admin on June 26th, 2009

Much of the US’s current energy policy is based on a perceived shortage of natural gas during the 1980′s.  The shortage was actually one of an inadequate distribution system that prevented transportation of adequate quantities of natural gas to Ohio and several states in the Northeast during an unusually cold winter.  The distribution inequities resulted in the US congress passing laws that made it very difficult for electric generation from natural gas, resulting in increased emphasis on coal. 

The US natural gas market is now in an oversupply condition, with several analysts expecting inventories to reach the maximum capacity of 3.9 trillion cubic feet later this year.

Today, LNG (natural gas that is transported on the high seas in liquid form by cooling it to a liquid state) represents about 28% of internationally traded natural gas.  In 2005 LNG was about 7% of world’s natural gas demand[1]. Processing and shipping costs from Qatari to the US are estimated at $2 per million British Thermal Units (BTU).  Qatar has the largest capacity for creating LNG, followed by Egypt, Algeria and Zimbabwe.  Japan, South Korea, Spain, France, Italy and Taiwan use significant users of LNG.  In the US, there is an existing LNG port off of Louisiana, and large LNG ports have been proposed near Long Island, Main, and the Texas/Louisiana Gulf Coast area, but are receiving significant opposition from environmental groups. 

“The average U.S field requires a Nymex natural-gas price of $7.79 per million BTU’s to earn a 10% return on capital.”  The current Nymex price is about $4 per million BTU, future prices are close to $6 per million BTU.[2]

In June, 2009, the Potential Gas Committee (a non-profit agency of the Colorado School of Mines) released a report suggesting that there has been a 35% increase in the year end estimate of natural gas reserves at the end of 2008 when compared with 2007.  The “United States possesses a total resource base of 1,836 trillion cubic feet (Tcf). This is the highest resource evaluation in the Committee’s 44-year history. Most of the increase from the previous assessment arose from reevaluation of shale-gas plays in the Appalachian basin and in the Mid-Continent, Gulf Coast and Rocky Mountain areas.”[3]

Given that the Congress is again tinkering with US energy policy (HR 2454 by Waxman/Marley), it is hoped that they take into account these various economic factors when developing a new policy. 




[1] Cook, Linda. “The Role of LNG in a Global Market” Oil and Money Conference, London, September 21, 2005 (downloaded: June 26, 2008 from

[2] Demning, Liam. “Exxon Mobil’s Weapons of Gas Destruction” Wall Street Journal, June 28, 2009 p c12

[3] Potential Gas Committee, “Potential Gas Committee reports unprecedented increase in magnitude of U.S. natural gas resource base” Golden, Colorado, June 18, 2009 (

admin on May 5th, 2009

There are several signs that the credit markets, especially for Commercial Mortgage Backed Securities (CMBS) have started to unfreeze.  The most definitive signal came on May 1, 2009 when the Federal Reserve modified the Terms and Conditions of their Term Asset-Backed Securities Loan Facility 1 (or TALF).  Starting June 2009, the Federal Reserve has authorized TALF loans with maturities of five years (up from the original one to three years).  That TALF program includes CMBS and securities backed by insurance premium finance loans as eligible collateral.  

 Insurance premium finance loans are extended through the Small Business Administration to small businesses for obtaining property and casualty insurance.  The loans, which are typically funded through the sale of asset-backed securities, had become very expensive since the disruption of the markets in late 2007.

 TALF was initially launched as a $200 billion program for the purchase of new auto, student and small-business loans, with terms of one to three year.  However, later the Treasury announced its plans to expand to facility to $1 trillion and also to include commercial mortgage-backed securities, residential MBS and for purchase of legacy assets under Public-Private Investment Program (PPIP).  The inclusion of CBMS and insurance premium finance loans in TALF is expected to ease the flow of credit in these markets.

The revised program stipulates that covered loans (among other things):

  • must have been made after July 1, 2008,
  • be fully-funded, first-priority mortgage loans that are current in payment at the time of securitization
  • Fixed rate (no interest only)
  • At the time of securitization, the CMBS must receive the highest long-term investment-grade rating category from more than one credit rating agency 
  • No CMBS may have an average life beyond ten years
  • Each TALF loan secured by a CMBS will have a three-year maturity or five-year maturity, at the election of the borrower.
    • A three-year TALF loan will bear interest at a fixed rate per annum equal to 100 basis points over the 3-year Libor swap rate. 
    • A five-year TALF loan is expected to bear interest at a fixed rate per annum equal to 100 basis points over the 5-year Libor swap rate
  • The collateral haircut for each CMBS with an average life of five years or less will be 15%.  For CMBS with average lives beyond five years, collateral haircuts will increase by one percentage point for each additional year of average life beyond five years.

Based on the above stipulations, it could be concluded that the TALF program is not meant to help banks clean up their balance sheets, but rather to unfreeze CMBS markets for future projects. 

Based on articles in the Wall Street Journal on May 3, it appears that these changes may be working, when it was reported that a small group of investors led by JP Morgan Chase & Co., put together a $5 billion bond offering backed by credit-card loans that is eligible for the program, sold at 1.55% over the LIBOR rate.  Based on advanced registrations, the WSJ expected about $10 billion in offerings to be made in May.2

The success of these programs is made more important when considering that the results of the April 30, 2009 “Stress-Test” suggest that in a worst-case scenario, the 19 largest US banks are expected to see losses of up to 12% on commercial real estate loans over the next two years.3  The same article noted that Moody’s Investors Service said that it downgraded $52.9 billion in commercial mortgage collateralized debt obligations that were part of a $83.1 billion portfolio under review. It was also noted that close to 3,000 banks and thrifts had commercial real estate portfolios that exceed 300% of their total risk-based capital.

1Federal Reserve Bank of New York. “Term Asset-Backed Securities Loan Facility (CMBS): Terms and Conditions” Effective May 1, 2009, downloaded May 3, 2009
2Shrivastava, Anusha and Michael Anerio. “Program to Unfreeze Credit Receives a $10 Billion Boost” The Wall Street Journal. May 5, 2009 p C1
3Wei, Lingling. “Small Banks Face Hits on Commercial Real Estate” The Wall Street Journal. May 5, 2009 p C1

      How many of you knew the $700 Billion TARP (Troubled Asset Relief Fund) – was all but abandoned by now former Treasury Secretary Henry Paulson within a month of deploying, but not before about ½ of the funds were used to bail out CitiGroup and the insurance group AIG, among others.  And neither the TARP, nor its successors (the TALF and P-PIP) are successfully addressing the Commercial Mortgage Backed Securities Market. 


       The US’s new bailout plan is the $800 Billion TALF (Term Asset-Backed Securities Loan Facility), primarily sponsored by the Federal Reserve, is funded by printing money.  With this new bailout program the Federal Reserve will purchase loans in two consumer based categories:

  1. Consumer loan guarantee program designed to help deal with defaulting consumer debt from auto loans, credit-card debt, and student loans, in which the Federal Reserve will allocate $200 billion to essentially insure the debt if a borrower defaults. Treasury department will provide $20 billion from the $700 billion the TARP fund to reimburse the Federal Reserve for any losses.
  2. Residential Mortgage program will purchase up $600 billion in debt and mortgage-backed securities from Fannie Mae, Freddie Mac, and Ginnie Mae, the three government-sponsored finance firms established to promote home ownership.

       Under the TALF program, the Federal Reserve Bank of New York will make non-recourse loans to issuers of asset-backed securities (ABS) with investment-grade ratings from at least two nationally recognized rating organizations.  Also available for purchase would be small business loans guaranteed by the Small Business Administration.  Substitution of collateral during the term of the loan will not be allowed. TALF loans will have a one to three year terms, with interest payable monthly. The term of TALF loans may be lengthened later if appropriate. TALF loans will not be subject to mark-to-market or re-margining requirements.  The TALF Fund is scheduled to stop making loans on December 31, 2009, unless the Board agrees to extend the facility[i]

     The Federal Reserve Bank of New York will pay for the securities by simply making a bookkeeping entry that unilaterally increases a member bank’s cash position with the Fed, thereby increasing the nation’s money supply.  When the economy recovers, the Fed will decrease the money supply by selling the securities back on the open market. 


      On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced a two part, $500 Billion Public-Private Investment Program (P-PIP) to buy so-called toxic assets from banks’ balance sheets.

  1. Legacy Loan Program will purchase residential loans with the FDIC providing up to 85% loan guarantees. Private sector and the US Treasury will provide additional support.
  2. Legacy Securities Program, will purchase investment grade securitized mortgages (RMBS, CMBS and ABS) with funding split 50% from TALF and 50% from TARP.

       The stated goal of this Public Private partnership program is to restart the market for legacy securities, allowing banks and other financial institutions to free up capital and stimulate the extension of new credit[ii]

So, How are things going so far? 

      The Federal Reserve started purchasing commercial paper in October 2008 in an attempt to unfreeze the credit market.  The Fed has said that up to $1.3 trillion in commercial paper could qualify for one of its programs.   The purchase of Government Sponsored Enterprise (GSE) mortgages from Fannie Mae, Freddie Mac and Ginnie Mae started January 5 in an attempt to bolster the housing market.  


Federal Reserve Assets
(Average for the week in $ billions)[iii]

Week Ending Wednesday (2009):   April 15   April 8

Commercial Bank 

$      48.5 $      49.2

Investment Firm 

$     12.9 $      17.6

Net Holdings of Commercial Paper 

$    250.2 $    349.0

Net Holdings of Residential (GSE) Mortgages 

$    287.2 $    236.6

Total Assets 

$ 2,098.0 $ 2,068.8

       The assets on the Federal Reserve balance sheet have more than doubled since the Fed started its emergency lending programs in October 2008. As the assets of the Fed increase, so does the nation’s money supply. According to the Quantity Theory of Money, inflation occurs when the growth in the velocity of money (number of times a dollar is used in a year) times the quantity of money exceeds the growth in industrial productivity.  There is evidence that the credit freeze has drastically reduced the velocity of money, so the impact of the increase in money supply will not be as inflationary as some expect.  Fed Chairman Ben Bernanke repeated assurances that the Fed will reduce the money supply correspondingly when economy recovers. 

        To date, these programs do not seem to be as successful as hoped.  The  Federal Reserve is currently considering how to further expand the programs to cover commercial mortgage backed securities (CMBS).  However, to be effective, these commercial loans would need to have terms of five years or more.  The Feds are concerned that loans of these longer terms will interfere with their ability to withdraw credit and raise interest rates when the economy recovers.  The real estate market is concerned that without the source of funds traditionally provided by the CMBS, as a record number of commercial loans become due between now and 2012, real estate prices will be depressed and defaults rise as borrowers are unable to refinance loans.[iv]   

[i] “Term Asset-Backed Securities Loan Facility (TALF) – Terms and Conditions” Federal Reserve, November 25, 2008.

[ii] “Public Private Partnership Investment Program Fact Sheet” US Treasury, March 23, 2009

[iii]Crutsinger, Martin “Banks, Investment Firms trim borrowing from Fed” The Journal Record (Associated Press) April 17, 2009 p 13A

[iv]Hilsenrath, Jon and Lingling Wei, “Fed Looks Long Term for TALF” The Wall Street Journal, April 17, 2009, p C-2

On April 17, the EPA Administration issued a “proposed endangerment finding” and a related proposed “cause or contribute finding” regarding greenhouse gases under section 202(a) of the Clean Air Act (section dealing with “Emission standards for new motor vehicles or new motor vehicle engines” [i]).  These findings are proposed and the endangerment finding now enters the public comment period, which is the next step in the deliberative process EPA must undertake before issuing final findings.[ii]

  1. Proposed Endangerment Finding – “the current and projected concentrations of the mix of six key greenhouse gases-carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and sulfur hexafluoride (SF6)-in the atmosphere threaten the public health and welfare of current and future generations”
  2. Proposed Cause or Contribute Finding – “the combined emissions of CO2, CH4, N2O, and HFCs from new motor vehicles and motor vehicle engines contribute to the atmospheric concentrations of these key greenhouse gases and hence to the threat of climate change.”

 The Proposed Findings will be published in the Federal Register and available in the Docket ( under Docket ID No. [EPA-HQ-OAR-2009-0171].  Before becoming final, there is a 60 day period for public comment, beginning after the date published in the Federal Register.  Further information on the Findings may be found from the EPA website (

 It would seem that the scope of the “proposed endangerment finding” is greater that was anticipated by the original 2007 Supreme Court ruling that initiated the process.  While the findings do not in and of themselves initiate any automatic rules, and the establishment of formal rules to implement the findings could be years away, its impact could be considered revolutionary.  The Wall Street Journal notes “Unless superseded by congressional action, the EPA ruling eventually could lead to stricter emissions limits.  Business that stands to be affected range from power plants and oil refineries to car makers and cement producers.  <ref> Weisman, Jonathan and Siobhan Hughes. “US In Historic Shift on CO2″ The Wall Street Journal, April 18-19, 2009 p-1.</ref>

 It should be noted that CO2 is not in-and-of-itself declared to be a pollutant. Rather its increase is said to be problematic to the “public health and general welfare of current and future generations.”  Research suggests that the greenhouse gasses described above tend to have an insulating effect in the atmosphere; the greater the greenhouse gas, the more heat is trapped.  The EPA endorsed the Intergovernmental Panel on Climate Change (IPCC) which concluded that natural variations such as solar activity could not explain raising average temperatures.  <ref> Johnson, Keith “How carbon Dioxide Became a Pollutant’” The Wall Street Journal, April 18-19, 2009 p-4</ref>

 It is anticipated that there will be increased interest in Emissions Trading, also known as Cap & Trade, as a result of this EPA ruling.   In addition to the automotive industry, this ruling has the potential of impacting the way buildings are operated (air conditioning and heating buildings can account for up to 50% of the cost of a building’s operation), the way we manufacture goods, they way we travel, and the way we grow food.  

The EPA suggests that the implementation of future rules will lead to increased employment.  The real question that should be asked is a bit more complex and is how the potential rules will impact productivity, i.e. will the new rules lead to a more efficient delivery of goods and services.  

Since cows are a major producer of CO2, will the EPA start regulating feed lots?  Since humans are a major producer of CO2, will the EPA start regulating population growth? 

 [i] US CODE, Clean Air Act, Title II – Emission Standards for Moving Sources

[ii] Environmental Protection Agency publication “Proposed Endangerment and Cause or Contribute Findings for Greenhouse Gases under the Clean Air Act”



     As a sign of the times: when does a real estate company with increasing Net Operating Income and a 92.5% average occupancy rate need to file for Bankruptcy? 
     The answer: when the company is General Growth Properties (GGP) 
GGP is a Real Estate Investment Trust with a complicated capitol structure including mortgage debt linked to specific properties and subsidiaries, and largely unsecured corporate debt largely linked to the 2004 purchase of the Rouse Companies for $14.2 billion.   
On April 16 (the day after tax day), GGP along with 360 other subsidiary companies filed for Chapter 11 bankruptcy protection in the US Bankruptcy court in Manhattan (Southern District of New York, No. 09-11977), listing listed total assets of $29.56 billion and total debts of $27.29 billion.  Kurtzman, Carson Consultants, has been hired to aid in the Bankruptcy (  
According to the GGP’s website (, the bankruptcy includes 169 operating retail, office and master planned community properties, including Sooner Fashion Mall ( in Norman and Washington Park Mall ( in Bartlesville.  An additional six properties under development were also included in the bankruptcy filings. 

 Not included in the Bankruptcy filings are 91 operating retail, office, master planned communities and development properties, including Quail Springs Mall ( in Oklahoma City.  Also not included in the filing are 24 properties managed by GGP.  The management company that manages the GGP properties was not included in the Bankruptcy filing.

 Chief Executive Adam Metz said in a conference call on April 16, that after the credit crunch hit last October, several major properties were considered for sale, and several offers were made, but none were accepted.  GGP’s fundamental business model is very sound, the average occupancy of the properties is 92.5%, almost the highest in the company’s history, and operating profits were higher in 2008 than in 2007.  Metz said that the primary consideration in the bankruptcy filing was the capital structure of the properties; those properties that had already had their loans restructured were not included in the filing. Properties that are in partnership with institutional investors are not included in the filing.  With the bankruptcy filing, the company will also be relieved of the dividend payout requirements the tax code currently mandates of REITs. 

Debtor in possession financing of $375 million by Pershing Square Capital LP, as agent, has been secured.  Pershing Square is a hedge fund run by William Ackman, who also has purchased about 25% of General Growth Properties since last October.  Ackman has expressed an interest to the company about joining the GGP board of directors.

 Reuters reported that at the end of 2008, GGP had about:

  • $15.17 billion of General Growth’s debt was comprised of mortgage loans that had been securitized into commercial mortgage-backed securities 
  • $1.18 billion in past due debt and an additional
  • $4.09 billion of debt that could be accelerated by its lenders. 

 Reuters also reported that earlier GGP had been negotiating the restructure $2.25 billion of Rouse bonds, offering bondholders a percentage on their bonds if they allowed the company to skip interest payments and principal until the end of the year. The necessary support it needed to restructure the debt was not obtained.  Another factor in the Chapter 11 filing seems to be an April 15 auction, where credit default swaps insuring the Debt of the Rouse company unit were found to be worth 29.25% of the debt they insured. Payments on the contracts were triggered after the GGP failed to pay more than $2 billion in debt due on March 16.

This bankruptcy is a result of the October Lehman Brothers surprise, the credit markets have frozen. 

Metz concluded the conference call by saying that interest on unsecured bond debt will not be paid but that mortgage interest will be paid.  Metz also said that it is not GGP’s ambition to be smaller.   Based on the business plan, the basic component of the restructuring, there is not an intent to sell any of the iconic properties.  Rather the focus of the restructuring will be to stretch out the maturity of debt and increase the company’s capital structure. 

Is this the first shoe to drop in the commercial real estate market meltdown?

admin on April 6th, 2009


 Since 1901, short-term interested rates have risen above long-term rages (inverting the “yield curve”).  Each time this yield curve inversion lasted longer than 11 months, the US entered a recession.  There have been four recessions without an inverted yield curve, typically at the end of a war.  Additionally, the policies of the Federal Reserve has, at least, partially caused all major recessions since 1900.

 The yield curve was inverted from the middle of 2006 and lasted until August 2007 with the financial panic started.  As a result of the panic, during 2007, the Federal Reserve increased assets on its balance sheet (i.e., increased the money supply) from $800 billion to $2.5 trillion. 

In 2009, the global poverty level standard is under $1.10 per day.  In 2000 it is estimated that 20% of the world population lived below the poverty level, and another 20% lived below $2.00 per day.  By 2007, it is estimated that 35% of the world’s population lived below $2.00 per day.  

There are two primary classes of tools that the Federal Government can use to combat recession:

  1. Fiscal Policy – the use of government spending and revenue collection to influence the economy, determined through the legislative process
  2. Monetary Policy – impacting interest rates and changing the supply of money to influence the economy, primarily at the direction of the Federal Reserve and its Federal Open Market Committee

 Note: Fiscal and Monetary policy are independently determined within the same political environment, and can either work in concert or counter-productively. 

Housing Bubble[2]

Economic bubbles occur when there is speculation in a market characterized by high transaction volumes at prices that are considerably at variance with the asset’s intrinsic value.  It is arguable that there are two primary and interrelated causes for the current recession, a housing bubble that was aggravated by lax credit standards in the mortgage backed securities market.    The current housing bubble seems to have started around 1997 with the elimination of capitol gains taxes on the first $500,000 on the sale of a home.  Since both the Clinton and Bush administrations aggressively pursued a social/political goal of expanding homeownership, at the time of the 2001 recession, credit standards eroded.  Lenders and investment banks that securitized mortgages used rising property prices to justify loans to buyers with limited assets and income.  Rating agencies overlooked their fiduciary duties and provided credit reports needed for their clients (the issuers of securitized mortgages) to sell their mortgage backed securities to investors looking for high rates of return.  

 Housing expenditures in most of the developed world have traditionally taken up about 30% of household income.  When the price of housing in the US doubled without a corresponding increase in household income, warning signs of a housing bubble started to emerge, but were largely ignored.  Monetary policy, tax-free capital gains, and lax lending standards lead to an average 56% annual increase in loan originations from 2000 to 2003, from $1.05 trillion to $3.95 trillion over those three years. 

 In 1983 the Bureau of Labor Statistics started using rental equivalence for home-owner-occupied units instead of direct home-ownership costs.  That direct home ownership costs were not a factor in the Consumer Price Index added to a false sense of security.  For example, in May 2004 the Case-Shiller 20-city composite index of single-family housing prices had increased 15.4% during the previous 12 months, but the related CPI housing component had increased only 2.4%.  Estimates are that resulting inflation was underreported by as much as 3%.

 To maintain transaction volume in light of higher housing prices, many lenders started issuing subprime loans to people of questionable financial status, and also started issuing interest only and Adjustable Rate Mortgages (ARM).  Sometime in 2006 the housing price increased to a point that they were no longer able to sustain the flow of new buyers, and the inevitable crash started. 

 This Recession Officially began December 2007[3] 

Industrial Production - Recession
Industrial Production – Recession

The panic started on August 9, 2007, when the French bank BNP Paribas (at the time, with assets in excess of $1.3 trillion, one of the 10 largest in the world) announced that shareholders in three mutual funds that it managed could not redeem their shares because the mutual funds owned bonds based on U.S. subprime mortgages that could not be valued at that time. At the time about 56% of all US debt was held by foreigners.Since February 13, 2008, government policy has committed $8 Trillion in fiscal stimulus.

 Lessons learned from Milton Freedman concerning Monetary Policy:

  • Inflation is always and everywhere a monetary phenomenon
  • Changes in monetary policy are seen in the markets with a varying degree of time lags, never quicker than 1 year nor longer than 3 years, with a 2.5 year average – the current relaxing of monetary policy started in September 2007, which suggests that the impact from lower interest rates and increased money supply will not appear until 2010 to 2011. 

 Construction Spending

 Many conservatives suggest that the current fiscal policy (the deficit spending) including (HR 1) the $787 billion American Recovery and Reinvestment Act of 2009 ( will be inflationary.  The package contains $288 billion in tax cuts, including $36 billion to subsidize locally issued bonds for school construction, teacher training, economic development, and infrastructure improvements.  There is about $43.6 billion for R&D, and technology upgrades for the Internet and other government and health care information systems.  $135.3 billion in spending for construction, deferred maintenance, and energy efficiency.  The remaining expenditures (about $320 billion) are in the form of supplemental government operating costs, and social program transfer payments such as income subsidies, and earmarks that are (at this time) difficult to identify. 

 Total construction spending in the US was $1.08 trillion in 2008, only 5.1% less than the $1.14 trillion spent in 2007.  Based on the author’s review of The American Recovery and Reinvestment Act of 2009, the bill contains about $133.8 billion in construction spending including $5.6 billion for military and homeland security projects, $4 billion for health care, $5 billion on energy infrastructure, $27.6 billion in energy efficiency and building deferred maintenance, and $4.8 billion in other government construction.  Other additional spending can be seen in the table below, which also contains total construction spending estimates in the US for 2007 and 2008.  

(in Billions) Total Construction Residential Education Highway Sewage & Water
2008 $1,080.0 $358.4 $85.5 $80.7 $41.4
2007 $1,140.0 $455.8 $78.8 $75.5 $39.3
Reinvestment act of 2009 $   135.3 $  24.9 $  2.9 $49.6 $10.9

 The American Society of Civil Engineers has released a “Report Card for America’s Infrastructure” ( and estimates the need for $2.2 trillion in spending over the next five years to get airports, bridges, dams, highways, schools, etc. up to modern standards. 

 It is suggested that the spending on infrastructure/construction ($135 billion) and spending on R&D, and information technology ($44 billion) should be treated as investments that will have different multiplier effects on the economy than would Transfer payments ($320 billion) authorized in the appropriation.  

 What’s Next?[4]

 Bubbles are typically followed by Panic.  It is arguable that a significant difference in the current recession vis-à-vis other recent recessions is the degree that the declining assets have been leveraged.  For example, the dot.Com bubble assets were primarily held by institutional and individual investors that either owned the assets outright, or only a small fraction of the value was purchased on margin, so losses were absorbed by the investor.  In this housing bubble, between 90% and 100% of the asset has been mortgaged (purchased on margin).  Losses are absorbed not only by the owner (investor) but also the lending institutions (investment banks, investors in mortgage-backed-securities, sellers of credit default swaps), and the issuer of last resort, the US Treasury.  

 Durable Goods Consumption

In a paper published in 1983, Ben Bernanke, current chair of the Federal Reserve, argues that one of the primary reasons the Great Depression was so “great” was that the financial system failed in its ability to perform its economic role of lending to households for durable goods consumption and to firms for working capitol for production and trade.[5]  It is arguable that we are seeing a similar problem with today’s recession.  Auto sales have fallen 41% between February 2008 and February 2009.  It is also estimated that a significant number of the retail closings before Christmas were a result of not having the working capital to purchase inventory, rather than stores that were not profitable. 

 Savings Rate

personal savings rateSavings it typically defined as defined as personal disposable income minus personal consumption expenditure.  It has also been theorized that savings rate (or spending) is influenced by perceived wealth – the value of a person’s home, for example.  In an economy based on consumption, that has seen it savings rate based an increase in the savings rate, there will be a reduced economic activity in the short term, because of reduced consumer goods expenditures, which is typically funded by disposable personal income. 


 It appears that “a financial crises that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system.  It appears that we are witnessing the second great consumer debt crash, [of the past 100 years], the end of a massive consumption binge.”[6] 


 [1] Smith, James F. “The World Economy is a Mess, But Oklahoma’s OK” Keynote Address at: “CREC Forecast 2009 Conference”, March 3, 2009 Skirvin Hilton, Oklahoma City, OK. 

[2] Gjerstad, Steven and Vernon L Smith “From Bubble to Depression?” The Wall Street Journal, April, 6, 2009 p A15

[3] Smith, ibid

[4] Gjerstad, ibid

[5] Bernanke, Ben S,  “Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression,” American Economic Review, American Economic Association, vol. 73(3), pages 257-76, June, 1983.

[6] Gjerstad, ibid

admin on April 3rd, 2009

The concept of Mark-to-Market accounting that establishes “fair value” for a company’s assets is generally defined by FASB Statement 157 – Fair Value Measurements, the following revisions are effective March 15, 2009. 


Statement 157 was issued in September 2006, primarily as a result of the problems surrounding the failure of the Enron Corporation.   The original purposes of the statement were to establish a single definition of fair value and a framework for measuring fair value in generally accepted accounting principles (GAAP), and describe disclosures about fair value measurements that were intended to provide quality information to users of financial statements.

 The “fair value” concept is defined by saying “A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).”

 The notion that a price for a forced liquidation or distress sale does not represent fair value is also discussed in paragraphs 10 and 17 of Statement 157.

Reasons for Modification of FASB Statement 157

The problem with the then existing interpretation of Statement 157 was that fair value hierarchies stated in the statement may be interpreted to use the concept of a “last transaction price” as the basis for establishing fair value, even when there is evidence that the market may not be functioning properly.  

Additionally, the Emergency Economic Stabilization Act of 2008 mandated a study of the Mark-to-Market accounting standard.  The Securities and Exchange Commission agreed that there should be additional modifications made to the standard. 


The Financial Accounting Standards Board modified rules, providing guidance to help determine whether a market is not active and a transaction is not distressed, by establishing a two-step process of evaluation.  The reporting entity is given considerable latitude in this two step process. 

 Step 1: Is the Market Active?

The reporting entity makes the determination of whether or not a market is active based on the significance and relevance of a variety of factors, including but not limited to the following:

  1. Few recent transactions (based on volume and level of activity in the market). Thus, there is not sufficient frequency and volume to provide pricing information on an ongoing basis.
  2. Price quotations are not based on current information.
  3. Price quotations vary substantially either over time or among market makers (for example, some brokered markets).
  4. Indexes that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values.
  5. Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared with reasonable estimates (using realistic assumptions) of credit and other nonperformance risk for the asset class.
  6. Abnormally wide bid-ask spread or significant increases in the bid-ask spread.
  7. Little information is released publicly (for example, a principal-to-principal market).

 Step 2: Does the Quoted Price represent a Distressed Transaction?

After making a determination that a market is not active, the reporting entity must assume that a quoted price is distressed unless there is evidence that both:

  1. There was sufficient time before the measurement date to allow for usual and customary marketing activities for the asset; and
  2. There were multiple bidders for the asset.

 If the reporting entity concludes that the quoted price is distressed, then other valuation techniques, such as income approach, should be used to establish fair value.  Variables used in the present value calculations should represent an assumption of an orderly transaction between market participants as well as reflect risks inherent in the asset.  A reasonable risk premium should take into account the ”uncertainty that would be considered in pricing the asset in a non-distressed situation.”

Impact on Mortgage-Backed Securities
 According to an article in the Wall Street Journal, this new rule “says that once an asset is other than temporarily impaired, only losses related to the underlying creditworthiness would affect earnings and regulatory capital. Losses attributed to market conditions would be disclosed and accounted for elsewhere.”  It is thought that this would help unfreeze the mortgage-backed securities market, which has seen little activity in trading of these securities. 

FASB Staff Position on FSP FAS 157-e
Scannell, Kara “FASB Eases Mark-to-Market Rules ” Wall Street Journal Online Edition, April 2, 2009

The following was originally written to be distributed to the members of Central Oklahoma’s Realtor’s Commercial Alliance (RCA), based on presentations at the National Association of Realtor’s 2008 Annual Conference in Orlando.

The problem of securitization of mortgages (so called toxic securities) is still a significant issue for both residential and commercial real estate markets.  The current freezing of the credit markets can be traced to the securitization of mortgages (both commercial and residential) whose securities received higher credit ratings than they should have.  When the mortgage default rate of the securities increased from the normal 0.5% to just under 20% for the so-called sub-prime group, the market value of the securities significantly dropped. 

This drop in market value for some mortgage backed securities has lead to catastrophic situation for Lehman Brothers as well as other financial institutions.  How these situations were created and what we can do about it was a topic of the National Association of Realtor’s November 2008 Annual Meeting in Orlando.

Federal Housing Finance Agency

On November 7, 2008 at the National Association of Realtor’s annual meeting in Orlando, James B Lockhart, III, Director of the Federal Housing Finance Agency, gave an update on Fannie Mae, Freddie Mac, and the Federal Home Loan Banks

 The Federal Housing Finance Agency is a newly created independent federal agency created by the Federal Housing Finance Regulatory Reform Act of (July) 2008 as the successor regulatory agency resulting from the merger of the Federal Housing Finance Board and the Office of Federal Housing Enterprise Oversight, with expanded legal and regulatory authority.

On September 7, 2008, FHFA director Lockhart announced he had put Fannie Mae and Freddie Mac under the conservatorship of the FHFA, in effect, nationalizing the quasi-government financial institutions.  Lockhart said that one of his first actions was to eliminate funding for Fannie and Freddie’s lobbying efforts – it seems that they were the largest political spenders in DC…

Securitized Mortgage Problems

The issue of “toxic mortgages” that have been securitized and sold as AAA securities is still a current problem adversely impacting credit markets.  For example, the November 23 issue of the New York Times, in a front page article, suggested that a primary source of CitiGroup’s financial trouble could be traced to its lack of oversight of its $43 billion portfolio of mortgage related assets, and subsequent $65 billion in losses, write-downs for troubled assets, and charges to account for future losses.  At current stock market prices, CitiGroup is worth $20.5 billion, significantly less than its $240 billion stock market value two years ago. 

It is assumed that the reason its current mortgage related losses are larger than its mortgage related portfolio is that CitiGroup was very involved in moving mortgages off its balance sheet into mortgage backed securities – securities which CitiGroup guaranteed payments of some loans that were placed in the mortgage backed securities. 

Home Mortgage Market:
Missing Feedback Loop

Lockhart identified one significant long term problem with the current system of securitizing home mortgages; that the system currently is missing a feedback loop that is currently found in the commercial market.  

Commercial Securities Scenario Mortgage Backed Securities Scenario
  • Current management prepares to issue securities backed by mortgages or other assets
  • Bank selects a wide variety of mortgages from their portfolio to be included in a mortgage backed security offering
  • Rating Agency evaluates both the company’s management (to make a judgment on the ability of the company to repay loan) as well as the collateral that secures the loan
  • Credit Agency gives the package a AAA, or other near investment grade rating (regardless of the underlying quality of mortgages)


  • If the company has bad management, the rating agency will lower the bond’s rating, increasing the company’s future cost of capital


  • If the mortgages as a group have a greater default rate than anticipated, rating agency is reluctant to reduce rating because:
    • They may not get future work
    • If rating is reduced below investment grade, banks will, based on mark-to-market accounting, need to decrease the book value of the securities they hold on the asset sheet, which may in-turn cause them to contract their loans
    • If a market is established in these subprime – investment grade securities, and their actual value is found to be 75% less than book value, a bank’s capital may disappear and a conservator may need to be appointed.
  • With increased borrowing costs, the company’s profit martin will decrease
  • With uncertainty in the value of mortgage backed securities, that may be used in inter-bank loaning, banks stopped loaning to each other, effectively stopping the credit market
  • With decreased profits, management will be impacted; either management will improve performance or they will be replaced

  • O O P S


 Additionally, is evidence that many banks kept what was perceived to be the safest securities for their own account, placing the weaker mortgages in mortgage back securities offerings, but still maintaining AAA credit ratings on the packages. 

 What’s Next?

The mortgage backed securitization model for both commercial and residential mortgages did not have the feedback loop of regular commercial securities.  To unplug the credit market, the Federal government needed to prop up the balance sheets of banks with significant mortgage backed security exposure on their balance sheets

The resulting lack of trust seems to have destabilized markets and turned what started out as a supply side recession (caused by excess inventory) into a Demand Side recession (caused by lack of demand for products and services) as evidenced by many the number of businesses can not afford (or can not obtain) working capital loans.  The net result of this credit contraction is that businesses are also contracting.  For example many retail organizations are closing locations because of the difficulty of obtaining credit to finance inventory.   

The Collateralized Mortgage Backed Securities markets (both commercial and residential) need to be unfrozen. As long as there are toxic loans, both commercial and residential, inter-bank loans will be problematic, and the banking industry will be at risk. As long as the banking industry is at risk, credit will be constricted, and we will remain in recession.

admin on January 15th, 2009

Tronox, Inc., successor to Kerr McGee Chemical’s lines of business (including former uranium processing, rail road tie manufacturing, and current titanium dioxide production facilities) filed for Chapter 11 bankruptcy protection on January 13, 2009.   The company currently holds about 12% of the global titanium dioxide (a white pigment used in paint) market, and the market for the pigment has been in decline since the first quarter of 2007. 

Tronox told a New York bankruptcy court that as of November 30, 2008 it had assets of $1.5 billion, estimated liabilities of $1.2 billion in addition to $350 million in publically traded debt.  Tronox’s is currently traded on the “Pink Sheets” with shares listed in the $0.03 to $0.05 range, with a market cap in the range of $1.6 million.  While still showing positive gross profit and positive EBITDA, the company has had trouble continuing operation with the environmental contingent liability it inherited from Kerr McGee. 

The primary reason for the bankruptcy filing was the environmental liabilities the company assumed from Kerr McGee when it was spun off as an independent entity in March 2006.  At the time of the spin off, Kerr McGee provided Tronox with up to a $100 million indemnity from the legacy pollution and required Tronox to assume $550 million in debt.  To date, Tronox has spent $148 million on remediation costs (of which $75 million has been reimbursed by 3rd parties) and Kerr McGee (Anadarko Petroleum, which later purchased Kerr McGee) has  provided about $4 million under terms of the indemnity provisions. 

Cleanup costs have been averaging between $30 million and $50 million per year and may increase.  Last September, Tronox was hit with a $280 million lawsuit filed by the US Environmental Protection Agency to cover cleanup costs associated with a Kerr McGee w00d-treatment plant in New Jersey that has been closed for more than 50 years. 

The moral of the story, Do a Phase I Environmental Assessment before purchasing any commercial property, especially those used in manufacturing or mining. 


Source: Price, Marie; The Journal Record, January 13, 2009, P1

The following are highlights of a presentation on Economic Issues & Commercial Real Estate Business Trends – by Lawrence Yun, PhD – NAR Chief Economist and Douglas Duncan, PhD – Fannie Mae Chief Economist, at the National Association of Realtor’s annual meeting held in Orlando during the first week in November, 2008. This post was originally written to be distributed to the members of the Realtor’s Commercial Alliance of Central Oklahoma.

The Current Situation

The national economy contracted during the 3rd quarter, and one can expect a further contraction for at least another three quarters. Non-residential fixed investment for 3rd quarter 2008 is down about 1%. Changes in Business Inventory have been decreasing for the past 4 quarters. Corporate after-tax profits seems to have topped out, and will probably be decreasing for the near future. The spread in corporate borrowing costs with LIBOR (London Inter Bank Borrowing Rate) has been increasing to unprecedented levels, reflecting the credit problems in today’s markets.

The increased job loss as well as an increase in productivity is a leading indicator and is adversely impacting that national office market. Net office absorption has been down for the last 2 quarters and vacancy rates have increased to just under 13.3%. Rents are flat and cap rates are around 7%.

Perceived personal wealth is decreasing. Stock market valuations are at the levels of about 3 years ago. Nationally, housing values have declined for the first time since the 1930”s (although Oklahoma housing values are holding steady.) Wealth decreases combined with declining jobs has lead to a decrease in Disposable Personal Income.

Consumers are tapped out and personal consumption is decreasing. Vehicle sales, normally about 16 million units, are down about 25%, more for Detroit cars, less for others. Retail sales growth, excluding autos, is close to zero. It was suggested that one reason the previous stimulus package was less successful that expected was that rather than spending the money on consumer goods, a significant majority of consumers used the tax refund to pay down debt, in effect, increasing the savings rate for the first time in decades.

A key negative factor for this recession is not just a credit contraction, but a credit stoppage. The role of securitization in the credit market has stopped and may not resume except for those related to housing and backed by organizations under the auspice of the Federal National Mortgage Association. From a commercial standpoint, about 50% of commercial credit was backed by banks, 22% commercial mortgage backed securities, 9% insurance companies, and 9% GSA/ The private mortgage backed securities market for both commercial and residential uses has stopped.

From a retail standpoint, many retail firms are finding it difficult to borrow for working capital; it was suggested a significant reason for closing stores was that there was not sufficient working capital to purchase inventory for the Christmas season for all stores.  Additionally, while Wal-Mart same store sales are up, the same can not be said across the board; lending to a conclusion that consumers are becoming more price conscious.  These factors have lead to a national decrease in retail absorption for the past two quarters, with national retail vacancy rates above 9.8% (Dallas, Ft Worth and Houston are significant markets above the national average).  Nationally, retail property transactions have been decreasing since the 2nd quarter of 2007, with average Cap rages around 6.8%, presumably increasing to cover increased anticipated risk. 

While productivity is still increasing, about 1.5% increase in the 3rd quarter, productivity rate of increase is down significantly from the 2nd quarter’s 3.1%.  Industrial vacancy is approaching 10.5% nationally, with negative rent growth.  Cap rates are around 7.25%

The only somewhat bright spot is the multifamily housing market. The US population is growing about 3 million a year, and housing starts are flat. However, there is a significant slowdown in housing formations – more people have roommates, either friends or are moving back home. Nationally, rental demand us up, vacancy rates are steady at 5.4%, rental growth is about 3% annually. Cap rates are about 6.5%

Things impacting the Short Term

 It is expected that the Obama administration will, based on campaign rhetoric, significantly modify or eliminate 1031 exchanges in the near future. Since about 95% of money for Tenant In Common exchanges come from 1031 exchanges, it is expected that TIC will become increasingly less significant in the market

Employment Data nationally is up to an unexpected degree; on the first day of the conference, it was announced that national unemployment had increased 240,000. Anticipate at least 1 million more job cuts during the next 12 months; however, if we do not see a seasonally adjusted upturn in January, unemployment may increase to 3 million. The October 2008 unemployment rate of 6.5% is now higher that the corresponding period during the last recession.

Things impacting the Long Term

According to Douglas Duncan, Chief forecaster of Freddie Mac, the federal agencies are not currently involved in any forward looking policies studies aimed at looking to provide long-term fixes to the problems; rather they are looking at trying to fix today’s problems.

There is a current over-arching problem in the residential market, that of over-leveraging (ex. 110% loans).  Whether there is a similar over-leveraging problem in the commercial markets will not be known until the 2015 to 2017 time frame, when commercial securities will roll-over on loan requirements. 

2015 is when net it is forecasted that net cash contributions to social security, Medicare and medicate will go negative.

Leading Indicators to Follow

In institutional markets (the top 27 or so metropolitan areas in the US), the condo market is a good leading indicator of the shape of the housing market.  Because most condos are second homes or investment properties, condos are more liquid that single family homes – the owner of the condo does not need to find a replacement home to move into after the home is sold.

When looking at long term fixes, some policy changes will impact the balance sheet and others will impact the income statement. For example, the problem of people losing their jobs and not being able to make mortgage payments is an income side problem. The problem of banks needing to write off junk status mortgage backed securities is a balance sheet problem. When you are tying to develop a fix for an income statement problem, one needs to be sure that there are no unintended consequences on the balance sheet. For example, lowering marginal tax rates, an income statement issue, would in today’s market not impact demand for housing.