not . you concentrated too much on patch and go . not this time old man ! this one will require a payback to every body in the US big and small ! no more steal and hide behind big Gov. and corp law bull double speak . what you think no americans are left who can add and subtract or keep score . you seem to know how these guys have friends . what's wrong with you ? talk payback or shut up talk national compensation or don't talk at all ! You seem to fail to realize the money is in better hands if its in the average americans hands they are the ones who spend directly into the producers hands , forget these lazy middlemen grifters using the law to profit at the little mans expense. Wow ! and you tried to sound so it can be fixed and all that . HUH! as long as one alien seed pod is left it will reproduce another evil creature . you will not and cannot eliminate part of this invasive species the root self reproduces . you or who ever is going to fix things must dig out the root . no more free ride to the banksters , the Fed and their cronies in our Gov. Get the round up and the hoe . the soil is good thats the Americans and their system its the weeds that need pulling !

  19. Ruth Kitzmann | March 10, 2010

    great articles — really enjoy!

  20. James | March 22, 2010

    In biblical days, every fifty years all debts were forgiven and everybody would start over again. Perhaps, the world should go back to ancient times and we start anew on a brand new, clean slate with all our debts erased! How utopian, just like this article. We all can dream, right Shah? Just let our imaginations run wild.

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