Five Insights with Morris Davis
Jody & Joan asked economist Morris Davis — former advisor to Alan Greenspan in his "previous life" with The Fed, now a professor at UW-Madison's Real Estate School — to "grade" the Federal Government's response to the recession, and to tell us where we're at. Here are brief excerpts of his answers when asked if the commercial construction meltdown could cause the next huge recessionary dip — and trigger bank failures — in the next 18 months.
What's going on with commercial building loans?
I'm actually an optimist about the U.S. economy … [but] if you wanted to be a bear, you could say that we are about to have an enormous shock to the banking system caused by impending defaults of about $400 to 500 billion worth of commercial mortgages.
What I've been told is going on is that banks and borrowers alike are just choosing to pretend that's not true. The way commercial mortgages works is that typically there is a five-year balloon payment. In 2007, you put 20% down. Today, you put 40% to 50% down (thank you FDIC and Fannie Mae).
Either way, there was a five-year balloon, and in five years' time, you just paid off the debt. The 2006 and 2007 mortgage payments are coming due.
Could that shock close some banks?
It's possible. There is this old saying in economics that if you anticipate something in the future, you should be able to respond to it today so that when the event actually arrives, it shouldn't be that big a deal.
We've had about three years to prepare for the fact that all these bad mortgages are going to come due soon … though, using the same argument, the Feds told everybody they were going to let Lehman Brothers go down, but I guess nobody believed them.
Why would construction companies default on loans?
Let's say in 2006, you closed on a building valued at $100. You had to put 20% down, so that was $20 equity, $80 debt. That building today might be valued at $50. Suppose your balloon payment comes due today — the bank calls you up on the phone and says, "Okay, if you want to keep the building, give me my $80 debt or roll it over." Why would you pay $80 for a building worth $50? No one would do that. Doesn't matter if it's fully leased. The market price is $50, so here are the keys.
The bank may then auction off the building or try to find a buyer. Who knows what the ultimate price would be if the bank had to dispose of it quickly? $40?
I've been told one thing going on is called "extend and pretend." It's as if the bank underwrites a new loan and kind of ignores the fact that the building is underwater. The bank has two options: it can say, "Give me my $80" — which it knows that will never happen — or it could say, "Okay, I'm just going to give you another five years. The building is worth $50, [but] you don't have to pay that $80 for another five years, and I'll give you the interest rate that you had."
I think this makes sense to the person that owns the building, as long as the income coming in is higher than their debt service. They move to a situation where they get some positive cash flow for the next five years, and could just hope that the economy recovers or prices recover.
Of course, prices aren't going to recover in five years' time, so all we are really doing is pushing this problem down the road.
That's actually unfair for two reasons. First, if you happen to be lucky enough to own the building and have a bank they didn't want to show bad assets on its balance sheet, then you get a loan underwritten at a [premium] loan-to-value ratio — an loan worth more than the building. That's unfair to [other] people trying to get loans who can't because these banks have all these bad assets on their balance sheets.
I think pretend-and-extend is just untenable if we believe that commercial real estate prices are not going to recover in the next five years.
I suspect we'll wind up with something that looks like another Resolution Trust Co. for people who have cash who are willing to buy these assets cheaply. But you have to ask, "If the current market value is $50, who could pay $50 [cash]?"
But this is being the pessimist. We've had three years to prepare for this. Maybe the good idea is for innovation [of private enterprise] to cause growth. Maybe that can occur despite the fact we're developing another sizable hole in the financial sector.
It takes liquidity to finance innovation. With stressed Angel and Venture funds, and restricted access to bank loans, where is the money for innovation going to come from?
So your question is: Where do investment dollars come from if they're not debt-financed? And the answer is, maybe we should do more equity financing … but we're all so stretched that we can't create an equity fund.
So I admit this is a problem. If you want to be a bear, you just point to this commercial real estate side and say, "We have another massive crisis about to hit the financial sector."
How would you grade Federal Reserve Chairman Ben Bernanke's performance?
A "B" with some caveats. He bailed out AIG, to which I was squarely opposed, but I understand why. On the other hand, [he was] very creative with what appears to be risk-free debt. He basically guaranteed all classes of debt; I think there was a healthy appetite for risk-free debt after the financial crisis.
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