“The Market Based Exchange is the future of Real Estate Capital Markets”, according to Mark Rose, Chairman of the Board of RIISnet (http://www.riisnet.com/) .  The pronouncement was made with the launch of a new product at RealComm, a patented, real-time supply and demand Internet Market-Place for the confidential or public sale and purchase of Institutional-Grade Commercial Real Estate that is an alliance with ARGIS Software and YARDI systems.  Rose made these comments on the first day of the RealComm 2008 conference in San Diego.  The purpose of RIISNET is to create a commercial real estate marketplace that is as efficient as other marketplaces, such as The New York Stock Exchange, NASDAQ, or eBay.  In effect, RIISnet is a privately operated national commercial MLS. 

In the United States, institutional-grade commercial real estate is generally defined as class A properties, above $10 million, located in tier-one cities.  According to Rose, the RIISnet application will establish a market in institutional-grade commercial real estate by maintaining a database of both (sellers) owners and their properties, as well as (buyers) institutional investors; their requirements, investment objectives.   Since Oklahoma City is not a Tier-One city and has very few transactions over $10 million each year, the import of this product in the local market will be limited. 

RIISnet’s interactive database allows users to determine the current value of any property in their portfolio using real-time supply and demand information. Users are able to see aggregate industry supply and demand information based on an investor’s current and annual acquisition and disposition plans, as well as on active searches and on suitable properties currently available for sale. With this information, investors can predict industry performance and position their acquisition and disposal strategies based on current information.

RIISnet also facilitates transparency of financial reports that are needed in a shortened due diligence period, allowing buyer, broker, and seller to quickly and efficiently determine if there is enough common ground to move forward to the contract stage.  This need for transparency in financial data will have implications for property managers, requiring them to institute daily procedures for daily reporting of:

• AR-Balances
• Expenses
• Cash Balances
• Rollovers
• Contributions/Distributions

For the 2009 year, I will be the Chair of Central Oklahoma’s Realtors^® Commercial Alliance (RCA), the local commercial Realtor affiliate of the National Association of Realtors.  My installation as Chair will be on Thursday January 22 at JBR Art Gallery in the Paseo (4:30 to 6:30 pm).  For ticket or other information, call Blair Bradley (bbradley@okcmarrealtors.org) at the Oklahoma City Metropolitian Association of Realtors (405) 841-5307. 

Membership is open to anyone interested in Central Oklahoma Commercial Real Estate. 

2009 Schedule of Meetings

Generally the 3^rd Wednesday of the Month

• OKCMAR offices: 3131 NW Expressway, Oklahoma City
  (405) 840-1493
• Ted’s Escondido Conference Center  6900 N May, Oklahoma City
• JBR Art Gallery at the Paseo 2810 North Walker. Oklahoma City, Oklahoma 73103, (405) 528-6336

Leadership

Chairs of Sub Committees of Program and Entertainment Committee

• Developers Day: Linda Dobson  linda@naisullivangroup.com
• Bus Tour: Joan Cunningham  jcunningham@oldrepublictitle.com

Mark Kingston, President and CEO of ARGUS Software (http://www.argussoftware.com/) made the following predictions as a first day keynote speaker at the RealComm conference in San Diego.  ARGUS software is one of the premier software developers, providing solutions in the real estate industry to improve the visibility and flow of information throughout their critical business processes.  These processes include property management, asset valuation, portfolio management, budgeting, forecasting, reporting and lease management. 

Kingston’s predictions in the real estate industry were based on Richard Laermer’s latest book, “2011: Trendspotting for the Next Decade” (McGraw Hill, 2008, ISBN-13: 978-0071497275).  Four of Kingston’s predictions are related to the evolution of the industry as a result of real estate being recognized as an investment class by financial advisers.  The remaining trends are related to energy, communication and cooperation. 

1. Real Estate is now an asset investment class which will lead to:
   1. Ticker results on transactions
   2. Real Time Reports on Liquidity and available capital pools
   3. Seamless transfer of property and portfolio data (ex. OSCAR standard); less about getting everyone to agree on definitions, more about using information
   4. 2-minute property acquisition; sovereign wealth funds and other investment pools will expect property exchanges similar to stock exchanges to allow for global market access to our real estate markets
2. Energy costs will be a significant factor in the long term, and even a more significant factor in the short-term, many are predicting oil at $200 to $300 dollars per barrel, building automation systems will become more important – it is not about innovation, it is about application
3. Communication – the proliferation of junk e-mail and the tendency for enterprise systems to screen for junk e-mail is leading to a resurgence of direct mail
4. “Coopetition” – Realtors are finding different ways to work together to deliver solutions. 

The concept of ICONIC Architecture/Media is to embed signage in buildings so people will remember the building. Current examples include over-sized jumbotron HD screens (similar to instant-replay screens found in football stadiums) being mounted on buildings. Another example of ICONIC Architecture/Media can be found in Ridley Scott’s cult movie, “Blade Runner.” The 1982 film, starring Harrison Ford, is set in Los Angles about 40 years in the future and features multi-story buildings with video display screens as the exterior skin of the building. The media skin of the building allows the building to become a huge sign with a motion component.

Current examples of ICONIC Architecture/Media from Standard Vision can be found at  www.standardvision.tv 

LED Transmedia Screen as seen from Inside the Building

Adrian Velicescu, an executive with Standard Vision LA (www.standardsite.com ), a multifaceted digital content creator that provides development and production services for advertising agencies, real estate corporations and entertainment conglomerates, presented his company’s vision of creating a Vertical Real Estate Channel ^TM that displays content that is created to be relevant and compelling to a community. These ICONIC Media buildings become landmark destinations in their own right; and can create a cohesive community, especially when exterior spaces are designed with hypersonic sound systems that target a beam of sound to a specific target location.

According to Velicescu, when ICONIC Media is used as advertising, a revenue model can be created that, to date, does not compete with traditional billboards, whether traditional or digital. Revenue models in tier 1 cities have been implemented that assume six hours of operation, with 60% of the time sold at a rate of $0.10 for a 10 second spot. Can be used effectively on 1960’s style aluminum, glass, or Dryvit skinned buildings when repositioning them from a class B or C Building into a landmark destination. The Standardvision  installed LED lighting uses about 63 watts per meter squared.

LED Transmedia Screen on Building Skin

The first image (above) shows an expression of an interior view from a building’s window with building skin consisting of LED lights required for the Iconic Media. The images are of a LED Transmedia Screen designed for Full Resolution Video 1440 x 320 pix, with a screen pitch of 100mm. The proposed building is of the Grand Indonesia, in Jakarta, Indonesia. The second images are exterior representations of the same building, with full motion video capabilities.

In the United States, these instillations are highly regulated and many local zoning codes are not designed with Iconic buildings in mind. There are also additional regulations when the building is within 1000 ft of an interstate highway and federal regulations prevent motion in signs.

We have had a few weeks to look at the impact of the federal bailout / nationalization of the US financial system and the stock market is still fluctuating wildly, the Feds are having trouble hiring people to manage the bailout, the election seems to be paralyzing investors, and the press seems to be blaming the current problems on low interest rates. Given the facts, there are two things I suggest we do:

1. Recognize that there is a difference between availability of credit and cost of capital. I would submit that the problems of overbuilding in the housing markets in the east and west coast are not the direct result of low interest rates, but rather the direct result of lowering credit standards to a point that average home ownership rates peaked at 69.1% in the First quarter of 2005 and having dropped to 67.9% by the third quarter 2008 (according to the US Census http://www.census.gov/hhes/www/housing/hvs/qtr308/files/q308press.pdf). With an estimated 130.4 million housing units in the US, this decrease in home ownership rates represents a shift from owner occupied to lease units of about 1.56 million units. Given that this rate was 65.9% in 1998, and that credit terms have reverted back from to the more stringent standards found 10 years ago, it can be expected that there will be a further shift away from owner occupied to rental units approaching 2.6 million units. Given that current FHA loan limits are $271,050 for a single-family resident in Oklahoma County, and that conventional lenders are making few (if any) home loans above that amount, there may be a housing imbalance with an abnormally high percentage of more expensive homes on the market. That we have had low interest rates during the Greenspan Years is a red hearing with regards to our current economic problems; the real problem has been lax credit standards which led to an abnormally high housing stock and an extremely high default rate on home loans.
2. Reduce Long-term Capital Gains Tax Rate — The current long-term capital gains tax rate is 15% and it is scheduled to increase to 20% in 2011. Based on standard internal rate of return calculations, that 5% increase in tax would result in a 5% to 6% decrease in value of real estate (depending on what is assumed for a normal growth rate). The one of the next potential shoes to drop in the sub-prime mess involves commercial real estate – not that there are bad loans, but that as the value of real estate drops in general, many real estate projects are bumping against current covenants concerning loan-to-value rations. Most commercial loans have requirements that there be a (for example) minimum ration of 20% equity to 80% loans in a project. As the value of real estate drops, and there is a corresponding drop in the equity of the project, many developers are being forced to add cash to their projects to maintain loan-to-value ratios. The October 25 edition of the Wall Street Journal reported that the nation’s largest public pension fund, known as Calpers, is unloading stocks in a falling market to make sure it has enough cash to meet its obligations to fund, in part, its capitol calls from its real estate partners. A cut in long-term capital gains from 15% to 10% would buoy the real estate market (both commercial and residential) and relieve some of the pressure to revalue assets under the current Mark-to-Market valuation standards.

It is suggested that there are at least 5 primary problems, many of which are the result of unintended consequences of federal policy, that have led to the current global financial meltdown.  A further discussion of the problems and recommendations may be found at www.bartbinning.com/meltdown.htm. (after October 12, 2008).

Most Sub-prime mortgages are in default (contingent liability around $1.7 trillion)

1. Credit default mortgage swap derivatives (contingent liability about $67 Trillion) – in effect, insurance policies treated as securities with no reserves for potential loss and premium income treated as profits and distributed as bonus income, current federal debt is about $11 trillion. 
2. No market for credit backed mortgage securities because no one know the true value of the securities, many may be worth par value, others may be worth nothing
3. mark-to-market accounting (because if there was a market, the securities would need to be revalued to about $0.27 on the dollar an many bank’s capital would be wiped out and they would go bankrupt
4. reduced property values are violating many loan to value covenants but in current market loans can not be refinanced

The current Fed bailout, if property executed, may help with the precipitating problem (sub-prime mortgages that are in default), but only about ½ the money needed to fix that problem has been authorized. Other things suggested that still need to be done:

1. unwind the credit default swap mortgage derivatives and regulate the instruments as insurance, not securities
2. Lower capital gains tax rate (when Cap gains increase from 15% to 25%, real estate values dropped 11% and the last real estate bubble burst)
3. modify the mark-to-market accounting rule, whose current form is valid for liquid securities, but not valid for real estate (authorized under 2008 Economic Stabilization Bill – HR 1424)
4. Modify the 1977 Community Reinvestment Act so that income verification and credit scores are required to be used in determination whether to grant a loan (many no-doc and stated income loans were generated to make loans to low income people required by the government so that the banks would not be charged with red-lining)
5. stop using Fannie Mae and Freddie Mac for social engineering (accept the idea that not all Americans are responsible enough and financially able to own a home)
6. establish regulations for bond rating services such as Standard & Poor’s which rated as AAA mortgage backed securities that had sub-prime mortgages as a significant percentage of the portfolio
7. after credit-default mortgage swaps are unwound, the Treasury can issue clean mortgage backed securities (which may mean more bank failures) to unfreeze credit market

On top of everything else, this credit mess seems to have been put us into a world wide recession, that will probably last 12 to 18 months, depending on how long it takes to fix the mess.

The $700 billion Economic Stabilization bill passed by congress last Friday, is actually three bills in one with several other topical areas covered in the 451 pages of HR 1424. A copy of the bill may be found at www.bartbinning.com/pdf/essabill.pdf. 

• Part A (first 113 pages) is the “Emergency Economy Stabilization Act
  of 2008”
  • Troubled Asset Relief Program (TARP)
    • Study of Mark-to-Market accounting
    • Temporary Increase in FDIC Insurance
  • Budget Related Provisions
  • Tax Provisions

• Part B (the next 148 pages) is the “Energy Improvement Extension
  Act of 2008.” 
  • Energy Production Incentives
  • Transportation and Domestic Fuel Security Provisions
  • Energy Conservation and Efficiency Provisions
  • Spending Reductions and Appropriate Revenue Raisers
• Part C (the final 190 pages) contains the
  • “Tax Extenders and Alternative Minimum Tax Relief Act of 2008”  
  • “Paul Wellstone and Pete Domenici Mental Health Parity and
    Addiction Equity Act of 2008”
  • Secure Rural Schools and Community Self-Determination Program
  • Heartland and Hurricane Ike Disaster Relief
  • Spending Reductions and Appropriate Revenue Raisers for New Tax
    Relief Policy

Part A – The Economic Stabilization Act

This section of the bill creates a 10^th assistant
secretary of the Treasury to oversee the “Troubled Asset Relief Program” (or
TARP) to purchase “troubled assets from any financial institution” issued prior
to March 14, 2008, including mortgage backed securities.  The program may also

• develop guarantees of troubled assets
• provide financial assistance to financial institutions of
  assets under $1 billion, that were adequately capitalized as of June 30,
  2008
• purchase troubled assets of retirement plans
• purchase real estate owned and instruments backed by
  mortgages on multifamily properties
• Make modifications to residential mortgage loan purchased
  including
  • Reduction in interest rates
  • Reduction in loan principal
  • Other similar modifications

These programs will terminate December 31, 2009, but may be
extended for two years at the discretion of the Secretary of the Treasury. 

The bill instructs the Securities and Exchange Commission to
conduct a study of Mark-to-Market accounting standards as provided in Statement
Number 157 of the Financial Accounting Standards Board and submit a report to
Congress within 90 days describing recommendations for modifications to the
rule. 

Until December 31, 2009, the bill authorized an increase in
FDIC insurance from $100,000 to $250,000. 

This section also contains seven pages describing special congressional
rules for handling the bill (Sec 115)

Part B – Energy Improvement Act

This section of the bill provides for Energy Production Incentives
including renewable energy credits for 

• marine renewable
• wind property and refined coal tax credits extended to January 1, 2010
• solar tax credits extended to January 1, 2017
• Fuel Cell tax credits extended to December 31, 2016
• Microturbine co-generation tax credits extended to December 31, 2016
• geothermal heat pumps
• (PORK) fuel tax credits for the steel industry extended to December 31,
  2009
• incentives for coal and coal gasification 
• cellulosic biofuel (switchgrass)
•  plug-in electric drive motor vehicles ($2,500 plus $417 for each KW)
• incentives to build new refineries
• bicycle commuters
• Biodeisel and renewable diesel tax credits extended to December 31, 2009

The bill also contains energy conservation and efficiency provisions 

• Qualified energy conservation bonds
• energy efficient commercial buildings deductions extended to December 31,
  2013 and Green building design projects extended to September 30, 2012
• energy efficient home credits extended to December 31, 2016 and new home
  credits extended to December 31, 2009
• modification for energy efficient appliance credits generally extended
  through 2010
• accelerated depreciation for smart electric meters
• qualified green building and sustainable design products
• accelerated depreciation for recycling

The bill contains a reduction of tax incentives for domestic oil production
to help offset energy costs and establishes new reporting requirements for
energy related securities transactions.    

Part C - 

Tax Extended & Alternative Minimum Tax Relief

• Alternative Minimum Tax Relief
• Extension of Individual Tax Provisions
  • Extension of Deduction for State and Local Sales Tax extended to
    January 1, 2010
  • Additional standard deduction for real property tax extended to
    December 31, 2009
• Extension of Business Tax Provisions
  • Extension and modification of research credit
  • Newmarkets tax credit extended to 2009

  • Extension
    of 15-year straight-line cost recovery for qualified leasehold

    improvements
    and qualified restaurant improvements; 15-year

    straight-line
    cost recovery for certain improvements to retail

    space extended to January 1, 2010

• Extension of charitable deduction for
  Books extended to December 31, 2009

• Permanent Authority for Undercover
  operations

• Permanent authority for disclosure if
  information relating to terrorist activities 

• PORK

  • modification of rum tax to Puerto
    Rico and Virgin Islands extended to January 1, 2010

  • Economic Development Credits for
    American Samoa extended to January 1, 2010

  • 7 year cost recovery for
    motorsport racing track facility

  • Tax incentives for investment in
    District of Columbia

  • Modification of duty for wool
    products

  • Film and Television production
    expensing rules extended to December 31, 2009

Wellstone & Domenici Mental Health

Secure Rural Schools and Community Self-Determination Program

Heartland and Hurricane Ike Disaster Relief

In order to understand What Went Wrong with financial markets, we first need to understand a few financial concepts like Securitization, Asset Backed Security, Derivative, Credit Derivative, Tranche, and Collateralized Debt Obligations. 

Securitization

Securitization is a process in which a series of cash-flow producing assets are pooled into a financial security that is then sold to an investor.  From an investor’s standpoint, the underlying concept that makes Securitization attractive involves risk and the Law of Large Numbers. 

The Law of Large Numbers, first described by Jacob Bernoulli in 1713 and further described by S.D. Poisson in 1835, states that given a random variable with a finite expected value, if its values are repeatedly sampled, as the number of these observations increases, their mean will tend to approach and stay close to the expected value. In terms of risk, this means that if you bundle a large number of assets (for example, mortgages), the probability that all mortgages will go into default is smaller, the more mortgages you have bundled. 

From a banker’s standpoint, securitization is attractive because, as a bank, at any one time, only a certain percentage of a bank’s assets can be used for loans.  By selling these loans to, (for example, if the loan is a mortgage on a house, to Fannie Mae), the bank receives cash (discounted based on interest rate, credit rating, etc.) for the loan and Fannie Mae received the right to receive interest payments at a specified rate for a specified period of time.  The bank can now make a new loan.  

Any asset with cash-flow can be securitized.  A Credit Derivative is usually used to change the credit quality of the underlying pool of assets so that the asset-backed security can be sold at a higher price to investors.  

Asset-Backed Security

An Asset-Backed Security (ABS) is a specific type of Securitized security regulated by the Securities and Exchange Commission, based on their regulation AB that was issued on January 18, 2005.  As currently defined in Form S-3, an ABS is a “security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to the security holders.”  In general, the SEC has interpreted “discrete pool” so as to require the composition of the pool to be set as of a specific date of issuance and can not change over time.  Types of Asset-Backed Securities include:

•  Home equity loans
• Auto loans
• Credit Card Receivables
• Student Loans

Derivative

A Derivative is defined as a financial instrument whose value depends on the underlying value of an asset or other financial instrument.  Derivatives typically classified as securities and may be traded on public exchanges.  Derivatives are agreements between two parties and major types of derivatives include:

• Futures – buy or sell an investment at some specific date in the future at a specified price
• Forwards – buy or sell an asset at a specified point of time in the future, the price is paid today but the title to the asset is transferred in the future
• Options – the right, but not the obligation to buy or sell an asset at some point in the future at a specified price.  With a Call Option, one has the right to purchase an asset at a specified price in the future.  With a Put Option, one has the right to sell an asset at a specified price in the future. 
• Swap – agreement to exchange one stream of cash flows for another stream of cash flows.  The streams are called the Legs of the swap

Credit Derivative

A Credit Derivative is a special form of derivative whose value is derived from the risk of an underlying asset, thereby transferring the credit risk of an asset to another party – in effect, insurance.  The types of risk that would be transferred to another party include:

•  Bankruptcy
•  Default (ex., failure to pay required payments on a bond or loan)
•  Acceleration (loan or bond is paid off faster than planned)
•  Repudiation/Moratorium (typically a government will legislatively negate obligations to repay loans)
•  Restructuring (ex. Interest or term of loan is changed)

It is very common for Credit Derivatives to be used in conjunction with Collateralized Debt Obligations to convert the security from what might be a B credit rating to an AAA credit rating, making the security more attractive to investors by reducing an investor’s perceived risk. 

Tranche

A Tranche is one of many securities offered as a part of the same transaction.  By grouping a portfolio of assets by credit risk, and selling the right to receive the cash-flow from the assets, securities of varying credit ratings and risk can be created.  In some portfolios, there may be a tranche with a first lien on the assets (the senior tranche) and these would be classified as very save investments, suitable for insurance companies and pension funds.  Tranches with either a second lien or no lien (junior notes) are less save and would be sold with a correspondingly increased interest rate to hedge funds. 

The benefit of a Tranche is that it allows for the ability to create a multiple classes of securities whose credit rating is higher than the average credit rating of the underlying assets that can be sold to a variety of investors with varying risk/return profile requirements. 

Collateralized Debt Obligations

As an investment vehicle, mortgage securities were initially authorized by the Tax Reform Act of 1986 which provided that under specific circumstances mortgage trusts are not subject to a double taxation as its income is passed- through to its interest holders.  Collateralized Debt Obligations (CDOs) first appeared in 1987 and are an Asset-Backed Security combined with a Credit Derivative that are structured in such a way that cash-flow streams are typically divided into Tranches (securities) that are sold to the public.  Tranches receive credit ratings based on the underlying quality of the assets, the seniority of the Tranche, and the type of Credit Derivative (insurance) associated with the Tranche.   Based on the underlying asset, there are four primary types of CDOs:

• Collateralized loan obligations – backed primarily by leveraged bank loans. payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches, in 2007 represented 45% of CDOs
• Collateralized bond obligations – backed primarily by leveraged fixed income securities, an example of which were those securities sold by Fannie Mae, in 2007 represented less that 10% of CDOs
• Collateralized synthetic obligations – backed primarily by credit derivatives.
• Structured finance – backed primarily by structured products (such as asset-backed securities and mortgage-backed securities), in 2007 represented 47% of CDOs
  

  % OF CDOS SOURCE: PEASLEE, JAMES M. & DAVID Z. NIRENBERG. FEDERAL INCOME TAXATION OF SECURITIZATION TRANSACTIONS. Frank J. Fabozzi Associates (2001, with annual supplements, www.securitizationtax.com): 775

To find out what I think should be done, stay tune for Part III

Why are we in the financial mess we are today?

When problem solving, it has been suggested that one should ask the question “WHY?” a minimum of three times to differentiate symptoms from the underlying problem.  To understand today’s financial problems; we need to ask the “Why” question several different ways. 

So, what are our problems today?  It is suggested that we have at least three different but related problems to track.   

First Problem Track:
Investment Bank & Other Failures

Within two weeks several of the nation’s largest financial services companies have ceased to exist as independent companies.  One week the Federal Reserve nationalized Fannie Mae and Freddie Mac.  At the beginning of the next week Lehman Brothers filed for bankruptcy.  Then the Federal Reserve nationalized the insurance company AIG.   Next, the Bank of America announced they were purchasing Merrill Lynch.  Lehman Brothers declared bankruptcy.  Both Goldman Sachs and Morgan Stanley converted themselves from investment banks to a Bank Holding Companies for the security of being able to access Federal funds in an emergency, and will now be regulated by the Feds’ rather than the SEC.  The following week, Washington Mutual was the largest bank failure in US history, with a sale of most of the assets to JP Morgan Chase.  And finally, the market is in for significant restructuring (a paradigm shift) because the SEC closed down its unit devoted to regulating large Investment Banks — there are none left to regulate. 

a. Why did large mortgage banks loose so much money and some fail?

These troubled mortgage banks were highly leverages and had contingent liabilities relating to their business of secularizing mortgage (primarily residential with some commercial) into mortgage backed securities that had significantly higher default rates than were predicted by rating agencies. 

b. Why did the default rates on these “sub-prime” mortgages increase?

Traditionally, it has been very difficult to get mortgage loans; in addition to having good credit, and investing your own cash into the home (typically 20% down), one needed to show they had the current income to pay off the loan.  Around the year 2000, loans started being issued with zero (0%) down, meaning the homeowner had no vested interest in repaying the loan if they ran into financial difficulty.  Additionally, No-Doc loans (no documents to substantiate what one told the loan officer) and Stated Income loans (no documents were required to verify income) began to appear.  According to one analysis of a group of sub-prime mortgage backed securities, 80% of Stated Income loans had income levels were incorrect and 60% of the No-Doc loans were in default.  As loans started to default, income from these mortgage backed securities decreased, causing their value to fall.  In some cases, these mortgage banks that created the mortgage backed securities guaranteed the income of the loans that were now in default, causing significant problems to their balance sheets.

c. Why did “sub-prime” borrowers get loans in the first place?

The 1977 Community Reinvestment Act compelled banks to make loans to poor borrowers who often cannot replay these loans.  The act was originally passed to outlaw the practice of “redlining” – the practice of either denying or increasing the cost of service based on sex, race or ethnicity, ie. denying loans to middle-income blacks or Hispanics that were made to lower-income whites of similar credit background.  While the initial intent of the Community Reinvestment Act was laudable, its implementation in the last decade was problematic.  The way regulators determined wither redlining was occurring was to perform statistical tests to, in effect, see if loan turn-down rates were correlated with race, ethnic origin, or other discriminatory factor – the problem was that credit risk was not a significant part of the equation.  This led to situations where, because a bank turned down loans because people had poor credit, the bank was sued for redlining because there were a disproportionate number of loans turned down in predominantly black or Hispanic neighborhoods.  To avoid redlining problems, no-doc and stated income loans were made available to mortgage-brokers and mortgage banks.  However, many mortgage-brokers (who tend to be small business people, not associated by major institutions) bent the rules to gain commission on the sale of mortgages. 

Second Problem Track:
Declining Real Estate Values - Fears of Recession

Property values are significantly higher on the east and west coasts in the country’s mid-section.  These property values were so high that the average person could not afford to purchase a home with a traditional mortgage.  In an attempt to make the purchase of housing affordable, balloon interest-only loans were created.  With these loans, interest only would be charged for the first five years or so of the loan, with principal and interest payments kicking in after five years.  If at the end of the five years you could not afford to also pay the principal payments, in theory, in a rising market, you could either re-finance the house or sell the house for a profit.  However, there is a problem if property values decrease or if there is a credit crunch that prevents refinancing. 

a. Why did property values start to decrease?

As the unexpectedly high default rate on sub-prime loans became apparent, investors became skittish and initially stopped purchasing mortgage backed securities containing the no-dock and stated income loans.  As the default rate increased, investors stopped purchasing mortgage backed securities all together.  As credit requirements increased, some people could not re-finance their balloon mortgages, forcing them to sell the homes.  As more and more homes came on the market (supply increased) the price of the homes decreased to the point that some people became upside down in their mortgages (the loan was worth more than the value of the house.)  As the value of the housing stock decreased, the housing bubble started to pop. 

b. Housing values are not decreasing that much where I live. 
    Why Should I be Concerned?

The easy credit made it easier for low income people to own their own homes.  Unfortunately, the easy credit also made it easier for people to purchase homes larger than they could afford.  Easy credit also made it easier for people to purchase second homes in vacation markets.  Easy credit lead to an increased and artificial demand for housing and when the easy credit ended, we were left with a significantly large surplus of housing in several major cities.  This surplus of housing lead to a decrease in housing starts, which in turn lead to an economic slowdown.  Everyone will be hurt if the economic slowdown turns into a recession. 

c. My job is not in the housing or real estate market.
    Why should I be Concerned?

Many commercial loans have interest rates based on the London Interbank Offered Rateor LIBOR, which is a measure of the banking system’s borrowing costs.  LIBOR is a daily rate based on the interest rates at which banks offer to lend unsecured funds (not guaranteed by Fannie Mae, Freddie Mac, or other government agency) to other banks in the London wholesale money market (or interbank market).  This interbank market is a significant source of funds used by businesses to finance their current operations.  Since these interbank loans are unsecured, and since there has been a significant number of financial institutions fail, many banks are just not lending to each other, and when they do, LIBOR rates are close to 30% higher today than 3 to 6 months ago (2.6% then vs 3.7% now.) An extended period of restricted credit will lead to a recession. 

Third Problem Track:
Why were these higher default rates not recognized earlier?

While many may argue blame, it is suggested that there are at least two regulatory events that happened several years ago that are primary causes of today’s problems:

1.  One reason why there were so many unknowns can be traced to the 2000 agreement with a settlement between New York Attorney General Eliot Spitzer and the securities industry that restructured the business of research analysts and the ability of stock brokerage and investment banking companies to provide their clients with free analytical information.  The result was that the best financial analysis’s went to work for hedge funds, who kept their research private.  The effect of Spitzer’s agreement was to invalidate a key assumption of the efficient stock market theory, the assumption that all information is known to all players in the stock market at the same time.  According to Gordon Crovitz (Wall Street Journal, Sept 22, 2008 p22) “Predictably, it was well-informed short sellers at these [hedge fund] firms who first alerted the market to the true value of credit derivatives and other mis-priced instruments by driving down shares of firms such as Lehman.”       
2. When accountants reconcile the “true value” of an asset, the accounting profession recognizes several different methods, including:
   • Historical Cost – the original value of an economic asset.  Various corrections to historical cost are used, including depreciation.  When applying the concept to real estate and equipment, cost includes:
     • Purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates;
     • Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating. These can include site preparation, delivery and handling costs, installation, assembly, testing, professional fees and the costs of employees directly involved in these activities.
   • Mark to Market is the act of assigning value to a financial instrument based on current market price. 

   Effective November 15, 2007, the Financial Accounting Standards Board issued Statement 157, “Fair Value Measurements”, which defines fair value as “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  The implementation of this rule forced banks to use the Mark to Market method for valuing assets such as mortgages.  There are at least two problems with FAS 157

   1. the standard makes no distinction between broken equipment or real estate with toxic chemical spills, which can have a zero value if no purchaser can be found in the resale market, and cash-generating assets like securities or sub-prime mortgage backed securities, for which there may not be a current market, but they still earn income from underlying assets.    
   2. required revaluation of real estate on an annual basis, based on current market conditions. While large REITS may include these revaluations as a cost of doing business, the Commercial Mortgage Backed Securities market, with its millions of individual mortgages bundled into the securities, did not have the resources for an accurate revaluation. Additionally, since the 2000 agreement with NY Attorney General, securities analysts were doing their work privately, and not for public consumption. (The Efficient Marketplace assumption of perfect market information is brought into question.)

So what was the effect of the convergence of these three problem tracks? 

LACK OF CONFIDENCE

The proverbial “straw that broke the camel’s back” occurred on September 18 when around $180 Billion was withdrawn from money market funds sponsored by investment banks and other financial institutions, leading to a “run on the bank” type environment in which the interest rate on Treasury securities was so low that the rate of return was negative.  The result was that the Federal Reserve announced a new program to guarantee many types of money market funds up to $100,000 – in the same way they guarantee bank deposits. 

 And that’s where we are today.

According to Hugo Chavez, Robert Mugabe, Slobodan Milosevic, Mahmoud Ahmadinejad, Ayatollah Ali Khamenei, and General Than Shwe (Prime Minister of Myanmar), the most dangerous man in their world is …. an obscure professor emeritus at Harvard University named Gene Sharp.

According to the Wall Street Journal (Philip Shiskin, “American Revolutionary” Sept 13, 2008, p A1) Professor Sharp’s dirty deed was writing a pamphlet, “From Dictatorship to Democracy”  (http://www.aeinstein.org/organizations/org/FDTD.pdf), whose ideas are so inflammatory that bookstores stocking the book in Russia have been burned, and whose ideas are being used by democratic movements in Eastern Europe (Serbia, Georgia, Ukraine, Kyrgyzstan, and others). Sharp’s earlier work, “Civilian-Based Defense” provided an important framework that was used by the Lithuanian, Latvian, and Estonian governments during their separation from the Soviet Union in 1991.

Sharp noted, as was stated in our Declaration of Independence, that the power of any state is derived by the citizens of that state. He expanded this idea to include the concept that power is not monolithic and, no matter what type of government, if citizens do not obey, leaders have no power.

In “From Dictatorship to Democracy” Sharp notes that when opposing a tyrant, violent techniques tend to produce a centralizing effect on subsequent governments which tend to promote succeeding dictatorships. On the other hand, nonviolent struggles tend to contribute to democratizing the political society by “providing the population with means of resistance that can be used to achieve and defend their liberties” (p 32). Sharp further notes that nonviolent struggle:

• can be used to assert the practice of democratic freedoms, such as free speech, free press, independent organizations and free assembly, in the face of repressive controls.
• contributes strongly to the survival, rebirth, and strengthening of independent groups (which provide individual support systems as well as social cohesiveness) which are important for democracy because of their capacity to mobilize the power of the population and impose limits on the effective power of any would-be dictator.
• provides experience that may result in a population being more self-confident in challenging a regime’s threat and capacity for violent repression

Sharp extols the virtues of strategic planning by noting that “many naively think that if they simply espouse their goal strongly, firmly, and long enough, it will somehow come to pass. Others assume that if they simply live and witness according to their principles and ideals in face of difficulties, they are doing all they can do to implement them…. Other opponents of dictatorship may naively think that if only they use enough violence, freedom will come… There are also activists who base their actions on what they ‘feel’ they should do. These approaches are, however, not only egocentric but they offer no guidance for developing a grand strategy of liberation…. Without strategic analysis, resistance leaders will often not know what that “next step” should be.” (p37)

Sharp also notes that there must be laid groundwork for a durable democracy, something that the US government forgot about when they invaded Iraq and Afghanistan. Sharp notes that “No one should believe that with the downfall of the dictatorship an ideal society will immediately appear…. Serious political, economic, and social problems will continue for years… There is apple historical evidence from France (the Jacobins and Napoleon), Russia (the Bolsheviks), Iran (the Ayatollah), Burma (SLORC) and elsewhere that the collapse of an oppressive regime will be seen by some … as merely the opportunity for them to step in as the new masters.” (p 63) “One important long-term beneficial consequence of the use of nonviolent struggle for establishing democratic government is that the society will be more capable of dealing with continuing and future problems…. And provide ways to defend democracy, civil liberties, minority rights, and prerogatives of regional, state, and local governments, and nongovernmental institutions. Such means also provide ways by which people and groups can express extreme dissent peacefully on issues seen as so important…” (p 69)

Sharp links “power to the people” with “democracy” — no wonder he is so dangerous.

This should be required reading for everyone…