Show Me The Money: Where Did The Capital Go And When Will We See It Again?

The economist John Kenneth Galbraith once said:  “The only function of economic forecasting is to make astrology look respectable.”  We feel much the same way about predicting when capital will return to retail developers, real estate investors and retailers.

The retail industry (and the Country in general) are all waiting for the same thing, we are all waiting for the capital markets to become “unclogged.”  To understand how (and when) this will occur, one needs to understand how this mess was created. The answer is both simple and very complicated. For the most part, lending institutions over approximately the last ten years discovered the way to make a healthy profit on its lending practices. In the old days, banks lent to homeowners and either held onto the loans or sold them on the secondary market to Fannie Mae (“Fannie”) or Freddie Mac (“Freddie”). With respect to the homeowner loans held by these banks, the underwriting standards were strict so as to minimize risk to the lending institution. With respect to those loans sold to Fannie or Freddie, the underwriting standards of Fannie and Freddie were also strict and required minimal risk (although these standards relaxed over the past few years). Fannie and Freddie packaged the loans they bought and sold them as mortgage backed securities to investors (which proved to be a reasonably safe investment for buyers, since the underwriting standards for these loans were reasonably strict).

With respect to commercial loans, most of these loans were retained by the originating lender (with the exception of certain larger loans that had other participating lenders to share in the risk of default). The underwriting standards for these commercial loans were strict but as the economy grew and real estate became the darling of the economy, even these underwriting standards began to be relaxed.

What changed the way financial institutions made loans was the addition of a new secondary market, a market that was in addition to that once dominated by Freddie and Fannie, one that Wall Street relished. This market did not have the strict underwriting standards of Freddie and Fannie or those of traditional banks, its main objective was “product”, and as long as this product could be bundled into debt instruments that could be sold in the secondary market all around the world as securities, Wall Street was happy. These debt instruments became known as commercial mortgage-backed securities (“CMBS”) and collateralized debt obligations (“CDO’s”) (hereinafter for simplicity collectively referred to as “CDO”). The CDO market permitted financial institutions, investment bankers, mortgage brokers, rating agencies and insurers (e.g., AIG)  to generate tremendous commissions and fees by making more and more home loans and bundling them into pools and then selling them off as securities. It also permitted large financial institutions to aggressively pursue commercial loans and then sell them through the CDO market. The more home loans that were made, the more home prices appreciated. The more home prices appreciated, the less likely it became for home buyers to afford homes other than by taking advantage of lax underwriting standards. Hence, a major “bubble” was created, just waiting to burst.

And bust it did!  As Warren Buffet so clearly explained in the annual report to the Shareholders of Berkshire Hathaway Inc., “As the year progressed, a series of life-threatening problems within many of the worlds’ great financial institutions was unveiled. This led to a dysfunctional credit market that in important respects soon turned non-functional. The watchword throughout the county became the creed I saw on restaurant walls when I was young:  ‘In God we trust; all others pay cash.’  By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear. The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified. Putting people in homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.”

So what happens from here?  The first government attempt to address the credit crisis (initially implemented during the Bush administration) was TARP (Troubled Asset Relief Program), a program that was initially believed to be designed to allow the United States Department of the Treasury to purchase up to $700 billion of “troubled” or toxic assets (hereinafter referred to as “Toxic Assets”) (recognizing that only some of these pools of Toxic Assets contained troubled loans), allowing banks to rid themselves of these Toxic Assets and begin lending again. This program, as originally conceived, would have also created a market for these Toxic Assets, thereby creating activity in the real estate industry. Unfortunately, the government decided not to use this money to buy up Toxic Assets but to lend it to major banks without any “strings” attached, allowing these banks to utilize the cash to shore up their balance sheets. Most (if not all) of these banks did not do anything to rid themselves of their Toxic Assets. Establishing values for pools of Toxic Assets is very difficult since many of the underlying homes are not presently saleable. A good portion of the TARP funds were also used to shore up troubled AIG which had insured may of the CDO pools through the use of credit default swaps. The reckless underwriting utilized by AIG put it in the position of being insolvent without the addition of the government “bailout” funds provided to it.

Since the inauguration of Barack Obama, his administration has implemented numerous programs to attempt to shore up the housing industry (e.g., its Foreclosure Prevention Plan) and to provide credit for student loans, car loans and small business loans (underwritten with very rigorous standards) and packaged into securities sold on the secondary market (e.g. the Term Asset-Backed Securities Loan Facility (“TALF”). The Treasury Department and the Federal Reserve plan to spend as much as $1 trillion to provide low-cost loans and guarantees to hedge funds and private equity firms that buy securities backed by these loans. However, it should be noted that the US Government now plans to expand TALF to also provide loans to purchase Toxic Assets.

However, the cornerstone of the Obama administration’ plan to deal with Toxic Assets is the Public-Private Investment Program (the “PPIP”) which was announced on March 23, 2009. The PPIP will initially draw on up to $100 billion in funds already approved by Congress under TARP, as well as additional funding from the Federal Reserve. The initiative will seek to entice private investors, including big hedge funds, to participate by offering billions of dollars in low-interest “non-recourse” loans to finance the purchases or Toxic Assets. The government plans to match private investment equity dollar-for-dollar, and the Federal Deposit Insurance Corp, will put up significant backing, up to $6 for every $1 invested, in exchange for a fee. Funding will be provided by the government or guaranteed by the FDIC for a fee. The loans are intended to be low interest “non-recourse” loans. The government will share in both the upside and downside of any investments. However, if any investment proves to be unwise, the private investor will be able to walk away from the investment at a loss only of its equity invested, but without any other loss (since the loans will be non-recourse). Observers believe that the PPIP will need at least an additional $400 billion to adequately deal with the Toxic Asset program.

The key to this program is the valuation of the Toxic Assets. The hope is that the partnership of this program with private investors will ensure that the price paid by the private-public partnership is appropriate. However, will the banks that hold (and want to sell) these Toxic Assets be willing to set a realistic price for these assets?  Much remains to be seen in the coming weeks.

The only thing that can be said with assurance is that the US government, through the Treasury Department, Federal Reserve and FDIC is throwing most every possible resource at the credit-crunch problem. Will it work?  Many believe that it will. However, many believe that much too much money has been utilized in connection with all of these programs, and much of it utilized unwisely. Sure, mistakes have been made. One just has to look at the initial use of the TARP funds. However, the government now seems to have finally grasped the real problem:  the entire liquidity of the banking system relies upon the ability of the government to cause there to be a marketplace for the Toxic Assets. Once this is established, transactions will begin to occur and valuations will be set. At this point, transactions of any type will begin to unclog the real estate markets. In addition, the hope is that once banks unload many of their Toxic Assets, their balance sheets will allow them to begin lending again for retail development and acquisitions. When this occurs, underwriting standards will be more rigorous. Banks will not soon return to the standards applied during much of the last decade.

Will all of this really occur?  Many of the pieces of the puzzle appear to be in place for this to happen. Consumer confidence has begun to reverse, if only slightly. The stock market is beginning to show signs of life. The automobile industry is in for more pain, but will hopefully see orders increase next year. Housing prices in many markets appear to have reached a low point. The wild card is impending commercial loan defaults and loan due dates. However, at this juncture, lenders appear to want to work with borrowers as opposed to becoming owners of substantial REO holdings. It appears that 2010 will likely be a better year for the real estate industry, and it will hopefully be a year in which developers and retailers begin to see the return of capital.