Legal 'Extend and Pretend'

Now that the FDIC has complied with “extend and pretend,” residential and/or commercial mortgage-backed securitization property values will not come close to returning to 2007 levels—or even 2004 levels for that matter.

By deteriorating future investor confidence in securities, the federal government’s “short-term gain-for-future-sacrifice” practice will likely stall an active return to RMBS and/or CMBS.

Just look at the situation right now. Although AAA bondholders can still be made whole on a 50 percent value drop in commercial real estate (Moody’s said property values are now down to 2002 levels), higher unemployment is causing prime residential loans to fail, causing losses for AAA RMBS bondholders. With the outlook of Option-A/Interest-Only extensions, residential loan modifications, etc., how long will it take for RMBS to return and, therefore, property values to reach anything resembling 2007 levels?

Likewise, CMBS faces a slow return to securitization with highest maturities from 2015-2017. Granted, one or two loans originated into the pipeline, but they require assistance through the Troubled Asset Loan Facility program. Without the TALF program, when does CMBS return? Will it return if unemployment remains above 10 percent and near 11 percent moving into 2011? Wells Fargo Securities forecasts 10.8 percent into 2011. As you mention, mark-to-market manipulation alters true valuation, transparency and buyer confidence. Have bondholders regained any confidence in the ratings agencies at this point? There are still many unanswered questions.

It is no secret that the Public-Private Investment Program has yet to gain legs because investors are leery of partnering with the government on deals, particularly based on some contractual wording. Plus, it doesn’t help that government changes the rules in the middle of the game. My nine-year old nephew tried doing that in our Monopoly game this weekend. As the banker, he said all the money in the bank belonged to him. I told him that acting like the Federal Government was not going to help him win the game. He said it was only play money. I said, “What do you think today’s currency is?”

It is ironic that most legislators see “bankruptcy cram down” on mortgages as a negative affect to the RMBS market because bondholders will not have confidence in current and future mortgage values, but the same logic does not seem to apply when government manipulates regulations and accounting principles. That’s okay, however, because stock prices go up, consumers look at their 401k’s and there is peace on earth.

Only the Fed is buying MBS right now, and the first hurdle for the Federal Government—holiday retail sales—is coming down the pike in 1Q 2010.

The second hurdle will likely be the unemployment rate, unlikely to drop through 2010.

The third hurdle involves higher delinquencies in FHA and rising defaults in Fannie Mae and Freddie Mac loans, forcing higher capital standards there and in banks. Let’s face it, higher capital standards mean less debt for businesses—small and large—keeping unemployment high for awhile. High unemployment means hotels, retail, office and industrial not returning anytime fast.

Sources tell me industrial is really getting slammed and, of course, we know CMBS delinquencies/defaults continue to rise for hotels and multifamily, not to mention retail, and they are rising in office. In 2010, we will likely see more of the same. Who will return to a CMBS market with increasingly rising default rates? Nobody is coming back to RMBS anytime soon.

The fourth hurdle becomes a Congress looking for reelection in November and passing regulatory reform that favors consumer approval either in Spring or Summer of 2010. By that time, hotels are history, retail will likely face severe damage and office properties will face higher defaults. How that legislation will affect financial markets and investor confidence is another major question. In some ways, it could increase investor confidence knowing that rules are in place that will not change.

However, the fifth hurdle is a weakening dollar that faces a threat of rising long-term rates and if rates start to rise, the printing press shuts down and a slow economy becomes no economy. If the situation gets dire by the third quarter, prior to elections, the good, the bad and the ugly bank scenario could come down the pike. Of course, that might mean placing some large banks into receivership or consolidating a couple of major financial institutions. Meanwhile, we are sure to see more banks shutting down and FDIC taking further hits. Assuming bank customers don’t panic and believe their assets are still safe and insured, the stock market should only drop by 30 percent until it shows true P/E ratios.

In any case, toxic assets remain in these banks and they do need to be removed before securitization returns—a AAA bond becomes a true AAA bond--and debt can flow again. Those assets need to be removed before unemployment declines and true valuations return. How they remove these assets remains a key question for the Fed and Treasury. With trillions of dollars in money spent, some strategies once on the table for the Fed and Treasury, are no longer possible.