2011 Bay Area Economic Engine:

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Each year at this time I boil down the Bay Area business news into a summary organized by the Bay Area’s major industries and project their economic direction in the upcoming year. 



To download detailed chart click here!

Here's what I found:

In 2011 the San Francisco Bay Area continued its slow economic recovery with most sectors stable and some sectors booming. However the recovery is not even. Booming sectors are located in San Francisco, the Peninsula and Northern Silicon Valley. High-tech jobs account for 65% of the net increase in Bay Area jobs created this year, but high-tech is only 18% of the Bay Area economy. GDP for the San Jose, Santa Clara, Sunnyvale SMSA grew 13.4% in 2010, compared to the National average of 2.5%.

Silicon Valley’s 150 largest companies reported record profits in 2010 according to the Mercury News. These profits came with record productivity; $486,000 in sales per employee. Employment is up, but even in Silicon Valley and San Francisco, employment is not back to 2008 levels. http://www.siliconvalley.com/valley.com/ 

The East Bay and North Bay are stable but lagging.  The East Bay and North Bay often benefit from a spillover effect when Silicon Valley’s and San Francisco’s rents soar.  This is happening in apartments and beginning to happen in the office sector as well.  

Any dark clouds?  Yes, two:

1. Government employment and industries that receive government spending; education, defense, basic research and biotech. 
2. The Financial sector:  The IPO sector needs to come back for funds to begin flowing again into the VC funds.  A second financial crises stemming from the Eurozone threatens the big banks.  Small banks are struggling with real estate loan write-downs but extend-and-pretend has helped them as cap rates compression causes values to recover.  

In a nutshell:

Assuming we can dodge another world-wide financial crisis, the Bay Area’s economic outlook for 2012 looks bright.

Click Here to download the 2011 Economic Engine.

The Legacy Trap

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What do a commercial property mortgage banker and a wealth management expert have in common? Both advise successful entrepreneurs on succession for their real estate legacy. And both bear witness to the sad consequences if estate and succession are not planned well, lawsuits that dismantle the family, mistrust and accusations that divide the children.

My colleague Rick Raybin, a wealth advisor specializing in cross generational wealth transfer and I collaborated on the attached article. In it we describe our different perspectives, and provide advice on how to avoid what we called the "Legacy Trap". A shorter version of the article was recently published in GlobeStreet.

Before it was published, I sent a draft to some of my clients who had experienced first hand inter-family lawsuits, families who had spent millions in legal fees, sons who took over the dad’s real estate business and found themselves ostracized by their siblings.  I received pages of heartfelt comments in response to the article and with approval, I put some of their comments in the sidebar. 

The article was written to help real-estate investors' heirs avoid the same fate, feel free to share.

Borrowers’ Biggest Financing Mistakes

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This week I spoke at the monthly meeting of the San Francisco Real Estate Investment Forum held at the offices of Holme, Roberts and Owen, LLP.  The theme of my talk was Borrowers’ Biggest Financing Mistake.   

My advice to any commercial property investor... build a stable of seasoned “trusted advisors”; mortgage banker, leasing and sale broker, attorney, architect, accountant, etc.  Ask these advisors to trouble-shoot your plans before they are implemented - and particularly ask them about mistakes they have seen made by other investors, facing similar choices.

During my talk I shared a list of borrowers' common strategy and process mistakes, based on great input from twenty experienced members of Newmark Realty Capital’s loan production department. You can download the "biggest mistakes" list and presentation slides here.

"Experience is the name everyone gives to their mistakes". Oscar Wilde

The Fed promises to push our economy out of balance for two more years

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The Board of Governors of the Federal Reserve issued a statement after meeting this week that the economic conditions are "likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013".
A free-market economy is an ecosystem.
Natural balances are reached between buyers and sellers, landlord and tenants, debtors and lenders.  Nature's ecosystems that suffer a shock can heal themselves with time: so could our free market economy if left alone from government meddling.  History has shown that when governments distort the free-market balance through price controls or other means, bad things happen. Watch out for unintended consequences!

Wage controls during World War II helped create our dysfunctional employer-pay health care system.  Totalitarian states of the communist era were famous for price controls that backfired.  Communist Poland wanted to give its population cheap bread and did so.  Eventually farmers were feeding their pigs bread instead of raw grain: wasting the efforts of the miller, the baker, the truck driver, the retailer and the energy to bake the bread.

unnatural balance

The housing boom was caused to a large extent by the Fed reducing the Fed Funds rate to 1% following the blowup of the dot-com boom.  The Fed has kept the Fed Funds rate set in a range of zero to 0.25% since January of 2009 as a response to the bust of the Great Debt-Driven Boom (see Capitalwisdom, October 15th, 2010). Now they promise to keep interest rates artificially low for another two years. If an organism or ecosystem is artificially contorted for four years straight it will not spring back. Expect the unintended consequences to last for a while!

What the Fed is doing is a form of price controls.

Keeping interest rates artificially below their market-clearing levels is a form of “Financial Repression” (See this month’s excellent newsletter from William L. Gross of PIMCO.  This financial repression is a hidden tax on investors and savers. If you talk to a group of senior citizens you will hear the rage and despair that comes from this unfair tax on savers. The Fed is sacrificing our retirement savings to send profits to the banks.

At the Fed’s Board of Governors meetings there is one member who consistently votes against this policy of extremely low interest rates; Thomas Hoenig, President of the Federal Reserve Bank of Kansas City. Mr. Hoenig points out that these low rates are having the opposite effect to stimulating the economy. Banks historically strive to make a 3% net spread between their loan yields and their cost of funds. Banks can make this yield today without making new loans, by paying near 0% to their depositors in interest and buying 10-year T-Bills yielding around 3%. Since they do not need to reserve for losses and do not have the cost of a lending operation, almost all of the yield from T-Bills is riskless profit. The banks lock in profits

and improve their capital ratios – a no-brainer.

Banks getting addicted to buying T-Bills instead of making loans to businesses: This is like Polish pigs eating subsidized bread instead of grain!

As happened in the last period of artificially low interest rates, Mr. Hoenig fears unintended consequences this time as well. He points out that bubbles occur when markets are out of whack. Investors desperate for yield do desperate things. He says he cannot name all the bubbles occurring this time around but he can point to agriculture land in his district that has tripled in value. Though low interest rates have helped the banks, the opposite effects can occur. Banks that lend against skyrocketing asset values, like Midwest farm land, will get hurt when those values fall. The Fed is setting up the next boom and bust cycle. See the interview with Mr. Hoenig at the PlanetMoney web site.
Since cheap money is not working to revitalize the economy, why is the government so keen to put its weight on the borrower side of the financial scales?

It may just be related to the fact that Uncle Sam is the biggest debtor of all.

Heads-up... don't set up your business in a way that is dependent on these low interest rates. At some point level heads may prevail and the Fed will allow the free-market to work. If that happens interest rates will rise to a healthy level and our financial system can achieve a market balance.

Silicon Valley in Transition

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An interesting study was published this month on the workforce implications of the renewed growth of Silicon Valley’s cluster of IT industries, the Information and Communications Technology (ICT) cluster; networks, computers, chips, telecom, software, hosting, social media, etc.
For a copy of “Silicon Valley in Transition” go to  http://connect.one-stop.org/lmi/TechStudyFullReport_03.pdf

Here are the highlights:

• The ICT sector added 13,000 jobs in greater Silicon Valley (now defined to include San Mateo, San Francisco and southern Alameda counties) since 2009.

• The ICT sector is conservatively estimated to grow 15% over the next two years, adding around 20,000 new jobs.

• Companies are already finding it hard to recruit in certain engineering fields.

• Average salaries in the ICT cluster are growing again and now exceed $150,000/year.

• Silicon Valley is a magnet for start-ups and venture capital because of its deep pool of highly skilled talent. This talent in Silicon Valley is seen as more flexible and willing to adopt and learn the new technologies that cannibalize the old. Without “positive destruction” Silicon Valley would not be what it is today.

• Even as other tech centers have proliferated, Silicon Valley share of total US venture capital investment has steadily grown, now exceeding 40% of the nation’s total VC funding. The Valley’s “infrastructure for innovation” attracts companies such as Facebook to relocate here and companies such as Groupon and Wal-Mart Online to move engineering here.

• The reviving IPO market (Pandora, LinkedIn, and soon Twitter and Zinga will go public), is letting the local VC players cash-in, so Silicon Valley’s share of the VC pie is likely to grow further.

 

Dear Amazon, you have to be kidding!

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This just in....
Amazon has filed a petition in California for a ballot measure asking voters to repeal the law passed in late June that was designed to force online retailers like Amazon to collect sales tax. Amazon will hire the firms that will collect over 430,000 signatures by late September to qualify the referendum for a statewide ballot on Feb. 7, 2012.

Paul Misener, vice president of public policy at Amazon, in a statement sent to journalists claims "This is a referendum on jobs and investment in California...."

Mr. Misener is correct. It is a referendum on jobs in California. Giving online sellers a 7-9% price-advantage over local California businesses, will shut down local businesses and will drive jobs out of California. If you need evidence, ask the19,000 employees at Borders. Borders was driven into bankruptcy largely due to this uneven playing field.

“It is in every Californian’s interest for online and store front businesses to play by the same rules," Betty Yee, first district member of the California Board of Equalization, said in a statement. "I strongly doubt Californians will support a loophole promoting out-of-state jobs, when holding Amazon.com accountable to the same rules as everyone else protects California’s economy.”

Let's hope so.  Support your local retailers who pay real estate taxes to our cities and collect sales taxes for both our state and cities.  Boycott Amazon.com.

See http://www.bizjournals.com/mobile/sanfrancisco/blog/2011/07/amazon-strategy-fight-california-tax-law.html

Time to boycott Amazon.com?

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A key component of California’s 2011-2012 budget is to require online retailers to collect sales tax. Amazon is not taking this lying down and sent an email June 29th, 2011 severing ties with all its California affiliates (not me - "Capital Wisdom” has no sponsors or advertisers). Amazon is refusing to pay the tax and is preparing a legal challenge.

It is time for us to say, “Enough!”  And, we in the commercial real estate industry need to be the loudest voice. 

We, who make our living from the bricks-and-mortar industry, see the effects of an uneven playing field on retail tenants.  Our bookstore chains are dead or dying and our electronics stores are sick.  You can download a bar-code-reader app to your smart phone, stand in the aisle at Best Buy and with a few clicks, order that exact model flat-screen TV from Amazon, delivered to your front door and save tens or hundreds of dollars in taxes. 

Competition is great, but true competition requires a level playing field. 
Bricks-and mortar retail stores pay rent to our industry.  But more than that, they pay sales tax and property taxes to our States and local communities; they hire our young people; they sponsor our little league teams and support local causes and charities. 

You might think a bricks-and-mortar retailer could open its own on-line outlet and achieve the same benefit as Amazon.  No; they can only avoid collecting sales tax if they have no stores in that state. 

The consumer is responsible for paying its own sales taxes on on-line purchases.  A system that requires people to voluntarily tax themselves: How stupid is that?

Write to your Congress person
Tell them to pass legislation to require all on-line retailers to collect sales tax based upon the sales tax-rate for the zip code where the goods are to be delivered.   Tell Congress to ignore the screaming that “This is too difficult!” These are automated systems – it's not that hard to do.

When dot.com retailing started, the San Francisco Bay Area was a center of this activity.  At that time I supported a special status for these retailers.  Ignoring sales tax was a way to get this fledgling industry born.  

Amazon.com went live in 1995; it is now a 16-year old:  We have a powerful, self-centered and headstrong teenager on our hands. Time to grow-up.  Time to shop local. Time to boycott Amazon.com.

Why We Do Not Want Two Classes of CMBS

The multitude of Dodd-Frank regulators are working on the new rules for CMBS 2.0.  Built into the Dodd-Frank legislation is the concept of a Qualified Commercial Mortgage (QCM) - a mortgage considered conservative enough that no risk retention (aka Skin in the Game) will be required.  QCM Pools will have different players, different subordination levels and better pricing than CMBS bonds made up of loans that do not qualify as Qualified Commercial Mortgages.

I would like Congress and the Regulators to look at the QCM issue from 30,000 feet.   If they do, I am hoping they will agree with me that creating two classes of CMBS will cause more harm than good.

What is being proposed are two classes of CMBS “Prime” and “Less than Prime.” (Let's not use the phrase "Sub-Prime")
You may feel a sense of déjà vu: We saw this before in residential.

Two classes of CMBS is a mistake for three reasons:
1. It is not good for commercial real estate.
2. It is not good for portfolio lenders.
3. It is not good for the CMBS industry.

Let me take these in order:

1. Threat to Commercial Real Estate
Quality commercial real estate is not suffering from a lack of capital. Quite the contrary, we are hearing the word “Bubble” being thrown around again. Life Companies are slugging it out to win the conservative loan business.  What is lacking is capital for properties that, for reasons of location, product type or leverage, are not targeted by the portfolio lending industry. This is why we need CMBS to come back. QCM pools are a distraction for the CMBS industry. Creating a “Less than Prime” second category of CMBS will discourage funds flowing to where it is desperately needed. And when these funds do flow it will increase the cost of borrowing for owners of real estate largely ignored by the portfolio lending industry

2. Threat to Portfolio Lenders
When Ronald Regan was in office there were two classes of commercial real estate and commercial loans; life insurance quality deals, and S&L Quality Deals. Things have not changed. The life insurance companies are lending on the same quality deals. CMBS came in in the 1990's to fill the void the S&L's left. Having the CMBS industry now target Life Company quality business with a source of very cheap capital is an unneeded threat to a vital portfolio lending industry.  A low cost of capital killed the residential portfolio lending industry and could do so again in commercial lending.

3. Threat to the CMBS Industry
What we had in CMBS 1.0 was pretty much an undifferentiated securities product, with mortgage pools containing both the diamonds and the dreck. Removing the diamonds will not make for better mortgage pools. This new two tier CMBS system is not in the interest of the bond investors. The QCM pools will lack risk retention and will be created with very high incentives to force deals to be qualified as QCM. Subordination levels on QCM pools will be minuscule. I think that time will show that QCM pools will be anything but risk-less.

CMBS bonds made for Less than Prime pools will be penalized in pricing:  By removing the diamonds from the dreck the cost of mortgage loans for non-QCM product will be high and financing for this class of property might not be very plentiful.

Lenders' Views

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Once a rising tide lifted all boats, but now lenders are looking for what they perceive are sure bets. So what are lender's current preferences? Apartments stay on top, with office bringing up the rear.

Apartments

Life Insurance lenders are beating the GSA's on good quality infill apartments. This could be because of where spreads are right now, but it could also be a political move on the part of the agencies. If the Tea Party wants to privatize FNMA-Fannie and FHLMC-Freddie, the best way to show a need for taxpayer support is for the agencies to be active where the private sector refuses to go, rural communities and C-Quality urban product. On the borrower side we are seeing active apartment owners rebuilding relationships with the life companies just in case the agencies are curtailed.

Retail

Lease provisions besides rent are more important than ever, effecting mortgage rates and property values. If owners are signing new or reworking old leases, they need to fight to get rid of co-tenancy clauses and to get annual reporting of retail sales. A mortgage rate might be 100 BP more for a big-box retailer without sales data versus a similar store where the owner can show the tenant has good sales performance.

Industrial
Lenders' adversity to single tenant deals is creating a big advantage for those owners who can do portfolio financings. Newmark Realty Capital has been able to get major discounts in interest rates for large industrial portfolios, say a single loan against 10 properties. With cheaper financing these larger players can bid higher for property to buy and bid lower rent to attract tenants to fill their buildings.
Office
Why, with 40+ million square feet of vacant office and R&D space in Silicon Valley, do we see major users designing campuses and leasing new buildings at twice the rent they would pay for a 1980's vintage R&D building? Partly tenants want safer more resilient buildings. To meet this resiliency demand from users the structural engineering profession is working on standards that will estimate a building's downtime after a major quake. ATC58 is in draft and should be issued in 2011. Just as important, tenants want spaces that can layout for the "office of the future", see my April posting.
Other Product Types
Newmark remains active in the outlying product types; self-storage, mobile home parks, data centers, hotels. If it generates income we can find a financing source, working with a wide range of lenders with a broad spectrunm of interests. We have a long list of life insurance correspondent lenders, are active in CMBS 2.0 and are also working with those banks that are back in the market.

To see the office of the future, watch how Tech does it

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Micro cubes & bull-pens requiring multiple break-out rooms. 5.7 employees/1,000 SF and growing. A negative trend for office buildings – especially suburban stock.

San Francisco’s tech sector employment is approaching the highs of the dot-com era. See the excellent article by Casey Newton in the SF Chronicle.

But don’t throw a party quite yet
What strikes me is the shrinking use of office space on a per employee basis is erasing the growth in employment. San Francisco’s Tech sector is now down to an average of 175 square feet per employee or 5.7 employees per 1,000 square feet, with many companies cramming 10 employees into 1,000 square feet.

Why is this important?
The tech sector is the harbinger of trends in office use. This makes sense: Tech companies refresh their build-outs often, because they are either growing or collapsing. Tech employees are generally younger and more willing to accept change. These companies have already adopted the latest technology, so their office layouts show what is coming next.


 Zynga’s space (Desks 2’x6’, Cubes 3’x6’):

Photo: Liz Hafalia / The Chronicle

Take a good look at the photo of Zynga's office space...

What is making this possible?

Changes in Work Style
If you want to get a hold of a baby boomer, pick up the phone. If you want to talk to a Y-gen, send them an IM. In a phone-based corporate culture, 175 feet per employee would sound like a call center. These densities only work when people communicate electronically.
Richard Pollack, principal architect for the office interiors firm, POLLACK architecture, comments; “It’s becoming more prevalent in the young-person tech world that you shouldn’t even expect to get a quick response if you send an email to them! In fact, the current electronic communication approach is centered on social networking, even within companies. Salesforce.com released Chatter in 2010 which is their social networking tool for use by their clients and staff, and Google relies strongly on their multi-user collaboration tools known as Google Apps. Both companies are POLLACK architecture clients.”

Changes in Design of the Work Place
John Able, a prominent office leasing broker in San Francisco, told me the secret to maintaining employee satisfaction, with bull-pens and micro-cubes, is the provision of ample “Break-Out Rooms” available on an unscheduled basis. Densities of up to 10 employees per 1,000 square foot can only work by providing unassigned private break-out rooms, available when an employee needs to harangue a supplier, pitch a potential big customer, meet with a colleague or set up a date for the weekend, i.e. If you are going to have an extended conversation you head to the break-out room.
Richard Pollack also notes that beyond the Break-Out Rooms, a current design focus is to provide significant open collaboration space, with massage chairs, foosball, ping pong, etc. These spaces often incorporate white board walls (sometimes using special “white board paint”). Other trends are a lot of glass, and all the perks that we hear about – dry cleaning, dental vans (the equivalent of a food truck), etc.


Tech jobs up; space per tech worker down

Changes in Corporate Priorities

Rent used to be the top expense after salaries for the most office users. No longer - many modern companies are now spending more on IT than rent. According to the Corporate Executive Board benchmarks, the average company spent $8,910 per employee per year on IT in 2010. Software and Tech companies spent slightly more at $11,470 per employee per year. If a typical Tech company finds space today at $35/sf/yr full service in San Francisco, with only 175 square foot per employee, their rent is only $6,125 per employee per year, little over half of their IT budget.

What does this mean for office buildings in the future?

Clearly the design of office interiors is changing. But what is also changing are the metrics – Companies are focused less on rent per square foot and more on rent per employee. This change in metrics effects tenants’ location decisions. If you want to cram 10 employees in 1,000 sf then a typical suburban office building in a business park is less appealing. A tenant will accept a higher rent if that location allows them to achieve a high employee density. The typical suburban inhabitant is not going to tolerate this cutting-edge work-style, which is more akin to a college study hall or university library then the office environment of the baby-boomer generation. If you want to lower your rent per employee you need to be near Generation Y , i.e. hip and urban areas. You will also need a location where much of your workforce can come by public transit because the typical suburban office parking lot with a parking ratio of 4 cars per 1,000 sf of office space will be overburdened.



What does this mean for the recovery in the office sector?



As employment picks up, we will be fighting a trend toward less office space per employee. The recovery of the office sector will be delayed unless your office building happens to be in a Generation Y hot-spot: In my mortgage banking territory that is Palo Alto-Mountain View, Berkeley, or San Francisco.

The graphs and pictures for this blog posting came from the San Francisco Chronicle;  click here to read the article



Some good news for commercial real estate landlords and lenders

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The Financial Accounting Standards Board and the International Accounting Standards Board have agreed to modify their proposed accounting rule changes that would have required balance sheet treatment for all commercial real estate leases.

The Incentive for Commercial Property Users to Lease-versus-Own Stays Intact.

The proposed changes to the FASB13 accounting rules would have jeopardized the current accounting treatment of operating leases by requiring all leases to be treated as capital leases, i.e. a lease obligation would show up as a liability on a tenant’s balance sheet. Read my blog post of December 22, 2010 for more details.
The real estate industry lobbied hard against this accounting rule change, with the ICSC (International Council of Shopping Centers) being especially active. The Mortgage Bankers Association (MBA) also weighed in heavily – and successfully turned around this controversial proposal.

Here’s the MBA’s recent report on the topic:

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the Boards) have agreed to modify their controversial proposed accounting rules that would have required balance sheet treatment for all commercial real estate leases. The Boards have agreed to consider separating leases into two categories: financial leases and other-than-finance leases. Financial leases would be put on the balance sheet as an asset and liability and paid down over time. However, other-than-financial leases would be considered operating leases and would not have to be capitalized, which is the current accounting treatment for commercial real estate leases. MBA strongly supports the other-than-financial accounting treatment of commercial real estate leases. In addition, the Boards eased the standard for when lease option periods would have to be included in the lease value from “more likely than not” (over a 50 percent probability) to a much higher threshold.

Rebuttal to the Rebuttals to the Financial Crises Inquiry Commission Final Report

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The Financial Crises Inquiry Commission issued its final report at the end of January. The commission split along party lines with the Republicans offering two dissenting opinions.
The dissenting reports do not dispute the facts of the crises. The key points of dissent boil down to how to answer these two questions:
1. Could knowledgeable people have foreseen the financial crises?
2. Could regulators have played an active role in heading off the crises or limiting its damage?
The Democratic members answer “YES”; the Republicans answer “NO”.
(The second dissent pins most of the blame on the government itself not for lax regulation but for its jiggering of the free market with government incentives for home ownership).
The Republican dissent casts doubt on the efficacy of regulation, i.e. Regulation only slows the economy and can have unforeseen consequences. No one saw this coming.
“Pro-Business” legislators tend to have a reflexive response, “Get the government as far away as possible and the free market will function best”. But are these pro-business politicians defending 0% - down, liar loans? That is the equivalent of advocating an unlimited speed limit on Highway 1 along the coast of Big Sur. People drove off the cliff? Really? No one saw that coming.

Support of free Capital Markets does not mean “no law” and does not mean “no policeman”
I am a great believer in free markets. As a young man (with hair), I was a big fan of Alfred Kahn and was able to meet with him in 1978 when he was deregulating the airline industry through the Civil Aeronautics Board. He is still a hero of mine. But, as a business person I quickly learned that market participants often conspire to keep their market from being anything but free and fair.

I respectfully dissent from the dissenting opinions.For some reason we feel that regulators must stay far away from financial markets. I disagree. If any other industry sold products known to be dangerous, that cost the public their fortunes, jobs and dreams – people would demand to see indictments and prosecutions and, if not, we would see public outrage and new laws. Yet, at this time, three years after Lehman’s demise – VERY LITTLE NEW REGULATION IS IN PLACE! The too-big-to-fail banks are even bigger.
The wisdom of our forefathers that separated depository institutions and investment banks was proven to be correct, yet in order to save the Investment Banks our government merged the two industries. “Financial Reform” has been kicked down the road by Congress to the regulatory arena – an arena dominated by the lobbyist of the Big Banks and Wall Street.

Many Cultural Myths about “free” financial markets need to be deflated...

“The Free Market Knows Best.” In our minds the free market is a buyer and seller each knowing the product, facing each other haggling over price: If a market is this direct and open, it works. To try to regulate it would allow either side to attempt to game the system. But, when the market is controlled by a re-packager and re-labeler of the product, who keeps buyer and seller apart so risks are hidden, watch out! IT IS NOT A FREE MARKET. It is a license to disorient and game both buyer and seller.

“In Time the Just Will Prevail.” The Wall Street vendors of CDO and Subprime-backed securities knew they were selling unsafe, if not poisonous, investments. The investment banks that survived were those who kept the least inventory or who bought more of the antidote (credit default swaps) than the companies that went toes up. The most cynical investment banks survived.
Why was AIG bailed out in the blink of an eye? They sold the antidote! Credit default swaps against these toxic pools of mortgage bonds.
Goldman Sachs, the clear winner in this debacle, designed and sold several CDO’s, in fact, 3 are within the top 5 highest default ratios. Goldman established a book-making operation taking bets on whether these products would default. They convinced their own clients to buy positions betting the bonds would perform. Goldman then reaped huge profits betting against their own bonds. Given how the mortgage pools were picked, a sure outcome. The SEC $500 million fine is a minor slap on the wrist given the magnitude of the profits made. (Goldman bet against the housing bubble, $21 Billion on Credit Default Swaps with AIG alone. We taxpayers made good on Goldman’s bet with AIG.)
When purveyors of dried milk added melamine and knowingly sold dangerous products to the people of China and the world – they paid the ultimate price – summary execution. And what happened to those who knowingly polluted our financial markets.

“These were Sophisticated Buyers Who Knew the Risks.” Who runs the investment desk at a company’s pension plan, union or government retirement fund? Generally not a sophisticated buyer. In the face of a commission-incentivized Wall Street Investment Banker that pension investor is cannon-fodder
“Only Fat Cats are harmed by Wall Street.” We know today, this is not true. We are all victims. This is everyman’s retirement money. Dreams melted into despair. We will each be working 5 to 10 years longer because our Government let this happen.
“All it takes is Full Disclosure.” So you read those inserts with your prescription medicine in 4 point type? They’re about the same. Wall Street lawyers are artists of obfuscation. With hundreds of pages of red herrings no wonder it is so hard to sniff out the real deal.
“The rating agencies are watching the store.” This myth needs no further deflation.

“The World of Finance is too complicated to regulate.” I’ve said before, nuclear power is complicated and we regulate that. Why? Because it can blow up in OUR FACES!
But finance is not that complicated. Ask a kindergartner:
What is a loan? If you lend a classmate a dollar, you expect him to pay it back.
What is loan underwriting? If that classmate is unlikely to pay it back, do not lend him the dollar.
Explain a credit default swap to a kindergartner? You offer a quarter to the friend of the kid to whom you lent the dollar, if he guarantees his friend will pay you back.
A derivatives’ market? You go to your fellow kindergartners and take bets on whether the borrower-classmate will or won’t pay his debt.

It is not that complicated. We need some common sense laws. And we need the government to police these laws.

Summary of the conclusions of the Financial Crisis Inquiry Commission:
http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_conclusions.pdf
Dissent Joined by Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas: http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_hennessey_holtz-eakin_thomas_dissent.pdf
Dissent by Peter J. Wallison: http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_wallison_dissent.pdf

For a lighter version the meltdown download my cartoon parable about the financial crises,” Mad Meat!”: http://www.scribd.com/doc/40224496/MAD-MEAT-September-2010

Scene and heard at CRE Finance Council Conference in Washington DC

View from the (departure lounge) bench
Stranded overnight at Dulles Airport in a snowstorm may not have been the ideal end to the CREF Finance Council January conference, but it left me plenty of time to contemplate the (other) memorable moments from this year’s January CREFC Conference.  Here's my summary of the event. For a selection of slides from the event click here.

Rational Exuberance?
The mood at the CREFC January 2011 event was near giddy.  CREFC’s events are attended heavily by Wall Street-oriented players; CMBS conduits, issuers, rating agencies, securities lawyers and bond investors.  I've said it before... what a difference a year makes.  Michael Heagerty, Newmark’s CFO, described the mood at last year’s conference as desperate to suicidal; in January 2010 conference speakers were predicting health would not return to the CMBS new issue-market for many years, if ever.  This year’s CREFC participants seemed to be shifting their outlook from relief at having survived to fully-pumped and ready for action.

2011 Likely Lending Volumes
Banks: Larger banks have worked through or written down much of their CRE loan problems and are coming in to 2011 pushing for resolution of distressed loans now that the real estate markets are seen to have stabilized.  As a result, banks are making noises about making new commercial real estate loans in 2011, maybe even making a construction loan here and there.
Life Companies: The life companies as an industry will increase volumes moderately in 2011 over 2010 levels of roughly $30 billion.  Life Companies generally increased their production targets for the coming year, but will face a lot more competition in 2011.
Wall Street:  CMBS loan production may exceed life company volumes in 2011.  In 2010 the industry did about $11.6 billion of new CMBS issuance.  However, in the first quarter of 2011 $11.3 +/- billion of CMBS are scheduled to come to market.  Various industry estimates for the 2011 full year range from $30 to $60 billion of new CMBS issuance.

2011 Rates and Spreads
Rates:  The conference saw a fairly universal prediction that long term interest rates will increase as the economy strengthens.  If you want low rates, root for a double-dip recession. Some speakers felt that with a full-paced recovery we could see a 5.5% yield on the 10-year T-Bill within a year.
Spreads:  Spreads are already down but might have 20 to 25 BP left to tighten.  Many CMBS investors have AAA bonds that were valued not long ago at 70 cents on the dollar, now find these same CMB Securities are valued at 105 cents on the dollar.   The managers in an investor’s CMBS department look like heroes even if they did nothing all year.  Investors are hungry for new issues and the 20 or so conduits that are now in the market are chasing the few good loans in the market.  The issuers are holding firm at making 4% to 5% in profit on each new issue brought to market.  So spreads will only tighten if the bond buyers are more comfortable and strongly bid for the bonds.

Hot topic - CMBS 2.0 vs. a rebooting of CMBS 1.2
There was much talk at the conference about the attempt to totally re-write the rules of engagement for CMBS under Dodd-Frank, an effort labeled CMBS 2.0.  Many felt that the crafting of new regulations is turning into a jump-ball where Big Banks have an unfair advantage.  The players at either end of the CMBS process, at the front borrowers and mortgage bankers and at the back bond investors and B Piece buyers, feel strong-armed by the dominant issuers of CMBS.
Each of the Big Four Banks (Chase, Wells, Citibank and BofA) plus Goldman Sachs and Morgan Stanley has more lobbyists in DC than any single trade association.  These banks are pushing for and likely to get new rules that will limit competition, protect their securitization profits and maximize their control of the process.  For example, the CMBS bond investors question the banks pushing for a vertical slice retention policy (a slice of each level of security from AAA to first-loss) to meet the 5% risk retention required by Dodd-Frank.  As an alternative, the bond-investors are calling for a return to the olden days of CMBS, say the 1999 to 2003 playbook - what people are calling CMBS 1.2, when there were strong B-Piece buyers who actually held the first-loss risk in the mortgage pools and actively kicked-out bad loans from the pools.
The banks have the balance sheet to meet the 5% retention requirements, which today basically means leaving in their securitization profits.  With a vertical slice the Big Bank’s retained profits will not be at risk – if the first loss piece is say 4% of the pool, 5% of that 4% is only 0.2% - a negligible amount of the Big Bank’s securitization profits.
Other Dodd-Frank regulations favoring the Big Banks: (a) Loan buy-back requirements in the proposed loan originator’s reps and warranties. (b) Planned Regulation AB changes making it hard for loan servicers with smaller balance sheets to stay in the game.

Competitive Landscape
JP Morgan/Chase had a 50%+ market share of the CMBS new issue volume in 2010.  Nothing speaks louder about the loss of competition than a single player achieving a 50%+ market share.  The Big Four US Banks, a few European Banks plus Goldman Sachs and Morgan Stanley will dominate the new CMBS world.  Many of the 20+ conduits who say they are in the market are really planning to feed loans into pools led by these few big players.

So is exuberance warranted? Does a middle seat in Economy look great after a night on a bench at Dulles Airport? You betcha.

Commercial mortgage loan restructuring - old skills, new toolbox

Standard & Poor’s reports that 354 securitized commercial real estate loans with a principal balance $15.6 billion were modified from January through November of 2010, up from 216 loans valued at $7.06 billion for all of 2009.

We can work it out…
Newmark’s Debt Advisory Group is very active working with borrowers who have existing CMBS loans that are underwater, i.e. where value < loan amount.  Since its formation in 2009, the group has achieved significant discounted pay offs (DPO’s) that have allowed properties to be recapitalized, achieving a better outcome than would have been achieved through foreclosure - for both the borrower and for the CMBS trust.

The three R’s still apply
Debt Advisory is a highly specialized area; even Newmark’s most experienced mortgage bankers do not attempt it on their own. But while the toolbox is completely different, debt advisory uses the same skills and strengths that are the foundation of a successful mortgage banker; what I call the three R’s:

1. Relationships
On the new loan production side, commercial property finance is a small community.  On the Special Servicing side it is a different and much smaller community.  There are very few Special Servicing firms and they are understaffed.  The asset managers for Special Servicers are deluged with calls from developers, brokers, and mortgage bankers all trying to get in the door to pitch their services and/or get an inside track on distressed notes and assets.  Most of these calls go unanswered and unreturned!
Ted Norman who heads Newmark’s Debt Advisory Group worked for two firms that are major special servicers and before that he ran a CMBS production shop for TIAA-CREF.  Newmarks contacts with the special servicers run through one person, so relationships build with each assignment. Ted gets his calls returned!

2. Reputation.
It is one thing to be known and another thing to be respected.  A stellar reputation is built upon years of doing business fairly, adding value for the fees earned and being reasonable.  And remember, Special Servicers are just doing their job, they want to deal with reasonable people; table pounders or those who use legal threats are best dealt with through foreclosure.  Ted gained his reputation through working to achieve and document a win-win result. He’s learned that presetting a borrower’s expectations to a realistic outcome is greatly appreciated by the Special Servicer.

3. Real Estate Knowledge.
What distinguishes top mortgage bankers is the depth and breadth of their knowledge of commercial real estate.  A gut-level knowledge of real estate values with the ability to back up these assessments with data is the most important value-add for commercial property mortgage banking.
The difference in loan workouts is that the mortgage banker is focused on distressed real estate vs. stabilized assets,   Instead of collecting the highest rent and value comps, the work-out specialist is collecting the lowest.  This glass-half-empty mind set is completely different than what is needed for new loan production, another reason Newmark created a specialized group to handle debt restructuring.

For an on-topic article by Ted Norman for the California Mortgage Bankers Association click here. 
Download Eric's CMBS workout's worksheet.