Premature Enthusiasm: All We Have To Fear Is Hope Itself
October 27, 2009
Home builders and real estate investors seem to have a bad case of premature enthusiasm, sparked by the hope that everything is better now that we’ve avoided a global financial melt down. Many economists and Wall Street analysts now believe we’re likely to see a significant downturn again later this year, and that the economy, real estate and banking all have a long, hard slog ahead.
According to Bloomberg News, Alec Phillips, head of Goldman’s Sachs Washington office, said in an Oct. 23rd note to clients, “The risk of renewed home price declines remains significant. Our working assumption is a further 5 percent to 10 percent decline by mid- 2010.” And, on October 23rd, Bloomberg quoted investor Jeremy Grantham as stating that, “ stocks will drop painfully from current level in the coming year amid disappointing economic data and shrinking profit margins.” Grantham is the chief investment strategist at Boston-based Grantham Mayo Van Otterloo & Co., which oversees about $89 billion.
Why? Well read on….
To start with, unemployment is expected to remain at or above 10% for another year or so, and to decline slowly thereafter. This will keep the foreclosure rate high, exacerbated by the fact that residential mortgage resets won’t peak until late 2011.
As a consequence of high unemployment, and the slow pace at which home builders are ramping down new home production, the economy has yet to sell most of the two million surplus homes Wall Street produced in the run-up to the 2006 housing peak. Only recently have new housing starts for the first time dropped slightly below the number of new home buyers entering the market. New homes have to be purchased by new home buyers, not just swapped between owners of existing homes, which is a zero sum game. Prices will move to investment value and remain there until most of this surplus inventory is sold. This will likely take several more years to work through.
As with the residential mortgage backed security pools (“RMBS”) that precipitated this mess in the first place (along with the credit default swaps insuring them), the commercial real estate loans that make up commercial mortgage backed securities (“CMBS”) are going into default at a breathtaking rate. However, they can’t be marked to market, foreclosed or sold due to the completely dysfunctional nature of the CMBS legal structure. This is now creating a huge overhang of zombie-like non-performing commercial property loans that have locked up the commercial property markets. Savvy investors are waiting on the sidelines for a growing tsunami of distressed commercial property to come to market. They will have to wait awhile longer.
Another major factor (and dirty little secret) is that something in the neighborhood of a one thousand banks are still effectively insolvent due to lack of capital (yes, Virginia, there are that many zombie banks still out there). These banks will need to be merged or liquidated. Even if the FDIC closed 25 banks every month, it would still take over four years just to close them, at a cost to the government of about one trillion dollars. Most of the non-performing real estate loans carried on the books of these banks can’t and won’t be foreclosed and sold until these banks are taken over by the FDIC. This will further hobble the commercial real estate markets for years to come.
So the good news is that we’ve dodged Great Depression II. A small celebration would seem to be in order. However, we wouldn’t party too long or too hard, as that light at the end of the tunnel still looks to us more like another big train headed our way.
