Commercial Real Estate

Finally! This issue has been neglected by the media…to think it only took George Soros to speak up about it.

from Bloomberg:

Billionaire investor George Soros said U.S. commercial real estate will probably drop at least 30 percent in value, causing further strains on banks.

“Commercial real estate has not yet fallen in value,” Soros, 78, speaking at a forum in Washington, said. “It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent.”

Soros said the risk of further declines in property prices is reason for the administration of President Barack Obama to move quickly to recapitalize banks. Soros said Obama acted too slowly on a banking overhaul and should have moved immediately upon taking office.

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Where’s Friedman Economics Right Now?

Bloomberg has had an interesting progression over the past 6 months on how Milton Friedman’s legacy is slowly diminishing – then again, who’s isn’t?

Here’s the first article, which quarrels with the principles of laissez-faire government, which were made possible through Friedman’s free market ideology – the belief that unadulterated by government policies, markets will determine the perfect prices and interest rates, based on supply and demand.

The article also goes as far as assigning Friedman some blame for the decay of our financial system:

In 1972, Friedman helped persuade U.S. Treasury Secretary George Shultz, former dean of Chicago’s business school, to approve the first financial futures contracts in foreign currencies.

Such derivatives grew more complex after Chicago economists created the mathematical formulas to price them, helping spawn a $683 trillion market that’s proved to be a root of today’s financial system breakdown.

The follow up article – written yesterday – makes some bolder conclusions:

After a three-decade run, the free-market philosophies of Friedman that shaped U.S. policy are being eclipsed by the pro- government ideas of Tobin, the late Yale economist and Nobel laureate who brought John Maynard Keynes into the modern era.

I generally like Bloomberg’s exclusives, since they’re always thought provoking. In this instance, I also agree with them; however I don’t necessarily believe that Wall Street has given up/will ever give up on Friedman Economics – it worked too well for them for 30 years.

I’m also not seeing this idea catch on anywhere else in the media, nor have I seen anyone blame Friedman the way Bloomberg does (most people are still focused on Alan Greenspan and Fannie Mae/Freddie Mac, neglecting the fact that “deregulation” is almost synonymous with the name “Milton Friedman”).

It would be naive to think we’ll have a paradigm shift back towards the ideals of Keynes/Galbraith (as these articles seem to suggest), since we haven’t yet identified the architect of the problem on a broad enough level – although I think Friedman is a good place to focus a lot of our criticism.

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Paulson’s Plan For 2009

Of course I’m referring to John Paulson (since Hank no longer matters), the guy who turned $500 million into $3.5 billion in a single year (2007) by shorting sub-prime mortgage backed securities through buying credit default swaps.

The New York Times received a copy of his year end letter, which gives his guidance for 2009…the NYT website won’t allow me to embed the letter, so here’s the link if you’re curious.

Since the report is 28 pages long, here’s some abridged analysis via Paul Kedrosky:

Looking forward to 2009, Paulson remains highly bearish. Here is his general strategy, he says, for the first half:

• Slight short exposure to equity markets
• Remain short financials
• Focus on long distressed opportunity
  • Mortgages
  • Bankrupt debt
  • Distressed
  • Capital restructurings
• Focus on strategic merger deals
• Maintain short focus on financials, with the belief that we only perhaps half-way thru

To remain short financials, he must believe on some level that a nationalization is in the cards to wipe out the equity of troubled banks. That’s not to say that nationalization is the only shoe left to drop, since rising unemployment is likely to go hand in hand with continued mortgage defaults, along with the potential for more trouble in commercial real-estate.

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Option ARMs

Via The New York Times:

As shown by the graphic, Wachovia was one of the biggest players in Option-Adjustable Rate Mortage origination – mainly because they acquired several banks which specialized in this field.

The article itself contains a very thourough history of how “Option ARMs” came into existence, and how they are predatory by nature:

“I don’t think anyone thought a Pick-A-Pay product was a customer friendly product,” says a former Wachovia executive who requested anonymity to preserve professional relationships. “It is easy to mislead them.”

Nice.

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“The Crisis & What to Do About It”

George Soros wrote an Oped in The New York Review of Books over the weekend, which provides updated analysis of his most recent book, The New Paradigm for Financial Markets. It is very comprehensive, and does a good job explaining how past credit crises have culminated into this greater economic turmoil (and pretty much summarizes his entire book for free). It’s a seemingly long piece, but the complexity of this crisis would be difficult to describe in a briefer fashion. Here’s a bit from the article – which is an insight as to how he views the role of what Warren Buffet would call “geeks with their models”:

Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and “managing” risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion.

The clear drawback in attempting to model the behavior of financial markets is that all results are grounded in the past; despite this glaring inefficiency, we continually revert back to their use in order to quantify risk. From the Financial Times:

When banks extend credit to hedge funds, they often use so-called “value at risk” models (VAR) to measure the risks attached to such loans. These models typically assess the riskiness of an asset by measuring how its market price has moved in the past.

During the Great Moderation, this approach cast a fabulously flattering light on the investment world, creating the impression that it was safe for banks to extend massive volumes of credit to hedge funds. Moreover, since banks typically use VAR to measure the risk attached to their own assets too, these models also seduced banks into feeling complacent about their own risks.

It would be ridiculous to say that models shouldn’t be used in the world of finance, however it’s clear we have become overly dependent on what they produce, particularly in trying to extrapolate characteristics which have often led us into problematic scenarios.

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“Massive Effort to Save Mortgages”

From the WSJ:

J.P. Morgan Chase & Co. launched an ambitious plan Friday to modify the terms of $70 billion in mortgages for borrowers who are behind on their payments or soon could be.

The move by the New York bank will cover as many as 400,000 borrowers. They’ll be moved into loans carrying lower interest rates, smaller principal amounts or other more-affordable terms.

This is great news…They must have figured that these high yielding, Option Adjustable Rate Mortgages aren’t worth too much if the borrowers default on the mortgage. Option ARM’s are particularly toxic since they allow the borrower to make a minimum payment which may not even cover the due interest – resulting in a higher loan balance (which accrues more interest over time).

The changes will particularly focus on a type of loan structured in such a way that the borrower’s outstanding balance sometimes grows month after month. J.P. Morgan inherited $54 billion of such loans with its takeover of the beleaguered thrift Washington Mutual Inc. in September.

The article goes on to point out that Wachovia had $120 billion worth of these exposures from their purchase of Golden West Financial, and that they had initiated the process of restructuring the terms of the loans. It is a smart step in making sure that home owners will be able to eventually pay down their principle; the last thing these banks want is an increase in mortgage defaults – therefore reducing mortgage interest rates is necessary in preventing this from happening. Now that the Government has replenished some of the lost capital in the banking system, giving the bigger banks as much as $25 billion, don’t be surprised to see Bank of America, Wells Fargo, and Citi follow JP Morgan’s footsteps.

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