[JPRT, 111th Congress]
[From the U.S. Government Publishing Office]
CONGRESSIONAL OVERSIGHT PANEL
FEBRUARY OVERSIGHT REPORT *
----------
COMMERCIAL REAL ESTATE LOSSES AND THE RISK TO FINANCIAL
STABILITY
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
February 10, 2010.--Ordered to be printed
* Submitted under Section 125(b)(1) of Title 1 of the Emergency
Economic Stabilization Act of 2008, Pub. L. No. 110-343
CONGRESSIONAL OVERSIGHT PANEL FEBRUARY OVERSIGHT REPORT
CONGRESSIONAL OVERSIGHT PANEL
FEBRUARY OVERSIGHT REPORT *
__________
COMMERCIAL REAL ESTATE LOSSES AND THE RISK TO FINANCIAL
STABILITY
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
February 10, 2010.--Ordered to be printed
* Submitted under Section 125(b)(1) of Title 1 of the Emergency
Economic Stabilization Act of 2008, Pub. L. No. 110-343
----------
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54-785 PDF WASHINGTON : 2010
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Washington, DC 20402-0001
CONGRESSIONAL OVERSIGHT PANEL
Panel Members
Elizabeth Warren, Chair
Paul S. Atkins
Richard H. Neiman
Damon Silvers
J. Mark McWatters
4 C O N T E N T S
__________
Page
Executive Summary................................................ 1
Section One: February Report..................................... 4
A. Introduction.............................................. 4
B. What is Commercial Real Estate?........................... 5
C. History of Commercial Real Estate Concerns................ 14
D. Present Condition of Commercial Real Estate............... 23
E. Scope of the Commercial Real Estate Markets............... 30
F. Risks..................................................... 51
G. Bank Capital; Financial and Regulatory Accounting Issues;
Counterparty Issues; and Workouts.......................... 67
H. Regulatory Guidance, the Stress Tests, and EESA........... 87
I. The TARP.................................................. 103
J. Conclusion................................................ 117
Annex I: The Commercial Real Estate Boom and Bust of the 1980s... 119
Section Two: Update on Warrants.................................. 127
Section Three: Additional Views.................................. 134
Section Four: Correspondence with Treasury Update................ 138
Section Five: TARP Updates Since Last Report..................... 139
Section Six: Oversight Activities................................ 152
Section Seven: About the Congressional Oversight Panel........... 153
Appendices:
APPENDIX I: LETTER FROM SECRETARY TIMOTHY GEITHNER TO CHAIR
ELIZABETH WARREN, RE: PANEL QUESTIONS FOR CIT GROUP UNDER
CPP, DATED JANUARY 13, 2010................................ 155
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FEBRUARY OVERSIGHT REPORT
_______
February 10, 2010.--Ordered to be printed
_______
EXECUTIVE SUMMARY *
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* The Panel adopted this report with a 5-0 vote on February 10,
2010.
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Over the next few years, a wave of commercial real estate
loan failures could threaten America's already-weakened
financial system. The Congressional Oversight Panel is deeply
concerned that commercial loan losses could jeopardize the
stability of many banks, particularly the nation's mid-size and
smaller banks, and that as the damage spreads beyond individual
banks that it will contribute to prolonged weakness throughout
the economy.
Commercial real estate loans are taken out by developers to
purchase, build, and maintain properties such as shopping
centers, offices, hotels, and apartments. These loans have
terms of three to ten years, but the monthly payments are not
scheduled to repay the loan in that period. At the end of the
initial term, the entire remaining balance of the loan comes
due, and the borrower must take out a new loan to finance its
continued ownership of the property. Banks and other commercial
property lenders bear two primary risks: (1) a borrower may not
be able to pay interest and principal during the loan's term,
and (2) a borrower may not be able to get refinancing when the
loan term ends. In either case, the loan will default and the
property will face foreclosure.
The problems facing commercial real estate have no single
cause. The loans most likely to fail were made at the height of
the real estate bubble when commercial real estate values had
been driven above sustainable levels and loans; many were made
carelessly in a rush for profit. Other loans were potentially
sound when made but the severe recession has translated into
fewer retail customers, less frequent vacations, decreased
demand for office space, and a weaker apartment market, all
increasing the likelihood of default on commercial real estate
loans. Even borrowers who own profitable properties may be
unable to refinance their loans as they face tightened
underwriting standards, increased demands for additional
investment by borrowers, and restricted credit.
Between 2010 and 2014, about $1.4 trillion in commercial
real estate loans will reach the end of their terms. Nearly
half are at present ``underwater''--that is, the borrower owes
more than the underlying property is currently worth.
Commercial property values have fallen more than 40 percent
since the beginning of 2007. Increased vacancy rates, which now
range from eight percent for multifamily housing to 18 percent
for office buildings, and falling rents, which have declined 40
percent for office space and 33 percent for retail space, have
exerted a powerful downward pressure on the value of commercial
properties.
The largest commercial real estate loan losses are
projected for 2011 and beyond; losses at banks alone could
range as high as $200-$300 billion. The stress tests conducted
last year for 19 major financial institutions examined their
capital reserves only through the end of 2010. Even more
significantly, small and mid-sized banks were never subjected
to any exercise comparable to the stress tests, despite the
fact that small and mid-sized banks are proportionately even
more exposed than their larger counterparts to commercial real
estate loan losses.
A significant wave of commercial mortgage defaults would
trigger economic damage that could touch the lives of nearly
every American. Empty office complexes, hotels, and retail
stores could lead directly to lost jobs. Foreclosures on
apartment complexes could push families out of their
residences, even if they had never missed a rent payment. Banks
that suffer, or are afraid of suffering, commercial mortgage
losses could grow even more reluctant to lend, which could in
turn further reduce access to credit for more businesses and
families and accelerate a negative economic cycle.
It is difficult to predict either the number of
foreclosures to come or who will be most immediately affected.
In the worst case scenario, hundreds more community and mid-
sized banks could face insolvency. Because these banks play a
critical role in financing the small businesses that could help
the American economy create new jobs, their widespread failure
could disrupt local communities, undermine the economic
recovery, and extend an already painful recession.
There are no easy solutions to these problems. Although it
endorses no specific proposals, the Panel identifies a number
of possible interventions to contain the problem until the
commercial real estate market can return to health. The Panel
is clear that government cannot and should not keep every bank
afloat. But neither should it turn a blind eye to the dangers
of unnecessary bank failures and their impact on communities.
The Panel believes that Treasury and bank supervisors must
address forthrightly and transparently the threats facing the
commercial real estate markets. The coming trouble in
commercial real estate could pose painful problems for the
communities, small businesses, and American families already
struggling to make ends meet in today's exceptionally difficult
economy.
* * * * *
This month's report also includes a brief summary of the
status of the disposition of the warrants that Treasury has
acquired in conjunction with its TARP investments in financial
institutions. The Panel had conducted its own review of the
initial results of Treasury's repurchases of warrants in its
July Report (TARP Repayments, Including the Repurchase of Stock
Warrants) and called for greater disclosure concerning
Treasury's warrant disposition process and valuation
methodology. In January, Treasury published its first report on
the warrants. Treasury's warrant sales receipts up to this time
total just over $4 billion, which is slightly more than
Treasury's own internal model estimates their value, but
slightly below (92 percent) the Panel's best estimate. The
Panel now projects receipts from the sale or auction of TARP
warrants--both those sold or auctioned to date and those yet to
be disposed of--will total $9.3 billion.
SECTION ONE: FEBRUARY REPORT
A. Introduction
Treasury is winding down the Troubled Asset Relief Program
(TARP), although the Program has been extended until October 3,
2010. The TARP financial assistance programs for banks and bank
holding companies (BHCs) have ended, and all but six of the
nation's largest BHCs have repaid the assistance they received;
\1\ in total, 59 of the 708 institutions that participated in
the financial assistance program have repaid fully.\2\
Simultaneously, however, federal financial supervisors and
private analysts are expressing strong concern about the
commercial real estate markets. Secretary Geithner's letter to
Congressional leaders certifying his decision to extend the
TARP cited as one of the reasons for the extension that
``[c]ommercial real estate losses also weigh heavily on many
small banks, impairing their ability to extend new loans.'' \3\
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\1\ Subject to the stress tests conducted by the federal bank
supervisors in the first half of 2009.
\2\ Although Citigroup repaid funds it had received under two TARP
programs, Treasury owns $24.4 billion in common shares and therefore
Citigroup is still participating in the CPP.
\3\ Letter from Timothy F. Geithner, Secretary of the Treasury, to
Nancy Pelosi, Speaker of the U.S. House of Representatives (Dec. 9,
2009) (online at www.ustreas.gov/press/releases/reports/
pelosi%20letter.pdf).
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The financing of commercial real estate is not identical to
that of residential real estate, nor is the way in which
potential defaults can be avoided. Nonetheless, the two markets
share core elements. Securitization of mortgage-backed loans is
a major factor in both; securitization of loans is concentrated
in large banks, while small banks generally hold whole loans on
their books. The difficulties residential real estate has
encountered and the difficulties commercial real estate has
started to experience are a combination of the real estate
bubble, the credit contraction, and the state of the economy.
And of course, both types of loans play an essential role in
financial institutions' operations, balance sheets, and capital
adequacy.
But the timing of the two sets of difficulties is
different. Home mortgages started to default at unprecedented
rates as the real estate bubble burst in 2007. Commercial real
estate defaults are rising, but the consensus is that the full
force of the problems in that sector and their impact on the
nation's financial institutions will be felt over the next
three years and beyond, after the TARP has expired.
The relationship between the commercial real estate markets
and the TARP has been a concern of the Panel for some time. The
Panel began to study the issue in detail in May 2009 at a field
hearing in New York City.\4\ Its August 2009 report on ``The
Continued Risk of Troubled Assets'' \5\ contained a specific
discussion of commercial real estate, and its June 2009 report
on ``Stress Testing and Shoring Up Bank Capital'' \6\ noted the
role of commercial real estate loss projections in the stress
test computations. The Panel held its second field hearing on
commercial real estate on January 27, 2010 in Atlanta, one of
the nation's most depressed commercial real estate markets;
this report reflects the testimony at that hearing.
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\4\ Congressional Oversight Panel, Field Hearing in New York City
on Corporate and Commercial Real Estate Lending (May 28, 2009) (online
at cop.senate.gov/hearings/library/hearing-052809-newyork.cfm).
\5\ Congressional Oversight Panel, August Oversight Report: The
Continued Risk of Troubled Assets, at 54-57 (Aug. 11, 2009) (online at
cop.senate.gov/documents/cop-081109-report.pdf) (hereinafter ``COP
August Oversight Report'').
\6\ Congressional Oversight Panel, June Oversight Report: Stress
Testing and Shoring Up Bank Capital, at 26, 41-43 (June 9, 2009)
(online at cop.senate.gov/documents/cop-060909-report.pdf) (hereinafter
``COP June Oversight Report'').
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The nation's bank supervisors expressed serious concern in
2006 about the potential effect of the commercial real estate
markets on the condition of the nation's banks. Congress
specifically authorized Treasury to deal with commercial
mortgages as part of the Emergency Economic Stabilization Act
(EESA). But the direct attention paid to that subject by
Treasury in its use, or planned use, of TARP funds has been
relatively small.
The most serious wave of commercial real estate
difficulties is just now beginning; experts believe that the
volume of bank write-downs and potential loan defaults may
swell in the coming years, in the absence of a strong immediate
improvement in the economy. This report examines the nature and
potential impact of a second wave of property-based stress on
the financial system--this time based on commercial rather than
residential real estate. To do so, it begins by outlining the
way commercial real estate is financed, explores the
relationship between the state of commercial real estate today
and the property bubble of 2005-2007, and highlights the all-
important impact of economic recovery on commercial real estate
values and the health of commercial real estate loans. The
report then details the nature, timing, and potential impact of
the risks involved in commercial real estate and the ways banks
and lenders can work to cushion the effect of temporary
dislocations pending an economic recovery. It also briefly
suggests ways in which the broader risks might be mitigated by
a combination of government and private sector actions.
These are not theoretical questions. The report examines
the way these risks can directly affect ordinary citizens and
businesses. A wave of foreclosures affecting multifamily
housing, for example, can displace families or reduce the
conditions in which they live. Mortgages on multifamily housing
make up 26.5 percent of the nation's total stock of commercial
real estate mortgages.\7\
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\7\ Board of Governors of the Federal Reserve System, Z.1 Flow of
Funds Account of the United States (December 10, 2009) (online at
www.federalreserve.gov/releases/Z1/Current/z1.pdf) (hereinafter
``Federal Reserve Statistical Release Z.1'').
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Commercial real estate issues--most likely serious ones--
have been identified for several years, and the nation
experienced a previous commercial real estate crisis during the
1980s. How the financial system and the government deal now
with a second wave of property-induced stress on the financial
system will indicate what Treasury, the bank supervisors, and
the private sector have learned from the last two years.
B. What is Commercial Real Estate?
Although ``commercial real estate'' has a variety of
definitions in academic and business literature, there are two
general ways of thinking about it. Relevant guidance from the
federal financial supervisors takes a straight-forward
approach, defining commercial real estate as ``multifamily''
property, and ``nonfarm nonresidential'' property.\8\ This
formulation reflects the division of the non-farm \9\ real
estate markets into a single-family residential market
(generally one to four family structures) and a largely
separate commercial market, which includes practically all
other property types.\10\
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\8\ See Board of Governors of the Federal Reserve System, Mortgage
Debt Outstanding (Dec. 2009) (online at www.federalreserve.gov/
econresdata/releases/mortoutstand/current.htm).
\9\ Id. As of the 3rd quarter of 2009, the total universe of real
estate debt consisted of $10.85 trillion of residential mortgages,
$3.43 trillion of commercial mortgages (including multifamily), and
$132.28 billion of farm mortgages.
\10\ See John P. Wiedemer, Real Estate Finance, Seventh Edition, at
244 (1995) (hereinafter ``Real Estate Finance, Seventh Edition'').
Following industry conventions, this report considers the
``residential'' category to consist of single family homes and two- to
four-unit multifamily properties. Although larger multifamily
properties are considered by some definitions (and by the IRS) to be
residential, they are more commonly included in the commercial category
because of characteristics these properties share with other types of
commercial property.
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That leads to the second defining characteristic, which
goes to the core of any discussion of commercial real estate
loans and financing. Commercial properties are generally
income-producing assets, generating rental or other income and
having a potential for capital appreciation.\11\ Unlike a
residential property, the value of a commercial property
depends largely on the amount of income that can be expected
from the property.\12\
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\11\ Id., at 244-245. Some property types that do not produce
traditional rental income are classified as commercial real estate. In
the case of a property owned by the tenant (``corporate real estate''),
such as a factory, the notional income generated by the structure is
subsumed within the results of the broader enterprise. Institutional
properties (e.g. museums, hospitals, schools, government buildings) are
considered commercial property due to their many similarities to more
traditional commercial property types, the fact that most of these
properties produce cash flow of some type, and because the properties
are financed in the commercial mortgage market. Land for development is
a precursor for an income producing property. Land is also often held
for appreciation as an investment. Conversely, some residential assets
are income producing, such as single family houses that are rented, or
small two- to four- unit apartment properties. Due to the methods of
finance and other characteristics, these properties are rarely
considered to be commercial real estate.
\12\ There are four common methods of valuing a commercial
property: capitalization rate, discounted cash flow, comparable sales,
and replacement cost. The first two methods are purely functions of
property income. The comparable sales method is implicitly based on
property income, since comparable property sale prices depend on other
buyers' assessments of value based on income. Replacement cost does not
depend on income, but is mainly used as a check on the other methods.
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1. Types of Commercial Real Estate
The characteristics of different categories of commercial
real estate are important when considering their respective
value and ability to support bank and other loans.
a. Retail Properties
Retail properties range in size from regional malls, free-
standing ``big-box'' retailers, and strip malls to single,
large or small buildings housing local businesses. To generate
the cash flow necessary to service their loans, all retail
properties depend, directly or indirectly, on the success of
the businesses that occupy the property (which in turn depends
on its own combination of financial, economic, and competitive
factors). For this reason, retail properties (as well as hotel
and tourist properties) are more directly affected by the
health of the economy than most other property types. Retail is
also the property type most sensitive to location.
b. Hotel and Tourist Properties
Hotel and tourist properties include resort, convention,
airport, extended stay, and boutique hotels, as well as
motels.\13\ The hotel sector is cyclical and volatile, in large
part because the ``lease term'' for a hotel is usually a few
days at most. Hotel income depends directly on the level of
occupancy and the daily rate charged; those rental rates are
sensitive to additional supply in the market and can change
daily. These factors, plus changing trends in both tourism and
business travel based on the economy or local conditions, make
future hotel income difficult to predict. Hotels also tend to
be highly leveraged, further increasing investment risk.\14\
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\13\ See William B. Brueggeman and Jeffery D. Fisher, Real Estate
Finance and Investments, at 211 (2001) (hereinafter ``Brueggeman and
Fisher'').
\14\ Precept Corporation, The Handbook of First Mortgage Lending: A
Standardized Method for the Commercial Real Estate Industry, at 253
(2002).
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c. Office Buildings
The office sector is a diverse grouping that includes all
properties in which office occupancy is the dominant use.\15\
Office buildings are designated by class, from A to C, in
descending order of quality and cost.\16\ Because office leases
are relatively long term, usually for three to ten years,
office properties can be more stable in their financial
performance than other classes of commercial real estate, at
least during the lease terms and assuming no defaults. Office
space tends to have significant costs during re-leasing,
including brokerage charges, downtime, and the considerable
amount of fit-out work that needs to be done to accommodate new
tenants.
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\15\ Again, some of the space is owner-occupied, e.g., by small
services businesses.
\16\ Urban Land Institute, Office Development Handbook, 2nd Edition
(Dec. 1998) ``Class A space can be characterized as buildings that have
excellent location and access, attract high quality tenants, and are
managed professionally. Building materials are high quality and rents
are competitive with other new buildings. Class B buildings have good
locations, management, and construction, and tenant standards are high.
Buildings should have very little functional obsolescence and
deterioration. Class C buildings are typically 15 to 25 years old but
are maintaining steady occupancy. Tenants filter from Class B to Class
A and from Class C to Class B.''
Other classification systems may set square footage standards for
the classes, and may include an ``unclassified'' category for space
below the standards of Class C or unusual property types that may be
difficult to lease.
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d. Industrial Properties
Industrial real estate traditionally consists of warehouse,
manufacturing, light industry and related, e.g., research and
development or laboratory, properties.\17\ Office and
industrial properties are sometimes combined into a single
``office/industrial'' category because some industrial
properties contain a significant amount of office space. Light
industrial and warehouse properties can often easily be
converted from one use to another; a heavy industrial property,
such as a mill, will be less amenable to conversion to other
uses.\18\ Industrial properties tend to have more stable
returns than office, hotel, or retail properties.\19\
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\17\ Johannson L. Yap and Rene M. Circ, Guide to Classifying
Industrial Property, Second Edition, Urban Land Institute, at viii
(2003) (hereinafter ``Guide to Classifying Industrial Property'').
\18\ See Brueggeman and Fisher, supra note 13, at 211.
\19\ Guide to Classifying Industrial Property, supra note 17, at
vi.
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e. Multifamily Housing and Apartment Units
Multifamily housing consists of buildings with multiple
dwelling units for rent. Unlike most residential properties,
multifamily properties are income generating, and generally use
the commercial mortgage market for financing. The basic
subtypes of multifamily are high rise, low rise, and garden
apartments.\20\ A number of other types of properties are
sometimes converted into apartments (such as loft units in
converted industrial properties) and would then fall into this
category.\21\
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\20\ Brueggeman and Fisher, supra note 13, at 211.
\21\ Condominium and assisted living properties share many
characteristics with multifamily rental properties, but are not
considered part of the multifamily category, although they do use the
commercial finance market. See Real Estate Finance, Seventh Edition,
supra note 10, at 199-200.
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Multifamily properties usually have a greater number of
tenants and shorter leases (six months to two years) than
retail, office, and industrial spaces. Again, cash flow is
relatively stable over the terms of any lease. Multifamily
properties, however, are susceptible to competition, because
the barriers to entry into the market are low.\22\
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\22\ Joseph F. DeMichele and William J. Adams, ``Introduction to
Commercial Mortgage Backed Securities,'' in The Handbook of Non-Agency
Mortgage-Backed Securities, at 335-336 (1997) (hereinafter ``DeMichele
and Adams'').
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Unlike other commercial property types, a significant
percentage of the multifamily sector is subsidized in some form
through government programs such as the Section 8 Housing
Choice Voucher Program or Low Income Housing Tax Credits
(LIHTC). These units are often referred to as ``affordable'' or
``assisted'' housing, as opposed to unsubsidized ``market
rate'' housing.
As of 2007 there were more than 17 million apartment units
in the United States, most of which have one or two bedrooms.
As can be seen in Figure 1, the South contained the largest
number of apartment units followed by the West, the Northeast,
and the Midwest.\23\ The highest median rents, however, were
seen in the West, followed by the Northeast, the South, and the
Midwest.\24\ Rents in certain markets, especially major
metropolitan areas such as New York, are significantly more
than the median.
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\23\ National Multi Housing Council, Quick Facts: Apartment Stock
(2009) (online at www.nmhc.org/Content/
ServeContent.cfm?ContentItemID=141).
\24\ Id.
FIGURE 1: MULTIFAMILY UNITS AND MEDIAN RENTS BY REGION
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Multifamily Property Size by Number of
Percent Median Units in Each Category
Region Number of of Total Monthly --------------------------------------------
Units Units Rent 5-9 10-24 25-49 50-99 100+
Units Units Units Units Units
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Northeast......................... 3,950 23% $714 871 1,062 679 577 762
Midwest........................... 3,556 20% 550 1,110 1,299 404 357 386
South............................. 5,577 32% 640 1,840 2,510 435 260 532
West.............................. 4,305 25% 800 1,317 1,603 586 373 427
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Total U.S..................... 17,389 100% 675 5,138 6,473 2,104 1,567 2,107
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The median household income of renters, as of 2007, was
$25,500, well below the national median of $47,000. The median
income of renters of unsubsidized market rate units was higher,
at $30,000. The median age of renters was 39. Nearly half of
apartments are occupied by only one person. Of renter
households, 22 percent have at least one child.\25\
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\25\ Id.
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f. Homebuilders
The development of residential properties is considered a
commercial real estate activity, and loans to businesses that
develop residential properties are also considered commercial
real estate loans.
2. How Commercial Real Estate Is Financed
The financing of commercial real estate reflects the prime
characteristics of commercial property, namely that (1) they
are built to generate income, (2) income is used to service the
loans obtained by the property developer or operator, and (3)
the value of the property depends largely on the amount of that
income.
The commercial and residential real estate industries share
many similarities in basic structure and terminology. Location
is a well-known factor influencing the property values of both
categories. Both types of property experienced bubbles in the
past decade. Loan underwriting and equity requirements were
loosened for both types of real estate, although the commercial
real estate bubble was smaller and less extreme; moreover, as
discussed throughout the report, the full force of the
commercial real estate bubble has yet to be felt.
The bubble in residential property also did much to fuel
directly the bubble in commercial property. Companies related
to residential real estate, construction, and home furnishing
grew rapidly as a result of the residential bubble and expanded
the demand for office and industrial space. Many new retail
properties were also built to serve new residential
development; the force of the credit-driven consumer economy
was even greater.
Commercial and residential real estate finance, however,
have significant differences. Unlike most residential
borrowers, commercial borrowers tend to be real estate
professionals. Commercial borrowers are also expected to pay
debt service from property income rather than from personal
income, unlike homeowners. Consequently, some of the loan
structures that are used in the residential mortgage market,
such as stated income loans or low introductory interest rates,
are not available in the commercial market. In addition, the
different tax treatment of commercial and residential
properties (especially the allowance of depreciation of
commercial properties) creates incentives for different types
of ownership and financing structures.
The two main categories of commercial real estate mortgages
are discussed below.
a. Construction and Development Financing
Construction loans--often called ``ADC,'' for
``acquisition, development, and construction'' or ``C&D'' for
``construction and development''--allow the developer to do
just what the name implies, that is, to obtain funds to build
on the property. ADC financing is usually short-term and almost
always supplied by a depository institution.
These loans usually have an adjustable rate, priced at a
spread over the prime rate or another benchmark.\26\ The bank
typically plays an active role in monitoring these loans and
approving ``draws'' as funds are needed for construction.\27\
Since a property under construction does not generate rental
income to cover debt service, a construction loan more often
than not includes an interest reserve which holds back enough
of the loan proceeds to cover the interest payments due during
the term of the loan. (Thus, the developer borrows the money to
pay the interest on the construction loan, because the
property, by definition, cannot generate cash flow to do so.)
Underwriting a construction loan requires forecasting the time
it will take the developer to lease up the property to a
sufficient extent to enable the loan to be converted into
permanent financing.
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\26\ Brueggeman and Fisher, supra note 13, at 445.
\27\ Brueggeman and Fisher, supra note 13, at 481-485.
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Unlike later stages of financing, construction loans are
usually recourse loans, that is, the lender has a right to
recover directly from any available general assets of the
developer if the loan is not repaid (a right that is meaningful
only to the extent that the developer has those assets in the
necessary amount).
FIGURE 2: CONSTRUCTION LOAN FLOWCHART \28\
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\28\ In smaller and some other non-securitized loans, the
relationship runs directly between the borrower and the lender, without
the use of a servicer.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
b. Permanent Financing
After construction is completed and the building leased,
the developer takes out a commercial mortgage as permanent
financing and uses the proceeds to repay the construction loan;
the need for permanent financing is built into the financing
and economics of the project from the outset.
The terms of the permanent financing and the attractiveness
of the property to lenders depend, again, on the income the
property is expected to generate, based on its initial leasing
rate, general economic conditions, and demand for properties of
that type. Translation of that income into a projected value
for the property sets the loan-to-value (LTV) ratio (the
principal balance divided by the property's value) backing the
debt and also affects the loan's interest rate.
Commercial mortgages may have a fixed or an adjustable rate
and may also be interest-only and negative-amortization
loans.\29\ The loan-to-value ratio is typically lower for
commercial mortgages than for single-family residential
mortgages, ranging from 50 to 80 percent. The remaining amount
is usually equity supplied by the borrower (either singly or
through a group of investors). The term for commercial
mortgages is fairly short, usually three to ten years. The
amortization schedule is often longer than the term of the
loan, usually 30 years, with a balloon payment of the remaining
outstanding principal due at loan maturity.
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\29\ In a negative amortization loan, the monthly payment is less
than the interest due. The unpaid interest is added to the principal
balance, which increases over the term of the loan, and both must be
paid in a balloon at maturity.
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Commercial borrowers usually refinance their properties at
the end of the loan term. During refinancing, the lender (often
a different lender than the original one) reevaluates the
property and bases the new loan terms on the current state of
the property and prevailing market conditions. Similarly, many
non-traditional or subprime residential loans were made with
the assumption that the loan would need to be refinanced at the
end of the introductory period when the rate reset. However,
unlike the commercial sector in which refinancings were
necessary three to ten years later, many non-traditional or
subprime loans required refinancing in only one to three years.
Thus, loose underwriting or other factors contributing to the
inability to refinance loans arose much more quickly in the
residential real estate sector than the commercial real estate
sector.
There are a number of other reasons why the commercial real
estate cycle tends to lag the residential cycle. The multi-year
leases common in commercial real estate lock in rental income
for the duration of the lease, even if the tenant's actual
space needs have decreased. In addition, it takes some time for
either economic growth or contraction to work its way through
the economy to the point where it influences commercial space
demand. For example, a retail store may have poor sales for
months or years before it closes and causes a loss of income to
the property owner. Unemployment, itself a lagging indicator,
greatly influences commercial real estate demand, since each
lost job means an empty office or factory work station, as well
as lower retail and hotel spending.
Unlike construction loans, commercial mortgages are
generally non-recourse loans; the borrower stands to lose only
its own investment if the property is foreclosed.\30\ The
lender may look only to the property itself to recover its
funds if the borrower defaults, generally through a sale to a
third party who wishes to take over the property. The
nonrecourse nature of the financing, again, makes careful
underwriting crucial.\31\
---------------------------------------------------------------------------
\30\ See Brueggeman and Fisher, supra note 13, at 447.
\31\ Commercial mortgages may have prepayment penalties to
discourage refinancing before the maturity date. Most securitized
mortgages incorporate a prepayment ``lock out'' that forbids prepayment
altogether unless there is ``defeasance,'' where the prepaying mortgage
is replaced in the pool with an equal amount of Treasury bonds.
---------------------------------------------------------------------------
FIGURE 3: PERMANENT MORTGAGE FLOWCHART \32\
---------------------------------------------------------------------------
\32\ Again, in smaller and some other, non-securitized, loans, the
relationship runs directly between the borrower and the lender, without
the use of a servicer.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
In a way, the term ``permanent financing'' is a misnomer.
Commercial mortgages generally have a short term, and they
require refinancing at the end of their original term, such as
seven years. At that point, the income experience of the
property, which largely sets its value, is re-examined, and the
new loan is originated based on that re-examination (often by a
lender different than the original one) plus then-prevailing
interest rates; such a refinancing may benefit the borrower or
the lender. Future refinancing is assumed during underwriting
of the original loan because the underwriting computations
assume a period far longer than the term of the loan; thus, a
drop in the value of the property as an income-producing asset
stiffens the loan terms and increases the economic costs to the
borrower. Those costs may make further operation of the
property by the developer untenable, transferring the loss of
value to the lender.
As discussed below, a number of different classes of
financial institutions provide permanent financing and
refinancing for commercial real estate projects. Depository
institutions, especially in smaller communities, are likely to
finance local projects and hold the loans on their books as
whole loans. Pension funds and insurance companies are major
whole loan investors, although they tend to originate their
loans through a contracted mortgage bank or mortgage brokerage
firm. And a large number of permanent loans are funded through
the issuance of commercial mortgage-backed securities (CMBS),
described below in Section E.2.
In order to fund a large whole loan mortgage, a group of
investors will often form a syndicate to invest in a project
jointly and thereby spread risks or allow larger amounts to be
funded. Smaller banks will often syndicate a large mortgage
among a group of banks with similar investment needs.
Real estate syndications are particularly common among
equity investors, although permanent mortgages, construction
loans, and various combinations of investment types are
syndicated as well. A syndicator, often the general partner of
a limited partnership, acts as the sponsor and organizer of the
syndication. The syndicator usually does not invest much of its
own capital; instead, it earns a fee for its management role.
Aside from limited partnerships, real estate investors use
numerous other types of syndication structures. These include
``blind pools,'' in which the syndicator has great discretion
over the properties or types of investments to be funded, and
public syndicates, which are structured to allow the interests
to be sold to investors in different states.\33\
---------------------------------------------------------------------------
\33\ See generally Brueggeman and Fisher, supra note 13, at 368-
386.
---------------------------------------------------------------------------
The patterns of commercial real estate financing--and loan
administration through a network of servicers--are discussed in
Section E.
3. Kinds of Difficulties Commercial Real Estate Can Encounter--An
Introduction
There are two types of difficulties that commercial real
estate financing arrangements encounter most frequently. The
first is credit risk, where the property produces insufficient
cash flow to service the mortgage. The second is term risk,
which involves difficulty refinancing the current mortgage on
the property at the end of the loan term. Term risk itself has
two parts. The first involves difficulties faced by owners of
relatively healthy properties, who cannot refinance because a
credit contraction or severe economic downturn either limits
the capital available or tightens underwriting standards. The
second type of term risk involves difficulties faced by owners
of projects that were originally financed based on faulty
underwriting at a time when commercial real estate values were
inflated. The problems posed by both credit risk and term risk
are discussed in Section F.2.
C. History of Commercial Real Estate Concerns
Commercial real estate concerns are not new. The nation
experienced a major commercial real estate crisis during the
1980s that resulted in the failure of several thousand banks
and cost the taxpayers $157 billion (nominal dollars). More
than half a decade ago, the banking supervisors began to
express worries about a new overconcentration in commercial
real estate lending, especially at the smaller institutions, as
discussed below, and in Section H.1.
1. Commercial Real Estate Crises of the 1980s and 1990s
Commercial real estate crises have happened, and challenged
the regulatory apparatus, before. Historically, the commercial
real estate market has been cyclical, and some oscillation
between booms and busts is natural.\34\ The last significant
U.S. real estate-related financial crisis before the 1980s
occurred in the late 1920s and early 1930s. The boom and bust
that occurred during the 1980s was characterized by commercial
property values that fell between 30 and 50 percent in a two-
year period--at the time the largest drop in property values in
the United States since the Great Depression.\35\
---------------------------------------------------------------------------
\34\ See C. Alan Garner, Is Commercial Real Estate Reliving the
1980s and Early 1990s?, Federal Reserve Bank of Kansas City--Economic
Review, at 91 (Fall 2008) (online at www.frbkc.org/Publicat/ECONREV/
PDF/3q08Garner.pdf) (hereinafter ``Garner Economic Review Article'').
\35\ Jim Clayton, Cap Rates & Real Estate Cycles: A Historical
Perspective with a Look to the Future, Cornerstone Real Estate Advisors
(June 2009) (online at www.cornerstoneadvisers.com/research/
CREACapRates.pdf). A more detailed description of the causes of the
1980s crisis appears in Annex I, infra.
---------------------------------------------------------------------------
The initial boom was so great that between 1980 and 1990
the total value of commercial real estate loans issued by U.S.
banks tripled, representing an increase from 6.9 percent to
12.0 percent of banks' total assets.\36\ Savings and loan
institutions (S&Ls) also increased their commercial real estate
loan portfolios as the proportion of their portfolios in
residential mortgage lending declined.\37\
---------------------------------------------------------------------------
\36\ This does not include the quantities being loaned by credit
unions or thrift institutions. See Federal Deposit Insurance
Corporation, History of the Eighties--Lessons for the Future, at 152
(Dec. 1997) (online at www.fdic.gov/bank/historical/history/
137_165.pdf) (hereinafter ``History of the Eighties'').
\37\ Id., at 26.
---------------------------------------------------------------------------
From the late 1980s, however, the value of commercial real
estate properties rapidly declined, and by 1991 a large
proportion of banks' commercial real estate loans were either
non-performing or foreclosed.\38\ Residential property values
also fell nine percent from 1980 to 1985.\39\ Due to the more
localized nature of banking during this period--the result of
public policies at both the federal and state levels that
discouraged or even prohibited interstate banking and
branching--states such as Texas and Florida were affected more
severely than other areas.\40\ Unable to recoup their losses,
roughly 2,300 lending institutions failed, and the government
was forced to expend $157.5 billion (approximately $280 billion
in 2009 dollars) \41\ protecting depositors' funds and
facilitating the closure or restructuring of these
organizations.
---------------------------------------------------------------------------
\38\ Id., at 153.
\39\ Robert Shiller, Irrational Exuberance (online at
www.econ.yale.edu/ centsshiller/data/Fig2-1.xls) (accessed Jan. 27,
2010). Percentage change is inflation adjusted.
\40\ See Frederic J. Mishkin, The Economics of Money, Banking, and
Financial Markets (Addison-Wesley, 2003). See also Lawrence J. White,
The S&L Debate: Public Policy Lessons for Bank and Thrift Regulation
(Oxford University Press, 1991).
\41\ Inflation-adjusted figures are calculated using the U.S.
Bureau of Labor Statistics' Consumer Price Index Inflation Calculator.
U.S. Bureau of Labor Statistics, CPI Inflation Calculator (online at
data.bls.gov/cgi-bin/cpicalc.pl) (accessed Feb. 8, 2010).
---------------------------------------------------------------------------
Between 1986 and 1994, 1,043 thrift institutions and 1,248
banks failed, with total assets of approximately $726 billion
(approximately $1.19 trillion in 2009 dollars).\42\ Although
the commercial real estate market was not the only market
suffering a downturn at this time and therefore cannot be
labeled as the only cause of these failures, an analysis of
bank assets indicates that those institutions that had invested
heavily in commercial real estate during the preceding decade
were substantially more likely to fail than those that had
not.\43\
---------------------------------------------------------------------------
\42\ $519 billion of these assets belonged to failed thrift
institutions, and $207 billion to failed banks ($851.91 billion and
$339.78 billion in 2009 dollars, respectively). See Timothy Curry and
Lynn Shibut, The Cost of the Savings and Loan Crisis: Truth and
Consequences, FDIC Banking Review, at 26 (Dec. 2000) (online at
www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf). See also
Federal Deposit Insurance Corporation, Number and Deposits of BIF-
Insured Banks Closed Because of Financial Difficulties, 1934 through
1998 (online at www.fdic.gov/about/strategic/report/98Annual/119.html)
(accessed at Jan. 15, 2010).
\43\ See Rebel A. Cole and George W. Fenn, The Role of Commercial
Real Estate Investments in the Banking Crisis of 1985-92, at 13 (Nov.
1, 2008) (online at ssrn.com/abstract=1293473) (hereinafter ``Cole and
Fenn'').
---------------------------------------------------------------------------
Congress responded to the banking and thrift crisis of the
1980s by passing the Financial Institutions Reform, Recovery
and Enforcement Act (FIRREA) in 1989. This Act consolidated the
major federal deposit insurance programs under the authority of
the Federal Deposit Insurance Corporation (FDIC) and created
the Resolution Trust Corporation (RTC), which was tasked with
liquidating the assets of insolvent thrift institutions and
using the revenue to recoup the government's outlays. The RTC
is generally considered to have been a successful program.\44\
---------------------------------------------------------------------------
\44\ COP August Oversight Report, supra note 5, at 40;
Congressional Oversight Panel, April Oversight Report: Assessing
Treasury's Strategy: Six Months of TARP, at 49-50 (Apr. 7, 2009)
(online at cop.senate.gov/documents/cop-040709-report.pdf).
---------------------------------------------------------------------------
One consequence of the thrift and banking crisis of the
late 1980s and early 1990s was the sharp decline in the number
of banks and thrifts: in 1980, there were 14,222 banks, but
only 10,313 by 1994. The thrift industry contracted from 3,234
savings and loans in 1986 to 1,645 institutions in 1995. The
banking sector also had become more concentrated over this
period, with the 25 largest institutions holding 29.3 percent
of insured banking deposits in 1980, growing to 42.9 percent in
1994.\45\
---------------------------------------------------------------------------
\45\ See Stephen Rhoades, Bank Mergers and Industrywide Structure,
1980-1994, at 25 (Jan. 1996) (online at www.federalreserve.gov/pubs/
StaffStudies/1990-99/ss169.pdf).
---------------------------------------------------------------------------
From 1990 onward, the commercial real estate market
gradually recovered, and by the end of the decade it was once
again a popular investment option.\46\ There were three broad
reasons. First, the basic factors necessary for market recovery
were present: the economy was in a sustained upswing, which
meant that the demand for office and retail space was still
growing, and the monetary and regulatory problems that had
allowed the market to run out of control had been resolved.\47\
---------------------------------------------------------------------------
\46\ Roger Thompson, Rebuilding Commercial Real Estate, HBS Alumni
Bulletin (Jan. 9, 2006) (online at hbswk.hbs.edu/item/5156.html)
(hereinafter ``Rebuilding Commercial Real Estate'').
\47\ See HighBeam Business, Operators of Nonresidential Buildings
Market Report (online at business.highbeam.com/industry-reports/
finance/operators-of-nonresidential-buildings) (hereinafter
``Nonresidential Buildings Market Report'') (accessed Jan. 19, 2010).
---------------------------------------------------------------------------
Second, the collapse prompted a restructuring of how the
commercial real estate market operated, which in turn brought
new investments. Many commercial property owners viewed going
public--moving from private ownership to the public real estate
investment trust (REIT) model (rarely used before 1990)--as a
way to recapitalize their holdings and operations, and thereby
avoid bankruptcy. These proved remarkably popular, and between
1992 and 1997, approximately 150 REITs were organized, with
aggregate equity value escalating from $10 billion to over $175
billion during that period.\48\ At the same time, Wall Street
banks--hitherto largely uninvolved in commercial real estate--
saw the defaulted loans the RTC was selling as a good
opportunity to move into the real estate market for a low entry
cost.\49\ These banks also came up with a proposal for how the
RTC could dispose of the billions of dollars in thrift loans
that were not in default: create commercial mortgage-backed
securities. These proved to be popular, too, and attracted
considerable investment.\50\
---------------------------------------------------------------------------
\48\ See Rebuilding Commercial Real Estate, supra note 46.
\49\ See Rebuilding Commercial Real Estate, supra note 46.
\50\ See Rebuilding Commercial Real Estate, supra note 46.
---------------------------------------------------------------------------
In addition to the need for the government to dispose of
these financial assets, the Tax Reform Act of 1986, which
created the Real Estate Mortgage Investment Conduit (REMIC),
facilitated the issuance of mortgage securitizations, including
CMBS.
Finally, although the bursting of the technology bubble of
2001 had negative repercussions across all markets, it caused
investors to become wary of new industries and move back toward
more traditional investment opportunities like commercial real
estate. It helped that most REITs were continuing to report
double-digit rates of return.\51\ This extra investment shored
up the commercial real estate market in a time when most other
markets were suffering.\52\
---------------------------------------------------------------------------
\51\ See Rebuilding Commercial Real Estate, supra note 46.
\52\ See Nonresidential Buildings Market Report, supra note 47
(accessed Jan. 19, 2010); see also Rebuilding Commercial Real Estate,
supra note 46.
---------------------------------------------------------------------------
2. Recognition of Commercial Real Estate Problems Before the Crisis
Broke
During the boom in residential real estate in the early to
mid-2000s, larger institutions and less regulated players came
to dominate most credit offerings to individual consumers, such
as home mortgages and credit cards.\53\ In response to this
increased competition in other areas, smaller and community
banks increased their focus on commercial real estate
lending.\54\ Commercial real estate lending, which typically
requires greater investigation into individual loans and
borrowers, also caters to the strengths of smaller and
community financial institutions.\55\ As a result, these
smaller institutions could generate superior returns in
commercial real estate, and many institutions grew to have high
commercial real estate concentrations on their balance sheets.
---------------------------------------------------------------------------
\53\ Federal Deposit Insurance Corporation, The Future of Banking
in America: Community Banks: Their Recent Past, Current Performance,
and Future Prospects (Jan. 2005) (online at www.fdic.gov/bank/
analytical/banking/2005jan/article1.html); Senate Committee on Banking,
Housing, and Urban Affairs, Testimony of John Dugan, Comptroller of the
Currency, The State of the Banking Industry, 110th Cong. (Mar. 4, 2008)
(online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=44b0e0bc-10ee-447b-a1e8-
8211ea4c70dc) (hereinafter ``Dugan Testimony, March 4, 2008 Senate
Banking Hearing'').
\54\ Dugan Testimony, Dugan Testimony, March 4, 2008 Senate Banking
Hearing, supra note 53. See also Board of Governors of the Federal
Reserve System, Speech of Chairman Ben S. Bernanke to the Independent
Community Bankers of America National Convention and Techworld (Mar. 8,
2006) (online at www.federalreserve.gov/newsevents/speech/
Bernanke20060308a.htm) (hereinafter ``Bernanke Community Bankers
Speech'') (discussing the evolution of unsecured personal lending from
a relationship lending paradigm to a highly quantitative paradigm more
suitable for larger financial institutions).
\55\ Bernanke Community Bankers Speech, supra note 54. See also
Dugan Testimony, Dugan Testimony, March 4, 2008 Senate Banking Hearing,
supra note 53.
---------------------------------------------------------------------------
At the same time, commercial real estate secured by large
properties with steady income streams, the highest quality
borrowers in the space, gravitated towards origination by
larger institutions with subsequent distribution to the CMBS
market.\56\ These properties typically require larger loans
than smaller and community banks can provide, and the greater
resources of larger institutions and the secondary market can
better satisfy these needs.\57\ The CMBS market therefore
captured many of the most secure commercial real estate
investments.
---------------------------------------------------------------------------
\56\ Dugan Testimony, Dugan Testimony, March 4, 2008 Senate Banking
Hearing, supra note 53; Richard Parkus, The Outlook for Commercial Real
Estate and Its Impact on Banks, at 17 (Jul. 30, 2009) (online at
www.cre.db.com/sites/default/files/docs/research/cre_20090730.pdf). The
CMBS market is discussed below, in Section E.2.
\57\ Dugan Testimony, Dugan Testimony, March 4, 2008 Senate Banking
Hearing, supra note 53.
---------------------------------------------------------------------------
In combination, these two trends meant that, even absent a
commercial real estate bubble or weak economic conditions,
smaller and community banks would have greater exposure to a
riskier set of commercial real estate loans. Alongside
substantial asset price corrections and deteriorating market
fundamentals, these conditions put smaller and community banks
at much greater risk than the collapse in residential real
estate did.
By early 2006, bank supervisors had reason to be concerned
about the state of the commercial real estate sector. As was
happening in the residential market, a confluence of low
interest rates, high liquidity in the credit markets, a drop in
underwriting standards, and rapidly rising ``bubble'' values
produced a boom in ``bubble-induced'' construction and real
estate sales based on a combination of unrealistic projections
and relaxed underwriting standards.\58\ In 2005 and 2006, a
survey of the 73 largest national banks found that their loan
standards were weakening, as Figure 4 shows.\59\ The banks'
commercial real estate lending portfolios were also becoming
riskier, as shown in Figure 5, and the outlook over the next 12
months was for the risks to continue to grow.\60\
---------------------------------------------------------------------------
\58\ Federal Deposit Insurance Corporation, Financial Institution
Letters: Managing Commercial Real Estate Concentrations in a
Challenging Environment (March 17, 2008) (online at www.fdic.gov/news/
news/financial/2008/fil08022.html) (hereinafter ``Financial Institution
Letters'').
\59\ Office of the Comptroller of the Currency, Survey of Credit
Underwriting Practices 2006, at 25-27 (Oct. 2006) (online at
www.occ.treas.gov/2006Underwriting/2006UnderwritingSurvey.pdf)
(hereinafter ``Survey of Credit Underwriting Practices'').
\60\ Id., at 25-27.
---------------------------------------------------------------------------
FIGURE 4: CHANGES IN UNDERWRITING STANDARDS FOR NON-CONSTRUCTION
COMMERCIAL REAL ESTATE LOANS \61\
---------------------------------------------------------------------------
\61\ Id., at 25-27.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 5: CHANGES IN THE LEVEL OF CREDIT RISK IN BANK PORTFOLIOS FOR
NON-CONSTRUCTION COMMERCIAL REAL ESTATE LOANS \62\
---------------------------------------------------------------------------
\62\ Id., at 25-27.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Lax underwriting was also evident in CMBS deals from 2005
to 2007. In the late 1990s, only six to nine percent of the
loans in CMBS transactions were interest-only loans, during the
term of which the borrower was not responsible for paying down
principal, as Figure 6 shows. By 2005, that figure had climbed
to 48 percent, and by 2006, it was 59 percent.\63\ The
Government Accountability Office (GAO) found in a report this
month that CMBS underwriting standards were at their worst in
2006-2007.\64\
---------------------------------------------------------------------------
\63\ Bloomberg data (accessed Jan. 12, 2010).
\64\ Government Accountability Office, Troubled Asset Relief
Program: Treasury Needs to Strengthen its Decision-Making Process on
the Term Asset-Backed Securities Liquidity Facility at 29 (Feb. 2010)
(online at www.gao.gov/new.items/d1025.pdf) (hereinafter ``GAO TALF
Report'') (also noting that commercial real estate prices have been
falling since early 2008, and CMBS delinquencies have been rising, and
stating: ``The Federal Reserve and Treasury have continued to note
their ongoing concerns about this segment of the market'').
---------------------------------------------------------------------------
FIGURE 6: PERCENTAGE OF CMBS THAT WERE INTEREST-ONLY AND PARTIAL
INTEREST-ONLY AT ORIGINATION, BY YEAR \65\
---------------------------------------------------------------------------
\65\ Bloomberg data (accessed Jan. 12, 2010). ``Interest only''
refers to the original percentage of the loans comprising the
collateral that are fully interest only, meaning that they do not
amortize. ``Partial interest only'' refers to the original percentage
of the loans comprising the collateral that are partially interest
only, meaning that they do not amortize over part of the term.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
But weakened underwriting was not the only reason for
supervisors to be concerned. In fact, beginning in 2003, the
Office of the Comptroller of the Currency (OCC) conducted an
examination of commercial real estate lending across multiple
institutions and found increasing policy exceptions,
lengthening maturities, and a lack of quality control and
independence in the appraisal process.\66\ At the same time
that loans were growing riskier, many banks' portfolios were
becoming less diversified generally and more concentrated in
commercial real estate lending. In 2003, banks with assets of
$100 million to $1 billion had commercial real estate
portfolios equal to 156 percent of their total risk-based
capital. That figure had risen to 318 percent by the third
quarter of 2006.\67\ The concentrations were particularly
worrisome in the West and the Southeast. By June 2005, in the
FDIC's San Francisco region, which covers 11 states including
California, Arizona, and Nevada, commercial real estate lending
at 60 percent of banks amounted to
---------------------------------------------------------------------------
\66\ Office of the Comptroller of the Currency, Remarks by John C.
Dugan, Comptroller of the Currency, Before the New York Bankers
Association, New York, New York (Apr. 6, 2006) (online at
www.occ.treas.gov/ftp/release/2006-45a.pdf) (hereinafter ``Dugan
Remarks Before the New York Bankers Association'').
\67\ Office of the Comptroller of the Currency, Board of Governors
of the Federal Reserve System, Federal Deposit Insurance Corporation,
Office of Thrift Supervision, Concentrations in Commercial Real Estate,
Sound Risk Management Practices (Jan. 9, 2006) (online at
www.occ.treas.gov/ftp/release/2006-2a.pdf) (hereinafter ``Agencies
Proposed Guidance'').
---------------------------------------------------------------------------
more than three times their capital levels.\68\ The picture was
only slightly less worrisome in the Atlanta region, which
covers seven states; the percentage of banks in the region that
exceeded the 300 percent threshold was 48 percent.\69\ The
broader market environment exacerbated the problem because when
mortgage markets froze, builders could not find buyers, and the
need for developed lots decreased dramatically, causing many
developers to leave behind unfinished projects with loans that
could not be serviced.\70\
---------------------------------------------------------------------------
\68\ Federal Deposit Insurance Program, Office of the Inspector
General, FDIC's Consideration of Commercial Real Estate Concentration
Risk in FDIC-Supervised Institutions, at 2 (Feb. 2008) (Audit Report
No. 08-005) (online at www.fdicig.gov/reports08/08-005.pdf)
(hereinafter ``FDIC's Audit Report'').
\69\ Id., at 2.
\70\ Congressional Oversight Panel, Testimony of Chris Burnett,
chief executive officer, Cornerstone Bank, Atlanta Field Hearing on
Commercial Real Estate (Jan. 27, 2009) (online at cop.senate.gov/
hearings/library/hearing-012710-atlanta.cfm) (hereinafter ``COP Field
Hearing in Atlanta Testimony of Chris Burnett'').
---------------------------------------------------------------------------
3. During the Late 2000s
Revelations about deteriorating loan performance in
subprime residential mortgages and resulting declines in the
value of residential mortgage backed securities (RMBS),
collateralized debt obligations (CDOs), and other instruments
began in the spring of 2007.\71\ The problems continued to
worsen through the summer of 2007.\72\ As the extent of this
crisis became apparent, analysts began warning of a potential
follow-on crisis in commercial real estate.
---------------------------------------------------------------------------
\71\ See, e.g., Senate Committee on Banking, Housing & Urban
Affairs, Subcommittee on Securities, Insurance and Investment, Written
Testimony of Warren Kornfeld, Managing Director, Moody's Investors
Service, Subprime Mortgage Market Turmoil: Examining the Role of
Securitization, 110th Cong., at 14 (Apr. 17, 2007) (online at
banking.senate.gov/public/
index.cfm?FuseAction=Hearings.List&Month=0&Year=2007) (``Pools of
securitized 2006 mortgages have experienced rising delinquencies and
loans in foreclosure, but due to the typically long time to foreclose
and liquidate the underlying property, actual losses are only now
beginning to be realized''); New Century Financial Corporation, New
Century Financial Corporation Files for Chapter 11; Announces Agreement
to Sell Servicing Operations (Apr. 2, 2007) (online at
www.prnewswire.com/news-releases/new-century-financial-corporation-
files-for-chapter-11-announces-agreement-to-sell-servicing-operations-
57759932.html).
\72\ G.M. Filisko, Subprime Lending Fallout, National Real Estate
Investor (July 1, 2007) (online at nreionline.com/finance/reit/
real_estate_subprime_lending_fallout/).
---------------------------------------------------------------------------
In November 2007, a Moody's report and a Citigroup
analyst's note both predicted falling asset prices and trouble
for commercial real estate similar to the crisis in the
residential real estate market.\73\ Other experts sounded an
alarm about commercial real estate as part of a broader alarm
about the worsening of the financial crisis. In testimony
before the House Financial Services Committee, Professor
Nouriel Roubini predicted that ``the commercial real estate
loan market will soon enter into a meltdown similar to the
subprime one.'' \74\
---------------------------------------------------------------------------
\73\ See, e.g., John Glover and Jody Shen, Deadbeat Developers
Signaled by Property Derivatives, Bloomberg (Nov. 28, 2007) (online at
www.bloomberg.com/apps/news?pid=newsarchive&sid=au2XBiCyWeME); Peter
Grant, Commercial Property Now Under Pressure, Wall Street Journal
(Nov. 19, 2007); Moody's Investor Service, Moody's/REAL Commercial
Property Price Indices, November 2007, at 1 (Nov. 16, 2007) (online at
www.realindices.com/pdf/CPPI_1107.pdf).
\74\ See, e.g., House Committee on Financial Services, Written
Testimony of Nouriel Roubini, Professor of Economics, New York
University Stern School of Business, Monetary Policy and the State of
the Economy, 110th Cong. (Feb. 26, 2008) (online at
financialservices.house.gov/hearing110/roubini022608.pdf).
---------------------------------------------------------------------------
This view was by no means unanimous. During late 2007 and
early 2008, a number of commentators challenged the assertion
that the commercial real estate market was in crisis, and
anticipated no collapse.\75\
---------------------------------------------------------------------------
\75\ While these analysts noted the downturn in commercial real
estate, they expressed the opinion that market fundamentals were sound.
See, e.g., Mortgage Bankers Association, Commercial Real Estate/
Multifamily Finance Quarterly Data Book: Q4 2007, at 55 (Mar. 26, 2008)
(online at www.mortgagebankers.org/files/Research/DataBooks/
2007fourthquarterdatabook.pdf); Keefe, Bruyette & Woods, KRX Monthly:
Is Commercial Real Estate Next?, at 1 (Mar. 4, 2008) (online at
www2.snl.com/InteractiveX/ResearchRpts/
ResearchReportDetails.aspx?KF=5701364&persp=rr&KD=7424418); Lew
Sichelman, Major Fall in CRE Deals Since End of Summer, National
Mortgage News (Nov. 5, 2007) (online at nationalmortgagenews.com/
premium/archive/?id=157677).
---------------------------------------------------------------------------
FDIC senior management also identified commercial real
estate as a potential problem during early 2008. Chairman
Sheila Bair testified before the Senate Banking Committee in
March and June 2008, both times emphasizing smaller banks'
concentrated holdings of problematic commercial real estate
investments.\76\ This position represented a shift in emphasis
from her position in December 2007, when she distinguished the
current market difficulties from the S&L crisis because of the
earlier crisis' roots in commercial real estate problems.\77\
---------------------------------------------------------------------------
\76\ Senate Committee on Banking, Housing, and Urban Affairs,
Written Testimony of Sheila Bair, Chair, Federal Deposit Insurance
Corporation, The State of the Banking Industry: Part II, 110th Cong.,
at 4-5 (June 5, 2008) (online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=9708bf58-20ac-4aa9-9240-
f0d772a1be25) (hereinafter ``June 5, 2008 Written Testimony of Sheila
Bair''); Senate Committee on Banking, Housing, and Urban Affairs,
Testimony of Sheila Bair, Chair, Federal Deposit Insurance Corporation,
The State of the Banking Industry, 110th Cong., at 11-12 (Mar. 4, 2008)
(online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=093111d0-c4fe-47f30-a87a-
b103f0513f7a) (hereinafter ``March 4, 2008 Written Testimony of Sheila
Bair'').
In responding to comments received on their proposed guidance on
commercial real estate lending in 2006, the supervisors noted the
concerns that smaller institutions expressed about the fact that real
estate lending had become their ``bread and butter'' business in part
because other lending opportunities for these smaller banks have
dwindled over time. Many observers have noted that small and medium
sized banks have lost market share in credit card lending and mortgage
financing, for example, leaving them less diversified and with
portfolios concentrated on riskier loans such as commercial real
estate. This, in turn, reflects the larger trends in financial
intermediation, particularly the growth in securitization of mortgages
and consumer and credit card loans as well as the economies of scale
that allow the largest banks to originate such loans in large volumes
either for their own portfolios or for inclusion in asset backed or
mortgage backed securities. See Agencies Proposed Guidance, supra note
67. See, e.g., Timothy Clark et al., The Role of Retail Banking in the
U.S. Banking Industry: Risk, Return, and Industry Structure, FRBNY
Economic Policy Review, at 39, 45-46 (Dec. 2007) (online at
www.newyorkfed.org/research/epr/07v13n3/0712hirt.pdf); Joseph Nichols,
How Has the Growth of the CMBS Market Impacted Commercial Real Estate
Lending at Banks?, CMBS World, at 18, 19-20 (Summer 2007) (online at
www.cmsaglobal.org/cmbsworld/cmbsworld_toc.aspx?folderid=1386).
\77\ House Committee on Financial Services, Testimony of Sheila
Bair, Chairman, Federal Deposit Insurance Corporation, Hearing on
Foreclosure Prevention, at 37, 110th Cong. (Dec. 6, 2007) (online at
frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=110_house_hearings&docid=f:40435.pdf).
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In June 2008, the FDIC indicated that its examiners were
aware of the potential for a crisis and continued to press
banks that were not in compliance with 2006 interagency
guidance on concentrations in commercial real estate.\78\
However, the FDIC Inspector General's Material Loss Review
found cases in which examiners did not call for action by the
FDIC in resolving the troubled bank involved soon enough.\79\
---------------------------------------------------------------------------
\78\ See, e.g., June 5, 2008 Written Testimony of Sheila Bair,
supra note 76, at 13.
\79\ Federal Deposit Insurance Corporation, Office of Inspector
General, Semiannual Report to the Congress, at 13 (Oct. 30, 2009)
(online at www.fdicoig.gov/semi-reports/SAROCT09/OIGSemi_FDIC_09-9-
09.pdf). See Section H.1, below.
---------------------------------------------------------------------------
The OCC and the Federal Reserve Board (Federal Reserve),
like the FDIC, also noted that many of their regulatory charges
were potentially overexposed in commercial real estate.\80\
Similarly, both agencies focused on ensuring that their
examiners who supervised smaller and community banks with large
commercial real estate exposures acted within the boundaries of
the 2006 interagency guidance.\81\
---------------------------------------------------------------------------
\80\ Senate Committee on Banking, Housing, and Urban Affairs,
Written Testimony of Donald L. Kohn, Vice Chairman, Board of Governors
of the Federal Reserve System, The State of the Banking Industry, 110th
Cong. (Mar. 4, 2008) (online at banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=5496f28d-b49b-4a58-befa-
8bb3708de3cb) (hereinafter ``Written Testimony of Donald Kohn''); Dugan
Testimony, March 4, 2008 Senate Banking Hearing, supra note 53.
\81\ Written Testimony of Donald Kohn, supra note 80.
---------------------------------------------------------------------------
In contrast to the FDIC, Federal Reserve, and OCC,
Treasury's public statements and initiatives during late 2007
and early 2008 concentrated mostly on the residential real
estate sector. To the extent that Treasury discussed commercial
real estate, it did so in the context of a broader real estate
market contraction or in the context of write-downs on
CMBS.\82\
---------------------------------------------------------------------------
\82\ Senate Committee on Banking, Housing, and Urban Affairs,
Testimony of Henry M. Paulson, Jr., Secretary of the Treasury, Recent
Developments in U.S. Financial Markets and Regulatory Responses to
Them, 110th Cong. (July 15, 2008) (online at banking.senate.gov/public/
index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=8f6a9350-3d39-43a0-
bbfb-953403ab19cc).
---------------------------------------------------------------------------
In the months leading up to the financial crisis and the
panic atmosphere that surrounded the consideration of EESA, the
Act giving the Treasury Secretary the authority to establish
the TARP, both private analysts and bank supervisors began
noticing warning signs that a commercial real estate collapse
could endanger the health of the financial system. But, again,
these warnings typically took place alongside more dire
warnings about the crisis in the residential real estate
market.\83\
---------------------------------------------------------------------------
\83\ John McCune, First-half 2008: far from a pretty picture, ABA
Banking Journal, at 7 (Sept. 1, 2008) (``The impact of the [residential
real estate] collapse also appeared to be percolating down into the
commercial real estate lending segment. . . . It remains to be seen if
this is the start of a larger trend, but is certainly something worth
paying attention to''); Mark Vitner, Senior Economist, Wachovia, and
Anika R. Khan, Economist, Wachovia, Could housing tremors shake
commercial real estate?, ABA Banking Journal, at 56 (May 1, 2008)
(``The abrupt collapse of the subprime mortgage market and severe
correction in home construction and prices has raised concerns the same
thing could happen to commercial real estate'').
---------------------------------------------------------------------------
4. Emergency Economic Stabilization Act and the TARP
During consideration of EESA, concerns about the commercial
real estate market occasionally surfaced as part of the floor
debate in both houses of Congress, especially in the context of
critiquing the bill for not doing more to protect the interests
of commercial real estate borrowers and lenders. For example,
Representative Steven LaTourette criticized the practice of
bank examiners insisting that banks write down commercial real
estate assets that had declined in value, resulting in
decreased credit capacity for community needs like additional
commercial real estate development.\84\ Senator Orrin Hatch
similarly highlighted the need to preserve commercial real
estate expansion and construction as part of broader economic
needs not addressed in EESA.\85\
---------------------------------------------------------------------------
\84\ Statement of Congressman Steven LaTourette, Congressional
Record, H10386-87 (Sept. 29, 2008) (``[I]f you are a bank and you have
a million dollar building in your portfolio but because the real estate
market isn't doing so well, the bank examiners have come in and they
have said your building is only worth $400,000 today. You haven't sold
it. Nothing has happened to it. You are still collecting rent on it,
but you have taken a $600,000 hit on your balance sheet. That has a
double-edged effect in that now that you have a reduced balance sheet,
you have to squirrel more cash so you can't make loans to people
wanting to engage in business, people wanting to buy homes'').
\85\ Statement of Senator Orrin Hatch, Congressional Record, S10263
(Oct. 1, 2008) (``The rest of the economy is in urgent need of
attention too. . . . We need to keep business fixed investment in new
plant and equipment and commercial construction moving forward. That
would help keep employment, productivity, and wages growing, and keep
the rest of the economy healthy'').
---------------------------------------------------------------------------
This legislative concern about commercial real estate
assets translated into specific authority in the final
legislation to address commercial real estate problems. EESA
signals that troubled commercial real estate assets, like
residential assets, are important to financial stability. The
statute itself identifies commercial mortgages, as well as
securities based on, or derivatives of, commercial mortgages,
as troubled assets, that Treasury may purchase without a
written determination that such a purchase is necessary for
financial stability.\86\ In contrast, other financial
instruments require that Treasury deliver such a written
determination to Congress prior to making a purchase.\87\
---------------------------------------------------------------------------
\86\ The mortgage must have been originated, or the security or
derivative must have been issued, prior to March 14, 2008. Residential
mortgages, securities, or derivatives also fall into this category of
Treasury's purchasing authority. 12 U.S.C. Sec. 5202(9)(A).
\87\ 12 U.S.C. Sec. 5202(9)(B).
---------------------------------------------------------------------------
Given congressional concerns regarding commercial real
estate, the Panel has conducted previous work on the potential
problems in the commercial real estate market. The Panel held a
field hearing in New York about commercial real estate credit,
hearing from analysts, market participants, and
supervisors.\88\ In its June Report, the Panel addressed the
failure to capture the risk posed by commercial real estate
loans as a major shortcoming of the stress tests conducted
under the Supervisory Capital Assistance Program in May
2009.\89\ The Panel further addressed the risks posed by
commercial real estate assets in its August Report on the
continuing presence of troubled assets on bank balance
sheets.\90\ This report, as well as its January 27, 2010 field
hearing in Atlanta, followed and amplified these efforts.
---------------------------------------------------------------------------
\88\ Congressional Oversight Panel, The Impact of Economic Recovery
Efforts on Corporate and Commercial Real Estate Lending (May 28, 2009)
(online at cop.senate.gov/documents/transcript-052809-newyork.pdf).
\89\ COP June Oversight Report, supra note 6.
\90\ COP August Oversight Report, supra note 5.
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D. Present Condition of Commercial Real Estate
The commercial real estate market is currently experiencing
considerable difficulty for two distinct reasons. First, the
current economic downturn has resulted in a dramatic
deterioration of commercial real estate fundamentals.
Increasing vacancy rates and falling rental prices present
problems for all commercial real estate loans. Decreased cash
flows will affect the ability of borrowers to make required
loan payments. Falling commercial property values result in
higher LTV ratios, making it harder for borrowers to refinance
under current terms regardless of the soundness of the original
financing, the quality of the property, and whether the loan is
performing.
Second, the development of the commercial real estate
bubble, as discussed above, resulted in the origination of a
significant amount of commercial real estate loans based on
dramatically weakened underwriting standards. These loans were
based on overly aggressive rental or cash flow projections (or
projections that were only sustainable under bubble
conditions), had higher levels of allowable leverage, and were
not soundly underwritten. Loans of this sort (somewhat
analogous to ``Alt-A'' residential loans) will encounter far
greater difficulty as projections fail to materialize on
already excessively leveraged commercial properties.
In both cases, inherently risky construction loans and the
non-recourse nature of permanent commercial real estate
financing increase the pressures that both lenders and
borrowers face. Construction loans are experiencing the biggest
problems with vacancy or cash flow issues, have the highest
likelihood of default, and have higher loss severity rates than
other commercial real estate loans. (For example, the 25
institutions from the Atlanta area that failed since 2008
reported weighted average ADC loans of 384 percent of total
capital a year before their failure.\91\ Because a lender's
recovery is typically limited to the value of the underlying
property, commercial real estate investments are increasingly
at risk as LTV ratios rise or the value of the collateral is no
longer sufficient to cover the outstanding loan amount.
---------------------------------------------------------------------------
\91\ Congressional Oversight Panel, Written Testimony of Doreen
Eberley, acting regional director, Atlanta Regional Office of the
Federal Deposit Insurance Corporation, Atlanta Field Hearing on
Commercial Real Estate, at 4, (Jan. 27, 2010) (online at
cop.senate.gov/documents/testimony-012710-eberley.pdf) (hereinafter
``Written Testimony of Doreen Eberley'').
---------------------------------------------------------------------------
The following three sections further analyze the current
state of the commercial real estate market and the risks posed
to financial institutions by commercial real estate loans. This
section, Section D, discusses the overall condition of the
economy and how negative economic growth, rising unemployment
rates, and decreased consumer spending have impacted commercial
real estate fundamentals. Section E discusses the current
landscape of the commercial real estate market, including
current levels of commercial real estate whole loans and CMBS
by holding institution, property type, and geographic region.
Section F discusses the risks posed by the current state of the
commercial real estate market, such as credit risk (the risk
that loans will default prior to maturity), term risk (the risk
that loans will default at maturity or will be unable to
refinance), the risk that borrowers will be unable to obtain
financing for commercial real estate purchases or developments,
and interest rate risk (the risk that rising interest rates
will make it harder for borrowers to finance or refinance
loans).
Again, no single factor is as important to the state of the
commercial real estate markets as a steady, and indeed swift,
economic recovery. It is questionable whether loans financing
properties on the basis of unrealistic projections, inflated
values, and faulty underwriting during 2005-2007 can survive in
any event, as discussed more fully below. But it is more
important to recognize that the continuing deep recession that
the economy is experiencing is putting at risk many sound
commercial real estate investments that were soundly conceived
and reasonably underwritten.
Economic growth and low unemployment rates lead to greater
demand for, and occupancy of, commercial office space, more
retail tenants and retail sales, and greater utilization of
travel and hospitality space.\92\ Without more people in
stores, more people at hotels, more people able to afford new
or larger apartments, and more businesses seeking new or larger
office space and other commercial property, the markets cannot
recover and the credit and term risk created by commercial real
estate loans cannot abate without the potential imposition of
substantial costs on lenders. Each of these factors has its own
impact on the broader commercial real estate problem. Thus,
retail and hotel-tourist property problems likely reflect
reduced cash flows not only from unemployment but also from
household deleveraging, i.e., higher family savings rates.
Perhaps even more important, the problem property owners and
lenders face derives both from an undersupply of tenants and
purchasers, and economic pressures that reduce incentives for
the flow of new sources of equity into the commercial real
estate markets.
---------------------------------------------------------------------------
\92\ See Congressional Oversight Panel, Written Testimony of Chris
Burnett, chief executive officer, Cornerstone Bank, Atlanta Field
Hearing on Commercial Real Estate, at 3-6 (Jan. 27, 2010) (online
atcop.senate.gov/documents/testimony-012710-burnett.pdf) (hereinafter
``Written Testimony of Chris Burnett'').
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1. Economic Conditions and Deteriorating Market Fundamentals
The health of the commercial real estate market depends on
the health of the overall economy. Consequently, the market
fundamentals will likely stay weak for the foreseeable
future.\93\ This means that even soundly financed projects will
encounter difficulties. Those projects that were not soundly
underwritten will likely encounter far greater difficulty as
aggressive rental growth or cash flow projections fail to
materialize, property values drop, and LTV ratios rise on
already excessively leveraged properties. New and partially
constructed properties are experiencing the biggest problems
with vacancy and cash flow issues (leading to a higher number
of loan defaults and higher loss severity rates than other
commercial property loans).\94\ Falling commercial property
prices are increasing debt-to-equity ratios, decreasing the
amount of equity the borrower holds in the property (putting
pressure on the borrowers) and removing the cushion that
lenders built into non- recourse loans to protect their
original investments (putting pressure on the lenders).
---------------------------------------------------------------------------
\93\ See, e.g., Congressional Oversight Panel, Written Testimony of
Jon D. Greenlee, associate director, Division of Bank Supervision and
Regulation, Board of Governors of the Federal Reserve System, Atlanta
Field Hearing on Commercial Real Estate, at 5-6 (Jan. 27, 2010) (online
at cop.senate.gov/documents/testimony-012710-greenlee.pdf) (hereinafter
``Written Testimony of Jon Greenlee'').
\94\ Id., at 7 (``As job losses continue, demand for commercial
property has declined, vacancy rates increased, and property values
fallen. The higher vacancy levels and significant decline in the value
of existing properties have placed particularly heavy pressure on
construction and development projects that do not generate income until
after completion'').
---------------------------------------------------------------------------
Since the summer of 2007, the ongoing economic crisis has
spread from credit markets, through the financial sector, and
into the broader economy. Economic indicators are sending mixed
signals as to whether the worst is over or whether the nation
should expect further weakening in the economy. Economic growth
has only recently returned after several quarters of decline,
suggesting that a recovery is beginning. However, despite
recent positive Gross Domestic Product (GDP) numbers,
unemployment has risen to levels not seen in decades. Figures 7
and 8 illustrate the evolution of the current economic
downturn.
FIGURE 7: SEASONALLY ADJUSTED ANNUAL GDP GROWTH RATES \95\
---------------------------------------------------------------------------
\95\ U.S. Department of Commerce, Bureau of Economic Analysis,
Gross Domestic Product: Third Quarter 2009 (Dec. 22, 2009) (online at
www.bea.gov/ newsreleases/ national/gdp/2009/xls/gdp3q09_3rd.xls). The
Bureau of Economic Analysis provides that the acceleration in real GDP
growth in Q4 2009, based on their advance estimate, primarily reflected
an acceleration in private inventory replenishment (adding 3.4
percentage points to the fourth quarter change of 5.7 percent), a
deceleration in imports (increasing 10.5 percent in Q4, as compared to
a 21.3 percent increase in Q3), and an upturn in nonresidential fixed
investment (increasing 2.9 percent in Q4, as compared to a 5.9 percent
decrease in Q3) that was partly offset by decelerations in federal
government spending (increasing 0.1 percent in Q4, as compared to an
8.0 percent increase in Q3) and in personal consumption expenditures
(increasing 2.0 percent in Q4, as compared to a 2.8 percent increase in
Q3). U.S. Department of Commerce, Bureau of Economic Analysis, Gross
Domestic Product: Fourth Quarter 2009 (Advance Estimate), at 1-2 (Jan.
29, 2010) (online at www.bea.gov/ newsrelease/national/gdp/
gdpnewsrelease.htm) (hereinafter ``BEA Fourth Quarter GDP Estimate'').
It is yet to be seen whether this growth, driven in part by inventory
replenishment, is sustainable. Sustainability of economic growth will
depend, to some extent, on how (or whether) inventory replenishment
translates into final sales to domestic purchasers.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 8: UNEMPLOYMENT RATES SINCE 2000 \96\
---------------------------------------------------------------------------
\96\ Bureau of Labor Statistics, Employment Status of the Civilian
Noninstitutional Population 16 Years and Over, 1970 to Date (online at
ftp.bls.gov/pub/suppl/empsit.cpseea1.txt) (accessed Feb. 9, 2010).
Underemployment, an alternative measure of the status of employment,
includes a larger percentage of the population and directly follows the
trend of unemployment. Both measures illustrate the continuing
deterioration of employment conditions since January 2008. As of
December 2009, underemployment was 17.3 percent and unemployment was 10
percent. Underemployment, as measured by the Bureau of Labor
Statistics, is comprised of the total number of unemployed as well as
marginally attached workers, discouraged workers, and individuals
employed part-time due to economic factors who would otherwise seek
full-time work. For further discussion of the measure, see Bureau of
Labor Statistics, Alternative Measures of Labor Utilization (Dec. 2009)
(online at www.bls.gov/ news.release/ empsit.t12.htm). In January 2010,
unemployment rates decreased from 10.0 to 9.7 percent and
underemployment decreased from 17.3 to 16.5 percent. Bureau of Labor
Statistics, Employment Situation Summary (Feb. 5, 2010) (online at
bls.gov/ news.release/ empsit.nr0.htm); Bureau of Labor Statistics,
Alternative Measures of Labor Utilization (Jan. 2010) (online at
www.bls.gov/ news.release/ empsit.t15.htm). However, for the week
ending January 30, 2010, the advance figure for initial jobless claims
for unemployment insurance rose to 480,000, an increase of 8,000 from
the previous week's revised figure. This was the fourth rise in initial
jobless claims in the last five weeks. See U.S. Department of Labor,
Unemployment Insurance Weekly Claims Reports, Feb. 4, 2010 (increase of
8,000), Jan. 28, 2010 (decrease of 8,000), Jan. 21, 2010 (increase of
36,000), Jan. 14, 2010 (increase of 11,000), and Jan. 7, 2010 (increase
of 1,000).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Other economic indicators that are vital to the health of
commercial real estate, such as consumer spending, have
experienced overall declines from pre-recession levels but do
not provide a clear message of recovery. For example, personal
consumption has declined from its peak in the fourth quarter of
2007, but quarterly changes have oscillated between positive
and negative.\97\ The extent and timing of the economic
recovery is important in assessing the magnitude of the
commercial real estate problem because, as a general rule,
commercial real estate metrics tend to lag overall economic
performance,\98\ and commercial real estate market fundamentals
have already deteriorated significantly.
---------------------------------------------------------------------------
\97\ U.S. Department of Commerce, Bureau of Economic Analysis,
National Income and Product Accounts Table (Table 2.3.3: Real Personal
Consumption Expenditures by Major Type of Product, Quantity Indexes)
(aggregate numbers, indexed to 2005) (online at www.bea.gov/ National/
nipaweb/ TableView.asp? SelectedTable=63&ViewSeries=
NO&Java=no&Request3 Place=N&3Place=N&FromView= YES&Freq=
Qtr&FirstYear=2007&LastYear= 2009&3Place=N&AllYearsChk=
YES&Update=Update &JavaBox=no#Mid) (accessed Feb. 8, 2010) (showing
increases in Q2 2008, Q1 2009, and Q3 2009).
\98\ Written Testimony of Doreen Eberley, supra note 91, at 7-8
(``Performance of loans that have commercial real estate properties as
collateral typically lags behind economic cycles. Going into an
economic downturn, property owners may have cash reserves available to
continue making loan payments as the market slows, and tenants may be
locked into leases that provide continuing cash flow well into a
recession. However, toward the end of an economic downturn, vacant
space may be slow to fill, and concessionary rental rates may lead to
reduced cash flow for some time after economic recovery begins''). For
example, although the economic recession in the early 2000s officially
lasted only from March 2001 to November 2001, commercial real estate
vacancies did not peak until September 2003 and did not begin to
decline until March 2004. See National Bureau of Economic Research,
Business Cycle Expansions and Contractions (online at www.nber.org/
cycles.html) (accessed Feb. 8, 2010); Mortgage Bankers Association,
Commercial Real Estate/Multifamily Finance Quarterly Data Book: Q3
2009, at 26-27 (Nov. 2009) (hereinafter ``MBA Data Book: Q3 2009'').
Commercial real estate fundamentals tend to track unemployment
rates, another lagging economic indicator, more closely than GDP
growth. The current economic crisis has so far followed this trend,
with vacancy rates continuing to rise even after the return of positive
economic growth. Similar to unemployment rates, vacancy rates began to
fall in 2003, began rising in 2007, and are still rising.
---------------------------------------------------------------------------
For the last several quarters, average vacancy rates have
been rising and average rental prices have been falling for all
major commercial property types.\99\ The following charts
present these changes in average vacancy rates and average
rental prices from 2003 to 2009.
---------------------------------------------------------------------------
\99\ MBA Data Book: Q3 2009, supra note 98, at 26-27.
---------------------------------------------------------------------------
FIGURE 9: COMMERCIAL REAL ESTATE AVERAGE VACANCY RATES BY PROPERTY TYPE
\100\
---------------------------------------------------------------------------
\100\ MBA Data Book: Q3 2009, supra note 98, at 27. Although
average vacancy rates are commensurate with 2003 levels, it should be
noted that the levels in 2003 were also the result of recessionary
conditions of the early 2000s, vacancy rates have been buffered by the
presence of long-term leases on some commercial properties, and the
increase in available commercial space has translated into an
increasing number of properties with vacancy issues.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 10: COMMERCIAL REAL ESTATE AVERAGE RENTAL PRICES BY PROPERTY
TYPE \101\
---------------------------------------------------------------------------
\101\ MBA Data Book: Q3 2009, supra note 98, at 27. See also
Written Testimony of Doreen Eberley, supra note 91, at 4-5 (``As of
third quarter 2009, quarterly rent growth has been negative across all
major commercial real estate property types nationally for at least the
last four quarters. Asking rents for all major commercial real estate
property types nationally were lower on both a year-over-year and
quarter-over quarter basis'').
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Current average vacancy rates and rental prices have been
buffered by the long-term leases held by many commercial
properties (e.g., office and industrial).\102\ The combination
of negative net absorption rates \103\ and additional space
that will become available from projects started during the
boom years \104\ will cause vacancy rates to remain high, and
will continue putting downward pressure on rental prices for
all major commercial property types. Taken together, this
falling demand and already excessive supply of commercial
property will cause many projects to be viable no longer, as
properties lose, or are unable to obtain, tenants and as cash
flows (actual or projected) fall.
---------------------------------------------------------------------------
\102\ See Richard Parkus and Harris Trifon, The Outlook for
Commercial Real Estate and its Implications for Banks, at 10 (Dec.
2009) (hereinafter ``Parkus and Trifon''). See additional discussion of
commercial properties at Section B.1.
\103\ Net absorption rates are a measure of the change in occupancy
levels or vacancy rates. Negative net absorption occurs when the amount
of available commercial space (e.g., through lease terminations and new
construction) exceeds the amount of space being taken off the market
(e.g., through new leases and renewals).
\104\ MBA Data Book: Q3 2009, supra note 98, at 28-29 (as shown by
the number of net completions).
---------------------------------------------------------------------------
In addition to deteriorating market fundamentals, the price
of commercial property has plummeted. As seen in the following
chart, commercial property values have fallen over 40 percent
since the beginning of 2007.\105\
---------------------------------------------------------------------------
\105\ Moody's Investors Service, Moody's/REAL Commercial Property
Price Indices, December 2009, at 1 (Dec. 21, 2009) (hereinafter ``Dec.
2009 Moody's/REAL Commercial Property Price Indices'') (``The peak in
prices was reached two years ago in October 2007, and prices have since
fallen 43.7%''). However, it should be noted that there was a small
uptick in commercial property prices in November. See Moody's Investors
Service, Moody's/REAL Commercial Property Price Indices, January 2010,
at 1 (Jan. 15, 2010) (``After 13 consecutive months of declining
property values, the Moody's/REAL Commercial Property Price Index
(CPPI) measured a 1.0% increase in prices in November. . . . The 1.0%
growth in prices seen in November is a small bright spot for the
commercial real estate sector, which has seen values fall over 43% from
the peak'').
---------------------------------------------------------------------------
FIGURE 11: COMMERCIAL REAL ESTATE PROPERTY PRICE INDICES \106\
---------------------------------------------------------------------------
\106\ See Massachusetts Institute of Technology Center for Real
Estate, Commercial RE Data Laboratory, Transactions-Based Index (TBI)
(accessed February 9, 2010) (measuring price movements and total
returns based on transaction prices of commercial properties
(apartment, industrial, office, and retail) sold from the National
Council of Real Estate Investment Fiduciaries (NCREIF) Index database);
Dec. 2009 Dec. 2009 Moody's/REAL Commercial Property Price Indices,
supra note 105, at 1, 3 (measuring ``the change in actual transaction
prices for commercial real estate assets based on the repeat sales of
the same assets at different points in time''). See also Massachusetts
Institute of Technology Center for Real Estate, Commercial RE Data
Laboratory, Moody's/REAL Commercial Property Price Index (CPPI)
(accessed February 9, 2010) (discussing the difference in Moody's/REAL
CPPI and NCREIF TBI); MBA Data Book: Q3 2009, supra note 98, at 34-35.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The decline in property value is largely driven by
declining cash flows that have resulted from increased vacancy
rates and decreased rental income.\107\ Contracting cash flows
(actual and projected) result in lower net present value
calculations. Tightened underwriting standards also decrease
the ability of borrowers to qualify for commercial real estate
loans, thus decreasing the demand for commercial property.\108\
Sharp decreases in the number of sales of commercial and
multifamily properties reflect such a decrease in demand.\109\
---------------------------------------------------------------------------
\107\ See, e.g., Written Testimony of Doreen Eberley, supra note
91, at 4; Parkus and Trifon, supra note 102, at 32.
\108\ Parkus and Trifon, supra note 102, at 32; see also Written
Testimony of Doreen Eberley, supra note 91, at 6-97 (providing that
tightened underwriting standards and a more risk-averse posture on the
part of lenders has resulted in reduced credit availability and that
reduced credit availability ``reduces the pool of possible buyers,
increases the amount of equity that buyers must bring to transactions,
and causes downward pressure on values'').
\109\ See MBA Data Book: Q3 2009, supra note 98, at 30-31; see also
Congressional Oversight Panel, Written Testimony of Mark Elliott,
partner and head, Office and Industrial Real Estate Group, Troutman
Sanders, Atlanta Field Hearing on Commercial Real Estate, at 1 (Jan.
27, 2010) (online at cop.senate.gov/documents/testimony-012710-
elliott.pdf) (hereinafter ``Written Testimony of Mark Elliott'') (``The
distress [in commercial loan markets in Atlanta] arises out of the
nearly complete shut down of new loans into the market, and a
corresponding and nearly as dramatic shut down of the replacement of
existing loans on commercial properties. . . . This shutdown of the
finance side has had an equally dramatic effect on the buy-side of
commercial real estate assets; without the means to finance an
acquisition, almost nothing is being bought or sold'').
---------------------------------------------------------------------------
It should be noted that pricing is in a state of adjustment
due to the decrease in the number of sales transactions. In the
absence of market comparables, it is difficult to establish
property values with any certainty. The few transactions that
are occurring are generally focused on distressed borrowers or
troubled loans \110\ and are being underwritten with higher cap
rates, lower initial rents, declining rent growth or cash flow
projections, and higher required internal rates of return.\111\
When fundamentals stabilize and lending resumes, the number of
sales transactions should increase, thereby decreasing the
spread between mortgage interest rates and the rate on
comparable Treasury securities.\112\
---------------------------------------------------------------------------
\110\ Written Testimony of Jon Greenlee, supra note 93, at 11
(``Given the lack of sales in many real estate markets and the
predominant number of distressed sales in the current environment,
regulated institutions face significant challenges today in assessing
the value of real estate'').
\111\ See Written Testimony of Doreen Eberley, supra note 91, at 5
(providing that in the current environment, investors are demanding
higher required rates of return on their investments, as reflected in
higher property capitalization rates and explaining that rising
capitalization rates cause property values to fall); RREEF Research,
Global Commercial Real Estate Debt: Deleveraging into Distress, at 3
(June 2009) (hereinafter ``Deleveraging into Distress'').
\112\ Deleveraging into Distress, supra note 111, at 3.
---------------------------------------------------------------------------
Overall, the general economic downturn, uncertainty about
the pace of any recovery, and low expectations for improving
commercial real estate market fundamentals mean that prospects
for a commercial real estate recovery in the near future are
dim.
E. Scope of the Commercial Real Estate Markets
Commercial real estate markets currently absorb $3.4
trillion in debt, which represents 6.5 percent of total
outstanding credit market debt.\113\ The commercial real estate
market grew exponentially from 2004 to its peak in Q4 2008,
with a 52 percent growth in debt; however, commercial real
estate debt growth appears to be winding back, decreasing 1.3
percent from its peak 2008 levels to Q4 2009.\114\ Although
peak commercial real estate debt outstanding was only one-third
that of residential mortgage debt at its peak in Q1 2008,\115\
the size of the commercial real estate market means that its
disruption could also have ripple effects throughout the
broader economy, prolonging the financial crisis.
---------------------------------------------------------------------------
\113\ Federal Reserve Statistical Release Z.1, supra note 7.
\114\ Federal Reserve Statistical Release Z.1, supra note 7.
\115\ Federal Reserve Statistical Release Z.1, supra note 7.
---------------------------------------------------------------------------
For financial institutions, the ultimate impact of the
commercial real estate whole loan problem will fall
disproportionately on smaller regional and community banks that
have higher concentrations of, and exposure to, such loans than
larger national or money center banks. The impact of commercial
real estate problems on the various holders of CMBS and other
participants in the CMBS markets is more difficult to predict.
The experience of the last two years, however, indicates that
both risks can be serious threats to the institutions and
borrowers involved.
FIGURE 12: CRE DEBT OUTSTANDING BY FINANCIAL SECTORS (billions of
dollars) \116\
---------------------------------------------------------------------------
\116\ Federal Reserve Statistical Release Z.1, supra note 7.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
As the figure above shows, commercial banks hold $1.5
trillion in commercial real estate debt outstanding, which is
the largest share of the market at 45 percent.\117\ The next
largest commercial real estate debt holders are asset-backed
security (ABS) issuers with 21 percent of the total
market.\118\ The remaining holders of commercial real estate
debt share a fairly equal slice of the pie, ranging from four
to nine percent. The total commercial real estate
---------------------------------------------------------------------------
\117\ Federal Reserve Statistical Release Z.1, supra note 7.
\118\ While the Federal Reserve uses the classification ``ABS
issuers'' when disaggregating credit market debt by sector, for the
purposes of this report, ABS issuers are equivalent to CMBS issuers.
---------------------------------------------------------------------------
debt outstanding includes both commercial real estate whole
loans and related securities (i.e., CMBS).
Banks are generally much more exposed to commercial real
estate than CMBS investors because of the quality of the
properties serving as collateral. Unlike the residential real
estate market where banks generally kept the best residential
mortgages and securitized the riskier loans into RMBS, CMBS
loans were generally made to higher quality, stable properties
with more reliable cash flow streams (e.g., a fully leased
office building).\119\ The CMBS market was able to siphon off
the highest quality commercial properties through lower
interest rates and more allowable leverage.\120\ Banks,
particularly mid-size and small banks, were left lending to
transitional properties or construction projects with more
uncertain cash flows or to less sought-after properties in
secondary or tertiary markets.\121\ CMBS losses will
potentially trigger capital consequences, as discussed in
greater detail in Section G.
---------------------------------------------------------------------------
\119\ See Parkus and Trifon, supra note 102, at 36.
\120\ See Parkus and Trifon, supra note 102, at 36; see also
Richard Parkus and Jing An, The Future Refinancing Crisis in Commercial
Real Estate Part II: Extensions and Refinements, at 25 (July 15, 2009)
(hereinafter ``The Future Refinancing Crisis, Part II'') (``[T]he CMBS
market grew dramatically over the past few years, from $93 billion in
issuance in 2004, to $169 billion in 2005, to $207 billion in 2006 to
$230 billion in 2007. Much of the growth in market share came at the
expense of banks, as CMBS siphoned off many of the desirable loans on
stabilized properties with extremely competitive rates. Banks, funding
themselves at L-5bp simply couldn't compete on price terms given the
execution that was available in CMBS at the time. This forced banks,
particularly regional and community banks, into riskier lines of
commercial real estate lending'').
\121\ Parkus and Trifon, supra note 102, at 26 (``Because of their
liability structure, bank commercial lending has always tended to focus
more on shorter term lending on properties with some transitional
aspect to them--properties with a business plan. Such transitional
properties typically suffer more in a downturn as the projected cash
flow growth fails to materialize''). These loans typically have three
to five year terms, are expected to mature at the trough of the
downturn (2011-2012), and have consistently had significantly higher
delinquency rates than CMBS loans. See also Richard Parkus and Harris
Trifon, The Outlook for Commercial Real Estate and Its Implications for
Banks, at 48 (Dec. 2009).
---------------------------------------------------------------------------
FIGURE 13: COMMERCIAL REAL ESTATE PRIVATE EQUITY \122\
---------------------------------------------------------------------------
\122\ Gail Lee, U.S. CRE Debt Markets: What's Next?, PREA
Quarterly, at 68-70 (Fall 2009) (hereinafter ``US CRE Debt Markets'').
Data excludes corporate, nonprofit, and government equity real estate
holdings as well as single-family and owner-occupied residences.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 14: COMMERCIAL REAL ESTATE PUBLIC EQUITY \123\
---------------------------------------------------------------------------
\123\ U.S. CRE Debt Markets, supra note 122. Data excludes
corporate, nonprofit, and government equity real estate holdings as
well as single-family and owner-occupied residences.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 15: BANK EXPOSURE TO COMMERCIAL REAL ESTATE, CMBS, AND CDS (AS OF 9/30/09) \124\
[Dollars in millions]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notional
Total CRE Total Notional Amount of Tier 1 CRE Whole CMBS/
Commercial Banks (classified by asset size) Total Whole CMBS Amount of Credit Risk- Loans/ Tier 1 CDS/ Tier
Assets Loan Exposure Credit Derivatives based Tier 1 Capital 1 Capital
Exposure Derivatives (Guarantor) Capital Capital
--------------------------------------------------------------------------------------------------------------------------------------------------------
> $10 billion (85 banks)...................... $9,460,306 $842,794 $47,304 $12,985,697 $6,273,213 $749,303 112.5% 6.3% 1733.0%
$1 billion to $10 billion (440 banks)......... 1,158,908 364,533 1,943 60 31 104,897 347.5% 1.9% 0.1%
$100 million to $1 billion (3,798 banks)...... 1,104,244 353,651 708 132 24 102,542 344.9% 0.7% 0.1%
< $100 million125 (2,588 banks)............... 142,938 26,955 58 0 0 16,315 165.2% 0.4% 0.1%
--------------------------------------------------------------------------------------------------------------------------------------------------------
124 Federal Deposit Insurance Corporation, Statistics on Depository Institutions (online at www2.fdic.gov/sdi/main.asp) (hereinafter ``Statistics on
Depository Institutions'') (accessed Jan. 22, 2010). Notional amount of credit derivatives is total credit derivative exposure of which credit default
swaps for CMBS are a portion.
125 Per SNL Financial, the weighted average of commercial real estate to tier 1 risk-based capital is 276 percent for banks with less than $25 million
in total assets.
Commercial real estate whole loans are spread among the
four commercial bank asset categories, with the mid-size banks'
commercial real estate to Tier 1 capital ratios reaching the
range considered ``CRE concentrated'' and the largest and
smallest banks' ratios being one-third of that.\126\ Tier 1
capital is the supervisors' preferred measurement of capital
adequacy. Although banks with over $10 billion in assets hold
over half of commercial banks' total commercial real estate
whole loans, the mid-size and smaller banks face the greatest
exposure. Thus, mid-size and smaller banks are less well-
capitalized against the risks of substantial commercial real
estate loan write-downs. In terms of securitized and structured
products, however, the largest banks dominate in market share.
CMBS exposure to Tier 1 capital is six percent at the largest
banks, two percent at mid-size banks, and negligible at the
smaller banks. Credit derivatives are virtually nonexistent on
all other banks' books but those of larger commercial
banks.\127\
---------------------------------------------------------------------------
\126\ Per the Final Guidance on Concentrations in Commercial Real
Estate Lending, Sound Risk Management Practices published by the OCC,
the Federal Reserve, and the FDIC, a bank is considered to be ``CRE
concentrated'' if loans for construction, land development, and other
land and loans secured by multifamily and nonfarm, nonresidential
property (excluding loans secured by owner-occupied properties) are 300
percent or more of total capital or if construction and land loans are
more than 100 percent of total capital.
\127\ Statistics on Depository Institutions, supra note 124
(accessed Jan. 22, 2010).
---------------------------------------------------------------------------
The current distribution of commercial real estate loans
may be particularly problematic for the small business
community because smaller regional and community banks with
substantial commercial real estate exposure account for almost
half of small business loans. For example, smaller banks with
the highest exposure--commercial real estate loans in excess of
three times Tier 1 capital--provide around 40 percent of all
small business loans.\128\
---------------------------------------------------------------------------
\128\ Dennis P. Lockhart, Economic Recovery, Small Businesses, and
the Challenge of Commercial Real Estate, Federal Reserve Bank of
Atlanta Speech (Nov. 10, 2009) (hereinafter ``Lockhart Speech before
the Atlanta Fed'').
---------------------------------------------------------------------------
FIGURE 16: CRE WHOLE LOAN EXPOSURE AND SMALL BUSINESS LENDING BY
INSTITUTION SIZE \129\
---------------------------------------------------------------------------
\129\ Statistics on Depository Institutions, supra note 124
(accessed Jan. 22, 2010).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The withdrawal of small business loans because of a
disproportionate exposure to commercial real estate capital
creates a ``negative feedback loop'' that suppresses economic
recovery: fewer loans to small businesses hamper employment
growth, which could prolong commercial real estate problems by
contributing to higher vacancy rates and lower cash flows. This
loop has a considerable impact on the overall economy
considering that small businesses have accounted for around 45
percent of net job losses in this recession (through 2008) and
have contributed to around one-third of net job growth in the
past two economic expansions.\130\ Federal Reserve Chairman Ben
Bernanke and Treasury Secretary Timothy Geithner have noted the
particular problems that small businesses are facing in the
current, challenging credit environment.\131\ In his January
27, 2010 State of the Union address, President Obama announced
a proposal to take ``$30 billion of the money Wall Street banks
have repaid and use it to help community banks give small
businesses the credit they need to stay afloat.'' \132\ For
further discussion of President Obama's proposal and its TARP
ramifications, see Section I.4.
---------------------------------------------------------------------------
\130\ Lockhart Speech before the Atlanta Fed, supra note 128. See
also Secretary of the Treasury Timothy F. Geithner and Small Business
Administration Administrator Karen G. Mills, Report to the President:
Small Business Financing Forum, at 18-20 (Dec. 3, 2009) (hereinafter
``Small Business Financing Forum'').
\131\ See Economic Club of Washington, D.C., Statement of Federal
Reserve Chairman Ben S. Bernanke (Dec. 7, 2009); Small Business
Financing Forum, supra note 130, at 18-19.
\132\ See Remarks by the President in State of the Union Address,
The White House Office of the Press Secretary (Jan. 27, 2010) (online
at www.whitehouse.gov/the-press-office/remarks-president-state-union-
address) (hereinafter ``State of the Union Remarks''). As discussed in
Section I.4 below, the Administration's proposal involves transferring
the necessary amount from the TARP to a separate fund.
---------------------------------------------------------------------------
In addition to the impact on the small business community,
the geographic areas serviced by the more exposed regional and
com-
munity banks may suffer as a result of tightened credit terms,
a contraction in bank lending, and possibly bank failures. To
the extent that smaller communities have fewer options for
available credit, these developments could have severe short-
term consequences. As far as individual commercial properties
or borrowers are concerned, the impact will depend on the type
of commercial property involved and local developments related
to commercial real estate fundamentals as well as the overall
economy. For example, apartment buildings in the South are
greatly underperforming the national statistics, while
apartment buildings in the East continue to perform
better.\133\ On the other hand, the Southern retail sector has
greatly outperformed the nation while the Eastern retail sector
was the worst performer nationally.\134\
---------------------------------------------------------------------------
\133\ See Dec. 2009 Dec. 2009 Moody's/REAL Commercial Property
Price Indices, supra note 105, at 7-8 (providing that the eastern
apartment index has fallen 13.2 percent, the national apartment index
has fallen nearly 40 percent, and the broader southern apartment index
has fallen 51.8 percent in the past year).
\134\ See Dec. 2009 Dec. 2009 Moody's/REAL Commercial Property
Price Indices, supra note 105 (providing that eastern retail prices
fell 31.9 percent, national retail prices fell 19.4 percent, and
southern retail prices fell 8 percent in the past year).
---------------------------------------------------------------------------
1. Whole Loans
A whole loan is simply the original mortgage loan made by a
lender for a series of principal and interest payments over
time. As indicated in Figures 12 and 15 above, 46 percent of
outstanding commercial real estate debt exists in the form of
whole loans, as it is the original source of funding.\135\
Through whole loans, investors provide capital to the
commercial mortgage market in exchange for the undiluted risks
and income associated with those loans. The securitization of
commercial real estate through CMBS began in the 1990s and
entered a stage of innovation in the 2000s; so, structured
commercial real estate products are relatively young.\136\ As
noted in Figure 15 above, commercial real estate loans
outstanding are split fairly evenly between larger banks and
mid-size banks. For the two mid-size classes of banks (i.e.,
assets from $100 million to $10 billion), however, the total
commercial real estate loans outstanding is between 347 and 345
percent of Tier 1 capital, compared to only 112 percent of Tier
1 capital at commercial banks with over $10 billion in
assets.\137\
---------------------------------------------------------------------------
\135\ The calculation is based upon the ``Total CRE Whole Loan
Exposure'' column of $1.587 trillion (Figure 15) divided by $3.434
trillion of ``Total CRE Debt Exposure By Financial Sector'' (totaling
all sectors) (Figure 12).
\136\ James R. Woodwell, The Perfect Calm, Mortgage Banking (Jan.
2007) (online at www.mbaa.org/files/Research/IndustryArticles/
Woodwell.pdf).
\137\ Statistics on Depository Institutions, supra note 124
(accessed Jan. 22, 2010).
---------------------------------------------------------------------------
Foresight Analytics, a California-based firm specializing
in real estate market research and analysis, calculates banks'
exposure to commercial real estate to be even higher than that
estimated by the Federal Reserve. Drawing on bank regulatory
filings, including call reports and thrift financial reports,
Foresight estimates that the total commercial real estate loan
exposure of commercial banks is $1.9 trillion compared to the
$1.5 trillion Federal Reserve estimate. The 20 largest banks,
those with assets greater than $100 billion, hold $600.5
billion in commercial real estate loans.\138\ The following
table shows the breakdown of commercial real estate loans
across banks by type.
---------------------------------------------------------------------------
\138\ Foresight Analytics, LLC, Commercial Real Estate Exposure by
Size of Bank as of 3Q 2009 (Jan. 13, 2009) (provided at the request of
the Congressional Oversight Panel) (hereinafter ``CRE Exposure by Size
of Bank''). The FDIC does not disaggregate data in public form beyond
the total assets ``greater than $10 billion'' category. The use of
Foresight Analytics data allows for a further disaggregation of FDIC
categories, although the number of banks reporting, and thus total
exposure across banks, are slightly different.
FIGURE 17: COMMERCIAL REAL ESTATE LOANS BY TYPE (BANKS AND THRIFTS AS OF Q3 2009) \139\
----------------------------------------------------------------------------------------------------------------
Bank Total CRE Commercial Multifamily Construction Unsecured
Institution Size by Total Assets Count Loans Mortgages Mortgages and Land CRE
----------------------------------------------------------------------------------------------------------------
> $100 Bn......................... 20 600.5 318.3 79.7 160.5 42.0
$10 Bn to $100 Bn................. 92 373.4 209.6 57.0 93.8 13.0
$1 Bn to $10 Bn................... 584 447.8 272.9 45.9 123.3 5.7
$100 Mn to $1 Bn.................. 4,499 412.5 269.0 32.0 108.0 3.5
$0 to $100 Mn..................... 2,913 29.7 20.7 1.9 6.7 0.4
-----------------------------------------------------------------------------
Total......................... 8,108 1,864.0 1,090.6 216.5 492.3 64.6
----------------------------------------------------------------------------------------------------------------
\139\ Id.
The OCC, the Federal Reserve, and the FDIC have published a
Final Guidance on Concentrations in Commercial Real Estate
Lending, Sound Risk Management Practices.\140\ Although the
Guidance does not place any explicit limits on the ratio of
commercial real estate loans to total assets, it states that
``if loans for construction, land development, and other land
and loans secured by multifamily and nonfarm, nonresidential
property (excluding loans secured by owner-occupied properties)
were 300 percent or more of total capital, the institution
would also be considered to have a [commercial real estate]
concentration and should employ heightened risk management
practices.'' \141\ The supervisors also classify a bank as
having a ``CRE Concentration'' if construction and land loans
are more than 100 percent of total capital.\142\
---------------------------------------------------------------------------
\140\ Concentrations in Commercial Real Estate Lending, Sound Risk
Management Practices, 71 Fed. Reg. 74580 (Dec. 12, 2006). This guidance
is discussed in more detail at pages 108-113 below.
\141\ Concentrations in Commercial Real Estate Lending, Sound Risk
Management Practices, 71 Fed. Reg. 74580, 74581 (Dec. 12, 2006).
\142\ Id.
FIGURE 18: COMMERCIAL REAL ESTATE EXPOSURE VS. RISK-BASED CAPITAL\ 143\
---------------------------------------------------------------------------
\143\ CRE Exposure by Size of Bank, supra note 138.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 19: BANKS CATEGORIZED AS HAVING ``CRE CONCENTRATIONS'' \ 144\
----------------------------------------------------------------------------------------------------------------
Bank Count
--------------------------------------------------------
Banks with CRE
Size Group CRE Concentrations/Total
Total Concentrations Banks within Asset
Class
----------------------------------------------------------------------------------------------------------------
> $100 Bn.............................................. 20 1 5%
$10 Bn to $100 Bn...................................... 92 27 29%
$1 Bn to $10 Bn........................................ 584 358 61%
$100 Mn to $1 Bn....................................... 4,499 2,115 47%
$0 to $100 Mn.......................................... 2,913 487 17%
--------------------------------
Total.............................................. 8,108 2,988
----------------------------------------------------------------------------------------------------------------
\144\ CRE Exposure by Size of Bank, supra note 138.
As seen in the Foresight Analytics data above, the mid-size
and smaller institutions have the largest percentage of ``CRE
Concentration'' banks compared to total banks within their
respective asset class. This percentage is especially high in
banks with $1 billion to $10 billion in assets. The table above
emphasizes the heightened commercial real estate exposure
compared to total capital in banks with $100 million to $10
billion in assets. Equally troubling, at least six of the
nineteen stress-tested bank-holding companies have whole loan
exposures in excess of 100 percent of Tier 1 risk-based
capital. See additional discussion of banks that have received
TARP assistance in Section H.
2. Commercial Mortgage Backed Securities (CMBS)
FIGURE 20: CMBS FLOWCHART
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
CMBS are asset-backed bonds based on a group, or pool, of
commercial real estate permanent mortgages. A single CMBS issue
usually represents several hundred commercial mortgages, and
the pool is diversified in many cases by including different
types of properties. For example, a given CMBS may pool 50
office buildings, 50 retail properties, 50 hotels, and 50
multifamily housing developments. (In residential mortgage
markets, loan terms are more standardized, and the overall
impact of an individual loan in the performance of the MBS is
minimal. In commercial mortgage markets, however, the
individual commercial real estate loan can significantly impact
the performance of the CMBS).\145\
---------------------------------------------------------------------------
\145\ Commercial Mortgage Securities Association, Chapter Four:
Issuing CMBS, CMSA E-Primer (www.cmsaglobal.org/assetlibrary/E0B68548-
4965-488A-8154-30691CB0F880/8be06679b07c4a5d93777548733482534.pdf).
---------------------------------------------------------------------------
As can be seen in Figure 21 below, the use of CMBS to
finance commercial real estate has grown very rapidly in recent
years, peaking near the height of the commercial real estate
bubble.
FIGURE 21: TOTAL COMMERCIAL REAL ESTATE SECURITIZED \146\
------------------------------------------------------------------------
Percent
Year Securitized
------------------------------------------------------------------------
1970.................................................... .1
1980.................................................... 1.5
1990.................................................... 3.8
2000.................................................... 18.9
2007--3rd Q (peak of securitization).................... 27.9
2009--3rd Q............................................. 25.4
------------------------------------------------------------------------
\146\ Commercial Mortgage Securities Association, Compendium of
Statistics: Exhibit 19: Holders of Commercial & Multifamily Mortgage
Loans (Dec. 10, 2009) (online at www.cmsaglobal.org/uploadedFiles/
CMSA_Site_Home/Industry_Resources/Research/Industry_Statistics/
CMSA_Compendium.pdf) (hereinafter ``Commercial Real Estate Securities
Association, Exhibit 19'') (updated Jan. 12, 2010). Exhibit 21,
Mortgage Securitization Levels.
Both original permanent and refinanced loans may be
securitized. The current lack of investor appetite for CMBS
greatly constrains the ability of commercial property owners to
obtain permanent loans to pay off construction loans or to
refinance existing permanent loans. And without the ability to
do so, outstanding commercial real estate loans have a reduced
chance of repayment, unless the original lender provides funds
for refinancing.
A CMBS pool is usually set up to be eligible for tax
treatment as a REMIC to allow taxation of income and capital
gains only at the investor level. This structure makes the tax
treatment of ownership of any particular tranche of a CMBS
comparable to the ownership of whole loans, which are only
taxed at the investor level.\147\ This issue is discussed
further in Section G.3.
---------------------------------------------------------------------------
\147\ See Brueggeman and Fisher, supra note 13, at 558-559.
---------------------------------------------------------------------------
CMBS structures stratify a pool of commercial real estate
mortgages into tranches (classes).\148\ This both enhances and
complicates the structure in comparison to typical single-class
residential MBS. The creation of tranches allows investors to
choose from varying risk/reward ratios. Most CMBS use a senior/
subordinate structure, sometimes referred to as a
``waterfall.'' In this arrangement, interest and principal due
to the most senior tranche is paid first, in full, from the
cash flow coming from the underlying mortgages. If the pool has
cash left over, the next tranche is paid. This process
continues down to the most junior or subordinate ``first loss''
tranche.\149\ If there is insufficient cash to pay all
tranches, the most subordinate tranche is not paid. Further
losses then flow up the subordination chain. Each class,
therefore, receives protection from the class below it, while
at the same time providing protection for the class directly
above it. These relationships are illustrated in Figure 20,
above.
---------------------------------------------------------------------------
\148\ Commercial Mortgage Securities Association, Chapter One: An
Overview of CMBS, CMSA E-Primer (www.cmsaglobal.org/assetlibrary/
CDACA8B2-5348-497A-A5AC-13A85661BF2E/
6baf4dcc38f14cefa99d85803fd283905.pdf).
\149\ DeMichele and Adams, supra note 22, at 329-330.
---------------------------------------------------------------------------
Senior tranches earn a better credit rating and yield a
lower interest rate than more subordinate tranches due to their
lower risk. Tranches are often referred to as either
``investment grade'' or ``B-piece.'' Investment grade tranches
have credit ratings from AAA to BBB- (to use S&P ratings) and
are bought by the more safety-conscious investors. The
investment grade category can be further divided into the AAA
rated senior tranche and lower rated ``mezzanine'' tranches. B-
pieces, which are rated BB and below or are unrated, are risky
and are purchased by specialized investors who thoroughly
scrutinize the deal and the underlying properties.\150\ Thus,
the stratification creates a CMBS structure in which risk is
theoretically concentrated in the lower-rated tranches, so the
credit enhancement of a tranche is provided through the
subordination of other tranches.\151\
---------------------------------------------------------------------------
\150\ DeMichele and Adams, supra note 22, at 329-330.
\151\ Nomura Fixed Income Research, Synthetic CMBS Primer, at 6
(Sept. 5, 2006) (online at www.securitization.net/pdf/Nomura/
SyntheticCMBS_5Sept06.pdf).
---------------------------------------------------------------------------
The B-piece buyer assumes a greater level of risk by taking
the most junior class yet receives in return a potentially
higher yield. CMBS structures often make the B-piece buyer the
``controlling class,'' which has special rights to monitor the
performance of each loan.\152\
---------------------------------------------------------------------------
\152\ Commercial Mortgage Securities Association and Mortgage
Bankers Association, Borrower's Guide to CMBS, at 6 (2004) (online at
www.cmsaglobal.org/CMSA_Resources/Borrowers_Page/Borrower_s_Page/)
(hereinafter ``Borrower's Guide to CMBS'').
---------------------------------------------------------------------------
A typical CMBS structure--and the risks that come with it--
can be illustrated by reviewing a specific CMBS deal and
tracing it from loan origination to securitization. For Trust
ML-CFC, Series 2007-5, Merrill Lynch served as depositor and
joined Countrywide, Keybank, and IXIS Real Estate Capital as
sponsors of a CMBS issue consisting of a pool of 333
commercial, multifamily, and manufactured housing community
mortgage loans with an aggregate initial mortgage balance of
$4.4 billion.\153\ The largest loan backing the CMBS pool is an
$800 million Peter Cooper Village and Stuyvesant Town loan
(PCV/ST), which represents 18 percent of the pool.\154\ Tishman
Speyer Properties, LP and BlackRock Realty acquired the New
York-based PCV/ST 56 building apartment complex through a $3
billion interest-only loan in 2006 and recently stopped
scheduled debt payment, triggering default.\155\ Trust ML-CFC,
Series 2007-5 securitizes an $800 million piece of the total
PCV/ST loan, while other CMBS trusts securitize the remaining
balance. The loan's LTV ratio at origination was 55.6
percent.\156\
---------------------------------------------------------------------------
\153\ SEC EDGAR Free Writing Prospectus, ML-CFC Commercial Mortgage
Trust 2007-5 (Feb. 26, 2007) (online at www.secinfo.com/dsvrn.u13t.htm)
(hereinafter ``ML-CFC Commercial Mortgage Trust 2007-5'').
\154\ Fitch Ratings, ML-CFC Commercial Mortgage Trust Series 2007-
5-U.S. CMBS Focus Performance Report (Dec. 7, 2009) (online at
www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=490406)
(hereinafter ``CMBS Focus Performance Report'').
\155\ ML-CFC Commercial Mortgage Trust 2007-5, supra note 153. See
also Dawn Wotapka, Tishman, Blackrock Default on Stuyvesant Town, WSJ
(Jan. 8, 2010) (online at online.wsj.com/article/
SB10001424052748703535104574646611615302076.html).
\156\ ML-CFC Commercial Mortgage Trust 2007-5, supra note 153.
---------------------------------------------------------------------------
As of November 2009, the loan was transferred to special
servicing (see explanation below) to facilitate debt
restructuring due to financial challenges from failed attempts
to deregulate rent-stabilized units and insufficient cash flow
to cover the debt service. While the PCV/ST loan is certainly
the most stressed loan within the pool, specially serviced
loans comprise 21 percent of the pool, and an additional 48
loans are classified by Fitch Ratings as ``loans of concern.''
\157\ Furthermore, approximately 46.9 percent of the pool had a
weighted average debt service coverage ratio less than 1.20 as
of year-end 2008.\158\
---------------------------------------------------------------------------
\157\ CMBS Focus Performance Report, supra note 154.
\158\ CMBS Focus Performance Report, supra note 154. The debt
service coverage ratio (DSCR) is the ratio between the annual debt
service and the annual net operating income of the property. This ratio
is a key underwriting criterion for lenders, as it refers to a
property's ability to pay debt service after paying other regular
expenses. A debt service coverage ratio of 1.1 to 1.0 means that the
property's cash flow exceeds debt service for a given period of 10
percent. Typically, lenders require a ratio greater than 1.0.
---------------------------------------------------------------------------
As with most CMBS, the securities issued by the sponsors
were organized into tranches. Fitch downgraded seven of these
tranches and maintained a negative rating outlook on 15 of the
24 rated tranches within the ML-CFC, 2006-1 trust pool on
October 30, 2009, driven by the projected losses and current
foreclosures and delinquencies on underlying loans.\159\ The
losses for this CMBS deal are higher than the Fitch-modeled
average recognized and have potential losses of 6.9 and 9.7
percent, respectively, for all CMBS 2007 vintages.\160\ As
losses increase, the relative loss protection from the upper
tranches decreases.
---------------------------------------------------------------------------
\159\ CMBS Focus Performance Report, supra note 154.
\160\ CMBS Focus Performance Report, supra note 154.
---------------------------------------------------------------------------
a. Servicing
After a commercial mortgage is originated, the borrower's
main contact with creditors is through the loan servicer. Loan
servicing consists of collecting and processing mortgage
payments; remitting funds either to the whole loan owner or the
CMBS trustee; monitoring the property; handling delinquencies,
workouts, and foreclosures; and performing other duties related
to loan administration.\161\ Servicers earn a servicing fee
(usually from 1 to 25 basis points) based on the outstanding
principal balance of the loan. Whole loans, which are held on a
bank's balance sheet, are typically serviced by the originating
lender.
---------------------------------------------------------------------------
\161\ See Real Estate Finance, Seventh Edition, supra note 10, at
303.
---------------------------------------------------------------------------
For CMBS pools, a Pooling and Servicing Agreement (PSA)
sets out the duties of the servicer and includes a ``servicing
standard'' that describes the roles of each servicer and
specific instructions for dealing with delinquencies, defaults,
and other eventualities.\162\ A CMBS structure provides for a
master and special servicers, and may or may not include
primary servicers as well.
---------------------------------------------------------------------------
\162\ Borrower's Guide to CMBS, supra note 152, at 3.
---------------------------------------------------------------------------
The master servicer is responsible for servicing all
performing loans in the pool through maturity. It also decides
when loans that are delinquent or in default are transferred to
the special servicer. For a delinquent loan where the late
payments are considered recoverable by the master servicer, the
latter will advance the missing principal and interest payments
to pay the CMBS bondholders. When the funds are recovered, the
master servicer will be refunded first, ahead of payments to
the senior tranche. If the master servicer deems the loan to be
unrecoverable, it will stop these advances.
In many cases, the master servicer handles all contact with
the borrower, including collecting payments, correspondence,
and site visits. However, in some cases, these contact duties
are subcontracted to one or more primary servicers.\163\ In
these cases, the primary servicer has responsibility for
contact with the borrower, leaving the master servicer to
handle higher-level administrative duties. The primary servicer
will often be the firm that originated the mortgage. This
arrangement can be advantageous because the primary servicer
maintains its personal relationship with the borrower, and the
CMBS investors gain the services of a person or firm very
familiar with the loan and property.\164\
---------------------------------------------------------------------------
\163\ Borrower's Guide to CMBS, supra note 152, at 5.
\164\ Borrower's Guide to CMBS, supra note 152, at 3.
---------------------------------------------------------------------------
The third class of servicer is the ``special servicer,''
which is responsible for dealing with defaulted or other
seriously troubled loans. The master servicer, following the
servicing provisions in the PSA, transfers servicing for these
loans to the special servicer. This usually occurs after the
loan is 60 days delinquent.\165\ The special servicer then
determines the appropriate course of action to take in keeping
with the servicing standard in the PSA. The controlling class
of the CMBS, usually the buyer of the first loss position,
often has the right to appoint a special servicer and direct
its course of action.\166\ The special servicer typically earns
a management fee of 25 to 50 basis points on the outstanding
principal balance of a loan in default as well as 75 basis
points to one percent of the net recovery of funds at the end
of the process.
---------------------------------------------------------------------------
\165\ John N. Dunlevy, Structural Considerations Impacting CMBS, in
The Handbook of Non-Agency Mortgage-Backed Securities, at 398 (1997).
\166\ Borrower's Guide to CMBS, supra note 152, at 6.
FIGURE 22: TOP 10 COMMERCIAL MORTGAGE MASTER SERVICERS \167\
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Parent Company/ TARP Number of Average
Rank Servicing Company Ownership Recipient Amount Loans Loan Size
----------------------------------------------------------------------------------------------------------------
1 Wells Fargo N.A./ Wells Fargo........... X $476,209 42,829 $11.1
Wachovia Bank N.A.
2 PNC Real Estate/ The PNC Financial X 308,483 32,087 9.6
Midland Loan Services. Services Group, Inc.
3 Capmark Finance Inc... Berkshire Hathaway, \168\ 248,739 32,357 7.7
Inc./Leucadia
National Corp.
4 KeyBank Real Estate Keycorp............... X 133,138 12,501 10.7
Capital.
5 Bank of America N.A... Bank of America....... X 132,152 9,953 13.3
6 GEMSA Loan Services LP GE Capital/CB Richard ......... 104,755 7,144 14.7
Ellis.
7 Deutsche Bank......... Deutsche Bank Group... ......... 63,812 2,446 26.1
8 Prudential Asset Prudential Financial.. ......... 62,826 6,004 10.5
Resources.
9 JP Morgan Chase Bank.. JPMorgan Chase & Co... X 50,410 42,914 1.2
10 NorthMarq Capital..... NorthMarq Capital..... ......... 37,903 5,387 7.0
----------------------------------------------------------------------------------------------------------------
\167\ Mortgage Bankers Association, Survey of Commercial/Multifamily Mortgage Servicing Volumes, Mid Year 09
(2009). This table includes multifamily properties of 2-4 units.
\168\ Capmark was formerly a subsidiary of GMAC, a TARP recipient. It was sold in September 2009 to Berkadia
III, LLC, a joint venture between Berkshire Hathaway, Inc. and Leucadia National Corporation. Neither of these
firms are TARP recipients.
b. Underlying Property and Location
The current outstanding CMBS market is valued at $709
billion. The CMBS market was virtually frozen from July 2008 to
May 2009, with no CMBS issued during this period, but $2.329
billion in issuances have occurred since June 2009.\169\ The
freeze in the CMBS market was primarily due to problems in the
broader mortgage security market. Decreased AAA-rated CMBS
yield spreads over 5- and 10-year Treasury yields and the
Federal Reserve's May 19, 2009 announcement of extending TALF
to high-quality legacy CMBS provided the cushion of credit
needed to begin the CMBS market thaw.\170\ Slowly, the
securitized commercial real estate market is coming to life
again. Using the data provided in Figure 15 [CRE, CMBS, CDS]
and the Commercial Mortgage Securities Association (CMSA)
statistic of $709 billion in CMBS outstanding, commercial banks
hold a mere seven percent of the CMBS market.\171\
---------------------------------------------------------------------------
\169\ Commercial Real Estate Securities Association, Exhibit 19,
supra note 146 (updated Jan. 12, 2010).
\170\ Federal Reserve Bank of Atlanta, Financial Highlights (July
22, 2009) (online at www.frbatlanta.org/filelegacydocs/FH_072209.pdf).
\171\ Statistics on Depository Institutions, supra note 124
(accessed Jan. 22, 2010).
---------------------------------------------------------------------------
Whereas commercial real estate whole loan exposure is
spread across the four size categories of banks, CMBS exposure
is concentrated in large commercial banks. According to
Foresight Analytics, the 20 largest banks (those with assets
over $100 billion) hold approximately 89.4 percent of total
bank exposure to CMBS.\172\ The FDIC data further confirms
this, as banks in the ``greater than $10 billion'' asset class
hold 94.5 percent of total bank exposure to CMBS. CMBS is a
negligible percentage of Tier 1 capital across commercial banks
compared to the same ratio for whole loans, as seen earlier in
Table 15.\173\
---------------------------------------------------------------------------
\172\ CRE Exposure by Size of Bank, supra note 138.
\173\ Statistics on Depository Institutions, supra note 124
(accessed Jan. 22, 2010).
---------------------------------------------------------------------------
FIGURE 23: CMBS OUTSTANDING BY PROPERTY TYPE (millions of dollars)
\174\
---------------------------------------------------------------------------
\174\ Commercial Real Estate Securities Association, Exhibit 19,
supra note 146.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Office and retail commercial property comprise 59 percent
of all CMBS underlying loans. Multifamily and lodging (hotel)
properties, though a more moderate property presence, comprise
15 and 10
percent, respectively. The remaining 16 percent of CMBS
property types are industrial, mixed use, and other.\175\
---------------------------------------------------------------------------
\175\ Commercial Real Estate Securities Association, Exhibit 19,
supra note 146.
FIGURE 24: CMBS BY PROPERTY LOCATION \176\
[Dollars in millions]
------------------------------------------------------------------------
Current Allocation
State Balance Percent
------------------------------------------------------------------------
California.................................... $104,965 16.9
New York...................................... 95,824 15.4
Texas......................................... 49,840 8.0
Florida....................................... 42,400 6.8
Illinois...................................... 24,740 4.0
Pennsylvania.................................. 19,910 3.2
Georgia....................................... 19,838 3.2
New Jersey.................................... 19,691 3.2
Maryland...................................... 18,585 3.0
All Other States (less than 3.0% of total $231,000 36
each)........................................
------------------------------------------------------------------------
\176\ Commercial Mortgage Securities Association, Compendium of
Statistics, at Exhibit 10: CMBS by Regions--Detail (Aug. 2008).
The loans securing CMBS deals are generally concentrated in
more populated states and do not include less sought after
properties in secondary or tertiary markets (or properties
associated with less populated areas).\177\ California and New
York commercial real estate loans represent nearly one-third of
all securitized loans. CMBS exposure to loans originated in
Texas, Florida, and Illinois is notable to a smaller degree,
and the remaining geographic CMBS loan exposure is spread among
all other states.\178\ As foreclosure rates vary widely across
states, knowing the state of origination for loans bundled in a
CMBS structure provides greater insight into potential CMBS
valuation issues.\179\
---------------------------------------------------------------------------
\177\ Id. For example, the ten states with the smallest CMBS market
share in December 2009 (from smallest to largest) were Wyoming,
Montana, South Dakota, North Dakota, Vermont, Alaska, West Virginia,
Idaho, Maine, and Rhode Island, with a combined total of 0.99 percent.
See U.S. CMBS: Moody's CMBS Delinquency Tracker, January 2010, at 16
(Jan. 15, 2010) (hereinafter ``CMBS Delinquency Tracker''). These
states were among the 13 least populated states according to U.S.
Census Bureau rankings. See U.S. Census Bureau, The 2010 Statistical
Abstract: State Rankings, Resident Population, July 2008 (available
online at www.census.gov/compendia/statab/2010/ranks/rank01.html) (last
accessed Jan. 22, 2010). The four most populated states (California,
Texas, New York, and Florida) also had the largest CMBS market share in
2009, with a combined total of 40 percent.
\178\ Commercial Mortgage Securities Association, Compendium of
Statistics, at Exhibit 10: CMBS by Regions--Detail (Aug. 2008); see
also CMBS Delinquency Tracker, supra note 177, at 16.
\179\ The potential impact of commercial real estate problems on
CMBS is magnified by so-called ``synthetic CMBS.'' Based on available
transaction data, DTTC reported 2,065 derivative contracts referencing
CMBS with a gross notional value of $24 billion as of January 8, 2010.
A synthetic product is simply a derivative instrument designed to mimic
the cash flows of a reference entity or asset. Synthetic CMBS allow an
investor to gain exposure to either a specific CMBS pool or a CMBS
index without actually taking ownership of the assets. The synthetic
CMBS market lacks transparency; thus, determination of its scope
relative to the commercial real estate market is difficult. The
Depository Trust and Clearing Corporation, Trade Information Data
Warehouse (Section I), at Table 3 (online at www.dtcc.com/products/
derivserv/data_table_i.php?id=table3_current) (hereinafter ``Trade
Information Data Warehouse'') (accessed Jan. 12, 2010).
---------------------------------------------------------------------------
The following chart, Figure 25, provides information on
CMBS delinquency rates for the top 10 metropolitan statistical
areas.
FIGURE 25: CMBS DELINQUENCY RATES BY TOP 10 METROPOLITAN STATISTICAL
AREAS \180\
---------------------------------------------------------------------------
\180\ Bloomberg data (accessed Jan. 12, 2010).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
This chart illustrates the variation in problems that more
populated areas are experiencing with commercial real estate
loans collateralizing CMBS deals.
3. CMBS Credit Default Swaps
Credit defaults swaps (CDS) are over-the-counter (OTC)
derivative \181\ instruments predicated on a contract between
two counterparties: a protection buyer and a protection seller.
CDS contracts
---------------------------------------------------------------------------
\181\ The Financial Accounting Standards Board defines a derivative
as an instrument that has one or more underlying assets and one or more
notional amounts or payment provisions which determine settlement,
requires no initial net investment, and whose terms permit net
settlement.
---------------------------------------------------------------------------
function in a similar manner to insurance contracts. A
protection buyer pays a periodic or up-front fee to a
protection seller, who must then pay the protection buyer a fee
in the occurrence of a ``credit event'' (e.g., bankruptcy or
credit rating downgrade), effectively transferring credit risk
from the buyer to the seller.\182\ An added layer of the CDS
structure is its inherent ``risk circularity,'' replacing
credit risk with counterparty risk.\183\ By safeguarding
against the risk of credit default through a CDS, the
protection buyer faces the risk that its counterparty will
default on the contract, leaving it exposed to the original
credit risk. This risk circularity was at the crux of American
International Group's (AIG) ``too big to fail'' status and
ultimate government bailout and payment to its CDS
counterparties.\184\
---------------------------------------------------------------------------
\182\ David Mengle, Credit Derivatives: An Overview, Federal
Reserve Bank of Atlanta Economic Review (Fourth Quarter 2007) (online
at www.frbatlanta.org/filelegacydocs/erq407_mengle.pdf).
\183\ European Central Bank, Credit Default Swaps and Counterparty
Risk (Aug. 2009) (online at www.ecb.int/pub/pdf/other/
creditdefaultswapsandcounterpartyrisk2009en.pdf) (hereinafter
``European Central Bank CDS Report'').
\184\ Dean Baker, The AIG Saga: A Brief Primer, The Center for
Economic and Policy Research (Mar. 2009) (online at www.cepr.net/
documents/publications/AIG-2009-03.pdf) (hereinafter ``The AIG Saga: A
Brief Primer'').
---------------------------------------------------------------------------
The intent of a credit default swap is generally either to
hedge or to speculate. An institution can hedge the credit risk
of assets by acquiring CDS protection on those assets and can
hedge the risk of counterparty default by acquiring CDS
exposure to another institution.\185\ For example, if an
investor held the CMBS pool MLCFC, Series 2007-5, he could
hedge exposure through CMBX.3, which references this CMBS pool.
CDS also allow an institution to gain exposure without any
possession of the underlying referenced entities or assets
through trading or speculative activities. An institution can
acquire long exposure to the credit assets by selling CDS
protection or acquire short exposure to the credit assets by
buying CDS protection.\186\ Either way, the investor is
speculating on the likelihood of a future credit event in
regards to the reference entity or assets in which the investor
possesses only exposure without actual ownership. Speculative
trading is commonly referred to as a ``naked'' swap, since the
investor has no cash position in the reference entity or
assets.\187\
---------------------------------------------------------------------------
\185\ European Central Bank CDS Report, supra note 183.
\186\ European Central Bank CDS Report, supra note 183. Long
exposure is speculation on the future upside potential and short
exposure is speculation on the future downside potential, meaning a
seller with long exposure is speculating on the unlikelihood of default
and a buyer with short exposure is speculating on the reverse.
\187\ European Central Bank CDS Report, supra note 183.
Congressional Oversight Panel, Special Report on Regulatory Reform, at
13-15 (Jan. 2009) (online at cop.senate.gov/reports/library/report-
012909-cop.cfm). As noted, a swap is a form of insurance, but the
holder of a ``naked'' swap owns nothing to insure. A common state
insurance rule bars purchasing insurance in the absence of an insurable
interest, e.g., in the purchaser's home or car, or for members of the
purchaser's family, precisely because buying insurance without such an
interest is a form of speculation. As noted in the Panel's Special
Report on Regulatory Reform, however, Congress prohibited the
regulation of most derivatives in 2000. That action barred, for
example, attempts to apply state insurance rules to ``naked swaps.''
---------------------------------------------------------------------------
The meltdown in the residential mortgage market and sub-
prime loan-backed RMBS caused a massive capital drain on the
major sellers of RMBS CDS in 2008 and heightened the
counterparty risk exposure of buyers. The gross notional seller
exposure to CDS backed by RMBS was $135.9 billion as of January
8, 2010, compared to CDS backed by CMBS exposure of $24.1
billion.\188\ However, net notional exposure for CMBS is $5.0
billion, compared to only $67.7 million for RMBS. (Net notional
exposure provides a more accurate view of actual exposure as it
represents the maximum amount of credit exposure or payout in a
credit default event.) \189\ Furthermore, this exposure is
concentrated in 2,067 CDS contracts, while the RMBS exposure is
spread throughout 27,908 contracts.\190\ Thus, the maximum
credit exposure for CMBS-backed CDS is not only bigger than
that of RMBS-backed CDS, but it is concentrated in a smaller
number of contracts. As noted in the European Central Bank's
report on Credit Default Swaps and Counterparty Risk, ``[i]n
practice, the transfer of risk through CDS trades has proven to
be limited, as the major players in the CDS market trade among
themselves and increasingly guarantee risks for financial
reference entities.'' \191\ The fact that RMBS credit default
exposure played a significant role in the 2008 collapse and
that the concentration of CMBS-backed CDS appears to be greater
than that in RMBS CDS must be carefully considered in assessing
the impact such swaps could have if the volume, nature, and
pace of foreclosures of securitized properties continue to
increase. Any attempt to gauge the potential impact--as was the
case of RMBS swaps and swaps written on other securities--is
difficult if not impossible owing to the opacity of the credit
default swaps' market. (Although that issue is generally beyond
the scope of this report, it should be noted that the Panel's
Reform Report called direct attention to the need for
transparency in the CDS markets.) \192\
---------------------------------------------------------------------------
\188\ Trade Information Data Warehouse, supra note 179, at Table 3.
\189\ Trade Information Data Warehouse, supra note 179, at Table 3.
\190\ The Depository Trust and Clearing Corporation, Trade
Information Warehouse, at Table 6 (online at www.dtcc.com/products/
derivserv/data_table--i.php?id=table6_current) (accessed Jan. 12,
2010).
\191\ European Central Bank CDS Report, supra note 183.
\192\ Congressional Oversight Panel, Special Report on Regulatory
Reform, at 13-15 (Jan. 2009) (online at cop.senate.gov/reports/library/
report-012909-cop.cfm).
---------------------------------------------------------------------------
The impact of commercial real estate losses on CMBS and
CMBS CDS markets ultimately affects the institutions that
invest in them. The extent of the impact is largely dependent
on the institution's size. As noted in section E.2(b), CMBS
exposure is concentrated in the 20 largest financial
institutions with assets over $100 billion.\193\ According to
discussions with market experts, the largest banks issued
higher quality commercial real estate loans for the purpose of
securitizing, packaging, and distributing them, which left mid-
size and smaller banks to do the remaining lending for
construction and local commercial real estate loans.\194\ Thus,
in terms of risk and exposure relative to assets and Tier 1
capital, the larger financial institutions are exposed to CMBS,
and the smaller and mid-size financial institutions are more
exposed to the whole loans. Given the size of notional CMBS
holdings, that risk and exposure require extremely careful
attention, in light of the experience of the last three years.
---------------------------------------------------------------------------
\193\ Commercial Mortgage Securities Association, Investors of CMBS
in 2008 (online at www.cmsaglobal.org/uploadedFiles/CMSAlSitelHome/
IndustrylResources/Research/IndustrylStatistics/Investors.pdf)
(accessed Jan. 20, 2010).
\194\ Staff conversation with The Real Estate Roundtable (Jan. 6,
2010).
---------------------------------------------------------------------------
4. Financing of Multifamily Housing
Multifamily housing is a subsection of commercial real
estate that overlaps the commercial and residential mortgage
markets in terms of structure and use. Although income-
producing and bearing commercial loan characteristics,
multifamily housing also serves as a residence for tenants.
Before delving deeper into the ramifications of commercial real
estate losses on communities and tenants, it is important to
understand the scope of multifamily housing. Multifamily
mortgage debt outstanding has shown steady growth for several
years, except for a $1.2 billion decrease from Q3 to Q4 2009,
ending the year at $912 billion. In comparison, both
residential mortgage and all other commercial mortgage debt
outstanding peaked in 2008 and has steadily decreased
since.\195\ Multifamily mortgage originations decreased 40
percent from Q3 2008 to Q3 2009, compared to an overall
decrease of 54 percent for all commercial property over the
same time period.\196\ Thus, while the market for residential
and other commercial mortgages experienced a ``boom and bust,''
multifamily has exhibited a steadier growth over time with less
substantial decrease in recent quarters.
---------------------------------------------------------------------------
\195\ Federal Reserve Flow of Funds Z.1, Dec. 10, 2009.
\196\ MBA Data Book: Q3 2009, supra note 98.
---------------------------------------------------------------------------
Government sponsored entities Fannie Mae and Freddie Mac
(the GSEs) hold the largest amount of multifamily mortgage debt
outstanding--39 percent. Commercial banks and CMBS/ABS issuers
follow in stair-step succession with 24 and 12 percent,
respectively, of total multifamily mortgage debt outstanding.
The remaining 25 percent is divided fairly evenly among
governments, savings institutions, life insurance companies,
and financing institutions.\197\ Only in recent years have the
GSEs come to hold such a large share of multifamily mortgage
debt, as private sources of funding supplied the market in the
past.\198\ As the CMBS market supports only 12 percent of the
$912 billion of multifamily debt outstanding, the bulk of
multifamily financing remains in whole loans.\199\
---------------------------------------------------------------------------
\197\ MBA Data Book: Q3 2009, supra note 98.
\198\ Donald S. Bradley, Frank E. Nothaft, and James L. Freund,
Financing Multifamily Properties: A Play with New Actors and New Lines,
Cityscape: A Journal of Policy Development and Research (Vol. 4, Num.
1, 1998) (online at www.huduser.org/Periodicals/CITYSCPE/VOL4NUM1/
article1.pdf).
\199\ Federal Reserve Flow of Funds Z.1, Dec. 10, 2009.
---------------------------------------------------------------------------
According to the National Multi Housing Council, nearly
one-third of American households rent and over 14 percent live
in multifamily apartment complexes.\200\ Multifamily rental
housing provides an alternative to home ownership for people in
recent geographic transition, in search of convenience, or in
need of a lower cost option. It also provides a more economic
option than single family structures in terms of social
services delivery, such as assisted living and physical
infrastructure.\201\ When looking at the default possibilities
of mortgages, the discussion often centers on the exposure to
the borrower, lender, and investors. Devaluations of and
defaults in multifamily mortgage loans indeed impact these
individuals through lower cash flows, difficulty in
refinancing, and potential loss of property. But this impact
also extends to the residents of multifamily housing who
potentially face deteriorating buildings, neglected
maintenance, and increased rent.
---------------------------------------------------------------------------
\200\ National Multi Housing Council, About NMHC (online at
www.nmhc.org/Content/ServeContent.cfm?ContentItemID=4493) (accessed
Jan. 21, 2010).
\201\ Harvard University Joint Center for Housing Studies, Meeting
Multifamily Housing Finance Needs During and After the Credit Crisis: A
Policy Brief (Jan. 2009) (online at www.jchs.harvard.edu/publications/
finance/multifamily_housing_finance_needs.pdf) (hereinafter ``Meeting
Multifamily Housing Finance Needs'').
---------------------------------------------------------------------------
Both the total commercial mortgage and multifamily mortgage
default rates have increased in recent quarters to 8.74 and
3.58 percent, respectively.\202\ Although multifamily loan
performance has remained strong compared to the overall
commercial mortgage market, as evidenced in the significantly
lower default rate, tightened credit, and broader challenges
for commercial real estate mortgages could hinder apartment
owners' ability to refinance and thus could cause increased
defaults.\203\ If financing is tight and capital costs
increase, owners may neglect property improvements or may
attempt to pass along costs to tenants through increased rent
and fees. Neglected property impacts the surrounding
neighborhood's condition and, ultimately, value.\204\
---------------------------------------------------------------------------
\202\ Federal Reserve Statistical Release, Charge-off and
Delinquency Rates (online at www.federalreserve.gov/Releases/ChargeOff/
delallsa.htm) (accessed Jan. 20, 2010). Sibley Fleming, Bank Default
Rates on CRE Loans Projected to Hit 4% in Fourth Quarter, National Real
Estate Investor (online at nreionline.com/news/CRE_bank_default_rates).
\203\ Meeting Multifamily Housing Finance Needs, supra note 201.
\204\ Meeting Multifamily Housing Finance Needs, supra note 201.
---------------------------------------------------------------------------
Currently, 79 percent of multifamily renters in the lowest
income quartile and 45 percent in the lower-middle income
quartile spend over half of their income on housing.\205\
Affordable, government-subsidized, multifamily units play a key
role in the multifamily mortgage market, as they answer the
low-income barrier to entry of home ownership. Low-income
housing tax credits and tax-exempt multifamily bonds buttress
the affordable housing market, but the credit crisis has
undermined their ability to do so. Tax credit prices have
fallen from 90 to 70 cents on the dollar, so more credits are
now required to deliver the same amount of equity. Tax-exempt
multifamily bond issuances have sharply decreased, cutting off
another equity source for development and rehabilitation.\206\
Renters in need of affordable housing cannot move to a new
complex in the face of increased rent or deteriorating
maintenance as easily as other renters can, so the need for
viable and prolific equity options is especially relevant in
this subsector of the commercial mortgage market.
---------------------------------------------------------------------------
\205\ Meeting Multifamily Housing Finance Needs, supra note 201.
\206\ Meeting Multifamily Housing Finance Needs, supra note 201.
---------------------------------------------------------------------------
While the multifamily mortgage market default rates are
lower than those of the commercial mortgage market as a whole,
multifamily default rates are still increasing. Furthermore,
vacancy rates as of Q3 2009 were 13.1 percent, up from 11
percent in Q3 2008. Some multifamily lenders used aggressive
estimates in their underwriting practices that have heightened
refinancing hurdles for those loans in the current market.\207\
Thus, the risks associated with property devaluation and
tightened credit are the same for multifamily as they are for
other commercial properties, but unlike other types of
commercial real estate, those risks have the potential to
translate into destabilized families and loss of affordable
housing.
---------------------------------------------------------------------------
\207\ Department of Housing and Urban Development, Eye on
Multifamily Housing Finance (online at www.huduser.org/portal/
periodicals/ushmc/fall09/ch1.pdf).
---------------------------------------------------------------------------
F. Risks
In the years preceding the current crisis, a series of
trends pushed smaller and community banks toward greater
concentration of their lending activities in commercial real
estate. Simultaneously, higher quality commercial real estate
projects tended to secure their financing in the CMBS market.
As a result, if and when a crisis in commercial real estate
develops, smaller and community banks will have greater
exposure to lower quality investments, making them uniquely
vulnerable.\208\
---------------------------------------------------------------------------
\208\ See additional discussion of smaller regional and community
bank exposure in Section E.
---------------------------------------------------------------------------
As discussed above, the combination of deteriorating market
conditions and looser underwriting standards, especially for
loans originating in the bubble years of 2005-2007, has
presented financial institutions holding commercial real estate
loans and CMBS with significant risks.\209\ These institutions
face large, potentially devastating losses as a result of loans
that become non-performing or go into default.\210\ The values
of the underlying collateral for these loans have plummeted,
cash flows and operating income have fallen, and the number of
sales transactions has been drastically reduced.\211\ One
measure of the risks associated with CMBS is the fact that the
Federal Reserve Bank of New York requires the largest haircuts
(15 per cent) for CMBS financings compared to other asset
classes in the Term Asset-Backed Securities Liquidity Program
(TALF), as the GAO report noted in a report issued this
month.\212\
---------------------------------------------------------------------------
\209\ See generally Parkus and Trifon, supra note 102; COP August
Oversight Report, supra note 5, at 54-57. GAO TALF Report, supra note
64, at 13 (showing that private investors must provide a 15 percent
``haircut,'' or equity contribution, on government-backed loans for
CMBS, compared with 5-10 percent for credit card loans, and 5-9 percent
for equipment loans).
In addition, other factors could affect leasing incentives. For
example, the Financial Accounting Standards Board has a current project
on its agenda which could affect lease accounting for all public and
private companies who lease property (the lessee). Currently lessees
who recognize their lease payments as an expense may be required under
certain circumstances to recognize their entire lease obligation as a
liability on their balance sheet. If adopted, lessess may not renew
their lease or terminate their lease obligation early. As a result,
this could further provide additional lending risks in the real estate
sector, since a borrower's cash flw could significantly cecrease due to
empty tenant space which could result in further delinquencies or
defaults in commercial real estate loans.
\210\ See Richard Parkus and Harris Trifon, Q4 2009 Commercial Real
Estate Outlook: Searching for a Bottom, at 3, 65-67 (Dec. 1, 2009)
(hereinafter ``Parkus and Trifon: Searching for a Bottom'').
\211\ See generally MBA Data Book: Q3 2009, supra note 98. For
example, values of commercial real estate fell around 40 percent from
Q3 2007 to Q3 2009. See id. at 34. In Q3 2009, for all major property
types, average vacancy rates increased (to 8.4 percent for apartments,
13 percent for industrial, 19.4 percent for office, and 18.6 percent
for retail) and average rental rates decreased (by 6 percent for
apartments, 9 percent for industrial, 9 percent for office, and 8
percent for retail) causing cash flows and operating income to fall.
Id. at 9. Sales transactions were 72 percent lower year-to date Q3 in
2009 than in 2008, which were 66 percent lower than 2007. Id. Note that
none of these numbers include construction or ADC loans. For an
additional discussion of commercial real estate fundamentals, see
Section B of this report.
\212\ GAO TALF Report, supra note 64, at 13.
---------------------------------------------------------------------------
As loan delinquency rates rise, many commercial real estate
loans are expected to default prior to maturity.\213\ For loans
that reach maturity, borrowers may face difficulty refinancing
either because credit markets are too tight or because the
loans do not qualify under new, stricter underwriting
standards.\214\ If the borrowers cannot refinance, financial
institutions may face the unenviable task of determining how
best to recover their investments or minimize their losses:
restructuring or extending the term of existing loans or
foreclosure or liquidation.\215\ On the other hand, borrowers
may decide to walk away from projects or properties if they are
unwilling to accept terms that are unfavorable or fear the
properties will not generate sufficient cash flows or operating
income either to service new debt or to generate a future
profit.\216\ Finally, financing may not be available for new
loans because of a scarcity of credit, rising interest rates,
or the withdrawal of special Federal Reserve liquidity
programs. This section will provide a more detailed analysis of
each of these problems and then turn to broader social and
economic consequences and the consequences for financial
institutions.
---------------------------------------------------------------------------
\213\ See The Future Refinancing Crisis, Part II, supra note 120,
at 4, 11; see also Goldman Sachs, U.S. Commercial Real Estate Take III:
Reconstructing Estimates for Losses, Timing, at 16-20 (Sept. 29, 2009)
(hereinafter ``Commercial Real Estate Take III'').
\214\ See Richard Parkus and Jing An, The Future Refinancing Crisis
in Commercial Real Estate, at 3 (Apr. 23, 2009) (hereinafter ``The
Future Refinancing Crisis in CRE'').
\215\ See Parkus and Trifon: Searching for a Bottom, supra note
210, at 3. For further discussion of the alternatives available, see
Section G of this report.
\216\ See, e.g., Realpoint Research, Monthly Delinquency Report--
Commentary, December 2009, at 5-6 (Dec. 30, 2009) (hereinafter
``Realpoint Report--December 2009''); Commercial Real Estate Take III,
supra note 213, at 18-20.
---------------------------------------------------------------------------
1. Loans Become Delinquent
The problem begins when commercial real estate loans become
delinquent (or past due) and worsens as new (or total)
delinquent loans increase and delinquent balances continue to
age.\217\
---------------------------------------------------------------------------
\217\ See, e.g., Parkus and Trifon Searching for a Bottom, supra
note 210, at 3, 67.
---------------------------------------------------------------------------
Although many analysts and Treasury officials believe that
the commercial real estate problem is one that the economy can
manage through, and analysts believe that the current condition
of commercial real estate, in isolation, does not pose a
systemic risk to the banking system, rising delinquency rates
foreshadow continuing deterioration in the commercial real
estate market.\218\ For the last several quarters, delinquency
rates have been rising significantly.
---------------------------------------------------------------------------
\218\ See, e.g., Parkus and Trifon Searching for a Bottom, supra
note 210, at 67; U.S. Department of the Treasury, Statement of
Secretary of the Treasury Timothy F. Geithner to the Economic Club of
Chicago, at 7 (Oct. 29, 2009) (providing that the commercial real
estate problem is ``a problem the economy can manage through, even
though it's going to be still exceptionally difficult''); see also
Written Testimony of Jon Greenlee, supra note 93, at 4, 9 (explaining
that banks face significant challenges and significant further
deterioration in their commercial real estate loans but that the
stability of the banking system has improved in the past year).
---------------------------------------------------------------------------
FIGURE 26: COMMERCIAL REAL ESTATE DELINQUENCIES FOR ALL DOMESTIC
COMMERCIAL BANKS \219\
---------------------------------------------------------------------------
\219\ Board of Governors of the Federal Reserve System, Data
Download Program: Charge-off and Delinquency Rates (Instrument:
Delinquencies/ All banks) (online at www.federalreserve.gov/
datadownload/Choose.aspx?rel=CHGDEL) (accessed Feb. 9, 2010). The
Federal Reserve defines delinquent loans as those loans that are past
due thirty days or more and still accruing interest as well as those in
nonaccrual status. See also Citibank, CMBS Collateral Update: CMBS
Delinquencies as of December 31, 2009, at 4-7 (Jan. 4, 2010) (providing
analysis on CMBS delinquency by property type, origination year,
region, and state); Realpoint Report--December 2009, supra note 216, at
1 (providing that ``the overall delinquent unpaid balance is up an
astounding 440% from one-year ago . . . and is now over 17 times the
low point . . . in March 2007''); MBA Data Book: Q3 2009, supra note
98, at 63-65 (providing that between the second and third quarters of
2009, the 30+ day delinquency rate on loans held in CMBS increased 0.17
percentage points to 4.06 percent and the 90+ day delinquency rate on
loans held by FDIC insured banks and thrifts increased 0.51 percentage
points to 3.43 percent); Parkus and Trifon, supra note 102, at 5-21;
GAO TALF Report, supra note 64, at 29.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The extent of ultimate commercial real estate losses is yet
to be determined; however, large loan losses and the failure of
some small and regional banks appear to some experienced
analysts to be inevitable.\220\ New 30-day delinquency rates
across commercial property types continue to rise, suggesting
that commercial real estate loan performance will continue to
deteriorate.\221\ However, there is some indication that the
rate of growth, or pace of deterioration, is slowing.\222\
Unsurprisingly, the increase in delinquency rates has
translated into rapidly rising default rates.\223\
---------------------------------------------------------------------------
\220\ See, e.g., Parkus and Trifon: Searching for a Bottom, supra
note 210, at 3, 67.
\221\ See generally Parkus and Trifon, supra note 102, at 12
(hotel, increasing), 15 (industrial, increasing), 17 (multifamily,
increasing), 19 (office, stable but expected to increase), 20-21
(retail, high but stable) (Dec. 2009).
\222\ See Federal Deposit Insurance Corporation, Quarterly Banking
Profile Third Quarter 2009, at 1-2 (Sept. 2009) (online at
www2.fdic.gov/qbp/2009sep/qbp.pdf) (providing that the amount of
noncurrent loans continued to increase but that the increase ``was the
smallest in the past four quarters, as the rate of growth in noncurrent
loans slowed for the second quarter in a row''); Parkus and Trifon,
supra note 102, at 9.
\223\ See, e.g., Parkus and Trifon: Searching for a Bottom, supra
note 210, at 27-30.
---------------------------------------------------------------------------
2. Loans Go Into Default or Become Non-Performing
A loan will technically be in default when a borrower first
fails to fulfill a loan obligation or promise, such as failure
to make timely loan payments or violation of a debt covenant
(for example, the requirement to maintain certain levels of
capital or financial ratios).\224\ However, for the purposes of
this report, a loan will be con-
sidered in default when it becomes over 90 days delinquent.
Thus, default rates will reflect the number of new loans that
are over 90 days delinquent.\225\ If a loan is over 90 days
delinquent, or is in nonaccrual status because of deterioration
in the financial condition of the borrower or because the
lender can no longer expect the loan to be repaid in full,\226\
the loan will become non-performing \227\ or noncurrent.\228\
The increasing number of loans that are delinquent by 90 days
or less, in default or delinquent by over 90 days, and in
nonaccrual status, shown in Figure 27, indicates problems with
the collectability of outstanding amounts and draws into
question the proper valuation of these assets on financial
institution balance sheets.\229\
---------------------------------------------------------------------------
\224\ See Barron's Real Estate Handbook, Sixth Edition at 228
(2005).
\225\ See The Future Refinancing Crisis, Part II, supra note 120,
at 15.
\226\ A loan is to be reported to the FDIC as being in nonaccrual
status if ``(1) it is maintained on a cash basis because of
deterioration in the financial condition of the borrower, (2) payment
in full of principal or interest is not expected, or (3) principal or
interest has been in default for a period of 90 days or more unless the
asset is both well secured and in the process of collection.'' See
Federal Deposit Insurance Corporation, Schedule RC-N--Past Due and
Nonaccrual Loans, Leases, and Other Assets: Definitions (online at
www.fdic.gov/regulations/resources/call/crinst/897rc-n.pdf) (accessed
Feb. 9, 2010).
\227\ A loan is non-performing when it is not earning income,
cannot be expected to be repaid in full, has payments of interest or
principal over 90 days late, or was not repaid after its maturity date.
See Barron's Real Estate Handbook, Sixth Edition, at 388 (2005).
\228\ See Written Testimony of Doreen Eberley, supra note 91, at 4
fn. 6.
\229\ Valuation issues will be discussed further in Section G.2.
---------------------------------------------------------------------------
FIGURE 27: DELINQUENT, DEFAULTED, AND NON-PERFORMING COMMERCIAL REAL
ESTATE LOANS FOR ALL DOMESTIC COMMERCIAL BANKS \230\
---------------------------------------------------------------------------
\230\ Statistics on Depository Institutions, supra note 124.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The increasing number of delinquent, defaulted, and non-
performing commercial real estate loans also reflects
increasing levels of loan risks. Loan risks for borrowers and
lenders fall into two categories: credit risk and term
risk.\231\ Credit risk can lead to loan defaults prior to
maturity; such defaults generally occur when a loan has
negative equity and cash flows from the property are
insufficient to service the debt, as measured by the debt
service coverage ratio (DSCR).\232\ If the DSCR falls below
one, and stays below one for a sufficiently long period of
time, the borrower may decide to default rather than continue
to invest time, money, or energy in the property. The borrower
will have little incentive to keep a property that is without
equity and is not generating enough income to service the debt,
especially if he does not expect the cash flow situation to
improve because of increasing vacancy rates and falling rental
prices.\233\ The number of term defaults, and accompanying
losses, has been steadily increasing for the last several
quarters, as exemplified by the following chart on CMBS loan
default rates.
---------------------------------------------------------------------------
\231\ See additional discussion of these risks in Section B.3.
\232\ The Debt Service Coverage Ratio (DSCR) is the metric for
determining when a property is earning sufficient income to meet its
debt obligations. DSCR is calculated by taking net operating income
(cash flows from the property) divided by debt service (required debt
payments). A DSCR of less than one indicates that the property is not
earning sufficient income to make debt payments. See Brueggeman and
Fisher, supra note 13, at 344-45.
\233\ See generally The Future Refinancing Crisis, Part II, supra
note 120, at 11. See additional discussion of credit risk in Section
B.3.
---------------------------------------------------------------------------
FIGURE 28: CMBS TERM DEFAULT RATES BY VINTAGE \234\
---------------------------------------------------------------------------
\234\ Data provided by Richard Parkus, Head of Commercial Real
Estate Debt Research, Deutsche Bank.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The level of credit risk is also reflected in the price of
commercial property (as a measure of the present value of
future cash flows) and the LTV ratio (as a measure of equity or
negative equity). As commercial property prices continue to
fall and LTV ratios continue to rise, the risk that additional
commercial real estate loans will default prior to maturity is
increasing.\235\ For example, most of the commercial real
estate loans from the 2002-2008 vintages are three-year to ten-
year loans with LTVs well over 100 percent.\236\ When combined
with further deterioration in commercial real estate
fundamentals, these loans are experiencing increasing credit
risk and are providing continued exposure to term
defaults.\237\
---------------------------------------------------------------------------
\235\ See Written Testimony of Jon Greenlee, supra note 93, at 4-5
(providing that ``the value of both existing commercial properties and
land has continued to decline sharply, suggesting that banks face
significant further deterioration in their CRE loans''); Dec. 2009 Dec.
2009 Moody's/REAL Commercial Property Price Indices, supra note 105, at
4; see also Commercial Real Estate Take III, supra note 213, at 3, 18-
19; Brueggeman and Fisher, supra note 13, at 344-45.
\236\ For example, Foresight Analytics LLC estimates that $770
billion (or 53 percent) of mortgages maturing from 2010 to 2014 have
current LTVs in excess of 100 percent. Foresight further provides that
over 60 percent of mortgages maturing in 2012 and 2013 will have LTVs
over 100 percent.
\237\ Dec. 2009 Moody's/REAL Commercial Property Price Indices,
supra note 105, at 4.
---------------------------------------------------------------------------
Term risk, on the other hand, reflects the borrower's
ability to repay commercial real estate loans at maturity, and
will depend more on the borrower's ability to refinance. As
indicated above, term risk can be experienced even by
performing properties.\238\
---------------------------------------------------------------------------
\238\ See Realpoint Report--December 2009, supra note 216, at 5
(providing that ``balloon default risk is growing rapidly from highly
seasoned CMBS transactions for both performing and non-performing loans
coming due as loans are unable to pay off as scheduled'').
---------------------------------------------------------------------------
3. Loans Are Not Refinanced
Holders of commercial real estate loans and related
securities are already experiencing significant problems with
maturing loans that are unable to refinance. As seen by the
following charts, the number of loans that are unable to
refinance at maturity is increasing steadily.\239\
---------------------------------------------------------------------------
\239\ See Parkus and Trifon, supra note 102, at 26-31 (providing
that the low level of loans paying off each month reflects the
``current scarcity of financing,'' ``the increasing number of loans
that do not qualify to refinance,'' and ``the unwillingness of
borrowers to refinance at high mortgage rates,'' and that the number of
maturity defaults and extensions also reflects ``the combination of
scarce financing options and increased number of loans that do not
qualify to refinance'').
---------------------------------------------------------------------------
FIGURE 29: CMBS LOAN PAYOFFS \240\
---------------------------------------------------------------------------
\240\ Data provided by Richard Parkus, Head of Commercial Real
Estate Debt Research, Deutsche Bank.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 30: NUMBER OF CMBS MATURITY DEFAULTS/EXTENSIONS
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
These problems with refinancing are expected to intensify.
Hundreds of billions of dollars of commercial real estate loans
are scheduled to mature in the next decade, setting the stage
for potentially continuing high levels of maturity
defaults.\241\ The following charts show projected maturity or
refinancing schedules for all commercial mortgages by lender
type, CMBS loans by vintage, and commercial real estate loans
held by banks by origination year.
---------------------------------------------------------------------------
\241\ See Parkus and Trifon, supra note 102, at 32-33; The Future
Refinancing Crisis in CRE, supra note 214, at 3. See additional
discussion of term risk in Section B.3.
---------------------------------------------------------------------------
FIGURE 31: COMMERCIAL MORTGAGE MATURITIES BY LENDER TYPE \242\
---------------------------------------------------------------------------
\242\ Data provided by Foresight Analytics LLP. Foresight estimated
gross originations for commercial and multifamily mortgages based on
Federal Reserve Flow of Funds data. Then, Foresight applied a
distribution of loan maturities to the origination year to project
future mortgage maturity dates.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 32: CMBS MATURITY SCHEDULE BY VINTAGE \243\
---------------------------------------------------------------------------
\243\ Data provided by Richard Parkus, Head of Commercial Real
Estate Debt Research, Deutsche Bank.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 33: MATURITY SCHEDULE FOR COMMERCIAL REAL ESTATE LOANS HELD BY
BANKS BY ORIGINATION YEAR \244\
---------------------------------------------------------------------------
\244\ Data provided by Foresight Analytics LLP. Foresight estimated
gross originations for commercial and multifamily mortgages based on
Federal Reserve Flow of Funds data. Then, Foresight applied a
distribution of loan maturities to the origination year (cross-
tabulating estimates with figures reported in the Call Reports) to
project future maturity dates for commercial real estate loans held by
banks.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
According to the Real Estate Roundtable, the total rolling
maturities for vulnerable commercial real estate loans for
CMBS, insurance companies, and banks and thrifts are $1.3
trillion through 2013 and $2.4 trillion through 2018.\245\ The
refinancing risk is particularly significant from 2010 to
2013.\246\ As a result, expected losses from term defaults and
maturity defaults are concentrated in the next few years when
many expect continued weakness or deterioration in the
commercial real estate market.\247\
---------------------------------------------------------------------------
\245\ The Real Estate Roundtable, Restoring Liquidity to Commercial
Real Estate Markets, at 4-5 (Sept. 2009) (online at www.rer.org/
ContentDetails.aspx?id=3045) (hereinafter ``Real Estate Roundtable
White Paper''). The Real Estate Roundtable is a trade association
comprised of leaders of the nation's top public and privately-held real
estate ownership, development, lending and management firms and leaders
of sixteen national real estate trade associations. The Roundtable
addresses key national policy issues and promotes policy initiatives
relating to real estate and the overall economy.
\246\ See, e.g., Written Testimony of Jon Greenlee, supra note 93,
at 7-8 (providing that ``more than $500 billion of CRE loans will
mature each year over the next few years''); Financial Crisis Inquiry
Commission, Written Testimony of Dr. Kenneth T. Rosen, chair, Fisher
Center for Real Estate and Urban Economics, University of California--
Berkeley's Haas School of Business, The Current State of the Housing,
Mortgage, and Commercial Real Estate Markets: Some Policy Proposals to
Deal with the Current Crisis and Reform Proposals to the Real Estate
Finance System, at 3 (Jan. 13, 2010) (online at www.fcic.gov/hearings/
01-13-2010.php) (providing that the number of commercial mortgage
maturities is expected to increase each year through 2013).
\247\ See The Future Refinancing Crisis, supra note 213, at 7, 14-
16, 23-26; see also Tom Joyce, Toby Cobb, Francis Kelly, and Stefan
Auer, A Return to Normalcy in 2010?, at 20 (Jan. 2010) (hereinafter
``Joyce, Cobb, Kelly and Auer''); Parkus and Trifon, supra note 102, at
30-33, 48; US CRE Debt Markets, supra note 122, at 68-70.
---------------------------------------------------------------------------
The inclusion of construction loan losses changes the
magnitude and timing of commercial real estate losses.
Construction loan losses have accelerated the commercial real
estate credit cycle because construction credit quality has
deteriorated faster than non-construction loan quality and
construction loans generally have
shorter terms.\248\ In addition, construction loans have higher
loss severity rates leading to higher peak losses.\249\
---------------------------------------------------------------------------
\248\ Commercial Real Estate Take III, supra note 213, at 11-14.
\249\ See Commercial Real Estate Take III, supra note 213, at 11-
14; The Future Refinancing Crisis, Part II, supra note 120, at 23-27;
see also Parkus and Trifon, supra note 102, at 40, 44-45.
---------------------------------------------------------------------------
The commercial real estate loans at issue--namely,
construction loans, mini-perm loans,\250\ short-term fixed rate
whole and CMBS loans, and short-term floating rate whole and
CMBS loans--are largely structured as interest only, partial
interest only, or partial amortization loans.\251\ This means
that the loans typically do not amortize the full principal,
leaving a large balloon payment at the end of the term. In
order to make these balloon payments, borrowers typically
attempt to refinance or apply for new loans with sufficient
proceeds to pay off the existing loans. Borrowers unable to
refinance these loans at maturity will have to locate
additional funds for the balloon payment, sell the property,
work out an alternative arrangement with the lender, or
default.\252\
---------------------------------------------------------------------------
\250\ A mini-perm loan is a short-term bank loan, similar to a
bridge loan, that is typically offered at the maturity of a
construction loan so that the borrower can establish an operating
history, in preparation for obtaining a term loan. See Brueggeman and
Fisher, supra note 13, at 437-38, 444.
\251\ See, e.g., Parkus and Trifon: Searching for a Bottom, supra
note 210, at 24-26, 45. See additional discussion of the structure of
commercial real estate loans in Section E.
\252\ See The Future Refinancing Crisis in CRE, supra note 214, at
11; Parkus and Trifon: Searching for a Bottom, supra note 210, at 33.
See additional discussion of the options for borrowers and lenders in
Section G.3.
---------------------------------------------------------------------------
To qualify for refinancing, under current conditions, the
borrower must generally satisfy three criteria: (1) the new
loan balance must be greater than or equal to the existing loan
balance, (2) the LTV ratio must be no greater than 70 (current
maximum LTVs are between 60 and 65), and (3) the DSCR (assuming
a 10-year, fixed rate loan with a 25-year amortization schedule
and an 8 percent interest rate), must be no less than 1.3.\253\
---------------------------------------------------------------------------
\253\ See The Future Refinancing Crisis in CRE, supra note 214, at
11; Parkus and Trifon: Searching for a Bottom, supra note 210, at 33.
---------------------------------------------------------------------------
a. Qualifying Loans Face Scarcity of Credit
Many commercial real estate loans from earlier vintages,
such as 1999 and 2000, that occurred before the dramatic
weakening in underwriting quality of the bubble years, have
experienced price appreciation and would normally qualify for
refinancing, even under the new, stricter underwriting
standards.\254\ However, as these loans are maturing, they are
having difficulty refinancing because most credit markets are
operating at dramatically reduced levels.\255\ For example, the
CMBS market was essentially frozen from July 2008 to May 2009
(with no CMBS issued during this time) and is only now starting
to thaw.\256\ Weak demand for credit, tightened lending
standards, and potentially large commercial mortgage losses
have contributed to a contraction in bank lending.\257\
Further, many banks have expressed a desire to decrease their
commercial real estate exposure rather than refinance existing
loans.\258\
---------------------------------------------------------------------------
\254\ The Future Refinancing Crisis in CRE, supra note 214, at 3.
\255\ See COP Field Hearing in Atlanta, supra note 70, at 6-7
(Testimony of Doreen R. Eberley); Congressional Oversight Panel,
Written Testimony of Timothy F. Geithner, Secretary of the Treasury,
COP Hearing with Treasury Secretary Timothy Geithner, at 3, 7-8 (Dec.
10, 2009) (online at cop.senate.gov/hearings/library/hearing-121009-
geithner.cfm) (hereinafter ``COP Hearing with Secretary Geithner'')
(``Lending standards are tight and bank lending continues to contract
overall, although the pace of contraction has moderated''); The Future
Refinancing Crisis in CRE, supra note 214, at 3.
\256\ See Commercial Real Estate Securities Association, Exhibit
19, supra note 146 (updated Jan. 12, 2010); COP Hearing with Secretary
Geithner, supra note 255, at 3 (``[A]lthough securitization markets
have improved, parts of those markets are still impaired, especially
for securities backed by commercial mortgages''). See also discussion
of the CMBS market in Section E.2.
\257\ See COP Hearing with Secretary Geithner, supra note 255, at
3, 8 (``The contraction in many categories of bank lending reflects a
combination of persistent weak demand for credit and tight lending
standards at the banks, amidst mounting bank failures and commercial
mortgage losses''); Board of Governors of the Federal Reserve System,
National Summary of the October 2009 Senior Loan Officer Opinion Survey
on Bank Lending Practices, at 2 (Nov. 2, 2009) (online at
www.federalreserve.gov/boarddocs/snloansurvey/200911/fullreport.pdf)
(providing that reduced risk tolerance, a less favorable or more
uncertain economic outlook, and a worsening of industry-specific
problem contributed to tightened credit standards for C&I loans); see
also Real Estate Roundtable White Paper, supra note 245, at 4 (accessed
Feb. 9, 2010).
\258\ See U.S. Department of the Treasury, Monthly Lending and
Intermediation Snapshot (Dec. 14, 2009) (online at
www.financialstability.gov/impact/
monthlyLendingandIntermediationSnapshot.htm) (hereinafter ``Treasury
Snapshot, Dec. 14 2009''). See also discussion of capital contraction
in Section G.1.
---------------------------------------------------------------------------
b. Loans that Fail to Qualify for Refinancing
Although capital contraction has posed a problem, the
significant number of loans--especially those originated during
the peak years of 2005 to 2007--that will not qualify for
refinancing at maturity pose a far greater problem. As noted
above, two general types of non-qualifying loans reflect
different levels of seriousness. The first type includes loans
that are performing at maturity but are unable to refinance due
to the collateral effects of wider economic problems, such as
increases in unemployment and decreases in consumer spending
leading to less demand for commercial space and higher vacancy
rates. These loans, while reasonable at their inception, fell
victim to an unexpected deterioration in commercial market
fundamentals. Loans that are performing at maturity but have
difficulty refinancing during a declining real estate market
because they have an ``equity gap'' provide a good example of
the first kind of non-qualifying loans.
As seen by the following table, if the market value of a
property has fallen significantly, the LTV ratio will rise,
since the loan-to-value ratio is the loan balance divided by
the value. Assuming the borrower has a lender who is willing to
refinance the mortgage, the borrower will need to come up with
additional equity in order to stay under the lender's LTV ratio
limit.
FIGURE 34: EXAMPLE OF EQUITY GAP
------------------------------------------------------------------------------------------------------------------------------------------------
2005 (Property Financed with 5-year Mortgage)
Property Value....................................... $1,000,000
Outstanding Principal Balance........................ $750,000
Equity............................................... $250,000
LTV.................................................. 75%2010 (Mortgage Matures--Borrower Must Refinance)
Property Value....................................... $750,000
Outstanding Principal Balance........................ $700,000
Equity............................................... $50,000
LTV.................................................. 93%Available Loan for 75% LTV (75% of $750,000)......... $562,500
Total Equity Needed ($700,000-$562,500).............. $187,500
Subtract $50,000 in Existing Equity
Equity Gap at 75% LTV................................ $137,500Available Loan for 65% LTV (65% of $750,000)......... $487,500
Total Equity Needed ($700,000-$487,500).............. $212,500
Subtract $50,000 in Existing Equity
Equity Gap at 65% LTV................................ $162,500
------------------------------------------------------------------------
In order to refinance, the borrower in this example needs
to come up with nearly $140,000 to refinance because of
declining property values, even though there is equity
remaining in the property. Increased underwriting standards
will exacerbate the equity shortfall in this example, requiring
an additional $25,000 to refinance based upon a more
conservative 65 percent LTV limit. Underwater borrowers with
negative equity will be in an even worse situation. Bear in
mind that the borrowers in this situation may own a property
that is fully leased and generating more than enough rental
income to cover debt service. Simply due to the recent decline
in property values, thousands of otherwise healthy properties
could now face default and foreclosure because of this problem.
The Real Estate Roundtable estimates that the total equity gap
for commercial real estate could be over $1 trillion.\259\
---------------------------------------------------------------------------
\259\ The Real Estate Roundtable, Challenges Facing Commercial Real
Estate, at 6 (2009).
---------------------------------------------------------------------------
The second type of non-qualifying commercial real estate
loans includes loans, performing or non-performing, that were
excessively speculative or based on inadequate credit checks or
underwriting standards. These loans do not qualify for
refinancing for reasons beyond the unexpected economic
downturn. Construction loans represent by far the riskiest
loans and provide a good example of the second type of non-
qualifying loans.
Currently, the markets are heavily penalizing properties
with vacancy issues, which translate into cash flow issues.
Newly or partially constructed commercial properties are
experiencing the biggest vacancy problems.\260\ Lenders are
also requiring much lower LTVs (or significantly less
leverage), and the values of newly constructed properties have
fallen dramatically. Construction loans originating from 2005
to 2008, or those based on aggressive rental and cash flow
projections, have a high likelihood of default and high loss
severity rates.\261\ The total delinquency rate of construction
loans is already 16 percent,\262\ but this percentage does not
necessarily portray the severity of the construction loan
problem, especially for the smaller and regional banks with the
highest exposure. Construction loans are generally structured
as short-term floating rate loans with upfront interest
reserves that are used to satisfy interest payments until the
project is completed. Because of historically low interest
rates, interest reserves are lasting longer, allowing many
construction loans to remain performing, even though the
underlying properties may be excessively leveraged or have
little profit potential. Thus, as interest rate reserves are
exhausted, delinquency rates and losses will likely increase
dramatically.\263\
---------------------------------------------------------------------------
\260\ Parkus and Trifon, supra note 102, at 40.
\261\ Parkus and Trifon, supra note 102, at 40.
\262\ Parkus and Trifon, supra note 102, at 44; see also Senate
Committee on Banking, Housing, and Urban Affairs, Subcommittee on
Financial Institutions, Statement of Daniel K. Tarullo, member, Board
of Governors of the Federal Reserve System: Examining the State of the
Banking Industry, at 7-9 (Oct. 14, 2009) (online at banking.senate.gov/
public/index.cfm?FuseAction=Files.View&FileStore_id=c123f6a9-0b8d-4b22-
ba68-fa900a712d86) (hereinafter ``Testimony of Daniel K. Tarullo'').
\263\ Parkus and Trifon, supra note 102, at 40-45.
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A number of construction projects have been delayed or
abandoned providing physical proof of problems with
construction loans. Stalled projects, ranging from high-profile
to smaller-scale developments, span the country. Higher profile
examples include a shopping district in Atlanta (Streets of
Buckhead), redevelopment of a retail store in Boston (Filene's
Basement), a mixed-use building in Phoenix, a large casino-
hotel in Las Vegas (Fontainebleau), and a retail project in the
New Jersey Meadowlands (Xanadu).\264\ From a community
standpoint, half-finished buildings or new commercial
properties that are vacant or largely vacant can be thought of
as merely irritating eyesores. But, they can also be symbolic
of greater problems or misfortunes resulting from the current
economic downturn (and its general effect on individuals,
businesses, unemployment, and spending), deterioration in the
commercial real estate market, and general capital contraction.
---------------------------------------------------------------------------
\264\ See Alexandra Berzon, Icahn Is Winning Bidder for Casino,
Wall Street Journal (Jan, 21. 2010); Carrick Mollenkamp and Lingling
Wei, Unfinished Projects Weigh on Banks, Wall Street Journal (Jan. 20,
2010).
---------------------------------------------------------------------------
4. New Loans Fail To Get Financing
The problems which persist for existing loans will also
contribute to an inability for new loans to get financing.\265\
High vacancy rates and weak demand for additional commercial
property will not only imperil the ability of current loans to
perform and current borrowers to refinance but also discourage
additional development and consequently the need for new loans.
Substantial absorption will have to take place before new
developments, and the accompanying loans, become
attractive.\266\ Sharp decreases in commercial and multifamily
mortgage loan originations, loans for conduits for CMBS, and
sales of commercial property reflect the existence of tight
credit conditions and low demand for new commercial real estate
loans.\267\
---------------------------------------------------------------------------
\265\ See additional discussion of scarcity of credit in Section
C.2.
\266\ See Written Testimony of Mark Elliott, supra note 109, at 7
(``Because of too much speculative development and the diminished
economy, there is a fundamental over-supply of real estate in every
product class and of every type''); COP Field Hearing in Atlanta, supra
note 70, at 1 (Testimony of Chris Burnett); Treasury Snapshot, Dec. 14
2009, supra note 258 (``Demand for new commercial real estate loans
remains low due to the lack of new construction activity. Real estate
developers are reluctant to begin new projects or purchase existing
projects under current poor economic conditions, which include a
surplus of office space as firms downsize and vacancies rise'');
Commercial Real Estate Take III, supra note 213, at 6-8. See also the
discussion of capital contraction above in Section G.1.
\267\ MBA Data Book: Q3 2009, supra note 98, at 30, 39-43; see also
Matthew Anderson and Susan Persin, Commercial Mortgage Outlook: Growing
Pains in Mortgage Maturities, at 1, 3 (Mar. 17, 2009) (``[W]e expect
the commercial real estate debt market to show minimal net growth
during the next decade. The high volume of loans maturing in the
multifamily and commercial mortgage markets will absorb most of the
origination volume for several years. . . . [W]e estimate that
refinancing of maturing mortgages comprised about 80% of total
originations in 2008, as compared to 35% during the 2000 to 2007
period'').
---------------------------------------------------------------------------
Further, banks facing large potential commercial real
estate losses may be unable to extend new loans.\268\ In an
effort to increase loan loss reserves and shore up additional
capital, banks will have less capital available to make new
loans.\269\ However, even assuming available capital, banks
with significant commercial real estate exposure may shy away
from additional commercial real estate loans, regardless of the
quality of such loans, opting instead to reduce their current
exposure because commercial real estate market fundamentals are
weak and not expected to improve in the near term.\270\ Banks
may also be unwilling to take originally loans onto their
balance sheet that will ultimately be securitized because of
warehousing and arbitrage risk, hindering recovery in the CMBS
market.\271\
---------------------------------------------------------------------------
\268\ See, e.g., COP Hearing with Secretary Geithner, supra note
255, at 3 (``Commercial real estate losses weigh heavily on many small
banks, impairing their ability to extend new loans'').
\269\ See COP Field Hearing in Atlanta, supra note 70, at 8-9
(Testimony of Chris Burnett).
\270\ See Treasury Snapshot, Dec. 14 2009, supra note 258
(``Finally, nearly all respondents indicated that they are actively
reducing their exposure to commercial real estate loans, as banks
expect commercial real estate loan delinquencies to persist and
forecasters expect weakness in the commercial real estate market to
continue'').
\271\ See Joyce, Cobb, Kelly and Auer, supra note 247, at 21.
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In addition, rising interest rates and the withdrawal of
Federal Reserve liquidity programs may exacerbate the
problem.\272\ A significant amount of commercial real estate
loans are floating rate loans. Historically low interest rates
are helping these loans perform in the face of decreased
operating income or cash flows by reducing interest payments or
the level of debt service. However, if interest rates begin to
rise, the values of commercial property would fall further and
cash flows and interest rate reserves would be exhausted
sooner, leading to an accompanying rise in loan defaults.
---------------------------------------------------------------------------
\272\ These included five programs, the Money Market Investor
Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual
Fund Liquidity Facility, the Commercial Paper Funding Facility, the
Primary Dealer Credit Facility, the Term Securities Lending Facility,
and the Term Asset-Backed Securities Loan Facility (TALF), designed to
expand the range and terms of the Board's provision of funds to support
financial institutions. The Term Auction Facility, which allows
depository institutions, upon provision of adequate collateral to
obtain short-term loans from the Board at interest rates determined by
auction, remains in operation as of the date of this report. Bank
supervisors have already begun advising the institutions they regulate
to adopt plans for addressing rising interest rates and illiquidity.
See, e.g., Board of Governors of the Federal Reserve System, Federal
Deposit Insurance Corporation, National Credit Union Administration,
Office of the Comptroller of the Currency, Office of Thrift Supervision
(OTS), and Federal Financial Institutions Examination Council State
Liaison Committee, Advisory on Interest Rate Risk Management (Jan. 6,
2010) (online at www.fdic.gov/news/news/press/2010/pr1002.pdf).
---------------------------------------------------------------------------
Rising interest rates would also impair refinancing for
properties that are not aggressively leveraged because of the
combination of an increasing cost of capital and diminished
operating income or cash flows. As the DSCR continues to fall,
the level of risk increases, causing lenders to charge even
higher rates of interest to compensate for additional
risk.\273\ The withdrawal of Federal Reserve liquidity
programs, such as TALF (a partially TARP funded program), may
result in wider spreads, less readily available capital for
commercial real estate, and more difficulty refinancing loans
at maturity.\274\
---------------------------------------------------------------------------
\273\ See Board of Governors of the Federal Reserve System, Speech
by Governor Elizabeth A. Duke at the Economic Forecast, at 9 (Jan. 4,
2010) (online at www.federalreserve.gov/newsevents/speech/
duke20100104a.htm) (discussing unfavorable outlook for commercial real
estate and higher rates of return required by investors).
\274\ See, e.g., COP Field Hearing in Atlanta, supra note 70, at 8
(Testimony of Jon Greenlee) (providing that TALF has been successful in
helping restart securitization markets and narrowing rate spreads for
asset-backed securities). See additional discussion of the TALF at
Section I.1.
---------------------------------------------------------------------------
From the banks' perspectives, rising interest rates will
typically reduce profitability as funding costs increase more
rapidly than the yield on banks' loans and investments. Such
reduced profitability will put further stress upon banks
already struggling with sizable exposures of delinquent or non-
performing commercial real estate loans in their portfolios and
thereby hasten the need for these banks to resolve the status
of such loans regardless of the accounting treatment of such
loans.
5. Broader Social and Economic Consequences
Declining collateral values, delinquent and defaulting
loans, and inability to secure refinancing in order to make a
balloon payment can all result in financial institutions having
to write-down asset values. These write-downs have already
caused financial institutions to fail, and if commercial real
estate losses continue to mount, the write-downs and failures
will only increase. But, it is important to realize that these
conditions will have a far broader impact.
Commercial real estate problems exacerbate rising
unemployment rates and declining consumer spending.
Approximately nine million jobs are generated or supported by
commercial real estate including jobs in construction,
architecture, interior design, engineering, building
maintenance and security, landscaping, cleaning services,
management, leasing, investment and mortgage lending, and
accounting and legal services.\275\ Projects that are being
stalled or cancelled and properties with vacancy issues are
leading to layoffs. Lower commercial property values and rising
defaults are causing erosion in retirement savings, as
institutional investors, such as pension plans, suffer further
losses. Decreasing values also reduce the amount of tax revenue
and fees to state and local governments, which in turn impacts
the amount of funding for public services such as education and
law enforcement. Finally, problems in the commercial real
estate market can further reduce confidence in the financial
system and the economy as a whole.\276\
---------------------------------------------------------------------------
\275\ Real Estate Roundtable White Paper, supra note 245, at 1-2
(accessed Feb. 9, 2010); see also COP Field Hearing in Atlanta, supra
note 70, at 4.
\276\ Real Estate Roundtable White Paper, supra note 245, at 1-2
(accessed Feb. 9, 2010).
---------------------------------------------------------------------------
To make matters worse, the credit contraction that has
resulted from the overexposure of financial institutions to
commercial real estate loans, particularly for smaller regional
and community banks, will result in a ``negative feedback
loop'' that suppresses economic recovery and the return of
capital to the commercial real estate market. The fewer loans
that are available for businesses, particularly small
businesses, will hamper employment growth, which could
contribute to higher vacancy rates and further problems in the
commercial real estate market.\277\
---------------------------------------------------------------------------
\277\ See Lockhart Speech before the Atlanta Fed, supra note 128;
see also COP Field Hearing in Atlanta, supra note 70, at 10, 12
(Testimony of Doreen Eberley) (providing that small businesses and
trade groups are having difficulty obtaining credit and renewing
existing lines of credit and that extending credit to businesses will
be essential in stimulating economic growth). Consumers or households
are experiencing similar problems obtaining access to credit, resulting
in reduced consumer spending. See COP Field Hearing in Atlanta, supra
note 70, at 4 (Testimony of Jon Greenlee).
---------------------------------------------------------------------------
The cascading effects of a financial crisis on the economy
was the justification for the use of public funds under EESA,
and future problems in the commercial real estate markets may
create similar conditions or causes for concern.
G. Bank Capital; Financial and Regulatory Accounting Issues;
Counterparty Issues; and Workouts
Some of the risks of commercial real estate loans can
produce a direct impact on bank capital, some trigger related
financial market consequences, and still others can be eased or
resolved by private negotiations short of any immediate impact.
This section discusses (1) the bank capital rules that set the
terms on which loan failures can affect bank strength, (2) a
general summary of the accounting policies involved, (3) the
risk of collateral financial market consequences, and (4) the
way in which workouts and loan modifications can reduce or
eliminate, at least for a time, such adverse impacts.
1. Commercial Real Estate and Bank Capital \278\
---------------------------------------------------------------------------
\278\ This discussion is taken from the Panel's August report. See
COP August Oversight Report, supra note 5, at 18-19.
---------------------------------------------------------------------------
Troubled loans have a significant negative effect on the
capital of the banks that hold them; the two operate jointly.
Although bank capital computations are often very technical and
complicated,\279\ the core of the rules can be stated simply. A
bank's capital strength is generally measured as the ratio of
specified capital elements on the firm's consolidated balance
sheet (e.g., the amount of paid-in capital and retained
earnings) to its total assets.\280\ Decreases in the value of
assets on a bank's balance sheet change the ratio by requiring
that amounts be withdrawn from capital to make up for the
losses. Losses in asset value that are carried directly to an
institution's capital accounts without being treated as items
of income or loss have the same effect.\281\
---------------------------------------------------------------------------
\279\ Capital adequacy is measured by two risk-based ratios, Tier 1
and Total Capital (Tier 1 Capital plus Tier 2 Capital (Supplementary
capital). Tier 2 capital may not exceed Tier 1 capital. Tier 1 capital
is considered core capital while Total Capital also includes other
items such as subordinated debt and loan loss reserves. Both measures
of capital are stated as a percentage of risk-weighted assets. A
financial institution is also subject to the Leverage Ratio
requirement, a non-risk-based asset ratio, which is defined as Tier 1
Capital as a percentage of adjusted average assets. See Office of
Thrift Supervision, Examination Handbook, Capital, at 120.3 (Dec. 2003)
(online at files.ots.treas.gov/422319.pdf); see also Federal Deposit
Insurance Corporation, Risk Management Manual of Examination Policies,
Section 2.1 Capital (April 2005) (online at www.fdic.gov/regulations/
safety/manual/section2-1.html#capital); Office of the Comptroller of
the Currency, Comptroller's Handbook (Section 303), Capital Accounts
and Dividends, (May 2004) (online at www.occ.treas.gov/handbook/
Capital1.pdf). In addition, the risk-based capital standards identify
``concentration of credit risk, risks of nontraditional activities, and
interest rate risk as qualitative factors to be considered in the
[supervisory] assessments of an institution's overall capital
adequacy.'' See Accounting Research Manager, Chapter 1: Industry
Overview--Banks and Savings Institutions, at 1.31 (online at
www.accountingresearchmanager.com/wk/ rm.nsf/0/
6EE8C13C9815FB4186256E6D00546497? OpenDocument&rnm= 673577&Highlight=2,
BANKS,SAVINGS,INSTITUTIONS).
\280\ The value of the assets is generally ``risk-weighted,'' that
is, determined based on the risk accorded the asset.
\281\ Although these losses are carried directly to the capital
account, they have no effect on regulatory capital calculations when
recorded in the other-comprehensive-income account.
---------------------------------------------------------------------------
During the financial crisis, all of these steps accelerated
dramatically. A plunge in the value of a bank's loan portfolio
that has a significant impact on the value of the bank's
assets--as it usually will--triggers a response by the bank's
supervisor, one that usually requires the institution to raise
additional capital or even push it into receivership.
Otherwise, the bank's assets simply cannot support its
liabilities and it is insolvent. The TARP attempted to restore
the balance during the crisis by shoring up bank capital
directly.\282\
---------------------------------------------------------------------------
\282\ Congressional Oversight Panel, Testimony of Assistant U.S.
Treasury Secretary for Financial Stability Herbert Allison, at 27 (June
24, 2009) (online at cop.senate.gov/documents/transcript-062409-
allison.pdf) (Treasury seeks to enable banks ``to sell marketable
securities back into [the] market and free up balance sheets, and at
the same time [to make] available, in case it's needed, additional
capital to these banks which are so important to [the] economy''); See
also id. at 28 (``Treasury . . . is providing a source of capital for
the banks and capital is essential for them in order that they be able
to lend and support the assets on their balance sheet and there has
been . . . there was an erosion of capital in a number of those
banks'').
---------------------------------------------------------------------------
The problem of unresolved bank balance sheets is
intertwined with the problem of lending, as the Panel has
observed before.\283\ Uncertainty about risks to bank balance
sheets, including the uncertainty attributable to bank holdings
of the troubled assets, caused banks to protect themselves
against possible losses by building up their capital reserves,
including devoting TARP assistance to that end. One consequence
was a reduction in funds for lending and a hesitation to lend
even to borrowers who were formerly regarded as credit-worthy.
---------------------------------------------------------------------------
\283\ See, e.g., COP June Oversight Report, supra note 6, at 6, 11-
12.
---------------------------------------------------------------------------
2. Accounting Rules \284\
---------------------------------------------------------------------------
\284\ For a more complete discussion of ``fair value accounting''
see COP August Oversight Report, supra note 5, at 18-19.
---------------------------------------------------------------------------
Under applicable accounting standards, financial
institutions in general value their assets according to ``fair
value'' accounting.\285\ Since the beginning of the financial
crisis, concerns about how financial institutions reflect their
true financial condition without ``marking their assets to
market'' have surfaced.
---------------------------------------------------------------------------
\285\ Financial Accounting Standard 157, adopted in 2006, was meant
to provide a clear definition of fair value based on the types of
metrics utilized to measure fair value (market prices and internal
valuation models based on either observable inputs from markets, such
as current economic conditions, or unobservable inputs, such as
internal default rate calculations).
---------------------------------------------------------------------------
Under the basic ``fair value'' standard, the manner in
which debt and equity securities and loans are valued depends
on whether those assets are held on the books of a financial
institution in its (1) trading account (an account that holds
debt and equity securities that the institution intends to sell
in the near term), (2) available-for-sale account (an account
that holds debt and equity securities that the institution does
not necessarily intend to sell, certainly in the near term), or
(3) held-to-maturity account (an account, as the name states,
for debt securities that the institution intends to hold until
they are paid off).
The bank designates assets that are readily tradable in the
near future by classifying these assets in a trading account.
Many of these assets are bought and sold regularly in a liquid
market, such as the New York Stock Exchange or the various
exchanges on which derivatives and options are bought and sold,
which sets fair market values for these assets.\286\ There is
no debate about market value. In the trading account, the value
must be adjusted to reflect changes in prices. The adjustments
affect earnings directly.
---------------------------------------------------------------------------
\286\ See Financial Accounting Standards Board, Statement of
Financial Accounting Standards No. 157: Fair Value Measurements (SFAS
157) (September 2006). If assets are not traded in an active market,
SFAS 157 describes the steps to be taken in the valuation of these
assets. In this regard, SFAS 157 specifies a hierarchy of valuation
techniques based on whether the inputs to those valuation techniques
are observable or unobservable. Observable inputs reflect market data
obtained from independent sources, while unobservable inputs reflect
the entity's market assumptions. SFAS 157 requires entities to maximize
the use of observable inputs and minimize the use of unobservable
inputs when measuring fair value of assets. These two types of inputs
have created a three fair value hierarchy: Level 1 Assets (mark-to-
market), Level 2 Assets (mark-to-matrix), and Level 3 Assets (mark-to-
model).
Level 1--Liquid assets with publicly traded quotes. The financial
institution has no discretion in valuing these assets. An example is
common stock traded on the NYSE.
Level 2--Quoted prices for similar instruments in active markets;
quoted prices for identical or similar instruments in markets that are
not active; and model-derived valuations in which all significant
inputs and significant value drivers are observable in active markets.
The frequency of transactions, the size of the bid-ask spread and the
amount of adjustment necessary when comparing similar transactions are
all factors in determining the liquidity of markets and the relevance
of observed prices in those markets.
Level 3--Valuations derived from valuation techniques in which one
or more significant inputs or significant value drivers are
unobservable. If quoted market prices are not available, fair value
should be based upon internally developed valuation techniques that
use, where possible, current market-based or independently sourced
market parameters, such as interest rates and currency rates.
See also footnote 289, which discusses how to determine if there is
an active market.
---------------------------------------------------------------------------
Assets in an available-for-sale account are carried at
their ``fair value.'' In this case, any changes in value that
are not realized through a sale do not affect earnings but
directly affect equity on the balance sheet (reported as
unrealized gains or losses through an equity account called
``Other Comprehensive Income''). However, unrealized gains and
losses on available-for-sale assets do not affect regulatory
capital. Assets that are regarded as held-until-maturity are
valued at cost minus repaid amounts (i.e., an ``amortized
basis'').
The treatment of these assets held in either an available-
for-sale or a held-to-maturity account changes when these
assets become permanently impaired.\287\ In this case the
permanent impairment is reported as a realized loss through
earnings and regulatory capital.
---------------------------------------------------------------------------
\287\ Credit impairment is assessed using a cash flow model that
estimates cash flows on the underlying mortgages, using the security-
specific collateral and transaction structure. The model estimates cash
flows from the underlying mortgage loans and distributes those cash
flows to various tranches of securities, considering the transaction
structure and any subordination and credit enhancements that exist in
the structure. It incorporates actual cash flows on the mortgage-backed
securities through the current period and then projects the remaining
cash flows using a number of assumptions, including default rates,
prepayment rates, and recovery rates (on foreclosed properties). If
cash flow projections indicate that the entity does not expect to
recover its amortized cost basis, the entity recognizes the estimated
credit loss in earnings.
---------------------------------------------------------------------------
When mortgage defaults rose in 2007 and 2008, the value of
underlying assets, such as mortgage loans, dropped
significantly, causing banks to write-down both whole loans and
mortgage-related securities on their balance sheets. As
discussed in the August report, financial institutions are
worried that reflecting on their balance sheets the amounts
they would receive through forced sales of assets will distort
their financial positions--to say nothing of threatening their
capital--although they are not in fact selling the assets in
question and in fact might well recover more than the fire sale
write-down price.\288\
---------------------------------------------------------------------------
\288\ John Heaton, Deborah Lucas, and Robert McDonald, Is Mark to
Market Destabilizing Analysis and Implications for Policy, University
of Chicago and Northwestern University (May 11, 2009).
---------------------------------------------------------------------------
In April 2009, the Financial Accounting Standards Board
again adjusted the accounting rules to loosen the use of
immediate fair value accounting. One of the new rules suspends
the need to apply mark-to-market principles for securities
classified under trading or available-for-sale if current
market prices are either not available or are based on a
distressed market.\289\ The rationale for this amendment is
that security investments held by an entity can distort
earnings in an adverse market climate by reducing those
earnings more than will be required if the loans are held to
maturity.
---------------------------------------------------------------------------
\289\ Financial Accounting Standards Board, FASB Staff Position:
Determining Fair Value When the Volume and Level of Activity for the
Asset or Liability Have Significantly Decreased and Identifying
Transactions That Are Not Orderly (FSP FAS 157-4) (Apr. 9, 2009). FSP
157-4 relates to determining fair values when there is no active market
or where the price inputs being used represent distressed sales. For
this the FSP establishes the following eight factors for determining
whether a market is not active enough to require mark-to-market
accounting:
1. There are few recent transactions.
2. Price quotations are not based on current information.
3. Price quotations vary substantially either over time or among
market makers.
4. Indexes that previously were highly correlated with the fair
values of the asset or liability are demonstrably uncorrelated with
recent indications of fair value for that asset or liability.
5. There is a significant increase in implied liquidity risk
premiums, yields, or performance indicators (such as delinquency rates
or loss severities) for observed transactions or quoted prices when
compared with the reporting entity's estimate of expected cash flows,
considering all available market data about credit and other
nonperformance risk for the asset or liability.
6. There is a wide bid-ask spread or significant increase in the
bid-ask spread.
7. There is a significant decline or absence of a market for new
issuances for the asset or liability or similar assets or liabilities.
8. Little information is released publicly.
---------------------------------------------------------------------------
A second new rule, also adopted on April 9, 2009, applies
to permanently impaired debt securities classified as
available-for-sale or held-to-maturity, upon which the holder
does not intend to sell or believes it will not be forced to
sell before they mature.\290\ Under the new rule, the part of
the permanent impairment that is attributable to market forces
does not reduce earnings and does not reduce regulatory
capital, but other impairment changes, such as volatility of
the security or changes due to the rating agency, will reduce
earnings and regulatory capital. The old rule did not
distinguish how the impairment was derived. All permanent
impairments, whether related to market forces or other
conditions, reduced earnings and reduced regulatory capital.
(The changes in these accounting rules are the subject of a
continuing debate on which, as in the August report, the Panel
takes no position.)
---------------------------------------------------------------------------
\290\ Financial Accounting Standards Board, FASB Staff Position:
Recognition and Presentation of Other-Than-Temporary Impairments (FSP
No. FAS 115-2 and FAS 124-2). This FASB Staff Position (FSP) amends the
recognition guidance for the other-than-temporary impairment (OTTI)
model for debt securities and expands the financial statement
disclosures for OTTI on debt securities. Under the FSP, an entity must
distinguish debt securities the entity intends to sell or is more
likely than not required to sell the debt security before the expected
recovery of its amortized cost basis. The credit loss component
recognized through earnings is identified as the amount of cash flows
not expected to be received over the remainder term of the security as
projected based on the investor's projected cash flow projections using
its base assumptions. Part of the entity's required expansion in
disclosure includes detailed explanation on the methodology utilized to
distinguish securities to be sold or not sold and to separate the
impairment between credit and market losses. For debt securities an
entity intends to sell before maturity or is more likely than not
required to sell prior to maturity, the entire loss must be recognized
through earnings. FSP FAS 115-2 does not change the recognition of
other-than-temporary impairment for equity securities.
---------------------------------------------------------------------------
As described below, effective in 2010, two new accounting
standards, SFAS 166 \291\ and SFAS 167,\292\ will have a
special impact on institutions' reflection of CMBS that they
originated, packaged, or both. Prior to 2010, those investments
in CMBS were generally placed in special purpose vehicles (so-
called ``SPVs'') that financial institutions were permitted not
to record as part of their balance sheet assets. As a result,
those assets were not reflected in the institution's financial
statements.\293\
---------------------------------------------------------------------------
\291\ Statement of Financial Accounting Standard (SFAS) No. 166,
``Accounting for Transfers of Financial Assets an amendment of
Statement No. 140'' (SFAS 166). SFAS 166 revises existing sale
accounting criteria for transfers of financial assets. Prior to 2010,
financial institutions that transferred mortgage loans, credit card
receivables, and other financial instruments to special purpose
entities (SPEs) that met the definition of a qualifying special purpose
entity (QSPE) were not currently subject to consolidation by the
transferor. Among other things, SFAS 166 eliminates the concept of a
QSPE. As a result, existing QSPEs generally will be subject to
consolidation in accordance with the guidance provided in SFAS 167. See
footnote 292 for a discussion of SFAS 167. See Financial Accounting
Standards Board, Statement of Accounting Standard No.166, Accounting
for Transfers of Financial Assets, an amendment of FASB Statement
No.140 (June 2009) (online at www.fasb.org/cs/
BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=
id&blobwhere=1175819183786&blobheader=application%2Fpdf).
\292\ SFAS No. 167, ``Amendments to FASB Interpretation No.
46(R).'' SFAS 167 significantly changes the criteria by which a
financial institution determines whether it must consolidate a variable
interest entity (VIE). A VIE is an entity, typically an SPE, which has
insufficient equity at risk or which is not controlled through voting
rights held by equity investors. Currently, a VIE is consolidated by
the financial institution that will absorb a majority of the expected
losses or expected residual returns created by the assets of the VIE.
SFAS 167 requires that a VIE be consolidated by the enterprise that has
both the power to direct the activities that most significantly impact
the VIE's economic performance and the obligation to absorb losses or
the right to receive benefits that could potentially be significant to
the VIE. SFAS 167 also requires that an enterprise continually
reassess, based on current facts and circumstances, whether it should
consolidate the VIEs with which it is involved. See Financial
Accounting Standards Board, Statement of Accounting Standards No. 167,
Amendments to FASB Interpretation No. 46(R) (June 2009) (online at
www.fasb.org/cs/
BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=
id&blobwhere=1175819183863&blobheader=application%2Fpdf).
\293\ In addition, if a financial institution declares bankruptcy,
the assets in a SPV are generally protected (``sometimes referred to as
''bankruptcy remote''') from creditors' claims against the institution.
However, when General Growth Properties, Inc. (GGP) filed for
bankruptcy in April 2009, it included its affiliates that were SPVs.
Those affiliates challenged their inclusion since they were considered
bankruptcy remote. However, given the ``unprecedented collapse of the
real estate markets'' and ``serious uncertainty'' about when and if
refinancing would be available, the United States Bankruptcy Court for
the Southern District of New York Court concluded that GGP's management
had little choice other than to reorganize the entirety of GGP's
enterprise capital structure through a bankruptcy filing. Further, the
court rebuked the commonly held misperception that a ``bankruptcy
remote'' structure is ``bankruptcy proof.'' The future impact of this
opinion, and its relationship to the change in accounting standards, is
unclear at best. See United States Bankruptcy Court Southern District
of New York, In re: General Growth Properties, Inc. et al., Debtors,
Case No. 09-11977 (August 2009) (online at www.nysb.uscourts.gov/
opinions/alg/178734--1284--opinion.pdf). For a summary of the case, see
Sutherland, Legal Alert, Bankruptcy Court Denies CMBS Lenders Request
to Dismiss Bankruptcy Petitions of SPE Affiliates of General Growth
Properties, Inc. (Aug. 2009) (online at www.sutherland.com/files/News/
c5bb2175090baa=0943310995b609 a8c6459ab057/=Presentation/
NewsAttachment/f5d5b364=09c8b1094283-af7f-ae99c0b083f3/
=RE%20Alert%208.19.09.pdf).
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SFAS 166 and SFAS 167 generally require that those
investments in CMBS and other assets that a financial
institution held in an SPV be restored to a financial
institution's balance sheet. As a result, it is estimated that
approximately $900 billion in assets will be brought back on
financial institutions' balance sheets.\294\ Of this amount,
the four largest stress-tested banks will recognize
approximately $454 billion. As disclosed in their public
filings, Citigroup, Bank of America, JPMorgan Chase, and Wells
Fargo will recognize additional assets of approximately $154
billion,\295\ $100 billion,\296\ $110 billion,\297\ and $48
billion,\298\ respectively.\299\
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\294\ See COP August Oversight Report, supra note 5, at 13
(footnote 26).
\295\ Citigroup disclosed in its 10-Q for the quarter ended
September 30, 2009 that the proforma effect of the adoption of these
new accounting standards will increase assets by approximately $154
billion. Of the total amount, $84 billion is related to credit cards,
$40 billion is related to commercial paper conduits, and $14 billion is
related to student loans. The disclosure did not quantify investments
in CMBS. Citigroup also disclosed that there will be an estimated
aggregate after-tax charge to Retained earnings of approximately $7.8
billion, reflecting the net effect of an overall pretax charge to
Retained earnings (primarily relating to the establishment of loan loss
reserves and the reversal of residual interests held) of approximately
$12.5 billion less the recognition of related deferred tax assets
amounting to approximately $4.7 billion. Further, Citigroup disclosed
that Tier I capital and Total capital ratios will be decreased by 151
and 154 basis points. See U.S. Securities and Exchange Commission,
Citigroup Inc. Form 10-Q for the quarter ended September 30, 2009, at
97 (Nov. 6, 2009) (online at sec.gov/Archives/edgar/data/831001/
000104746909009754/a2195256z10-q.htm).
\296\ In its fourth quarter earnings release, Bank of America
disclosed that of the $100 billion of added loans, $72 billion includes
securitized credit cards and home equity receivables. The disclosure
did not quantify investments in CMBS. In addition, regulatory capital
will be reduced by $10 billion including deferred tax asset
limitations. Further, it estimates that Tier I Capital will decrease
between 70 to 75 basis points and Tier I Common Ratio will decrease
between 65 to 70 basis points. On December 31, 2009, Tier I capital and
Tier 1 Common Ratio was 10.4 percent and 7.8 percent, respectively. See
U.S. Securities and Exchange Commission, Bank of America Form 8-K,
Exhibit 99.2 (Jan. 20, 2010) (online at sec.gov/Archives/edgar/data/
70858/000119312510008505/dex992.htm).
\297\ JPMorgan Chase did not disclose the category of assets that
would be added to the balance sheet. In addition, JPMorgan Chase
further disclosed that the ``[r]esulting decrease in the Tier I capital
ratio could be approximately 40 basis points. See U.S. Securities and
Exchange Commission, JP Morgan Chase & Co. Form 10-Q for the quarter
ended September 30, 2009, at 97 (Nov. 6, 2009) (online at sec.gov/
Archives/edgar/data/70858/000119312509227720/d10q.htm).
\298\ Wells Fargo did not disclose the category of assets that
would be added to the balance sheet. See U.S. Securities and Exchange
Commission, Wells Fargo and Company Form 10-Q for the quarter ended
September 30, 2009, at 13 (Nov. 6, 2009) (online at sec.gov/Archives/
edgar/data/72971/000095012309059235/f53317e10vq.htm).
\299\ The supervisors recognized that the adoption of SFAS 166 and
SFAS 167 could significantly affect the risk-based capital requirements
of financial institutions and in December 2009 adopted a regulatory
capital rule that would give a financial institution the option to
recognize the effects of these new accounting standards over a four-
quarter period. Citigroup disclosed that upon the adoption of these new
accounting standards, its risk-based capital ratio would decrease by
approximately 151 basis points. Similarly, Bank of America and JP
Morgan disclosed that its risk based capital ratio would decrease by
approximately 75 basis points and 40 basis points, respectively.
Upon adoption of the regulatory capital rule, FDIC Chairman Shelia
Bair stated that ``[t]he capital relief we are offering banks for the
transition period should ease the impact of this accounting change on
banks' regulatory capital requirements, and enable banks to maintain
consumer lending and credit availability as they adjust their business
practices to the new accounting rules.'' However, only time will tell
how financial institutions will adjust their business practices to the
new accounting rules and how their capital levels will be affected.
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When these assets are put back on the balance sheet, the
accounting standards require that these assets reflect the
amounts (i.e., carrying value) that would have been reflected
on an institution's balance sheet. Because these assets were
not previously reflected on the institution's balance sheet,
the institution was not required to recognize any losses
incurred from holding them. As a result, the recognition of
these new assets on an institution's balance sheet may result
in an increase to loan loss reserves (allowance for loan
losses) as well as additional losses from the write-down in
values of investments in CMBS. The addition of these assets
coupled with the decline in value of commercial and commercial
real estate whole loans (commercial whole loans) could also
significantly affect the capital of a financial institution.
For a financial institution, the allowance for loan losses
is the dollar amount needed to absorb expected loan
losses.\300\ It is increased by management's estimates of
future loan losses and by recoveries of loans previously
recorded as a loss (charged-off) and reduced by loan losses
incurred when the borrower does not have the ability to repay
the loan balance. There is no ``check the box'' formula for
determining the appropriate level of loan losses. Rather, it is
based upon a high degree of judgment by management.\301\
Because this account is based upon management's judgment, there
is a high degree of risk that a financial institution's
allowance for loan losses may be insufficient, especially in
regard to the additional assets that will be recognized upon
the adoption of these new accounting standards.
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\300\ The allowance for loan loss is a balance sheet account. Under
generally accounting principles (GAAP) in the review of the adequacy of
loan loss allowance, loans that have common characteristics such as
consumer and credit cards loans are reviewed by a financial institution
on a group basis. Commercial real estate loans and certain commercial
loans are required to be reviewed on an individual basis.
Further under GAAP, the recognition of loan losses is provided by
SFAS No. 5, Accounting for Contingencies and No. 114, Accounting by
Creditors for Impairment of a Loan (SFAS No. 114). An estimated loss
from a loss contingency, such as the collectability of receivables,
should be accrued when, based on information available prior to the
issuance of the financial statements, it is probable that an asset has
been impaired or a liability has been incurred at the date of the
financial statements and the amount of the loss can be reasonably
estimated. SFAS No. 114 provides more specific guidance on measurement
of loan impairment and related disclosures but does not change the
fundamental recognition criteria for loan losses provided by SFAS No.
5. Additional guidance on the recognition, measurement, and disclosure
of loan losses is provided by Emerging Issues Task Force (EITF) Topic
No. D-80, Application of FASB Statements No. 5 and No. 114 to a Loan
Portfolio (EITF Topic D-80), FASB Interpretation No. 14, Reasonable
Estimation of the Amount of a Loss (FIN 14), and the American Institute
of Certified Public Accountants (AICPA) Audit and Accounting Guide,
Banks and Savings Institutions. Further guidance for SEC registrants is
provided by Financial Reporting Release No. 28, Accounting for Loan
Losses by Registrants Engaged in Lending Activities (Dec. 1, 1986). See
SEC Staff Accounting Bulletin No.102--Selected Loan Loss Allowance
Methodology and Documentation Issues, 1. Accounting for Loan Losses--
General, at 4 (July 6, 2001) (online at sec.gov/interps/account/
sab102.htm).
\301\ See Financial Reporting Release No. 28 (FRR 28), Accounting
for Loan Losses by Registrants Engaged in Lending Activities,
Securities Act Release No. 6679,1986 WL 1177276 (Dec. 1, 1986). See
also FRR 28A, Amendment of Interpretation Regarding Substantive
Repossession of Collateral, Securities Release No. 7060, 56 SEC Docket
1731, 1994 WL 186824 (May 12,1994).
In order to determine the dollar amount needed to absorb expected
future loan losses, management reviews the credit quality of all loans
that comprise a financial institution's loan portfolio (i.e., consumer,
credit cards, and commercial and commercial real estate loans). The
accounting guidelines require that management's assessment
``incorporate [its] current judgments about the credit quality of the
loan portfolio through a disciplined and consistently applied
process.'' For example, management's assessments of the credit quality
of the loan portfolio should include the following characteristics:
past loan loss experience, known and inherent loss risks in the
portfolio, adverse situations that may affect the borrower's ability to
repay, the estimated value of any underlying collateral, current
economic conditions, in addition to any pertinent characteristics of
the loan. See SEC Staff Accounting Bulletin (SAB) No.102--Selected Loan
Loss Allowance Methodology and Documentation Issues, Question. 1 at 5
(July 6, 2001) (online at sec.gov/interps/account/sab102.htm). Question
1 further states that'' [a] systematic methodology that is properly
designed and implemented should result in [an entity's] best estimate
of its allowance for loan losses.''
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The new accounting standards will force more accuracy in an
institution's financial statements, but the increased accuracy
will mean that the parlous state of commercial whole loans will
be even clearer.
3. Commercial Real Estate Workouts
a. Options for Resolving Defaulting or Non-Performing Loans
When a permanent commercial mortgage borrower defaults, the
borrower and the lender or special servicer have a number of
options available to them to resolve the situation and recover
as much of their respective interests as possible: (1) the
lender or servicer can foreclose, (2) the parties can engage in
a ``workout'' and modify the loan by lowering the principal,
the interest rate, or both, and (3) the lender can extend the
borrower's loan on the same terms for an additional period.
Each of these actions may be the best choice in appropriate
situations.
In some cases, after analyzing the property, the servicer
may determine that foreclosure is the best option. Properties
with very poor operating fundamentals, such as high vacancy,
may be unlikely to recover under any probable scenario. In
these cases it may be best for the lender to resolve the
situation promptly by taking the property and booking the loss.
In order to avoidforeclosure costs and delays, commercial real
estate lenders may be willing to agree to an alternative to a
traditional hostile foreclosure, such as a deed in lieu of foreclosure,
a voluntary ``friendly foreclosure'' (where the borrower does not fight
the foreclosure process), or a short sale.
If possible, commercial lenders will often arrange for a
new borrower to step in after foreclosure to purchase the
property and replace the defaulted borrower. In January 2010,
Tishman Speyer Properties and BlackRock defaulted on $4.4
billion in debt from its 2006 purchase of Stuyvesant Town and
Peter Cooper Village in Manhattan. In defaulting, they turned
the property over to the lenders. Within several weeks, lenders
were in serious discussions with potential purchasers and
property managers.\302\ Also, in December 2009, Morgan Stanley
and its lenders performed an ``orderly transfer'' of five
downtown San Francisco office buildings that it had purchased
in 2007.\303\
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\302\ Oshrat Carmiel and Sharon L. Lynch, Wilbur Ross May Go All
the Way,' Buy Stuyvesant Town, Bloomberg (Jan. 26, 2010) (online at
www.bloomberg.com/apps/news?pid=newsarchive&sid=aMe55gpowv2g).
\303\ Dan Levy, Morgan Stanley to Give Up 5 San Francisco Towers
Bought at Peak, Bloomberg (Dec. 17, 2009) (online at www.bloomberg.com/
apps/news?pid=20601110&sid=aLYZhnfoXOSk).
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These alternative strategies are more common in commercial
real estate than in residential. With residential properties,
more typically after a default or foreclosure, a property will
sit vacant for weeks or months before the lender is able to
sell the home. Commercial defaults are also significantly less
disruptive to communities and families, as the lenders are
usually able to manage properties as productive assets.
Residential foreclosures, on the other hand, force families out
of their homes and burden neighborhoods with vacant and
sometimes derelict properties. However, newly built commercial
properties, especially those built ``on spec'' with no pre-
leased tenants, often do remain empty for some time.
Loans on properties with viable fundamentals and income
which cannot support the current payment, but which could
support a slightly lower payment, may benefit from a loan
modification such as a rate or principal reduction. In these
cases, the lender must weigh the present value cost of the
modification with the costs of foreclosure, which may be
substantial.
As with the residential market, commercial borrowers with
negative equity (``underwater'') have an incentive to default
in order to avoid an almost certain loss.\304\ Workouts that do
not address the incentives inherent in negative equity
situations run the risk of simply delaying an inevitable
redefault and foreclosure, which can be costly for both lender
and borrower. Even borrowers in negative equity that continue
to service their debt may make significant cuts in property
maintenance and other discretionary expenses in an attempt to
limit their potential losses.
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\304\ Jun Chen and Yongheng Deng, Commercial Mortgage Workout
Strategy and Conditional Default Probability: Evidence from Special
Serviced CMBS Loans, Real Estate Research Institute Working Paper (Feb.
2004) (online at www.reri.org/research/article_pdf/wp120.pdf)
(hereinafter ``Chen and Deng: Commercial Mortgage Workout Strategy'').
The GAO made a similar observation in a report about the risks
associated with TALF, the government lending facility: ``A number of
scenarios could result in a borrower walking away from a loan. For
example, the collateral could lose value so that the loan amount
exceeded the value of the collateral.'' GAO TALF Report, supra note 64,
at 18.
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Principal reductions, or write-downs, have the advantage of
removing the incentive for these borrowers to default, since
the new principal balance will usually be less than the sale
proceeds from the property. The borrower will no longer have to
come up with cash to pay off the loan when they sell the
property. On the other hand, principal reductions are not
favored by many lenders because they are costly, and because
they force the recognition of a loss on what may already be a
weak balance sheet. In the case of a bank, this may cause it to
run afoul of its supervisors over capital requirements.
Borrowers facing foreclosure may choose to declare
bankruptcy in order to halt temporarily foreclosure
proceedings. Unlike the situation in residential real estate,
bankruptcy courts can order a write-down of a commercial real
estate loan balance under certain circumstances.\305\ Borrowers
may be able to use this possibility as a negotiating tactic
with the lender. The usefulness of this option can be
influenced by the use of a SPV to hold each property.\306\
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\305\ See Brueggeman and Fisher, supra note 13, at 39-41.
\306\ Proskauer Rose, LLP, Real Estate Bankruptcy Cramdowns: Fact
or Fiction (Mar. 16, 2009) (online at www.mondaq.in/unitedstates/
article.asp?articleid=76162). But see footnote 293 regarding the
bankruptcy of GGP. When GGP filed for bankruptcy it included its
affiliates that were SPVs. Those affiliates challenged their inclusion
since they were considered bankruptcy remote. However, the bankruptcy
court held that SPVs may be bankruptcy remote but are not bankruptcy
proof.
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An interest rate reduction reduces the monthly payment and
may prevent a marginal borrower from defaulting. Lenders may
also prefer this option to a principal reduction because it
does not force them to book a large loss. But rate reductions
do not remove the incentive for underwater borrowers to
default. And, the low-yielding loan that results from such a
workout will drop sharply in value if interest rates rise; the
fact that current interest rates are near record lows makes
this potential for a dramatic drop in value a serious concern.
Perhaps the most palatable workout option for the lender is
a term extension. It does not force a recognized loss, nor does
it saddle the lender with a low yielding investment sensitive
to interest rate risks. Unfortunately, there are only certain
situations where extensions make sense.
Borrowers that cannot pay their debt service or are
marginal have little to gain from a term extension. Additional
time will not enable them to pay their debt service if they
cannot do so already.\307\ There are a few exceptions, such as
a case in which a delinquent borrower expects a major increase
in revenue due, for example, to a large new tenant whose lease
begins in a few months. In such a case, the borrower may be
sustained by the extension long enough for the new tenant to
begin paying rent that will allow the borrower to continue
paying its debt service. This is an unlikely scenario in the
current market. In general, extensions will not help properties
that have low income due to bad business fundamentals, and
continued loans to failing projects that are simply recycled to
meet debt service requirements recall some of the worst abuses
of the last commercial real estate crisis and cannot be
recreated.
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\307\ In residential mortgage workouts, term extensions may extend
the amortization schedule as well, and thereby reduce the monthly
payment. Commercial real estate loans tend to have an amortization
schedule that is longer than the loan term. Extending the term (while
not changing amortization) will not reduce the mortgage payment, since
the monthly principal payment will remain unchanged.
---------------------------------------------------------------------------
The most promising use for term extensions is to help
healthy borrowers that have sufficient property income but
cannot refinance due to market difficulties. Most of these
borrowers will have also suffered losses in property value and
may be in a negative equity situation, further complicating
refinancing. In these cases, an extension may make sense if the
lender and borrower both believe that the property value will
recover enough over the term of the extension to put the
borrower back into positive equity.
However, there is an inherent tension between the economic
benefits to lenders of modifying loan terms and restructuring
financing arrangements, on the one hand, and the risk that
doing so only delays ultimate--some commentators would say
inevitable--write-downs, foreclosures, and losses.\308\
Performing loans will likely require long extensions at below-
market rates that will result in large real losses, even
assuming an absence of principal loss.\309\ The underwriting
standards of the bubble years were so aggressive that improving
economic conditions are unlikely to be enough to save the loans
made during this time. Accelerated amortization of loan
balances over a moderate time period is unlikely to address
sizeable equity deficiencies. And, the likelihood of
significant price appreciation is remote given tightened
financing terms and the billions of dollars of distressed loans
and commercial property that are accumulating due to maturity
extensions.\310\ Balancing all of these considerations--and
distinguishing those loans that will continue to perform until
conditions readjust--and those for which delay in accepting a
less than full recovery of value--with the requirement of
accompanying write-downs--is at the core of a bank's and
investor's judgment about loan strength and responsible credit
and capital management.
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\308\ See, e.g., Mortgage Bankers Association, Commercial Real
Estate/Multifamily Finance Quarterly Data Book Q3 2009, at 22 (Nov.
2009); The Future Refinancing Crisis in CRE, supra note 214, at 21; The
Future Refinancing Crisis, Part II, supra note 120, at 27.
\309\ Parkus and Trifon: Searching for a Bottom, supra note 210, at
67.
\310\ See The Future Refinancing Crisis in CRE, supra note 214, at
21.
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Even under more forgiving standards, many loans will not
warrant workouts, extensions, or modifications because the
borrowers cannot show creditworthiness, the problems extend
beyond a decrease in collateral value, or lenders cannot expect
to collect the loan in full. Lenders must recognize the losses
from these poor quality loans when incurred. However, as the
statistics in Section H.3 suggest, the loss recognition, net
write-down, and net charge-off process has only just begun.
Another issue associated with workouts is their impact on
investor trust and expectations, especially for CMBS. Changing
the terms of loan contracts from what was originally agreed,
especially for troubled, but not defaulted or imminently
defaulting borrowers, can reduce investor trust in the
certainty of contracts and cause them to rethink their risk
expectations in this type of investment.\311\ This loss of
confidence by investors could impede the recovery of the
commercial real estate secondary market, which is a necessary
part of a commercial real estate recovery. This consideration,
as well as other moral hazard concerns must, be balanced
against the benefits that can be achieved by workouts.
---------------------------------------------------------------------------
\311\ Commercial Mortgage Securities Association, Concerns with
REMIC Proposals to Authorize Loan Modifications and Restructure
Contracts (July 13, 2009).
---------------------------------------------------------------------------
Successful workouts often depend on access to sufficient
equity capital. The ``equity gap'' problem borrowers experience
in a falling market was discussed in section F.3 (b). So far in
this downturn, there has been very little new equity investment
in commercial real estate. Foreign investors such as sovereign
wealth funds, as well as other types of opportunistic
investors, may prove to be a major source of equity investment
in the future, whether as purchasers of distressed properties
or as investors in properties that need equity in order to
refinance. One prominent expert has estimated that more than
$100 billion in equity capital from foreign investors and other
sources is currently waiting on the sidelines for the right
market conditions. So far, most commercial property owners have
been reluctant to sell property or accept equity investment at
the deeply discounted terms these investors are seeking. This
standoff between property owners and investors has been
described as ``a game of chicken.'' \312\ As the prospects of
commercial real estate become clearer over the next few years,
it is likely that one side or the other will capitulate. This
may lead to a mass of equity transactions at discounted, but
ultimately stabilized, prices as this enormous pool of capital
competes for available properties. The discounted prices will
in turn generate substantial bank write-downs and capital
losses. (Prudently managed banks build some assessment of
default risk into the pricing and terms of the commercial real
estate (and other) loans they make. But, as noted elsewhere in
this report, that may well have less effect now, both because a
number of the loans at issue were not prudently made in the
first place, and even prudently managed banks could not foresee
the as yet unknown depth of the financial crisis and economic
downturn that has marked the last two years.)
---------------------------------------------------------------------------
\312\ David Geltner, The U.S. Property Market in 2010: The Great
Game of Chicken, PREA Quarterly (Winter 2010) (hereinafter ``Geltner
PREA Report'').
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Defaulted construction loans are more difficult to resolve
successfully than are permanent mortgages. Construction lending
is lending at the margin, and despite careful underwriting and
provisions such as interest reserves, it is an inherently risky
activity. While a completed and leased property may be able to
ride out a recession, new development depends on the marginal
demand for commercial space, which is likely to collapse
quickly in a recession. Even in safer build-to-suit
construction, pre-leased tenants may back out or go under in
hard times, causing a chain reaction ending in foreclosure.
In a weak real estate market, the developer has significant
incentives to default, due to the additional expense needed to
complete construction, and because of the slim chances of
successfully leasing the property upon completion. Another risk
is that the developer goes bankrupt before completion, leaving
the lender with no borrower and an incomplete property.
Construction loans carry their own type of term risk. In
most cases, the construction lender and developer count on a
permanent lender to take out, or pay off, the construction loan
upon completion of the property. The construction lender
usually requires that the developer obtain a commitment for
this takeout before closing on the construction loan.\313\ In a
credit crunch and real estate crash, however, permanent lenders
may renege on their prior loan commitments, or may have simply
gone out of business by the time the property is completed.
Under these economic circumstances, it is hard to find a
replacement lender. Without a takeout, the construction lender
will probably end up with the property, and with a number of
problems that this entails.
---------------------------------------------------------------------------
\313\ Brueggeman and Fisher, supra note 13, at 439-445.
---------------------------------------------------------------------------
Lender real estate owned foreclosures (REOs) obtained from
construction loans present a particular burden to lenders,
since they (1) generate no income, (2) are probably unfinished,
requiring additional investment before they can be leased, (3)
are difficult to sell in a depressed market, since there is
likely to be oversupply of similar properties already, (4) are
prone to vandalism and theft of materials and fixtures, and (5)
may present a public relations problem for the lender, since
surrounding property owners and residents will be unhappy at
having a half-finished, derelict property nearby.
Workout options for construction loans are generally
similar to those used for permanent mortgages but require more
careful attention and creativity in structuring the workout.
Term extensions, principal write-offs, rate reductions, changes
to the amortization schedule, conversion to a different type of
loan (e.g., amortizing to interest-only), participation stakes,
and bringing in new investors are all possible options, and
depend on what can be negotiated considering the unique
circumstances of the development project. As is the case with
permanent loans, construction loan workouts often involve a
degree of hope that the market will turn around in relatively
short order. In some cases, however, the market may have
changed to such an extent that the property is simply not
viable in the foreseeable future, and no reasonable workout can
be arranged.
The FDIC's October 30, 2009 policy statement on workouts,
discussed in Section H.3, directly addresses construction and
land loan workout strategies, as well as provides some
illustrative examples with explanations of how they would be
treated from a regulatory point of view.\314\ It is interesting
to note that the FDIC statement devotes as much space to
discussing construction loans as it does to permanent
mortgages, despite the much smaller pool of construction loans,
underscoring the concern they appear to have about this
category of assets.
---------------------------------------------------------------------------
\314\ Federal Deposit Insurance Corporation, Policy Statement on
Prudent Commercial Real Estate Loan Workouts (Oct. 30, 2009) (online at
www.fdic.gov/news/news/financial/2009/fil09061a1.pdf) (hereinafter
``Policy Statement on CRE Workouts'').
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Considering that U.S. banks own $481 billion in
construction and land loans, this concern is well founded.\315\
The approximately 50 percent recovery rate of invested capital
from defaulted construction loans in 2009, shown in Figure 36
below, suggests that the ultimate losses from these loans could
be enormous.\316\
---------------------------------------------------------------------------
\315\ SNL Financial (accessed on Jan. 13, 2010).
\316\ Real Capital Analytics, Q4 Update: Recovery Rates on
Defaulted Mortgages (2010) (hereinafter ``Q4 Update: Recovery Rates on
Defaulted Mortgages'').
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b. Can different structural models and servicing
arrangements allow private markets to function more
effectively than was true for residential real
estate?
Financial institutions and federal supervisors appear to be
inclined to extend prudent, performing loans that are unable to
refinance at maturity. Lenders have an incentive to work with
borrowers, where possible, to delay, minimize, or avoid writing
down the value of loans and assets or recognizing losses.
Workout strategies such as modifications and extensions may
help lenders avoid the significant costs and discounted or
distressed sales prices associated with foreclosures and
liquidations. The hope is that the economy will improve or that
commercial real estate loans will not be as problematic as
expected. This may be the case if the economy rebounds during
the extension period, vacancy rates decrease (or absorption
rates increase), cash flows strengthen, or commercial property
values rise. Current historically low interest rates help both
lenders and borrowers of floating rate loans by significantly
lowering the debt service so that cash flows and interest rate
reserves carry loans longer.
As is the case in the residential real estate market, a
falling commercial real estate market poses risks to all
property owners, even supposedly healthy ones. If the
commercial real estate market does not recover as quickly as
the lender anticipates in structuring the workout, the property
is likely to go into default again. The large number of loans
that for various reasons cannot be refinanced, combined with
loans in default due to poor property income, puts additional
downward pressure on property values and discourages lending.
Since falling values make loans harder to refinance, a falling
market has the tendency to create a vicious circle of defaults
of weak properties leading to defaults of stronger properties.
A number of factors make the consequences of default less
damaging and somewhat more acceptable to commercial borrowers
than for residential borrowers. Commercial real estate
investors often hold their properties in limited partnership or
limited liability company structures, often with only one
property in each business entity. This provides a degree of
protection in default and bankruptcy. REITs organize their
holdings into single-property limited partnerships, partly for
this reason. Residential borrowers are unprotected by any
corporate or liability limiting structure, although the non-
recourse clause in residential mortgages does limit losses in
default to the property itself.
There is some evidence that commercial borrowers may also
have a more lenient or at least pragmatic attitude toward
default than most residential borrowers. At least in theory,
commercial borrowers make default decisions based on profit and
loss considerations, rather than emotional desires or a sense
of moral obligation. They may opt for a ``strategic default,''
and preemptively declare bankruptcy (as discussed in Section
H.3), in cases where they stand to lose a great deal from
continuing to pay their debt service.
The options available to commercial mortgage servicers in
dealing with delinquencies and defaults are generally similar
to the options available to residential servicers. One of the
significant advantages that commercial mortgage servicers have
over their residential counterparts is that they service fewer,
larger loans, and can therefore give each loan more individual
attention. A typical CMBS deal may be backed by a pool of a
hundred or so loans, while a residential mortgage backed
security deal may contain many hundreds or thousands of loans.
This is a major advantage in dealing with defaults, since a
successful workout requires that the servicer become intimately
familiar with the property and its income sources. Office and
retail leases in particular are often quite complicated and
include various reimbursements, cost sharing arrangements, and
other negotiated terms. These leases require thorough study in
order to model properly the cash flows that can be expected
from the property. The commercial real estate servicer or
special servicer is also more likely to be dealing with a
borrower that is knowledgeable about real estate. This may make
it easier to arrange a workout or other strategy, because the
borrower is well prepared to discuss and evaluate the options.
c. Are workouts actually happening? If not, why not?
Unfortunately, publicly available information on commercial
real estate workouts is extremely limited, and lacks enough
detail about the type of workout strategy to draw many
conclusions about what is currently occurring in the commercial
real estate market. This is largely due to the fragmented
nature of workout reporting. Individual servicers, whether for
CMBS or whole loans, normally report workout information only
to their lender client or investors. Banks report information
on loan losses, but typically provide little detail on the
strategies that were used to resolve defaulted loans.
Figure 35 below, adapted from research by Real Capital
Analytics, shows current ``troubled'' (delinquent or defaulted)
commercial mortgage assets in the United States and their
status. The terms used in Figure 35 are defined directly below
the table.
FIGURE 35: TROUBLED COMMERCIAL MORTGAGE U.S. ASSETS AS OF DECEMBER 2009
\317\
------------------------------------------------------------------------
Number of Volume in Millions of
Assets Properties Dollars
------------------------------------------------------------------------
Troubled.......................... 6,425 $139,500.6
Restructured/Modified............. 725 17,109.4
Lender Real Estate Owned (REO).... 1,411 21,992.1
Total Current Distressed.......... 8,651 178,602.1
Resolved.......................... 1,314 24,508
-------------------------------------
Total......................... 9,875 $203,110.4
------------------------------------------------------------------------
\317\ Real Capital Analytics, Troubled Assets Radar: United States
Troubled Assets (online at www.rcanalytics.com/commercial-troubled-
assets-search.aspx) (accessed Jan. 25, 2010).
Troubled: Properties in the process of being
foreclosed, in bankruptcy, or undergoing workouts.
Restructured/Modified: Properties where the lender
has implemented a workout strategy, including loan extensions
of less than two years.
Lender REO: Properties that lenders have taken
back through foreclosure.
Resolved: Properties that have moved out of
distress via refinancing or through a sale to a financially
stable third party.
It is clear from Figure 35 that relatively few properties
have completed workouts, only 725 out of a total of 9,875. This
does not necessarily indicate reluctance by lenders and
servicers to deal with troubled assets. Dealing with defaulted
properties, whether by foreclosure, workout, or another
strategy, is a lengthy process. It is possible that many of
these troubled loans are early in the process of resolution due
to the rapid increase in defaults during 2009.
Due to the lack of detailed information on workouts, the
Panel consulted with numerous commercial mortgage lenders,
servicers, trade organizations, and other knowledgeable
commercial real estate professionals about their assessments of
the number and types of workouts currently occurring. Their
comments were quite consistent, but unfortunately, lacking in
much useful detail. The consensus is that workout activity has
increased significantly since the decline in commercial
property values began, but no quantification is available.
According to industry experts, commercial real estate servicers
are actively pursuing workouts where they believe it is
reasonable. As was mentioned earlier, the large dollar amount
of the individual loans, combined with the sophistication of
the commercial real estate borrowers (as compared to
residential) encourages lenders to attempt workouts where they
make sense for both parties.
Anecdotal evidence suggests that whole loans are more
likely to undergo a workout than securitized loans. It is not
clear whether this is because of the lower quality collateral
that is held by whole loan investors, a greater eagerness on
their part to work out problem loans, or because of issues
related to CMBS servicing arrangements and standards. Some PSAs
require the consent of most or all investors in order to modify
the terms of a loan, making any changes difficult.
Bank supervisors have sought to deal with these issues in
an updated policy statement on commercial real estate loan
workouts (the Policy Statement). That statement is discussed in
Section H.3.
An ominous indicator of the future losses that may be
expected from defaulted commercial real estate debt is the
declining recovery rate, or the amount of the loan balance that
the lender ultimately recoups after either foreclosing on or
working out a defaulted loan. Recovery rates from defaulted
mortgages fell significantly in the 4Q 2009, as lenders dealt
with an increasing number of non-performing loans. As with
residential real estate, foreclosures of commercial real estate
put additional downward pressures on property values, reducing
the ultimate recovery rate for all lenders. The provider of
this data, Real Capital Analytics, uses different terminology
for the basic categories of real estate debt than has been used
thus far in this report. Its acquisition/refinancing category
corresponds to what has been termed permanent mortgages, and
its development/redevelopment category corresponds to
construction and development loans.
Mean recovery rates for development/redevelopment loans
declined from 57 percent during the first three quarters of
2009 to 52 percent. Mean recovery rates from acquisition/
refinancing loans similarly declined from 69 percent to 63
percent over the same time period. On a weighted average basis,
the decline in acquisition/refinancing loan is even more
severe, with a drop of 14 percent, as can be seen in Figure 36
below. The authors of this report interpret the falling
recovery rates as being the result of lower market pricing as
well as an increasing willingness on the part of lenders to
deal seriously and realistically with the large number of non-
performing loans, even if it means incurring additional
losses.\318\
---------------------------------------------------------------------------
\318\ Q4 Update: Recovery Rates on Defaulted Mortgages, supra note
316.
FIGURE 36: RECOVERY RATES ON DEFAULTED MORTGAGES \ 319\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Q1-Q3 2009 Q4 2009 2009 Total
-----------------------------------------------------------------------------------------
Loan Type Weighted Weighted Weighted
Mean Average Mean Average Mean Average
(Percent) (Percent) (Percent) (Percent) (Percent) (Percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Development/Redevelopment..................................... 57 49 52 50 56 49
Acquisition/Refinancing....................................... 69 69 63 55 67 66
Overall....................................................... 65 61 59 52 63 59
--------------------------------------------------------------------------------------------------------------------------------------------------------
\319\ Q4 Update: Recovery Rates on Defaulted Mortgages, supra note 316.
All property types had declining recovery rates in the
fourth quarter of 2009, with the exception of industrial
properties. For the entire year of 2009, the lowest recovery
rates were for bare land and properties under development, with
mean recovery rates of 46 percent and 50 percent respectively,
as shown in Figure 37 below. A more unexpected finding was that
the highest recovery rate was among retail sector mortgages, at
73 percent.\320\
---------------------------------------------------------------------------
\320\ Real Capital Analytics, Recovery Rates by Property Type
(2010) (hereinafter ``Recovery Rates by Property Type'').
FIGURE 37: MEAN RECOVERY RATES BY PROPERTY TYPE (2009)\ 321\
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Number of Mean Recovery
Property Type Outstanding Defaulted Rate
Balance Mortgages (Percent)
----------------------------------------------------------------------------------------------------------------
Office.......................................................... $1,746.7 47 64
Industrial...................................................... 153.7 29 72
Retail.......................................................... 568.3 26 73
Hotel........................................................... 360.2 25 67
Multifamily..................................................... 1,913.4 130 63
Development Sites............................................... 404.6 13 46
Land............................................................ 471.0 24 50
--------------------------------
Total....................................................... $5,617.8 294 63
----------------------------------------------------------------------------------------------------------------
\321\ Recovery Rates by Property Type, supra note 320.
The lowest recovery rates by location were in the areas
hardest hit by the recession--Michigan, Florida, and
Arizona.\322\ When looked at by lender type, insurance
companies had the highest recovery rates overall, recouping 79
percent of their invested capital on acquisition/refinancing
loans. Although the exact reasons for this are not apparent, it
is worth noting that life insurance companies are very
conservative lenders (for example, they often require recourse
clauses in their loans), because of the long-term nature of
their own obligations to their policy holders. Interestingly,
CMBS performed the poorest at recovering losses from
acquisition/refinancing loans of all lender types, returning
only 62 percent of invested capital. On the whole, banks
recovered more of their capital, with the smaller regional or
local banks slightly outperforming their larger national and
international counterparts in both the development and
acquisition/refinancing categories.\323\
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\322\ Real Capital Analytics, Recovery Rates by Location (2010).
\323\ Real Capital Analytics, Recovery Rates by Lender Type (2010).
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d. Potential Impediments to Successful Workouts
Several tax issues complicate workouts and new investment
in commercial real estate. Although investors have been willing
to put in additional equity, and although banks and servicers
have engaged in workouts and other modifications, these issues
make resolution of problematic commercial real estate loans
without provoking a financial crisis more difficult.
i. REMIC
Although CMBS can be designed in a number of ways, many are
structured as REMICs.\324\ REMICs are pass-through entities;
they are not taxed on their income, but rather pass it directly
through to investors.\325\ Without the REMIC status, the CMBS's
income could be taxed at the corporate level and then again at
the investor level.\326\ To maintain the REMIC status, the
entity must follow strict rules.\327\
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\324\ A REMIC is a tax entity, not a legal form of an organization.
\325\ 26 U.S.C. Sec. 860A.
\326\ Prior to the 1986 law that created the REMIC status, an MBS
with only a single type of ownership interest could maintain pass-
through status. An MBS with multiple tranches or both equity and
residual interests could be seen by the IRS as requiring more active
management than a pass-through vehicle could allow. The REMIC status
allows a pass-through entity to have multiple tranches and interests.
Brueggeman and Fisher, supra note 13, at 558.
\327\ Rev. Proc. 2009-45, Section 3.
---------------------------------------------------------------------------
One of these rules is that if a REMIC makes a ``significant
modification'' to a loan, the IRS can impose severe
penalties.\328\ These penalties can be up to 100 percent of any
gain that the REMIC receives from modifying the loan.\329\ The
REMIC could also lose its status as a pass-through entity.\330\
The rules provide an exception for loans that are either in
default, or for which default is ``reasonably foreseeable.''
\331\
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\328\ A significant modification will cause the mortgage to no
longer be treated as a qualified mortgage. It will be considered to be
a prohibited transaction under 26 U.S.C. Sec. 860F. 26 CFR Sec. 1.860G-
2(b). The purpose behind this is that the REMIC should be a passive
vehicle, and cannot engage in active business activities.
A ``modification'' is defined as ``any alteration, including any
deletion or addition, in whole or in part, of a legal right or
obligation of the issuer or a holder of a debt instrument, whether the
alteration is evidenced by an express agreement (oral or written),
conduct of the parties, or otherwise.'' 26 CFR Sec. 1.1001-3(c)(1)(i).
In general, ``a modification is a significant modification only if,
based on all facts and circumstances, the legal rights or obligations
that are altered and the degree to which they are altered are
economically significant.'' 26 CFR Sec. 1.1001-3(e)(1).
\329\ 26 U.S.C. Sec. 860F(a).
\330\ A significant modification can cause a mortgage to no longer
be a qualified mortgage. A REMIC can lose its pass-through status if
one or more significant modifications of its loans cause less than
substantially all of the entity's assets to be qualified mortgages.
Rev. Proc. 2009-45 Section 3.09.
\331\ 26 CFR Sec. 1.860G-2(b)(3)(i).
---------------------------------------------------------------------------
To enable REMICs to modify loans more freely, the IRS
published guidance and new regulations in September 2009.\332\
These expanded the types of modifications that a REMIC was
permitted to undertake and provided a safe harbor for certain
modifications. The safe harbor applies if there is ``a
significant risk of default . . . upon maturity of the loan or
at an earlier date'' and if the modification ``presents a
substantially reduced risk of default.'' \333\
---------------------------------------------------------------------------
\332\ Rev. Proc. 2009-45; 74 FR 47436. The new regulations were
initially issued for comment in 2007, so they were not necessarily in
response to issues in the current commercial real estate market.
\333\ Rev. Proc. 2009-45, Sections 5.03, 5.04.
---------------------------------------------------------------------------
Though this guidance provides REMICs with more flexibility,
it is not a panacea. First, some believe that the guidance is
vague, and because of the steep penalties, are still wary of
modifying loans. Second, the PSAs were written under the
previous rules, and many have language that tracks the earlier
rules, making modifications either very complicated or barred
for servicers. At the Panel's Atlanta hearing, Brian Olasov, a
real estate professional who specializes in securitizations,
described the REMIC guidance as a ``complete non-event,''
saying that the REMIC rules did not ``tie the hands'' of the
special servicers in ``seeking the highest NPV resolution.''
\334\
---------------------------------------------------------------------------
\334\ COP Field Hearing in Atlanta, supra note 70 (Testimony of
Brian Olasov).
---------------------------------------------------------------------------
ii. Taxation of Foreign Investors in U.S. Real Estate
Outside investors are a possible solution to the equity
crunch that might hit the commercial real estate sector over
the next few years. Although many believe that billions of
dollars in non-U.S. equity are waiting to be invested in U.S.
commercial real estate, there can be negative tax consequences
for non-U.S. purchasers of or investors in U.S. real estate.
Non-U.S. investors can be hit with double or even triple
taxation on their investments in U.S. real estate.
Generally, nonresident aliens are not subject to capital
gains taxes on U.S. investments.\335\ Nonresident aliens are
generally only subject to U.S. capital gains tax if the income
is ``effectively connected to a U.S. trade or business.'' \336\
The Foreign Investment Real Property Tax Act (FIRPTA), however,
makes an exception for real estate, and imposes the U.S. tax on
real estate holdings.\337\ It does so by deeming gains or
losses from the disposition of real estate ``as if such gain or
loss were effectively connected with such trade or business.''
\338\ Therefore, a nonresident alien seeking to invest in the
United States will have a financial incentive to choose stocks
or bonds over real estate.
---------------------------------------------------------------------------
\335\ 26 U.S.C. Sec. 871(a)(2).
\336\ 26 U.S.C. Sec. 871(a)(2).
\337\ 26 U.S.C. Sec. Sec. 897, 882. This tax can be capital gain or
ordinary income, depending on the character of the asset. 26 U.S.C.
Sec. Sec. 897, 1221.
\338\ 26 U.S.C. Sec. 897(a)(1).
---------------------------------------------------------------------------
If the non-U.S. investor is a corporation, it can be
subject to two additional layers of tax. The branch profits
tax, a dividend equivalent tax, subjects a foreign
corporation's U.S. connected income to a 30 percent tax.\339\
The corporation could then also be subject to the standard U.S.
corporate income tax.
---------------------------------------------------------------------------
\339\ 26 U.S.C. Sec. 884.
---------------------------------------------------------------------------
Some have called for congressional or IRS action to
alleviate this tax burden on nonresident alien investments in
U.S. real estate.\340\
---------------------------------------------------------------------------
\340\ Real Estate Roundtable White Paper, supra note 245 (accessed
on Jan. 25, 2010).
---------------------------------------------------------------------------
e. Loss Recognition
The problem of commercial real estate reflects three
related timelines. The first is the timeline for recovery of
the economy to a sufficient point that borrowers' cash flows
return to normal and loan values increase. The second is the
timeline of loan extensions and restructurings. The third is
the timeline along which commercial real estate credit markets
reopen for sound projects. If these timelines do not cross
within an acceptable period, and there is not a dramatic
turnaround and quick recovery in commercial real estate prices,
many commercial real estate loans will produce unavoidable
losses that in the end must be borne by the borrower, the
lender, or the taxpayer.
When prudently managed banks evaluate the strength of
commercial real estate loans in their portfolios today, they
try to determine the prospect of each project, against their
judgment of the path of the three timelines. This means
projecting, among other things, the income that can be produced
by the property, the borrower's record in servicing the debt,
and the present ratio of the property's value to the amount of
the loan. On that basis, the lender must decide whether the
loan can be repaid and whether changing the terms of the loan
increases that possibility. The same judgments are involved in
setting the terms for a refinancing.
These judgments are decisions about potential losses. If
the lender decides that the loan will not be repaid--either
because the borrower has stopped making payments for a
sufficiently lengthy period, or because refinancing is
impossible on terms the lender can accept--it faces the
prospect of foreclosing and recognizing some degree of loss on
the loan. If it modifies the loan to accept a lesser amount on
repayment, it must write-down the difference between the
original and renewed loan amount. If it decides that the
borrower and the project have the potential strength, and that
economic conditions are sufficiently unsettled, it may reach an
agreement with the borrower to provide an additional period
before final action is required. The lender hopes, of course,
that by doing so it will avoid losses as the loan strengthens.
The extent to which banks should write off their loan in whole
or in part now or should be encouraged to provide the lender
with an extended period of time through one of the arrangements
described in the report is perhaps the major point of
contention in the commercial real estate markets today.\341\
---------------------------------------------------------------------------
\341\ Those who fear that the modifying loan terms will make banks
appear stronger than they really are (because banks are unrealistically
extending loans) and provide an artificial floor for commercial real
estate prices (postponing accurate market pricing) refer to it as
``kicking the can down the road'' or ``extend and pretend.''
---------------------------------------------------------------------------
The extent to which banks recognize commercial real estate
losses and how and when they choose to do so can have a direct
impact on the future viability of many banks. The details of
workouts, loan extensions, modifications, or refinancings and
foreclosures can also have collateral consequences for healthy
institutions as they understandably take steps to protect
themselves. In particular, it is likely that these banks will
reduce their lending because, or in anticipation, of loan
losses, as discussed elsewhere in the report.
The precipitous drop in commercial property values since
2007 ultimately means that banks may have to take losses in the
range of $200 billion-$300 billion.\342\ The timing of the loss
recognition is critical, but there is no single way to time
those losses. In many cases, loans that were sound when they
were made may end up producing little or no loss, because
economic conditions recover, new investors are found to close
the equity gap (especially as property values rise), or some
combination of the two. In other cases, a clear-sighted
analysis will show that loss from a loan is likely, and banks
whose loan portfolios contain those loans in amounts large
enough to threaten their capital should in many cases be placed
into receivership now.
---------------------------------------------------------------------------
\342\ See Parkus and Trifon: Searching for a Bottom, supra note 210
at 65. This estimate appears to be generally consistent with another
recent estimate by Moody's Investors Service. Moody's projects $77
billion in commercial real estate losses between Q4 2009 and the end of
2011 at the banks it rates. This number would be higher were it not for
the fact that the banks Moody's rates hold only about 50 percent of the
total bank exposure to commercial real estate. The Moody's report also
does not include losses incurred in 2012 and beyond. Joseph Pucella et
al., Moody's Investors Service, U.S. Bank Ratings Incorporate Continued
High Commercial Real Estate Losses (Feb. 6, 2010).
---------------------------------------------------------------------------
Any attempt to evaluate these consequences, however, is
complicated because many loans have yet to mature and many
borrowers continue to make required payments under their
existing loans. The problems looming in commercial real estate
will fully emerge over the next seven to nine years during the
waves of refinancing expected in 2011-2013 and then in 2016-
2017.\343\ A huge number of the affected properties are now
under water--that is, they have a value less than the loan
amount--but the rate of economic recovery and its effect on
loans that continue to perform are difficult to predict.\344\
This does not mean that there is no looming crisis.\345\ Banks
are already experiencing significant losses on construction
loans, which have shorter terms of three to four years but in
many cases financed projects from the bubble years of 2005-
2007, and in others are coming due as values have fallen, and
incomes have dropped, significantly. The warnings about
commercial real estate loans are extremely serious, and the
condition of construction loans now gives these predictions
substantial credence.
---------------------------------------------------------------------------
\343\ See Real Estate Roundtable, Continuing the Effort to Restore
Liquidity in Commercial Real Estate Markets at 5 (online at
www.rer.org/uploadedFiles/RER/Policy_Issues/Credit_Crisis/
2009_09_Restoring_Liquidity_in_CRE.pdf?n=8270) (accessed on Feb. 6,
2010); see also The Future Refinancing Crisis in CRE, supra note 214,
at 3.
\344\ See Footnote 242 Foresight Analytics LLC estimates that $770
billion (or 53 percent) of mortgages maturing from 2010 to 2014 have
current LTVs in excess of 100 percent. Foresight further provides that
over 60 percent of mortgages maturing in 2012 and 2013 will have LTVs
over 100 percent, supra.
\345\ See section F.3(b), supra.
---------------------------------------------------------------------------
In dealing with potential commercial real estate losses,
not all banks should be treated in the same way. Banks whose
portfolios are weak across the board (``C'' banks) should be
forced to recognize all losses, whatever the consequences.
``A'' banks, those that have operated on the most prudent terms
and have financed only the strongest projects, and ``B'' banks,
those with commercial real estate portfolios that have weakened
but are largely still based on performing loans, should be
dealt with more carefully.\346\
---------------------------------------------------------------------------
\346\ The ``A'', ``B'', and ``C'' classification used in this
discussion is not meant to reflect any regulatory classification but is
only used for ease of reference.
---------------------------------------------------------------------------
There are three reasons not to force all potential losses
to be recognized immediately. First, doing so could create a
self-fulfilling prophecy, as selling commercial real estate at
fire-sale prices could depress values of even relatively strong
properties. In this way, real estate prices would be driven
below actual long-term values, pushing the commercial real
estate sector into what has been termed a negative bubble, not
only forcing more banks in a particular region into perhaps
unnecessary insolvency, but having ripple effects across the
broader markets for commercial real estate.\347\
---------------------------------------------------------------------------
\347\ Geltner PREA Report, supra note 312.
---------------------------------------------------------------------------
Second, real estate prices have already fallen far from
their peak, and some analysts believe prices are now in line
with historical trends.\348\ Write-downs do not cause sales,
but a drop in values based on the data generated by unnecessary
write-downs may indirectly threaten banks, by allowing new
investors to buy at unrealistically low prices. (As noted
above, investors holding a great deal of money, much of it
currently overseas, are waiting for the right time to invest in
U.S. commercial real estate.) \349\
---------------------------------------------------------------------------
\348\ Geltner PREA Report, supra note 312.
\349\ Geltner PREA Report, supra note 312.
---------------------------------------------------------------------------
Third, loan write-downs are as much about the allocation of
profits as losses. Purchasers of property at depressed values
obtain the gain potential inherent in that property. That is
wholly appropriate when a fire-sale discount is required by
economic realities. But forcing write-downs can also operate
unfairly--and be economically inefficient--by unnecessarily
transferring the profit potential from the banks whose strength
would increase as the economy--and property values--recover to
investors pushing to depress prices before that happens.
In this situation, the job of policy makers, bankers, and
CMBS master servicers is to determine when and how to evaluate
honestly the components of the crisis and try to moderate them.
This does not mean allowing banks that are not viable because
of the quality of the commercial real estate loans they hold,
to continue to operate; but neither does it mean forcing banks
that engaged in relatively prudent lending, but were undercut
by the depth of the recession, into the same position.
Again, it is important to recognize that some of the
economic factors that will determine which side of the argument
is correct lie outside of the commercial real estate sector.
Assessing the likelihood and pace of the operation of those
factors is beyond the scope of this report; nonetheless, they
provide a picture of the complex economic forces at work here.
H. Regulatory Guidance, the Stress Tests, and EESA
As Treasury and federal financial supervisors brace for the
expected wave of problems in the commercial real estate sector,
they should consider their decisions in the context of the
actions already taken by the banking supervisors. In terms of
commercial real estate, the most important regulatory steps
during the recent economic cycle have been the following: (1)
The issuance of regulatory guidance in 2006 about the growing
risks associated with the concentration of commercial real
estate loans in banks; (2) the supervisors' administration of
the stress tests in the first half of 2009 for the nation's 19
largest BHCs; (3) the issuance of expanded regulatory guidance
on loan workouts in 2009; and (4) decisions made by supervisors
with respect to banks' exit from the TARP. In this section the
report explores those steps.
1. Supervisors' Role Before Mid-2008
As the credit bubble grew, the supervisors reminded banks
of commercial real estate risks. In March 2004, FDIC Chairman
Donald Powell noted, in a speech to members of the Independent
Community Bankers Association:
The real question in all this is--and the thing you
should think about on the plane ride home--what happens
when interest rates rise significantly from these
historic lows? . . . The performance of commercial real
estate loans has remained historically strong during
the past three years even though market fundamentals
have been poor. Low interest rates have bailed out many
projects that would have sunk if the environment had
been different. When the tide of low interest rates and
heavy fiscal stimulus recedes, we'll see some
vulnerabilities exposed that are currently hidden from
view. It is hard to predict how serious these are
because we've never seen a cycle quite like this
before.\350\
---------------------------------------------------------------------------
\350\ Federal Deposit Insurance Corporation, Remarks by Chairman
Donald Powell Before the Independent Community Bankers Association, San
Diego, Calif. (Mar. 16, 2004) (emphasis added) (online at www.fdic.gov/
news/news/press/2004/pr2204.html).
The concern actually predated the Powell speech. In 2003, a
year before the Powell speech, the supervisors began working on
a more formal regulatory statement about commercial real estate
lending concentrations, especially those accumulating at small
and mid-sized banks.\351\ In January 2006, the supervisors
issued proposed guidance for public comment.\352\ (Regulatory
guidance is a statement of standards that banks should observe,
rather than a set of legal requirements. Nonetheless, such
guidance can serve as part of the basis for regulatory action
against a particular institution.)
---------------------------------------------------------------------------
\351\ The situation that sparked the supervisors' concern is
outlined above, in Section E.
\352\ Agencies Proposed Guidance, supra note 67.
---------------------------------------------------------------------------
The January proposal noted that commercial real estate
markets are cyclical and stated that some banks were not
setting aside adequate capital or taking other steps necessary
to manage the risks associated with these loans. The
interagency proposal included two numerical thresholds for
determining whether heightened risk-management practices were
warranted at a particular bank. First, bank examiners were to
look at whether the bank's outstanding portfolio of
construction and development loans exceeded its total capital.
Second, examiners were to determine whether the bank's
outstanding portfolio of commercial real estate loans exceeded
300 percent of its total capital.\353\ The proposal also
included guidance that banks were to use to manage their risks
and to ensure that they were holding enough capital to protect
against future losses.\354\
---------------------------------------------------------------------------
\353\ Agencies Proposed Guidance, supra note 67.
\354\ Agencies Proposed Guidance, supra note 67. The proposed
guidance noted that ``institutions with CRE concentrations . . . should
hold capital higher than regulatory minimums and commensurate with the
level of risk in their CRE lending portfolios.''
---------------------------------------------------------------------------
The proposed guidance drew more than 4,400 comment letters,
most of which came from financial institutions and their trade
groups and strongly opposed the proposal. Many letters argued
that existing regulations and guidance were adequate to address
the risks associated with lending concentrations in commercial
real estate.\355\ In addition, several comment letters asserted
that banks' underwriting practices were stronger than they had
been in the late 1980s and early 1990s, when banks suffered
losses on their commercial real estate loans, because banks had
learned lessons from those times.\356\
---------------------------------------------------------------------------
\355\ U.S. Department of the Treasury, Office of the Comptroller of
the Currency, Board of Governors of the Federal Reserve System, Federal
Deposit Insurance Corporation, and Office of Thrift Supervision,
Concentrations in Commercial Real Estate Lending, Sound Risk Management
Practices (Dec. 12, 2006) (online at www.fdic.gov/regulations/laws/
federal/2006/06notice1212.html) (hereinafter ``Concentrations in CRE
Lending'').
\356\ Concentrations in CRE Lending, supra note 355.
---------------------------------------------------------------------------
During the comment period, the supervisors gave the banking
community a nuanced view of their meaning. In an April 2006
speech that Comptroller of the Currency John Dugan gave to the
New York Bankers Association, Mr. Dugan made the following
statement:
Concentrations in commercial real estate lending--or
in any other type of loan for that matter--do raise
safety and soundness concerns. . . . Our message is
not, `Cut back on commercial real estate loans.'
Instead it is this: `You can have concentrations in
commercial real estate loans, but only if you have the
risk management and capital you need to address the
increased risk.' And in terms of `the risk management
and capital you need,' we're not talking about
expertise or capital levels that are out of reach or
impractical for community and mid-size bankers--because
many of you already have both.\357\
---------------------------------------------------------------------------
\357\ Dugan Remarks Before the New York Bankers Association, supra
note 66.
In June 2005, then-Federal Reserve Governor Susan Bies
noted her concerns about the rising concentration of commercial
real estate loans at some banks, particularly in light of the
sector's historical volatility. She also said that underwriting
standards might be under downward pressure but offered the
assurance that they remained at much higher levels than they
had been in the periods preceding earlier crises.\358\
---------------------------------------------------------------------------
\358\ Board of Governors of the Federal Reserve System, Remarks of
Governor Susan Schmidt Bies at the North Carolina Bankers Association's
109th Annual Convention, Kiawah Island, South Carolina (June 14, 2005)
(online at www.federalreserve.gov/boarddocs/speeches/2005/20050614/
default.htm). One key to the commercial real estate crisis of the 1980s
was similar shoddy underwriting, as the report discusses elsewhere. See
Annex I.
---------------------------------------------------------------------------
In congressional testimony in September 2006, the new FDIC
Chairman Sheila Bair also expressed concern about lending
concentrations in commercial real estate, in measured tones:
While the rapid price appreciation seen in recent
years in several locations is certainly not sustainable
over the long-term, we do not anticipate a wide-spread
decline in prices. Overall, market fundamentals are
generally sound and FDIC economists do not foresee a
crisis on the horizon.\359\
---------------------------------------------------------------------------
\359\ House Committee on Financial Services, Subcommittee on
Financial Institutions and Consumer Credit, Statement of Sheila C.
Bair, Chairman, Federal Deposit Insurance Corporation, Statement on
Interagency Proposals Regarding the Basel Capital Accord and Commercial
Real Estate Lending Concentration, 109th Cong., at 14 (Sept. 14, 2006)
(online at financialservices.house.gov/media/pdf/091406scb.pdf).
The final guidance, issued in mid-December 2006,\360\
reflected changes in response to the comments the proposal had
generated. (Despite the change, the Office of Thrift
Supervision did not join in the final statement, choosing
instead to issue its own guidance.) \361\
---------------------------------------------------------------------------
\360\ Concentrations in CRE Lending, supra note 355.
\361\ John Reich, director of the OTS, explained the decision to
issue separate guidance by saying: ``I thought the guidance was too
prescriptive, that the numbers would be interpreted by bank examiners
across the country as ceilings, not screens or thresholds for further
examination.'' Barbara A. Rehm, Steven Sloan, Stacy Kaper, and Joe
Adler, OTS Breaks from Pack on Commercial Real Estate Loan Guidelines,
American Banker (Dec. 7, 2006) (online with subscription at
www.americanbanker.com/issues/171_239/_297668-1.html).
---------------------------------------------------------------------------
In the final guidance, the proposed 300 percent threshold
was changed so that banks with total commercial real estate
loans representing at least 300 percent of their total capital
would be identified for further analysis only in cases where
their commercial real estate portfolios had increased by 50
percent or more in the previous three years.\362\ New language
was added to state that the numerical thresholds were not
limits, but rather a ``monitoring tool,'' \363\ subject to the
discretion of individual examiners. Text accompanying the final
guidance contained a related warning that ``some institutions
have relaxed their underwriting standards as a result of strong
competition for business.''\ 364\ (The manner in which the
guidance has been used in individual bank examinations is not
known, because the results of each examination are confidential
unless it results in a public supervisory action.)
---------------------------------------------------------------------------
\362\ Concentrations in CRE Lending, supra note 355.
\363\ Concentrations in CRE Lending, supra note 355. The final
guidance stated that ``[a]n institution with inadequate capital to
serve as a buffer against unexpected losses from a CRE concentration
should develop a plan for reducing its CRE concentrations or for
maintaining capital appropriate to the level and nature of its CRE
concentration risk.''
\364\ Jon D. Greenlee, associate director of the Federal Reserve
Board's Division of Bank Supervision and Regulation, summarized the
reasons for the changes from the proposed to the final guidance at the
Panel's recent field hearing in Atlanta. He explained that the
supervisors were seeking to allow banks to pursue their business plans,
and to avoid overly stringent requirements. COP Field Hearing in
Atlanta, supra note 70, at 41.
---------------------------------------------------------------------------
After the 2006 guidance was issued, the cause for concern
about the commercial real estate sector continued to grow. In
2007, warning signs emerged in the housing sector, which had
key parallels with the commercial real estate market,
including, most notably, the formation of an asset bubble fed
by poor underwriting standards.\365\ But starting in early
2008, federal bank supervisors also began warning about bank
exposure to potentially toxic commercial real estate assets.
Noting that small and community banks often had especially high
levels of such exposure, these supervisors began acknowledging
the potential for a financial crisis resulting from a
commercial real estate downturn and the resulting
disproportionate effect on the balance sheets of smaller and
community banks.
---------------------------------------------------------------------------
\365\ See Congressional Oversight Panel, December Oversight Report:
Taking Stock: What Has The Troubled Asset Relief Program Achieved? at
8-9 (Dec. 9, 2009) (online at cop.senate.gov/documents/cop-120909-
report.pdf) (hereinafter ``COP December Oversight Report'').
---------------------------------------------------------------------------
In February 2008, the FDIC Office of Inspector General
released a report on commercial real estate that concluded:
``commercial real estate concentrations have been rising in
FDIC-supervised institutions and have reached record levels
that could create safety and soundness concerns in the event of
a significant economic downturn.'' \366\ The Inspector
General's report found that the rising concentrations were in
part a reflection of demand for credit, as well as banks'
searches for loans that would yield higher profits. The report
expressed particular concern about the increasing reliance on
commercial real estate loans at small and mid-sized banks.\367\
The report also found that examiners underutilized tools at
their disposal to uncover and address excessive concentration
in commercial real estate assets.\368\ In particular, examiners
were often not adhering to 2006 regulatory guidance issued
jointly by the FDIC and other federal bank supervisors.\369\
---------------------------------------------------------------------------
\366\ Federal Deposit Insurance Corporation, Office of Inspector
General, FDIC's Consideration of Commercial real estate Concentration
Risk in FDIC-Supervised Institutions, at 2 (Feb. 2008) (online at
www.fdicoig.gov/reports08/08-005.pdf) (hereinafter ``FDIC's
Consideration of CRE Risk'').
\367\ FDIC's Consideration of CRE Risk, supra note 366, at 2.
\368\ FDIC's Consideration of CRE Risk, supra note 366, at 8.
\369\ State banking regulatory organizations had also been active
in implementing the 2006 Federal regulatory guidance. See Neil Milner,
President and CEO of the Council of State Bank Supervisors, Iowa Day
with the Superintendent (Apr. 12, 2007) (online at
www.idob.state.ia.us/bank/docs/ppslides/DWS07/CSBSPresentation.ppt).
The guidance materials called for further scrutiny of banks with at
least 300 percent of total capital in commercial real estate loans and
where commercial real estate portfolios had increased 50 percent or
more in the past three years. 71 Fed. Reg. 74580, 74584.
---------------------------------------------------------------------------
The FDIC responded to the 2008 Inspector General report by
issuing a Financial Institutions Letter about the risks
associated with loan concentrations in commercial real estate
to state banks that it regulates.\370\ The letter recommended
that banks with significant commercial real estate
concentrations ensure appropriately strong loan loss allowances
and bolster their loan workout infrastructures and risk
management procedures, among other precautions.\371\ The FDIC's
March 2008 letter was more strongly worded than the 2006
interagency guidance had been. It stated that the agency was
``increasingly concerned'' about commercial real estate
concentrations; it also ``strongly recommended'' that banks
with commercial real estate concentrations increase their
capital to protect against unexpected losses.\372\
---------------------------------------------------------------------------
\370\ Financial Institution Letters, supra note 58. As far back as
2003, the FDIC Inspector General found that its examiners were not
properly estimating risks associated with commercial real estate loans.
Federal Deposit Insurance Program, Office of the Inspector General,
Examiner Assessment of Commercial Real Estate Loans (Jan. 3, 2003)
(Audit Report No. 03-008) (online at www.fdicoig.gov/reports03/03-008-
Report.pdf).
\371\ Federal Deposit Insurance Corporation, Press Release: Federal
Deposit Insurance Corporation Stresses Importance of Managing
Commercial Real Estate Concentrations (Mar. 17, 2008) (online at
www.fdic.gov/news/news/press/2008/pr08024.html).
\372\ Financial Institution Letters, supra note 58.
---------------------------------------------------------------------------
Around the time that the FDIC sent its letter, the
commercial real estate market began to slow considerably.
Lending standards rose in early 2008,\373\ and spending on
commercial construction projects slowed.\374\ In March 2008,
FDIC Chairman Sheila Bair testified before a congressional
committee that liquidity in commercial real estate capital
markets was sharply curtailed, and that loans were showing
signs of deterioration at a time when loan concentration levels
were at or near record highs.\375\ At the same hearing, Federal
Reserve Vice Chairman Donald Kohn testified that the agency had
recently surveyed its bank examiners in an effort to evaluate
the implementation of the 2006 guidance. This survey found that
while many banks had taken prudent steps to manage their
commercial real estate lending concentrations, other banks had
used interest reserves and maturity extensions to mask their
credit problems, or had failed to update appraisals despite
substantial changes in local real-estate values.\376\
---------------------------------------------------------------------------
\373\ Board of Governors of the Federal Reserve System, Minutes of
the Federal Open Market Committee (Jan. 29-30, 2008) (online at
www.federalreserve.gov/monetarypolicy/fomcminutes20080130.htm).
\374\ Board of Governors of the Federal Reserve System, Minutes of
the Federal Open Market Committee (Apr. 29-30, 2008) (online at
www.federalreserve.gov/monetarypolicy/fomcminutes20080430.htm).
\375\ March 4, 2008 Written Testimony of Sheila Bair, supra note
76.
\376\ Written Testimony of Donald Kohn, supra note 80.
---------------------------------------------------------------------------
By late summer 2008, the securitization markets for
commercial real estate had shut down, a milestone followed by
the market panic of September 2008 and the enactment of EESA.
2. Supervisors' Role in the Stress Tests
In February 2009, the Obama Administration announced that
bank supervisors would subject the nation's 19 largest BHCs to
stress tests to determine their ability to weather future
economic distress. The stress tests began with the
determination of three variable assumptions: unemployment,
housing prices, and GDP. The assumptions were used to test the
banks' portfolios over 2009 and 2010 under two scenarios: a
``baseline'' scenario and a ``more adverse'' scenario. Banks
were required to hold a capital buffer adequate to protect them
against the more adverse downturn.
For specific loan categories, including commercial real
estate, the supervisors established ``indicative loss rates,''
which they described as useful indicators of industry-wide loss
rates, and from which banks could diverge if they provided
evidence that their own estimated ranges were appropriate.\377\
These indicative loss rates were estimated expected loss rates
if the economy followed either the baseline or more adverse
scenarios. The supervisors explained that they derived the
indicative loss rates ``using a variety of methods for
predicting loan losses, including analysis of historical loss
experience at large BHCs and quantitative models relating the
performance of individual loans and groups of loans to
macroeconomic variables.'' \378\
---------------------------------------------------------------------------
\377\ The supervisors described these indicative loss rates as
``useful indicators of industry loss rates and [could] serve as a
general guide.'' Banks could vary from these loss rates if they
provided evidence that their own estimated ranges were appropriate.
Federal Reserve Board of Governors, The Supervisory Capital Assessment
Program: Overview of Results at 5 (May 7, 2009) (online at
www.federalreserve.gov/newsevents/press/bcreg/bcreg20090507a1.pdf)
(hereinafter ``SCAP Overview of Results'').
\378\ Federal Reserve Board of Governors, The Supervisory Capital
Assessment Program: Design and Implementation at 8 (Apr. 24, 2009)
(online at www.federalreserve.gov/newsevents/press/bcreg/
bcreg20090424a1.pdf).
---------------------------------------------------------------------------
The indicative loss rates for commercial real estate loans
were broken into loss rates for construction, multifamily, and
non-farm/non-residential; they are shown in Figure 38.
FIGURE 38: STRESS TEST INDICATIVE LOSS RATES FOR COMMERCIAL REAL ESTATE
(CUMULATIVE 2009-2010, IN PERCENTAGES) \379\
------------------------------------------------------------------------
Baseline More Adverse
------------------------------------------------------------------------
All commercial real estate.............. 5-7.5 9-12
Construction........................ 8-12 15-18
Multifamily......................... 3.5-6.5 10-11
Non-farm, Non-residential........... 4-5 7-9
------------------------------------------------------------------------
\379\ SCAP Overview of Results, supra note 377.
In May 2009, the results of the stress tests were released,
providing a window into the potential losses that large
financial institutions faced in seven different lending
markets, including commercial real estate. The results showed
that most of the stress-tested 19 institutions hovered around
or well below a median loss rate of 10.6 percent for commercial
real estate loans. Three institutions had significantly higher
loss rates: GMAC at 33.3 percent, Morgan Stanley at 45.2
percent, and State Street at 35.5 percent. While useful, the
details of the results that the supervisors released publicly
are limited. For example, although the indicative loan loss
rates for commercial real estate are broken into three buckets,
the institution-specific results did not provide this level of
detail, only showing estimated commercial real estate losses.
Also, the results did not break down estimated losses by year,
showing instead total estimated losses for 2009 and 2010.\380\
In addition, at its September 10, 2009 hearing and in a follow-
up letter, the Panel questioned Secretary Geithner on the
inputs for and results of the stress tests. Secretary Geithner
stated that he would provide further information, but after two
request letters and three months, he provided no additional
data. Instead he referred the Panel back to the bank
supervisors, who have not yet provided any data.\381\
---------------------------------------------------------------------------
\380\ For further discussion of the limits of the stress tests, see
the Panel's June report. COP June Oversight Report, supra note 6, at
30, 39-49. In the June Report, the Panel recommended, among other
things, that ``more information should be released with respect to the
results of the stress tests. More granular information on estimated
losses by sub-categories (e.g., the 12 loan categories that were
administered versus the eight that were released) should be
disclosed.'' COP June Oversight Report, supra note 6, at 49 .
\381\ Letter from Chair Elizabeth Warren, Congressional Oversight
Panel, to Secretary Timothy F. Geithner (Sept. 15, 2009) (online at
cop.senate.gov/documents/letter-091509-geithner.pdf); Letter from Chair
Elizabeth Warren, Congressional Oversight Panel, to Secretary Timothy
F. Geithner (Nov. 25, 2009) (cop.senate.gov/documents/letter-112509-
geithner.pdf); Letter from Secretary Timothy F. Geithner to Chair
Elizabeth Warren, Congressional Oversight Panel, at 188 (Dec. 10, 2009)
(cop.senate.gov/documents/cop-011410-report.pdf). The Panel requested
inputs and formulae for the stress tests, more information about
estimates for indicative loss rates, actual loss rates two quarters
after the implementation of the stress tests, and the impact of
unemployment metrics.
---------------------------------------------------------------------------
The results of these tests are of very limited value in
evaluating commercial real estate losses in the tested BHCs.
First, the testing measured only losses through the end of
2010.\382\ As discussed, commercial real estate losses are
expected to continue and possibly even accelerate in 2012 or
beyond.\383\ Thus, the degree to which the capital buffers
required through 2010 will be sufficient for later periods is
unclear.
---------------------------------------------------------------------------
\382\ With the exception of loan losses, for which institutions
would be required to reserve in 2010 for 2011 loan losses.
\383\ COP June Oversight Report, supra note 6, at 41-42.
---------------------------------------------------------------------------
More important, of course, as the Panel has noted several
times before, no effort has been made by the Federal Reserve
Board and the other supervisors to extend the regulatory stress
testing regime in an appropriate way to other banks. (The 2006
guidance did suggest that banks conduct their own stress
testing if their concentrations of commercial real estate
lending were significantly high.)
Second, since February 2009, the economic indicators used
in the stress testing have been moving in unanticipated
directions. The most recent figures for those three metrics
show that GDP increased at an annual rate of 5.7 percent from
the third to the fourth quarter of 2009,\384\ a 9.3 percent
annual unemployment rate as of December 2009,\385\ and a 4.5
annual percent decrease in housing prices as of the end of
November 2009.\386\ Real GDP decreased by 2.4 percent from 2008
to 2009.\387\ Under the more adverse predictions for 2009, GDP
fell by 3.5 percent, housing fell by 22 percent, and
unemployment was at 8.9 percent. For the entire year, while the
housing price indicator is performing significantly better than
expected, unemployment is higher, and the change in GDP is
approaching its range in the more adverse scenario. As
discussed in the Panel's June Report, the Federal Reserve would
not disclose to the Panel the model used for the stress tests,
making a complete evaluation of the process impossible.\388\
The Panel cannot, therefore, determine how different variables
were weighted in the tests, and their interactive effects.
---------------------------------------------------------------------------
\384\ BEA Fourth Quarter GDP Estimate, supra note 95. See section
D,1 supra, for a discussion of economists' views of the 5.7 percent GDP
growth.
\385\ This represents an average of the monthly unemployment rate
for the previous 12 months. Bureau of Labor Statistics: Labor Force
Statistics from the Current Population Survey (Jan. 24, 2010) (online
at data.bls.gov/PDQ/servlet/
SurveyOutputServlet?data_tool=latest_numbers&series_id=LNS14000000).
\386\ Id.
\387\ BEA Fourth Quarter GDP Estimate, supra note 95.
\388\ COP June Oversight Report, supra note 6.
---------------------------------------------------------------------------
Figure 39 shows, for each of the 19 stress test
institutions, the commercial real estate loans outstanding, and
the stress test loan loss rates for commercial real estate.
These institutions have not publicly disclosed their actual
commercial real estate losses, so it is difficult to evaluate
the accuracy of the stress test loss rates.
FIGURE 39: COMMERCIAL REAL ESTATE EXPOSURE OF STRESS TEST INSTITUTIONS (AS OF Q3 2009) \389\
----------------------------------------------------------------------------------------------------------------
CRE Loans CRE/ Risk
Outstanding CMBS Holdings Based
Total Assets (thousands of (thousands of Capital
dollars) dollars) (Percent)
----------------------------------------------------------------------------------------------------------------
Bank of America Corporation............. $2,251,043,000 $91,031,681 $7,931,055 49.3
JPMorgan Chase & Co..................... 2,041,009,000 66,281,865 6,010,000 43.5
Citigroup Inc........................... 1,888,599,000 16,904,864 2,119,000 12.7
Wells Fargo & Company................... 1,228,625,000 96,424,887 11,163,000 79.4
Goldman Sachs Group, Inc................ 882,185,000 219,000 -- 1.0
Morgan Stanley.......................... 769,503,000 1,106,000 -- 14.0
MetLife................................. 535,192,209 30,495,694 15,534,957 99.1
PNC Financial Services Group, Inc....... 271,407,000 14,290,871 6,825,278 97.8
U.S. Bancorp............................ 265,058,000 28,988,774 161,982 110.4
Bank of New York Mellon Corporation..... 212,007,000 1,523,042 2,895,000 10.5
GMAC Inc................................ 178,254,000 1,473 -- 0.0
SunTrust Banks, Inc..................... 172,717,747 16,448,434 -- 99.5
Capital One Financial Corporation....... 168,463,532 17,625,230 -- 100.5
BB&T Corporation........................ 165,328,000 27,450,854 51,842 173.7
State Street Corporation................ 163,277,000 592,344 3,903,374 5.2
Regions Financial Corporation........... 139,986,000 24,639,026 20,993 165.6
American Express Company................ 120,445,000 9,614 -- 0.2
Fifth Third Bancorp..................... 110,740,000 13,435,515 139,901 85.3
KeyCorp................................. 96,989,000 15,340,865 45,607 131.1
----------------------------------------------------------------------------------------------------------------
\389\ SNL Financial (accessed on Jan. 13, 2010). MetLife was not a TARP participant.
The stress tests were a central element of Treasury's
Financial Stability Plan, intended to ``clean up and strengthen
the nation's banks.'' \390\ The markets and the public have
placed a great deal of confidence in the results, and yet
serious questions remain about the timeframe, variables, and
model, especially with regard to commercial real estate losses.
As much of the statement of economic recovery is based on the
stress test results, the Panel renews its call to the
supervisors to provide more transparency in the process and
possibly to rerun the tests with a longer time horizon, in
order to capture more accurately commercial real estate losses.
---------------------------------------------------------------------------
\390\ U.S. Department of the Treasury, Secretary Geithner
Introduces Financial Stability Plan (Feb. 10, 2008) (online at
www.financialstability.gov/latest/tg18.html).
---------------------------------------------------------------------------
3. Supervisors' Role Regarding Loan Workouts
As 2009 continued, the outlook for commercial real estate
loans continued to worsen. At the end of the second quarter,
nine percent of the commercial real estate debt held by banks
was delinquent, almost double the level of a year earlier.
Prospects were particularly bad for construction and
development loans, more than 16 percent of which were
delinquent.\391\ By October 2009, commercial property values
had fallen 35 to 40 percent from their peaks in 2007.\392\ And
there were signs of more trouble ahead. Comptroller of the
Currency John Dugan told a congressional committee in October
2009 that construction and development loans for housing,
which, as noted above, are classified as commercial real estate
loans, were by far the largest factor in commercial bank
failures over the previous two years. He stated that the health
of the broader commercial real estate sector was dependent on
the overall performance of the economy.\393\ FDIC Chairman
Sheila Bair voiced additional concerns about the risk that
commercial real estate posed to community banks. She said that
commercial real estate comprised more than 43 percent of the
portfolios of community banks. In addition, she noted that the
average ratio of commercial real estate loans to total capital
at these banks was above 280 percent--or close to one of the
thresholds established in the 2006 regulatory guidance.\394\
---------------------------------------------------------------------------
\391\ Testimony of Daniel K. Tarullo, supra note 262.
\392\ Testimony of Daniel K. Tarullo, supra note 262, at 7-9.
\393\ Senate Committee on Banking, Housing & Urban Affairs,
Subcommittee on Financial Institutions, Written Testimony of John C.
Dugan, Comptroller of the Currency: Examining the State of the Banking
Industry, 111th Cong. (Oct. 14, 2009) (online at banking.senate.gov/
public/index.cfm?FuseAction=Files.View&FileStore_id=a2046ce1-1c34-4533-
91ef-d6d6311760a7) (hereinafter ``Testimony of John Dugan'').
\394\ Senate Committee on Banking, Housing, and Urban Affairs,
Subcommittee on Financial Institutions, Statement of Sheila C. Bair,
chairman, Federal Deposit Insurance Corporation: Examining the State of
the Banking Industry, 111th Cong. (Oct. 14, 2009) (online at
banking.senate.gov/public/
index.cfm?FuseAction=Files.View&FileStore_id=6277ecd6-1d5c-4d07-a1ff-
5c4b72201577).
---------------------------------------------------------------------------
The supervisors took their first major step to address
these problems on October 30, 2009, releasing a policy
statement that takes a generally positive view of workouts for
commercial real estate loans.\395\ The policy statement came
amid concerns from banks that supervisors too often look
askance at workouts, which allow lenders to protect themselves
against defaults, because the supervisors worry that workouts
allow lenders to delay acknowledging the bad loans on their
books. The 33-page document, titled ``Policy Statement on
Prudent Commercial Real Estate Loan Workouts,'' states the
following:
---------------------------------------------------------------------------
\395\ The regulatory agencies that released the statement were the
Board of Governors of the Federal Reserve System, the Federal Deposit
Insurance Corporation, the Office of the Comptroller of the Currency,
the Office of Thrift Supervision, the National Credit Union
Administration, and the Federal Financial Institutions Examination
Council State Liaison Committee. Policy Statement on CRE Workouts,
supra note 314.
The regulators have found that prudent commercial
real estate loan workouts are often in the best
interest of the financial institution and the borrower.
Examiners are expected to take a balanced approach in
assessing the adequacy of an institution's risk
management practices for loan workout activity.
Financial institutions that implement prudent
commercial real estate loan workout arrangements will
not be subject to criticism for engaging in these
efforts even if the restructured loans have weaknesses
that result in adverse credit classification. In
addition, renewed or restructured loans to borrowers
who have the ability to repay their debts according to
reasonable modified terms will not be subject to
adverse classification solely because the value of the
underlying collateral has declined to an amount that is
---------------------------------------------------------------------------
less than the loan balance.
Elsewhere, the document states that ``loans to sound
borrowers that are renewed or restructured in accordance with
prudent underwriting standards should not be adversely
classified or criticized unless well-defined weaknesses
jeopardize repayment. Further, loans should not be adversely
classified solely because the borrower is associated with a
particular industry that is experiencing financial
difficulties.'' \396\ But the document also makes clear that
write-downs are still necessary in some cases. For example, it
states that if an underwater borrower is solely dependent on
the sale of the property to repay the loan, and has no other
reliable source of repayment, the examiner should classify the
difference between the amount owed and the property value as a
loss.\397\ It also states that performing loans should be
adversely classified when they have ``well-defined weaknesses''
that will ``jeopardize repayment.'' \398\
---------------------------------------------------------------------------
\396\ Policy Statement on CRE Workouts, supra note 314, at 7.
\397\ Policy Statement on CRE Workouts, supra note 314, at 9.
\398\ Policy Statement on CRE Workouts, supra note 314, at 7.
---------------------------------------------------------------------------
While the policy statement does not establish many bright
lines for what qualifies as a prudent workout, it does provide
guidance in the form of hypothetical examples. One such example
involved a $10 million loan for the construction of a shopping
mall. The original loan was premised on the idea that the
borrower would obtain long-term financing after construction
was completed, but with a weak economy and a 55 percent
occupancy rate at the mall, such financing was no longer
feasible. In these circumstances, the lender split the loan in
two--a $7.2 million loan that would have enough cash flow to
allow the borrower to make payments, and a $2.8 million loan
that the lender charged off, reflecting the loss on its books.
For the lender, creating a good loan and a bad loan, as opposed
to keeping one bad loan on its books, provided certain
accounting benefits, and the regulator did not object to the
debt restructuring.\399\
---------------------------------------------------------------------------
\399\ The description here is a condensed version of a scenario
described in the supervisors' policy statement. It is meant to provide
only a general understanding of the kinds of loan workouts that
supervisors deem prudent. See Policy Statement on CRE Workouts, supra
note 314, at 18-19.
---------------------------------------------------------------------------
A second hypothetical example of a workout deemed
acceptable by the supervisors involved a $15 million loan on an
office building, under which the borrower was required to make
a $13.6 million balloon payment at the end of the third year.
Over those three years, the property's appraised value had
fallen from $20 million to $13.1 million, meaning that the
outstanding value of the loan now exceeded the property's
value. Two factors suggested that the loan could be paid off if
it were restructured, even though the property was valued at
less than the remaining amount owed under the loan: (1) the
borrower had been making timely payments; and (2) the office
building was generating more revenue than the borrower owed
each month. Under these circumstances, the lender was not
penalized for restructuring the loan in such a way that the
outstanding $13.6 million was amortized over the next 17
years.\400\
---------------------------------------------------------------------------
\400\ The description here is a condensed version of a scenario
described in the supervisors' policy statement. It is meant to provide
only a general understanding of the kinds of loan workouts that
supervisors deem prudent. See Policy Statement on CRE Workouts, supra
note 314, at 14-0915.
---------------------------------------------------------------------------
The key point that industry participants have taken from
the policy statement is that under certain circumstances an
underwater loan will not have to be written down as long as the
borrower is able to make monthly payments on the restructured
debt. Indeed, the document states: ``The primary focus of an
examiner's review of a commercial loan, including binding
commitments, is an assessment of the borrower's ability to
repay the loan.''\401\ Focusing on the borrower's ability to
service the loan, even when the borrower owes more than the
value of the loan, of course carries the risk of
underestimating the impact that negative equity has on rates of
default and, consequently, on losses for lenders.\402\
---------------------------------------------------------------------------
\401\ Policy Statement on CRE Workouts, supra note 314, at 3. See
David E. Rabin and David H. Jones, New Policy on Commercial Real Estate
Loan Workouts--Providing Welcomed Flexibility, K&L Gates Distressed
Real Estate Alert (Nov. 10, 2009) (online at www.klgates.com/newsstand/
detail.aspx?publication=6010) (hereinafter ``Rabin and Jones'').
\402\ A 2004 research paper found that CMBS borrowers are likely to
decide whether to make payments based not only on their cash flow, but
also on their equity position in the mortgage. Chen and Deng:
Commercial Mortgage Workout Strategy, supra note 304. This greater
willingness to walk away from a property that is underwater has also
been observed in residential real estate. A July study found that 26
percent of underwater borrowers decided to walk away even when they can
afford to pay their mortgage. Luigi Guiso, Paola Sapienza, and Luigi
Zingales, Moral and Social Constraints to Strategic Default on
Mortgages, Financial Trust Index (July, 2009) (online at
www.financialtrustindex.org/images/
Guiso_Sapienza_Zingales_StrategicDefault.pdf). Another complicating
factor involves whether the loan is recourse, in which case the lender
can recover from other assets of the borrower, or non-recourse. There
are instances of both types of loan in the residential sector; in the
commercial real estate sector, as discussed in infra, most construction
loans are recourse, while most permanent loans are non-recourse. It is
unclear whether the phenomenon's effects are larger, similar in size,
or smaller in the commercial sector. On one hand, real estate
developers are less likely than homeowners to worry about the stigma
associated with walking away from a loan. In addition, people need a
place to live, and consequently residential borrowers are often more
tethered to their properties than commercial borrowers are. On the
other hand, commercial properties produce income, which is usually not
true of residential properties. Rental income may be large enough to
change the commercial borrower's calculus, so that the borrower decides
to continue making payments even when the loan is worth more than the
property.
---------------------------------------------------------------------------
At the Panel's January 27 field hearing on commercial real
estate, Doreen Eberley, acting regional director in the FDIC's
Atlanta Regional Office, argued that loans should not be
written down solely because the property value has fallen. She
noted that the primary source of repayment for a loan is the
borrower's ability to pay, while the collateral is the
secondary source. There is no reason to write down a loan, she
argued, when a borrower has the wherewithal and the
demonstrated willingness to repay it. And she said that
requiring banks to mark all of their loans to their fair market
value would lead to a lot of volatility on bank balance
sheets.\403\ Jon Greenlee, associate director of the Federal
Reserve's Division of Bank Supervision and Regulation, said
that the upcoming wave of expected refinancings is one reason
why loan workouts are necessary. If a borrower can continue to
make payments at a certain level, Mr. Greenlee argued, that is
a better outcome than foreclosure for both the bank and the
borrower.\404\ Chris Burnett, chief executive officer of
Cornerstone Bank, an Atlanta-based community bank, offered a
different rationale in favor of the regulatory policy statement
on loan workouts. He stated that if banks were required to mark
their loan portfolios to their fair market value, it is unclear
how deep the holes in their capital bases would be.\405\
---------------------------------------------------------------------------
\403\ Written Testimony of Doreen Eberley, supra note 91, at 57,
61-62.
\404\ Written Testimony of Jon Greenlee, supra note 93, at 59.
\405\ Written Testimony of Chris Burnett, supra note 92, at 126.
---------------------------------------------------------------------------
The impact of the policy statement is subject to debate, in
three broad areas.
The first involves the statement's immediate effect on loan
write-downs. As noted above, there is no single write-down
formula that applies to all loans. Too few write-downs can
allow banks that have acted imprudently or even recklessly in
managing their loan portfolios to survive unjustifiably. But in
other cases forcing write-downs can create self-fulfilling
prophecies. For every ``extend and pretend,'' there can also be
an ``extend and soundly lend.''
Second, the policy statement has the potential to affect
banks' capital. If it leads to fewer write-downs, that may mean
that banks will be required to set aside less capital; banks
often seek to avoid larger capital reserves, because they
reduce the bank's ability to earn profits. It is important to
note, however, that the policy statement does not change the
accounting rules that apply to the effects of loan write-downs
on bank balance sheets, and that banks will still have to take
write-downs when their auditors instruct them to do so.
Third, the policy statement may have an impact on bank
lending. Banks with overvalued loans on their books may hoard
capital and reduce sound lending. But if instead banks were
being forced prematurely to write down possible losses, that
could lead them to curtail lending.
Again, as discussed above, there is no one solution that
fits all banks or all loans and properties; that is why the
crisis requires forcing losses where necessary to protect the
deposit insurance system, but not forcing banks into insolvency
or depressing the value of projects that have a substantial
chance of regaining value as the economy recovers, or as
changes in real estate prices draw investors back into the
market to close the equity gap. Often, a partial write-down may
be appropriate as part of a refinancing package.
It is also important to note that the 2009 policy statement
is not entirely new. It closely resembles another policy
statement that federal banking supervisors issued in 1991,
during that earlier wave of problems in the commercial real
estate sector. In 1991 supervisors published a document that
instructed examiners to review commercial real estate loans
``in a consistent, prudent, and balanced fashion'' and to
ensure that regulatory policies and actions not inadvertently
curtail the flow of credit to sound borrowers.\406\ The 1991
statement also stated that evaluation of real estate loans ``is
not based solely on the value of the collateral'' but on a
review of the property's income-producing capacity and of the
borrower's willingness and capacity to repay.\407\ The issuance
of a similar document in 2009 highlights the subjective nature
of bank examinations; indeed, bank examiners must apply the
rules, along with their own judgment and discretion, to the
specific facts they encounter. The new policy statement
provides a reminder of the criteria that are to be applied, and
therefore may have an impact in situations where the question
of whether to write-down the loan's value is not clear cut. It
is unclear how much impact the 2009 policy statement is having
at the field level, but especially in light of bankers'
concerns that supervisors tend to become overly cautious in
depressed markets,\408\ the actual impact could be smaller than
banks would like it to be.\409\
---------------------------------------------------------------------------
\406\ House Financial Services Committee, Written Testimony of
Elizabeth Duke, Federal Reserve Governor, Credit Availability and
Prudent Lending Standards, 111th Cong. (Mar. 25, 2009) (online at
www.federalreserve.gov/newsevents/testimony/duke20090325a.htm).
\407\ Office of the Comptroller of the Currency, Federal Deposit
Insurance Corporation, Federal Reserve Board, Office of Thrift
Supervision, Interagency Policy Statement on the Review and
Classification of Commercial Real Estate Loans (Nov. 7, 1991) (online
at files.ots.treas.gov/86028.pdf).
\408\ See, e.g., House Financial Services Committee, Subcommittee
on Oversight and Investigations, Written Testimony of Michael Kus,
Legal Counsel, Michigan Association of Community Bankers, Field Hearing
on Improving Responsible Lending to Small Businesses, 111th Cong. (Nov.
30, 2009) (online at www.house.gov/apps/list/hearing/financialsvcs--
dem/kus--testimony.pdf) (``[I]nstead of working with community banks to
help both banks and their customers overcome current economic stress,
some federal examiners have become extremely harsh in their assessment
of the value of commercial real estate loans and their collateral. This
extreme examination environment is adding to the commercial real estate
contraction for small businesses. Community banks are effectively being
forced to avoid making good loans out of fear of examination criticism,
forced write-downs and the resulting loss of income and capital'').
\409\ See, e.g., Written Testimony of Mark Elliott, supra note 109
(stating that ``the guidance given is still open to interpretation and,
in this environment, that interpretation will trend toward the cautious
. . .'').
---------------------------------------------------------------------------
The policy statement has evoked a range of reactions among
industry participants. Lenders obviously like it because it
allows them to avoid writing down problematic loans. On the
other hand, investors who would like to buy those distressed
loans at a discount have a less favorable view.\410\ The likely
net effect is to make the downturn in commercial real estate at
least somewhat less severe in the short term while also
extending the period of uncertainty by pushing some losses
further into the future. It is critical that bank supervisors
fully recognize and are publicly clear about the potential for
a commercial real estate crisis and are quick to force loss
recognition where necessary before the commercial real estate
sector can return to health.
---------------------------------------------------------------------------
\410\ Rabin and Jones, supra note 401 (``lenders now have new
breathing room and may be permitted to retain billions of dollars of
undersecured commercial real estate loans without having to write-down
these assets. The investors who have been waiting on the sidelines
thinking that this recession might present a new opportunity to pluck
out investments for pennies on the dollar . . . will have to keep
waiting'').
---------------------------------------------------------------------------
4. Supervisors' Role in Banks' Exit from the TARP
Bank supervisors play a key role in determining when TARP-
recipient banks may leave the program, and their judgments
about commercial real estate loans continue to impact that
success. A bank may not repurchase its preferred stock without
the approval of its primary federal regulator.\411\ If a bank
has significant commercial real estate holdings, it might be
told by its regulator that it will benefit from continuing to
hold TARP funds, although it could also reach the same judgment
by itself. Some banks might have capital levels that appear
safe and stable, but are choosing not to repay because of the
possibility of future commercial real estate losses. For
example, as of the 3Q 2009, Marshall & Ilsley Corp., a
Wisconsin bank, had a tier 1 capital ratio of 9.61
percent,\412\ but in its 3Q 10-Q has disclosed that it had $6.3
billion in construction and development loans, of which $984.5
million is non-performing.\413\ M&I's CFO explained that
``[f]rom our perspective, it's still good to have that
incremental capital. As we get through the economic cycle and
return to profitability, I think we then start considering what
our TARP repayment strategies are going to be.''\414\ Other
banks have been allowed to repay, even though they hold
significant commercial real estate assets. For example, Sun
Bancorp, Bank of Marin Bancorp, Old Line Bancshares, and Bank
Rhode Island have all repurchased their Capital Purchase
Program (CPP) preferred stock, and have commercial real estate
loans to total loans of 42.3, 41.2, 36.0, and 23.2 percent,
respectively.\415\ This shows that commercial real estate
concentrations are high even in some institutions that are
considered well capitalized.
---------------------------------------------------------------------------
\411\ 12 U.S.C. 5221(g).
\412\ Marshall & Ilsley Corp., Form 10-Q for the quarter ended
September 30, 2009, at 44 (Nov. 9, 2009) (online at www.sec.gov/
Archives/edgar/data/1399315/000139931509000034/micorp10q--09-2009.htm)
(hereinafter ``Marshall & Ilsley Form 10-Q'').
\413\ Marshall & Ilsley Form 10-Q, supra note 412.
\414\ Marshall & Ilsley Corp, Remarks by Gregory A. Smith, Senior
Vice President and Chief Financial Officer at the Merrill Lynch 2009
Banking and Financial Services Conference (Nov. 11, 2009) (online at
phx.corporate-ir.net/External.File?item=UGFyZW50
SUQ9MzU4ODEzfENoaWxkSUQ9MzUxMzEzfFR5cGU9MQ=&t=1). In its 3Q 2009 10-Q,
Marshall & Ilsley explained: ``Notwithstanding the current national
capital market impact on the cost and availability of liquidity,
management believes that it has adequate liquidity to ensure that funds
are available to the Corporation and each of its banks to satisfy their
cash flow requirements. However, if capital markets deteriorate more
than management currently expects, the Corporation could experience
stress on its liquidity position.'' Marshall & Ilsley Form 10-Q, supra
note 412, at 74.
\415\ SNL Financial (accessed on Jan. 13, 2010).
---------------------------------------------------------------------------
Among the large banks, BB&T, for which commercial real
estate makes up a larger proportion of its assets than other
large banks, has commercial real estate holdings (loans and
CMBS) constituting 24.47 percent of its total assets. Wells
Fargo, which also holds larger proportions of commercial real
estate holdings, has a commercial real estate to total assets
ratio of 11.63 percent. Figure 40 shows the commercial real
estate holdings of the top 10 institutions that have redeemed
their TARP funds, as well as an aggregated number for the
remaining institutions that have redeemed. The top 10
institutions have a commercial real estate to total assets
ratio of 5.35 percent, while the institutions outside of the
top 10 have a ratio of 16.17 percent.
FIGURE 40: PERCENTAGE OF CRE LOANS TO TOTAL LOANS OF REDEEMED CPP PARTICIPANTS (AS OF 3Q 2009) \416\
----------------------------------------------------------------------------------------------------------------
CRE Loans CRE/Risk
Outstanding CMBS Holdings Based Capital
Total Assets (thousands of (thousands of (Percent)
dollars) dollars)
----------------------------------------------------------------------------------------------------------------
Bank of America Corporation............. $2,251,043,000 $91,031,681 $7,931,055 49.3
JPMorgan Chase & Co..................... 2,041,009,000 66,281,865 6,010,000 43.5
Wells Fargo & Company................... 1,228,625,000 96,424,887 11,163,000 79.4
Goldman Sachs Group, Inc................ 882,185,000 219,000 ................. 1.0
Morgan Stanley.......................... 769,503,000 1,106,000 ................. 14.0
U.S. Bancorp............................ 265,058,000 28,988,774 161,982 110.4
Bank of New York Mellon Corporation..... 212,007,000 1,523,042 2,895,000 10.5
Capital One Financial Corporation....... 168,463,532 17,625,230 ................. 100.5
BB&T Corporation........................ 165,328,000 27,450,854 51,842 173.7
State Street Corporation................ 163,277,000 592,344 3,903,374 5.2
--------------------------------------
Top 10 Total............................ 8,146,498,532 331,243,677 32,116,253 57.8
All Others Total........................ 521,017,638 55,639,492 145,666 136.8
---------------------------------------------------------
Total .............................. $8,667,516,170 $386,883,169 $32,261,919 63.0
----------------------------------------------------------------------------------------------------------------
\416\ This figure is based on guidance established by federal supervisors in December 2006. The numerator, total
commercial real estate loans, is comprised of items 1a, 1d, 1e, and Memorandum Item 3 in the Call Report FFIEC
031 and 041 schedule RC-C. The denominator, total risk-based capital, is comprised of line 21 in the Call
Report FFIEC 031 and 041 schedule RC-R-Regulatory Capital. Office of the Comptroller of the Currency, Board of
Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation, Concentrations in
Commercial Real Estate Lending, Sound Risk Management Practices (Dec. 12, 2006) (online at
frwebgate1.access.gpo.gov/cgi-bin/PDFgate.cgi?WAISdocID=661175176921+0+2+0&WAISaction=retrieve).
There are two other issues involving commercial real estate
that may have an impact on financial institutions' exit from
the TARP. First, although many banks have already taken write-
downs on their CMBS portfolios, there may be more write-downs
to come. For banks that have already repaid their TARP funds,
these write-downs could affect their capital levels. For those
that still hold TARP funds, write-downs could keep them in the
program longer than expected. At the Panel's field hearing in
Atlanta, Doreen Eberley, the acting Atlanta regional director
of the FDIC, testified that ``capital is the most significant
concern facing [Atlanta area] financial institutions'' and that
these institutions are ``facing capital pressures now.'' \417\
---------------------------------------------------------------------------
\417\ Written Testimony of Doreen Eberley, supra note 91.
---------------------------------------------------------------------------
Figure 41 shows commercial real estate loans and CMBS as a
percentage of all assets for the top 20 institutions that are
still participating in the CPP, as well as aggregated numbers
for the remaining participating institutions. The top 20
institutions have a commercial real estate to all assets
percentage of 4.84 percent; the remaining institutions'
percentage is 38.03 percent.
FIGURE 41: PERCENTAGE OF CRE LOANS TO TOTAL LOANS OF CURRENT CPP PARTICIPANTS (AS OF 3Q 2009) \418\
----------------------------------------------------------------------------------------------------------------
CRE Loans CRE/Risk-
Outstanding CMBS Holdings Based
Total Assets (thousands of (thousands of Capital
dollars) dollars) (Percent)
----------------------------------------------------------------------------------------------------------------
Citigroup Inc........................... $1,888,599,000 16,904,864 2,119,000 12.7
American International Group, Inc....... 844,344,000
Hartford Financial Services Group, Inc.. 316,720,000
PNC Financial Services Group, Inc....... 271,407,000 14,290,871 6,825,278 97.8
Lincoln National Corporation............ 181,489,200
GMAC Inc................................ 178,254,000 1,473 ................. 0.0
SunTrust Banks, Inc..................... 172,717,747 16,448,434 ................. 99.5
Fifth Third Bancorp..................... 110,740,000 13,435,515 139,901 85.3
KeyCorp................................. 96,989,000 15,340,865 45,607 131.1
Comerica Incorporated................... 59,590,000 9,292,959 ................. 110.7
Marshall & Ilsley Corporation........... 58,545,323 14,792,400 ................. 245.5
Zions Bancorporation.................... 53,298,150 15,246,020 ................. 242.9
Huntington Bancshares Incorporated...... 52,512,659 10,528,342 ................. 203.8
Discover Financial Services............. 42,698,290
Popular, Inc............................ 35,637,804 5,888,803 ................. 184.5
Synovus Financial Corp.................. 34,610,480 12,353,093 1,566 362.6
First Horizon National Corporation...... 26,465,852 2,677,495 ................. 59.1
Associated Banc-Corp.................... 22,881,527 4,198,449 ................. 204.5
First BanCorp........................... 20,081,185 3,795,482 ................. 201.9
City National Corporation............... 18,400,604 2,648,255 19,629 146.7
---------------------------------------------------------
Top 20 Total............................ 4,485,981,821 157,843,320 9,150,981 63.4
Total of All Others..................... 709,674,170 175,437,021 937,419 273.2
---------------------------------------------------------
Total............................... $5,195,655,991 $333,280,341 $10,088,400 106.4
----------------------------------------------------------------------------------------------------------------
\418\ This figure is based on guidance established by federal supervisors in December, 2006. The numerator,
total commercial real estate loans, is comprised of items 1a, 1d, 1e, and Memorandum Item 3 in the Call Report
FFIEC 031 and 041 schedule RC-C. The denominator, total risk-based capital, is comprised of line 21 in the
Call Report FFIEC 031 and 041 schedule RC--R--Regulatory Capital. Office of the Comptroller of the Currency,
Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation, Concentrations in
Commercial Real Estate Lending, Sound Risk Management Practices (Dec. 12, 2006) (online at
frwebgate1.access.gpo.gov/cgi-bin/PDFgate.cgi?WAISdocID=661175176921+0+2+0&WAISaction=retrieve).
A similar issue arises with regard to the effect of SFAS
167. Banks large and small will be required to bring off
balance sheet vehicles back onto their balance sheets. Bringing
these assets onto the balance sheets of institutions that still
hold TARP funds could require them to remain in the program for
longer than they would have without the new accounting rule.
5. Summary
The effect of the 2006 guidance on banks and examiners and
the impact it might have had if it had been proposed earlier,
or in more binding form, are impossible to gauge. The stress
tests provided greater clarity about the impact of troubled
assets on balance sheets, but only for the nation's largest
banks.\419\ Furthermore, their usefulness beyond 2010, when a
large wave of commercial real estate loans comes due, is less
clear.
---------------------------------------------------------------------------
\419\ See COP June Oversight Report, supra note 6.
---------------------------------------------------------------------------
The moderating effect of the 2009 policy statement on loan
workouts depends on the clarity and clear-sightedness with
which both banks and examiners apply its terms. The Panel is
concerned about the possibility that the supervisors, by
allowing banks to extend certain underwater loans rather than
requiring them to recognize losses, will inadvertently delay a
rebound in bank lending. But the opposite scenario--in which
bank write-downs themselves cause other banks to restrain
lending, as prices fall and a negative bubble starts to grow--
is also worrisome.
In assessing the supervisors' actions and attempts to
balance the considerations involved in the face of uncertain
economic timelines, the Panel notes that it is neither
desirable nor possible to prevent every bank failure. The
greatest difficulty is determining the point at which the
number and velocity of failures can create a broader risk to
the financial sector, the citizens who rely on smaller banks,
and the people and communities whose lives are affected by
property foreclosures. As noted throughout the report,
stabilization of the commercial real estate market is dependent
on a broad economic recovery; \420\ likewise, a long downturn
in the commercial real estate sector has the potential to
stifle a recovery.
---------------------------------------------------------------------------
\420\ See Written Testimony of Doreen Eberley, supra note 91, at
51; see also Written Testimony of Jon Greenlee, supra note 93.
---------------------------------------------------------------------------
I. The TARP
Since the passage of EESA, Treasury has periodically taken
steps to address specific risk and potential losses in the
commercial real estate market. For example, in November 2008,
Treasury, the FDIC, the Federal Reserve, and Citigroup agreed
on a pool of ring-fenced Citigroup assets the three agencies
would guarantee as part of the Asset Guarantee Program
(AGP).\421\ The asset pool included certain commercial real
estate investments,\422\ though neither the value of the
commercial real estate assets in the pool, nor the ratio of
commercial real estate assets to other assets, is clear. But
Treasury exhibited enough concern about the risk posed by some
of Citigroup's commercial real estate investments in November
2009 to provide a guarantee of these assets in order to
stabilize the bank.
---------------------------------------------------------------------------
\421\ U.S. Department of the Treasury, Summary of Terms: Eligible
Asset Guarantee (Nov. 23, 2008) (online at www.ustreas.gov/press/
releases/reports/cititermsheet_112308.pdf).
\422\ Board of Governors of the Federal Reserve System, Report
Pursuant to Section 129 of the Emergency Economic Stabilization Act of
2008: Authorization to Provide Residual Financing to Citigroup, Inc.
for a Designated Asset Pool, at 3 (Nov. 23, 2009) (online at
www.federalreserve.gov/monetarypolicy/files/129citigroup.pdf).
---------------------------------------------------------------------------
In this section the report describes the accomplishments
and limitations of the TARP with respect to commercial real
estate, and also explores what other support Treasury might
consider providing under the TARP. It should be noted at the
outset that there is no indication that Treasury has treated
commercial real estate as a separate category of problem faced
by one or more classes of financial institutions.
1. The Term Asset-Backed Securities Loan Facility (TALF)
The TALF was established by the Federal Reserve Bank of New
York (FRBNY) and Treasury in November 2008, with the goal of
restarting lending for asset-backed securities, a class of
securities that includes consumer-sector loans for credit cards
and auto purchases.\423\ Under the TALF, the government extends
loans to securities investors, and the assets that comprise the
securities serve as collateral aimed at protecting the
government against losses. Interest rates on TALF loans are
below the prevailing market rates.\424\ Thus, the TALF is both
a way to provide liquidity to impaired markets, as well as a
subsidy that reduces the price investors otherwise would have
to pay for the securities they are buying.
---------------------------------------------------------------------------
\423\ For a broader discussion of TALF's implementation and impact,
see the Panel's May and December reports. Congressional Oversight
Panel, May Oversight Report: Reviving Lending to Small Businesses and
Families and the Impact of the TALF (May 7, 2009) (online at
cop.senate.gov/documents/cop-050709-report.pdf); COP December Oversight
Report, supra note 365.
\424\ Federal Reserve Bank of New York, Term Asset-Backed
Securities Loan Facility: Frequently Asked Questions (Jan. 15, 2010)
(online at www.newyorkfed.org//markets/talf_faq.html#12) (``The
interest rates on TALF loans are set with a view to providing borrowers
an incentive to purchase eligible ABS at yield spreads higher than in
more normal market conditions but lower than in the highly illiquid
market conditions that have prevailed during the recent credit market
turmoil'').
---------------------------------------------------------------------------
In February 2009, Treasury announced its intention to
expand the TALF to commercial mortgage-backed securities as
part of its comprehensive Financial Stability Plan.\425\ In May
2009, the Federal Reserve followed through by expanding
eligible TALF collateral to include new CMBS issuance (i.e.,
CMBS issued in 2009 and beyond) and legacy CMBS (i.e., CMBS
issued in 2008 or earlier).\426\ Newly issued CMBS includes not
only new mortgages, but also loans that provide refinancing of
existing commercial mortgages.
---------------------------------------------------------------------------
\425\ U.S. Department of the Treasury, Fact Sheet: Financial
Stability Plan, at 4 (Feb. 10, 2009) (online at
www.financialstability.gov/docs/fact-sheet.pdf).
\426\ Board of Governors of the Federal Reserve System, Press
Release (May 19, 2009) (online at www.federalreserve.gov/
monetarypolicy/20090519b.htm); Board of Governors of the Federal
Reserve System, Press Release (May 1, 2009) (online at
www.federalreserve.gov/newsevents/press/monetary/20090501a.htm).
---------------------------------------------------------------------------
In order to qualify for TALF financing, newly issued CMBS
must meet specific criteria, which are designed to protect the
government against losses; for example, the underlying
commercial mortgage loans must be fixed-rate, they cannot be
interest-only loans, and the borrowers must be current on their
payments at the time the loans are securitized. Similarly,
legacy CMBS must meet various criteria in order to qualify for
the TALF. For example, legacy securities must hold the most
senior claim on the underlying pool of loans; consequently,
only the senior-most piece of the CMBS, which generally carries
an AAA rating, is eligible for government financing.\427\
---------------------------------------------------------------------------
\427\ Federal Reserve Bank of New York, Term Asset-Backed
Securities Loan Facility: Terms and Conditions (Nov. 13, 2009) (online
at www.newyorkfed.org/markets/talf_terms.html).
---------------------------------------------------------------------------
Treasury has committed up to $20 billion in TARP funds to
the TALF. Those dollars are in a first-loss position, meaning
that if the TALF loses money, the TARP would pay for the first
$20 billion in losses.\428\
---------------------------------------------------------------------------
\428\ Board of Governors of the Federal Reserve System, Term Asset-
Backed Securities Liquidity Facility (TALF) Terms and Conditions
(online at www.federalreserve.gov/newsevents/press/monetary/
monetary20081125a1.pdf). Treasury projects that it will actually make
money from the TALF. The GAO, however, projects that the CMBS portion
of the TALF could lose as much as $500 million under what GAO deemed a
worst-case scenario for commercial real estate prices. Some of those
losses would likely be offset, though, by interest payments on other
TALF loans; in addition, Treasury disputes GAO's methodology, and says
that commercial real estate prices would have to decline by 65 percent
for the CMBS portion of TALF to incur losses. GAO TALF Report, supra
note 64.
---------------------------------------------------------------------------
There are different ways to assess the TALF's impact on the
commercial real estate market. One measure is the volume of
commercial mortgages that have been securitized since the
program was unveiled. Prior to the time CMBS was made eligible
under TALF, the market for commercial mortgage-backed
securities was frozen. At the market's peak in 2006 and 2007,
$65 billion to $70 billion in commercial mortgage-backed
securities were being issued each quarter; but between July
2008 and May 2009, not a single CMBS was issued in the United
States.\429\ That changed following the announcement that CMBS
would become eligible under the TALF. Between June and December
2009, a total of $2.33 billion of U.S. CMBS was issued.\430\
While this figure represents a small fraction of the commercial
mortgage securitization volume at the market's peak, that peak
was in part the result of an asset bubble. Given the current
upheaval in the commercial real estate market--with property
values plummeting, rents falling and vacancy rates rising--it
is not clear what a healthy level of commercial mortgage
securitization would be. It is also not clear how much of the
partial return of this previously moribund market is
attributable to the TALF. Of the $2.33 billion in CMBS issued
in 2009, $72.25 million, or about three percent of the total,
was financed through the TALF.\431\
---------------------------------------------------------------------------
\429\ Commercial Real Estate Securities Association, Exhibit 19,
supra note 146 (accessed Jan. 12, 2010).
\430\ Commercial Real Estate Securities Association, Exhibit 19,
supra note 146 (accessed Jan. 12, 2010).
\431\ Federal Reserve Bank of New York, Term Asset-Backed
Securities Loan Facility: CMBS (online at www.newyorkfed.org/markets/
CMBS_recent_operations.html) (hereinafter ``Term Asset-Backed
Securities Loan Facility: CMBS'') (accessed Jan. 22, 2010).
---------------------------------------------------------------------------
The TALF has financed a larger volume of sales of
commercial real estate securities in the secondary market.
Between July and December 2009, $9.22 billion was requested
through the TALF for legacy CMBS.\432\ As was described above,
these TALF loans are not providing new financing for the
commercial real estate market, but they do offer a channel to
finance the resale of existing real estate debt. As such, they
provide a government-subsidized channel for the removal of
troubled commercial real estate assets from bank balance
sheets. It is important to note, though, that the $9.22 billion
in TALF funds requested for legacy CMBS represents only about 1
percent of the approximately $900 billion CMBS market.\433\ In
comparison to the entire commercial real estate debt market,
which is valued at over $3 trillion,\434\ the program's impact
is even smaller. Figure 42 shows the total value of TALF CMBS
loans requested by month, including both legacy and newly
issued CMBS.
---------------------------------------------------------------------------
\432\ See Term Asset-Backed Securities Loan Facility: CMBS, supra
note 431 (accessed Jan. 22, 2010).
\433\ Joint Economic Committee, Testimony of Jon D. Greenlee,
Associate Director, Division of Bank Supervision and Regulation, Board
of Governors of the Federal Reserve System, Commercial Real Estate
(July 9, 2009) (online at www.federalreserve.gov/newsevents/testimony/
greenlee20090709a.htm).
\434\ Board of Governors of the Federal Reserve System, Flow of
Funds Accounts of the United States: Flows and Outstandings, Third
Quarter 2009, at 96-97 (Dec. 10, 2009) (online at
www.federalreserve.gov/Releases/z1/Current/z1r-1.pdf).
FIGURE 42: TALF CMBS LOANS REQUESTED BY MONTH \435\
---------------------------------------------------------------------------
\435\ Requested funds do not all result in actual loans; the
requested figure is used because the FRBNY did not report the amount of
actual ``settled'' loans until October 2009. Term Asset-Backed
Securities Loan Facility: CMBS, supra note 431 (accessed Jan. 22,
2010).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Another way to evaluate the TALF's impact is by assessing
how the program has affected the market's view of the risk
associated with real-estate bonds. In particular, the spread
between the interest rate paid on Treasury notes and the rate
paid on the highest-rated pieces of CMBS shows the market's
view of the riskiness of those investments. Prior to the credit
crunch that began in 2007, these spreads were generally at or
below 200 basis points. What this means is that if Treasury
notes were paying four percent interest, the top-rated pieces
of CMBS generally paid interest of six percent or less. Spreads
on these bonds rose in 2007 and skyrocketed in 2008, reflecting
the rise in perceived risk. At their peak, the spreads were
above 1,000 basis points, meaning that these bonds were paying
interest rates more than 10 percentage points above the
Treasury rate.\436\ Needless to say, in such an environment it
was difficult, if not impossible, to find reasonably priced
financing for commercial real estate. Spreads began to fall
around the time that the TALF was introduced in May 2009. By
the summer of 2009, spreads were back in the range of 400-500
basis points--still elevated by historical standards, but
reflecting a healthier real-estate finance market.\437\ Market
observers attribute the fall in spreads to the announcement
that CMBS would become eligible under the TALF,\438\ and market
data support that hypothesis.\439\
---------------------------------------------------------------------------
\436\ Commercial Real Estate Securities Association, Exhibit 19,
supra note 146 (accessed Jan. 12, 2010).
\437\ Commercial Real Estate Securities Association, Exhibit 19,
supra note 146 (accessed Jan. 12, 2010).
\438\ See, e.g., Bank of America Merrill Lynch, CMBS Year Ahead:
2010 Year Ahead: Better, but not Out of the Woods Yet (Jan. 8, 2010)
(hereinafter ``CMBS Year Ahead: 2010'') (``Of the changes that occurred
in 2009, we think the introduction of TALF to CMBS was one of the
biggest drivers of spreads throughout the year. We believe that CMBS
spreads would have tightened even absent TALF, but to a far lesser
degree. We think this is true despite the fact that both the new issue
and the legacy portions have been used less than most people
anticipated'').
\439\ In the spring and summer of 2009, spreads on lower-rated
commercial real-estate bonds, which are not eligible for financing
under the TALF, did not fall substantially the way that spreads on
TALF-eligible bonds did. Commercial Real Estate Securities Association,
Exhibit 19, supra note 146 (accessed Jan. 12, 2010).
---------------------------------------------------------------------------
Still, the TALF's impact on the pricing of credit in the
commercial real estate market should not be exaggerated.
Spreads on lower-rated CMBS bonds, which are not eligible under
the TALF, remain remarkably high--in the range of 3,000-7,000
basis points as of August 2009.\440\ Spreads on new CMBS deals
will be lower, because the underlying loans are less risky than
loans in older CMBS; still, these data help to explain the
constrained market for new CMBS deals.
---------------------------------------------------------------------------
\440\ See Commercial Real Estate Securities Association, Exhibit
19, supra note 146 (accessed Jan. 12, 2010).
---------------------------------------------------------------------------
In general, though, private actors have been making
commercial real estate loans on more favorable terms since the
introduction of the TALF.\441\ And while it is impossible to
untangle the impact of the TALF from the effect of improved
economic conditions, it is fair to conclude that when all else
is equal, a market with a liquidity facility like the TALF will
almost certainly have narrower spreads and more readily
available credit than a market that does not have such a
facility.\442\ The TALF is scheduled to expire this year--the
last subscriptions secured by legacy CMBS are to be offered in
March, and the last subscriptions secured by newly issued CMBS
are to be offered in June.\443\ Many analysts anticipate that
the program's withdrawal will exacerbate the difficulties
associated with refinancing commercial real estate loans.\444\
Some analysts doubt that credit markets will have sufficient
capacity to refinance the loans coming due in the next few
years without additional government liquidity.\445\ If credit
is available only on less favorable terms, or if the market
simply contains insufficient credit to accommodate maturing
commercial real estate loans, then more loans will default at
maturity, forcing banks to take losses, resulting in greater
strain on the financial system. On the other hand, Treasury
states that liquidity has re-entered the commercial real estate
sector; \446\ three CMBS deals closed late in 2009, including
two that did not rely on TALF financing.\447\
---------------------------------------------------------------------------
\441\ See, e.g., David Lynn, Signs of Life Emerge in Commercial
Real Estate Lending Market, National Real Estate Investor (Dec. 7,
2009) (online at nreionline.com/finance/news/signs_of_life_emerg_1207/
).
\442\ See, e.g., U.S. Department of the Treasury, The Consumer and
Business Lending Initiative: A Note on Efforts to Address
Securitization Markets and Increase Lending, at 3 (Mar. 3, 2009)
(online at www.ustreas.gov/press/releases/reports/
talf_white_paper.pdf).
\443\ Board of Governors of the Federal Reserve System, Press
Release (Aug. 17, 2009) (online at www.federalreserve.gov/
monetarypolicy/20090817a.htm) (hereinafter ``TALF Extension Press
Release'').
\444\ See, e.g., Standard & Poor's, Report From ABS East 2009:
Securitization Begins To Move Past The Fear, at 10 (Nov. 6, 2009)
(online at www.securitization.net/pdf/sp/ABS-East_6Nov09.pdf); New Oak
Capital, TALF for CMBS: A Bridge to Better Days or a Bridge to Nowhere?
(Feb. 26, 2009) (online at www.newoakcapital.com/market-outlook/?p=67).
\445\ CCIM Institute, December 2009 Legislative Bulletin, at 1-2
(Dec. 2009) (online at www.ccim.com/system/files/2009-12-legislative-
bulletin.pdf) (hereinafter ``CCIM Institute Bulletin'').
\446\ Treasury conversations with Panel staff (Feb. 2, 2010).
\447\ Strong investor demand surrounded the recent issuance of a
new CMBS issuance in November 2009, only a portion of which was TALF-
eligible, contributing to narrower than expected spreads. Two non-TALF
new CMBS issuances followed in December. Anusha Shrivastava, Investors
Welcome Commercial Mortgage Deal Without TALF, Dow Jones Newswires
(Nov. 18, 2009) (online at www.nasdaq.com/aspx/company-news-
story.aspx?storyid=200911181112dowjonesdjonline000478); CCIM Institute
Bulletin, supra note 445, at 1.
---------------------------------------------------------------------------
The Federal Reserve has previously extended the TALF out of
a concern that the securitization markets lacked sufficient
liquidity to function properly on their own, and it could do so
again.\448\ If the Federal Reserve decides to end the TALF for
CMBS in the first half of 2010,\449\ the decision will likely
reflect a judgment that the markets have become healthier or a
judgment that the TALF is not a solution to those problems that
continue to plague the commercial real estate markets.
---------------------------------------------------------------------------
\448\ The Federal Reserve could also extend the new issue CMBS
portion of TALF, while terminating the legacy securities portion, or
vice versa. TALF Extension Press Release, supra note 443.
\449\ One large bank, Bank of America, believes the legacy CMBS
portion is unlikely to be extended, but assigns a higher probability to
the extension of the newly issued CMBS portion. CMBS Year Ahead: 2010,
supra note 438.
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2. The Public Private Investment Program (PPIP)
Treasury announced the PPIP in March 2009. The idea behind
this program is to combine TARP funds with private investment
in an effort to spur demand for the troubled assets that have
been weighing down bank balance sheets. Like the TALF, by
providing a subsidy to investors, the PPIP is designed to
increase liquidity in the marketplace. Assets that are eligible
for purchase under the PPIP include both residential and
commercial real estate loans. If these assets increase in
value, the government shares the profits with private
investors. If the assets lose value, the two parties share the
losses. The PPIP has two components: a program for buying
troubled securities, which is now under way; and a program for
buying troubled whole loans, which has yet to launch on a large
scale.
The program for buying troubled securities is known as the
Legacy Securities PPIP. Treasury has committed $30 billion in
TARP funds to the program, comprised of $10 billion in equity
and up to $20 billion in debt. The taxpayer dollars are being
split between eight separate funds, which are under private-
sector management, and which will also hold private-sector
investments totaling $10 billion.\450\ The investment funds may
only buy certain types of securities--specifically, commercial
and residential mortgage-backed securities that were issued
prior to 2009 and originally had AAA ratings.\451\ As such, the
program overlaps with the TALF, providing support to the
secondary market for commercial mortgage-backed securities, but
only for the highest-rated bonds. So far, the program's impact
on the CMBS market appears to be quite limited.\452\ This is in
part because the program only recently became operational;
eight investment funds were established between late September
and mid-December 2009, and as of Dec. 31, 2009, they had
invested only $3.4 billion. Just $440 million, or 13 percent of
the total, was spent buying CMBS.\453\ Even in the long term,
the program appears unlikely to have a large impact on the $900
billion CMBS market because the investment funds will only be
able to spend a maximum of $40 billion, and they will likely
spend the large majority of that money on residential mortgage
bonds.
---------------------------------------------------------------------------
\450\ Originally, the $30 billion was to be split between nine
funds, but Treasury is dissolving one of the funds, the UST/TCW Senior
Mortgage Securities Fund, under a contractual provision that allowed
for its dissolution upon the departure of key personnel. The eight
remaining funds are the Invesco Legacy Securities Master Fund;
Wellington Management Legacy Securities PPIF Master Fund;
AllianceBernstein Legacy Securities Master Fund; Blackrock PPIF; AG
GECC PPIF Master Fund; RLJ Western Asset Public/Private Master Fund;
Marathon Legacy Securities Public-Private Investment Partnership; and
Oaktree PPIP Fund. Treasury conversations with Panel staff (Jan. 5,
2010); U.S. Department of the Treasury, Troubled Asset Relief Program
Transaction Report for Period Ending February 1, 2010 (Feb. 2, 2010)
(online at www.financialstability.gov/docs/transaction-reports/2-3-
10%20Transactions%20Report%20as%20of%202-1-10.pdf) (hereinafter
``Treasury Transaction Report'').
\451\ For the complete eligibility rules, see U.S. Department of
the Treasury, Legacy Securities Public-Private Investment Funds,
Summary of Proposed Terms (Apr. 6, 2009) (online at www.treas.gov/
press/releases/reports/legacy_securities_terms.pdf).
\452\ CMBS Year Ahead: 2010, supra note 438 (stating that the
PPIP's arrival led to CMBS purchases by non-PPIP investment managers,
and that the PPIP has helped to keep CMBS spreads in check, but also
that the activity of PPIP funds within CMBS has been ``rather muted'').
\453\ Of the $440 million total, the PPIP funds spent $182 million
on super-senior tranches of CMBS at a median price of 81.1 percent of
their par value. They spent $169 million on AM tranches, which were
below the super-senior tranches but still initially rated AAA, at a
median price of 72.1 percent of par. And they spent $89 million on AJ
tranches, which were the lowest-rated AAA tranches, at a median price
of 64.7 percent of par. U.S. Department of the Treasury, Legacy
Securities Public-Private Investment Program: Program Update--Quarter
Ended December 31, 2009 at 4, 6 (Jan. 29, 2010) (online at
financialstability.gov/docs/External Report--12-09 FINAL.pdf).
---------------------------------------------------------------------------
The second program, known as the Legacy Loans Program, was
also announced in March 2009. It has since been indefinitely
postponed,\454\ although the FDIC says that it continues to
work on ways to refine the program.\455\ The Legacy Loans
Program was meant to purchase whole loans from banks, using a
combination of public and private equity capital and debt
guaranteed by the FDIC.\456\ The program would have benefitted
smaller banks that hold whole loans, as opposed to securities.
At this stage, though, it has not had any impact on the
commercial real estate market. According to Treasury, the
program's key problem was that banks that held commercial real
estate loans were unwilling to sell them at prices investors
were willing to pay.\457\
---------------------------------------------------------------------------
\454\ Following a test run in the summer of 2009, which involved
assets from failed banks, the FDIC has been unable to resolve two major
problems with the program: (1) how to protect the FDIC from losses if
the purchased assets lose value; and (2) how to devise a pricing
mechanism that determines the loans' long-term value and that results
in sale prices that selling banks would accept. FDIC conversations with
Panel staff (Jan. 11, 2010); Federal Deposit Insurance Corporation,
Legacy Loans Program--Winning Bidder Announced in Pilot Sale (Sept. 16,
2009) (online at www.fdic.gov/news/news/press/2009/pr09172.html)
(describing results of pilot sale).
\455\ COP Field Hearing in Atlanta, supra note 70 (Testimony of
Doreen Eberley).
\456\ Federal Deposit Insurance Corporation, Legacy Loans Program--
Program Description and Request for Comments (Apr. 15, 2009) (online at
www.fdic.gov/llp/progdesc.html).
\457\ Treasury conversations with Panel staff (Feb. 2, 2010).
---------------------------------------------------------------------------
Both the legacy securities and legacy loan programs,
moreover, raise two more general points. Unless the CMBS and
whole loans are bought at or close to par, the purchases will
not prevent write-downs that can reduce bank capital.\458\ At
the same time, buying the assets at inflated prices causes its
own problems, by exposing the government to future losses.\459\
---------------------------------------------------------------------------
\458\ COP August Oversight Report, supra note 5, at 45-46.
\459\ COP August Oversight Report, supra note 5, at 45-46.
---------------------------------------------------------------------------
3. The CPP
A third, albeit indirect way that Treasury has addressed
the looming problems in commercial real estate is by injecting
capital into banks. To date, 708 financial institutions have
received capital injections from the government under the
TARP's CPP. Providing assistance to commercial real estate
lenders was never a stated goal of the CPP, but it was one
effect of the program. Before the CPP expired at the end of
2009, Treasury used the program to provide nearly $205 billion
to financial institutions, generally by purchasing preferred
stock in those institutions. The banks that received CPP funds
put them to a variety of uses, but one fairly common use was
for the maintenance of an adequate capital cushion so that the
bank could absorb losses on its portfolios,\460\ including
commercial real estate loans.
---------------------------------------------------------------------------
\460\ Office of the Special Inspector General for the Troubled
Asset Relief Program, SIGTARP Survey Demonstrates That Banks Can
Provide Meaningful Information On Their Use of TARP Funds, at 9 (July
20, 2009) (online at www.sigtarp.gov/reports/audit/2009/
SIGTARP_Survey_Demonstrates_That_Banks_Can_Provide_Meaningfu_Information
On_Their_Use_Of_TARP_Funds.pdf) (``[M]ore than 40 percent of banks
reported using some TARP funds to generate capital reserves to help the
institution remain well-capitalized from a regulatory capital
perspective'').
---------------------------------------------------------------------------
The CPP, which was meant to restore stability to the
financial system, was, perhaps not surprisingly, a blunt
instrument for remedying the problems related to commercial
real estate. First, while some banks that received CPP funds
held large concentrations of commercial real estate loans, a
large majority of the funds went to big banks,\461\ which, as
noted earlier, tend to be much less dependent on commercial
real estate lending than their smaller counterparts.\462\
Treasury argues that it could not force small banks to
participate in the CPP.\463\ But there are also stories of
small banks that made great efforts to get these funds but were
denied them,\464\ although it is difficult from the outside to
assess whether a particular bank met the program's criteria.
Second, because Treasury did not attach strings to the money it
provided to CPP recipients--Treasury could have required the
banks to submit regular lending plans, for example--the flow of
credit to commercial real estate borrowers, and particularly
those borrowers who rely on small banks, remained more
constricted than it might have if the program had been designed
differently. Third, Treasury closed the CPP at the end of 2009.
---------------------------------------------------------------------------
\461\ Roughly $163.5 billion of the CPP funds disbursed, or nearly
80 percent, went to 17 large financial institutions. The 18
institutions were Citigroup, Bank of America, JPMorgan Chase, Goldman
Sachs, Morgan Stanley, Wells Fargo, The Bank of New York Mellon, State
Street, SunTrust, BB&T, Regions Financial, Capital One, KeyCorp, U.S.
Bancorp, PNC, Fifth Third Bancorp, and American Express. Treasury
Transaction Report, supra note 450.
\462\ As of June 2009, large national banks held commercial real
estate loans valued at 56 percent of their capital, while the same
percentage for mid-size banks and community banks was 191 percent.
Testimony of John Dugan, supra note 393, at 25.
\463\ Treasury conversations with Panel staff (Feb. 2, 2010).
\464\ See, e.g., Written Testimony of Chris Burnett, supra note 92
(``The application process was perhaps the most frustrating regulatory
experience in my 30 years in this business. Our bank applied in 2008 as
soon as the program was announced. We were finally told to withdraw our
application in October, 2009, almost a year after the program began.
Early in the process, we had new capital lined up to invest alongside
TARP, but after ten months of waiting for an answer, those capital
sources had dried up'').
---------------------------------------------------------------------------
Thus, until now, to the extent that the TARP has had any
impact on the commercial real estate sector, that impact has
been centered around the CMBS market; the TALF focuses on
securitizations, and the PPIP is designed to buy legacy
securities--that is, already-issued mortgage-backed
instruments. In light of the fact that large banks tend to have
more exposure to securitized commercial real estate loans than
smaller banks do, and smaller banks tend to have more relative
exposure to whole loans,\465\ the TARP's assistance in the
commercial real estate market has been confined mostly to the
large financial institutions. While Treasury notes that the
TALF and the PPIP have had a positive impact on the cost of
financing throughout the commercial real estate sector,\466\
the fact remains that Treasury has not used the TARP to provide
direct targeted help to smaller banks with commercial real
estate problems.
---------------------------------------------------------------------------
\465\ The 20 largest banks have 89.4 percent of the total bank
exposure to CMBS, as noted in Section E.2, even though they hold only
57 percent of assets in the banking system. But those same 20 large
banks have an average commercial real estate exposure equal to 79
percent of their total risk-based capital--far lower than for banks
with assets under $10 billion, where the average commercial real estate
exposure equals 288 percent of total risk-based capital. COP staff
calculations based on CRE Exposure by Size of Bank, supra note 138.
\466\ Treasury conversations with Panel staff (Feb. 2, 2010).
---------------------------------------------------------------------------
This disparity creates a tension with EESA, which contains
provisions aimed at ensuring that small banks are able to
benefit from the TARP. The statute directs the Secretary, in
exercising his authority, to consider ``ensuring that all
financial institutions are eligible to participate in the
program, without discrimination based on size, geography, form
of organization, or the size, type, and number of assets
eligible for purchase under this Act . . ..'' \467\ The law
also directs the Secretary to consider providing assistance
under certain circumstances to financial institutions with
assets of less than $1 billion.\468\
---------------------------------------------------------------------------
\467\ 12 U.S.C. Sec. 5213.
\468\ Specifically, the law refers to financial institutions with
assets of less than $1 billion that had been adequately capitalized or
well capitalized but experienced a drop of at least one capital level
as a result of the 2008 devaluation of Fannie Mae and Freddie Mac
preferred stock. See 12 U.S.C. 5213.
---------------------------------------------------------------------------
4. Small Banks, Small Business, and Commercial Real Estate
In October 2009, the Administration announced another TARP
initiative that held the potential to have an impact on the
commercial real estate sector, and specifically on small banks
and the whole loans they tend to hold. The program was to look
much like the CPP--it would have provided low-cost capital to
financial institutions--but with modifications aimed at
remedying some of the CPP's previously mentioned shortcomings.
First, only small financial institutions--specifically,
community banks and community development financial
institutions (CDFIs)--were to be eligible to participate.\469\
Second, in order to qualify, the institutions were to submit
small business lending plans, and the TARP funds would have to
be used to make qualifying small business loans.\470\
---------------------------------------------------------------------------
\469\ The proposal stated that participating community banks would
have access to capital at a dividend rate of 3 percent, compared with
the 5 percent rate under the CPP. Community development financial
institutions, which are lenders that serve low-income or underserved
populations, would be able to borrow at 2 percent. White House,
President Obama Announces New Efforts to Improve Access to Credit for
Small Businesses (Oct. 21, 2009) (online at www.whitehouse.gov/assets/
documents/small_business_final.pdf) (hereinafter ``President's Small
Business Announcement'').
\470\ President's Small Business Announcement, supra note 469.
---------------------------------------------------------------------------
Even though commercial real estate was not mentioned in the
press release announcing this new program, Treasury has noted
that the problems of commercial real estate and the restricted
flow of credit to small business are related.\471\ When the
inability of small businesses to borrow causes them to close
their doors, vacancy rates increase, which then drag down
commercial real estate values.\472\ In a recent speech, Dennis
Lockhart, president of the Federal Reserve Bank of Atlanta,
expanded on this theme. He spoke about ``the potential of a
self-reinforcing negative feedback loop'' involving bank
lending, small business employment, and commercial real estate
values.\473\ Lockhart noted that small businesses tend to rely
heavily on smaller financial banks as a source of credit. He
further noted that smaller financial institutions tend to have
a larger-than-average concentration in commercial real estate
lending.\474\ Lastly, he noted that banks with the highest
levels of exposure to commercial real estate loans account for
almost 40 percent of all small business loans.\475\ What this
means is that a small bank that does not make many loans--
perhaps because it is hoarding capital to offset future losses
in the value of its commercial real estate portfolio--can feed
a vicious cycle that does additional damage to the bank itself.
The lack of lending may mean that small businesses that rely on
the bank as a source of credit will be forced to shut their
doors. This drives up vacancy rates on commercial real estate
in the local region, which puts more downward pressure on real
estate prices, and those falling prices can lead to additional
write-downs in the bank's commercial real estate portfolio.
---------------------------------------------------------------------------
\471\ Treasury conversations with Panel staff (Nov. 4, 2009).
\472\ Treasury conversations with Panel staff (Nov. 4, 2009).
\473\ Federal Reserve Bank of Atlanta, Speech by President and
Chief Executive Officer Dennis P. Lockhart to the Urban Land
Institute's Emerging Trends in Real Estate Conference: Economy
Recovery, Small Business, and the Challenge of Commercial Real Estate
(Nov. 10, 2009) (online at www.frbatlanta.org/news/speeches/
lockhart_111009.cfm) (hereinafter ``Lockhart Speech at the Urban Land
Institute'').
\474\ Banks with total assets of less than $10 billion accounted
for only 20 percent of commercial banking assets in the United States,
but they accounted for almost half of all commercial real estate loans.
Small banks also accounted for almost half of all small business loans.
Lockhart Speech at the Urban Land Institute, supra note 473.
\475\ Lockhart Speech at the Urban Land Institute, supra note 473.
---------------------------------------------------------------------------
It is therefore possible that a program aimed at improving
access to credit for small businesses could also have
beneficial effects on the commercial real estate sector.
However, the program announced in October 2009 never got off
the ground. At a Panel hearing in December, Secretary Geithner
said that banks are reluctant to accept TARP funding and
participate in the program because they fear being stigmatized,
and they are concerned about restrictions that the program
would impose; he said that dealing with those concerns would
require action by Congress.\476\ Some small banks told Treasury
that they were not interested in participating--in part because
of the stigma associated with the TARP, and in part because of
the TARP's restrictions, including its limits on executive
compensation.\477\ So in February 2010, Treasury announced that
it was splitting the small business lending initiative into two
parts. One part would remain with the TARP, while the other
much larger part would not.
---------------------------------------------------------------------------
\476\ Congressional Oversight Panel, Testimony of Treasury
Secretary Timothy Geithner, at 24 (Dec. 10, 2009).
\477\ Even though small bank employees generally do not earn as
much as their counterparts at the largest banks, they are not exempt
from certain executive compensation restrictions under the TARP. For
example, restrictions on bonuses and golden parachutes apply to the
highest paid employees of a TARP-recipient financial institution,
regardless of the employees' salaries. Treasury conversations with
Panel staff (Feb. 2, 2010).
---------------------------------------------------------------------------
Within the TARP, Treasury proposes to provide up to $1
billion in low cost capital to CDFIs (lending institutions that
provide more than 60 percent of their small business lending
and other economic development activities to underserved
communities).\478\ The plan would allow CDFIs to apply for
funds up to five percent of their risk-weighted assets. They
would pay a two percent dividend, well under the CPP's five
percent dividend rate. CDFIs that already participate in the
CPP would be allowed to transfer into this new program. If the
CDFI's regulator determines that it is not eligible to
participate, it would be allowed to take part in a matching
program. Under the matching program, Treasury would match
private funds raised on a dollar-for-dollar basis, as long as
the institution would be viable after the new capital has been
raised.\479\ As announced, the CDFI program does not include
any requirement that the participating financial institutions
increase their small business lending. Treasury says that
CDFIs, by virtue of their mission of lending in underserved
areas, are already fulfilling the Administration's lending
objectives.\480\
---------------------------------------------------------------------------
\478\ U.S. Department of the Treasury, Obama Administration
Announces Enhancements for TARP Initiative for Community Development
Financial Institutions (Feb. 3, 2010) (online at
www.financialstability.gov/latest/pr_02032010.html) (hereinafter
``Community Development Announcement'').
\479\ Treasury will not provide capital until the CDFI has raised
the private funds, and Treasury's contribution will be senior to the
private investment. Community Development Announcement, supra note 478;
Treasury conversations with Panel staff (Feb. 2, 2010).
\480\ Treasury conversations with Panel staff (Feb. 2, 2010).
---------------------------------------------------------------------------
President Obama announced the second part of the small
business lending initiative during his recent State of the
Union Address.\481\ It would require legislation, and would
establish a new $30 billion Small Business Lending Fund outside
of the TARP. The program would be aimed at midsized and
community banks, those with assets under $10 billion, which
have less than 20 percent of all bank assets but account for
more than 50 percent of small business lending.\482\ Because
the funds would not be provided through the TARP, participating
banks would not be subject to the TARP's restrictions,
including those on executive compensation.\483\ The Fund would
provide capital to those banks with incentives for them to
increase their small business lending. The dividend rate paid
by participating banks would be five percent, but it would
decrease by one percent for every two and a half percent
increase in incremental small business lending over a two-year
period, down to a minimum dividend rate of one percent.\484\
Consequently, banks that increase their small business lending
by at least two and a half percent would get the money on more
favorable terms than were available under the CPP. Banks could
borrow up to between three and five percent of risk weighted
assets, depending on the size of the institution.\485\ As with
the CDFI program, financial institutions that currently
participate in the CPP would be able to convert their capital
into the new program.\486\
---------------------------------------------------------------------------
\481\ State of the Union Remarks, supra note 132.
\482\ White House, Administration Announces New $30 Billion Small
Business Lending Fund (Feb. 2, 2010) (online at www.whitehouse.gov/
sites/default/files/FACT-SHEET-Small-Business-Lending-Fund.pdf)
(hereinafter ``Administration Announces Small Business Lending Fund'').
\483\ Id.
\484\ The baseline for the bank's small business lending would be
2009. Id.
\485\ Banks with less than $1 billion in assets would be eligible
to receive capital equal to as much as five percent of their risk-
weighted assets, while banks with between $1 billion and $10 billion in
assets could receive capital equal to as much as three percent of their
risk-weighted assets. Id.
\486\ Id.
---------------------------------------------------------------------------
Banks received another signal aimed at spurring small
business lending--this time from their supervisors--in a
February 5, 2010 interagency statement. The document cautions
that financial institutions may sometimes become overly
cautious in small business lending during an economic downturn,
and states that bank examiners will not discourage prudent
small business lending.\487\
---------------------------------------------------------------------------
\487\ Federal Deposit Insurance Corporation, Office of the
Comptroller of the Currency, Board of Governors of the Federal Reserve
System, Office of Thrift Supervision, National Credit Union
Administration, Conference of State Bank Supervisors, Interagency
Statement on Meeting the Credit Needs of Creditworthy Small Business
Borrowers (Feb. 5, 2010) (online at www.federalreserve.gov/newsevents/
press/bcreg/bcreg20100205.pdf).
---------------------------------------------------------------------------
At this stage it is unclear whether the Small Business
Lending Fund will have a significant impact on small business
lending and, by extension, commercial real estate. The first
hurdle the program faces is getting congressional
authorization.\488\ Even if that happens, it remains an open
question whether a sufficiently large number of banks will
choose to participate. And even if many banks do participate,
it is unclear whether it will result in a large increase in
small business lending. Unlike the Administration's initial
plan, the new program encourages banks to increase their small
business lending, but does not require them to submit quarterly
reports detailing those lending activities.\489\
---------------------------------------------------------------------------
\488\ In addition to the Administration's proposal, members of
Congress have made proposals to increase small business lending. For
example, in late 2009, Senator Mark Warner (D-VA) and 32 other senators
proposed the creation of a loan pool, using $40 billion of TARP funds
and an additional $5 billion-$10 billion contributed by participating
banks. Participating banks would make small business loans from this
pool, and the funds would remain off the banks' balance sheets, so that
they could not be used to bolster capital levels rather than to make
loans. Senator Mark Warner, Press Release, Warner Urges Action to
Revive Lending to Small Businesses (Oct. 21, 2009) (online at
warner.senate.gov/public/
index.cfm?p=PressReleases&ContentRecord_id=7dd28f00-d69f-44e4-a6b9-
8826c1106a88&ContentType_id=0956c5f0-ef7c-478d-95e7-
f339e775babf&MonthDisplay=10&YearDisplay=2009). Senator Cardin has also
proposed that Treasury and the Small Business Administration jointly
establish a small business lending fund, using $30 billion from the
TARP. Under this proposal, loans would ``have the same terms and
conditions as, and may be used for any purpose authorized for, a direct
loan under section 7(a) of the Small Business Act.'' Boosting
Entrepreneurship and New Jobs Act, Section 5, S. 2967 (Jan. 28, 2010).
\489\ President's Small Business Announcement, supra note 469.
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5. What Approach to Take?
This report has outlined the risks posed by the current and
projected condition of commercial real estate. A second wave of
real-estate driven bank difficulties, even if not as large as
the first, can have an outsize effect on a banking sector
weakened by both the current crisis and by the economy
remaining in a severe recession. In the same way, even if
smaller absolute numbers are involved, a second wave of bank
losses and defaults can have a serious effect on public access
to banking facilities in smaller communities, lending to small
business, and more importantly, on confidence in the financial
system. The system, as noted above, cannot, and should not,
keep every bank afloat. But neither should it turn a blind eye
to the impact of unnecessary bank consolidation. And the
failure of mid-size and small banks because of commercial real
estate might even require a significant recapitalization of the
FDIC with taxpayer funds.
As the report has pointed out, the risks are not limited to
banks and real estate developers. A wave of foreclosures can
affect the lives of employees of retail stores, hotels, and
office buildings, and residents of multifamily buildings. It
can reduce the strength of the economic recovery, especially
the small business recovery. And it can change the character of
neighborhoods that contain foreclosed buildings whose condition
is deteriorating.
Moreover, worries about the problems facing commercial real
estate may already be adding to the very credit crunch that, by
limiting economic growth, makes those risks more likely to
mature. In the words of Martin Feldstein, professor of
economics at Harvard University and a former chair of the
Council of Economic Advisors:
Looking further ahead, it will be difficult to have a
robust recovery as long as the residential and
commercial real estate markets are depressed and the
local banks around the country restrict their lending
because of their concern about possible defaults on
real estate loans.\490\
---------------------------------------------------------------------------
\490\ Martin Feldstein, U.S. Growth in the Decade Ahead, American
Economics Association (online at www.aeaweb.org/aea/conference/program/
retrieve.php?pdfid=449).
The risks on the horizon could open a way to undoing what
the TARP has accomplished, but any crisis triggered by problems
in commercial real estate will reach fruition after the
Secretary's TARP authority expires at the beginning of October
2010. Loans generated during the bubble period are likely to go
bad in substantial numbers; LTVs, and even loan servicing, for
other properties have dropped despite what may have been
careful underwriting of the initial loans. It is unlikely,
however, that the actual extent of the projected difficulties
can be determined until the onset of the refinancing cycles
that begin in 2011-13 and beyond (that may themselves be
subject to extensions or workouts).
Supervisors, industry, Congress, and the public could
consider one, or a combination of the approaches discussed
below. The Panel takes no position on which are preferable,
other than to note that any continued subsidization with
taxpayer funds creates substantial additional problems.
Continued subsidization is not an essential element of any
solution.
a. Mid-Size and Small Banks
According to witnesses at the Panel's field hearing, adding
capital to banks whose commercial real estate exposure exceeds
a certain level, is composed of a higher proportion of low
quality properties, or both, could provide a cushion against
potential commercial real estate losses.\491\ Capital additions
could be supplemented by attempts to remove especially risky
assets from bank balance sheets altogether through a public or
private purchase program (perhaps a structure that is a variant
of the never-used legacy loans program). Either way it will be
essential to manage potential bank exposures carefully in light
of economic conditions. This means forcing immediate write-
downs where necessary to reflect the true condition of an
institution holding a high percentage of the weakest commercial
mortgages, in order to protect both bank creditors and the
FDIC. But it also means recognizing that managing risk involves
difficult judgments about the level LTVs will ultimately reach
at the time refinancing is required and working with borrowers
to prevent foreclosure when new equity and improved economic
conditions can make loans viable.
---------------------------------------------------------------------------
\491\ COP Field Hearing in Atlanta, supra note 70.
---------------------------------------------------------------------------
Capital enhancement and removal of troubled assets from
balance sheets could be the subject of a revised government
effort under the TARP (or thereafter). Stronger banks could be
induced to offer packages of those loans for purchase by
investment vehicles combining TARP and private capital, at
manageable discounts (perhaps also reflecting Treasury
guarantees). Treasury could use its EESA authority to create a
guarantee fund for loans held by banks below a certain size,
upon payment of regular premiums, to support commercial real
estate loans that meet defined standards, preventing write-offs
and aiding in refinancing. The agencies could revive and expand
the PPIP legacy loans program and create a fund, through either
the FDIC or the Federal Reserve System, that can support the
purchase of legacy loans after October 3, 2010. And the TALF
could be extended for both legacy and new CMBS, either to
complement other actions or to keep the securitization markets
liquid.\492\
---------------------------------------------------------------------------
\492\ If the potential crisis that the report identifies comes to
pass, stronger action could prove necessary to prevent unwarranted bank
failures. As the Panel discussed in its April and January Reports, at
pages 39 and 23 respectively, the Emergency Banking Act of 1933
authorized the Reconstruction Finance Corporation to make preferred
stock investments in financial institutions and instituted procedures
for reopening sound banks and resolving insolvent banks. As part of the
effort to restore confidence in the banking system, only banks liquid
enough to do business were to be reopened when President Roosevelt's
nation-wide banking holiday was lifted. As part of the process, banks
were separated into three categories, based on an independent valuation
of assets conducted by teams of bank examiners from the RFC, Federal
Reserve Banks, Treasury, and the Comptroller of the Currency. The
categories comprised: (1) banks whose capital structures were
unimpaired, which received licenses and reopened when the holiday was
lifted; (2) banks with impaired capital but with assets valuable enough
to repay depositors, which remained closed until they could receive
assistance from the RFC; and (3) banks whose assets were incapable of a
full return to depositors and creditors, which were placed in the hands
of conservators who could either reorganize them with RFC assistance or
liquidate them. See James S. Olson, Saving Capitalism: The
Reconstruction Finance Corporation and the New Deal, 1933-1940, at 64
(1988).
---------------------------------------------------------------------------
But there are also arguments for another approach, based on
a conclusion that the problem of commercial real estate can
only be worked through by a combination of private market and
regulatory action. Any government capital support program can
create as much moral hazard for small banks as for large
financial institutions, and government interference in the
marketplace could result in bailing out the imprudent,
upsetting the credit allocation function of the capital
markets, or protecting developers and investors from the
consequences of their decisions.
``Awareness'' on the part of both the private and public
sectors would be the hallmark of the second approach. The
supervisors would manage their supervisory responsibilities for
the safety and soundness of the banking system and individual
institutions to allow failures where necessary and apply
guidance to give more soundly capitalized banks breathing room
for economic recovery. Banks that should fail on the basis of
an objective assessment of their record and prospects would be
allowed to fail. Commercial real estate lenders and borrowers
(who are business professionals) would understand that the
government would not automatically come to their rescue and
that taking on new equity, taking losses, admitting true
positions and balance sheets, were all necessary. They would
know that if they agreed to refinancing based on faulty
underwriting or unrealistic expectations of economic growth,
traffic in particular retail establishments or the prospects of
changing the occupancy rates and rents in multifamily
buildings, they were doing so at their own risk.
b. Large Banks
The situation of the large banks is more complicated.
Although it is impossible to predict whether CMBS exposure
poses a risk of reigniting a financial crisis on the order of
2008, there are disquieting similarities between the state of
the RMBS markets then and the CMBS markets now. To be sure,
there are some important differences; asset quality is
reportedly higher, pools are smaller, and the supervisors have
at least promised more extensive monitoring.\493\ But if the
economy does not recover in time, a high default rate remains a
possibility (or, in the view of some observers, more than a
possibility).\494\ No one agrees on the point at which default
levels can cause a severe break in CMBS values, but a break
could trigger the same round of capital-threatening write-downs
and counterparty liability that marked the financial crisis of
mid-2007. Again, more flexible extension and workout terms can
buy time until the economy recovers and values strengthen
sufficiently to permit the return of the markets to normal
parameters. But without a willingness to require loss
recognition on appropriate terms, postponement will be just
that.
---------------------------------------------------------------------------
\493\ The degree to which that monitoring is in fact occurring and
is matched by appropriately strong regulatory action is outside the
scope of this report, as is the degree to which bank auditing is
sufficiently strict to prevent financial reporting distortions.
\494\ COP Field Hearing in Atlanta, supra note 70, at 50 (Testimony
of Doreen Eberley).
---------------------------------------------------------------------------
Given the stress tests and promises of greater regulatory
and market vigilance, it may be that the large institution
sector can be left without additional assistance. But for that
to be a safe approach, supervisors must monitor risk and not
hesitate to increase capital to offset prospective losses in
place of the capital that came from Treasury during the TARP.
Without stronger supervision, the risks of commercial real
estate even for large institutions are not negligible. The
willingness of supervisors to engage in such supervision before
the fact is the most important factor in preventing those risks
from occurring.
J. Conclusion
There is a commercial real estate crisis on the horizon,
and there are no easy solutions to the risks commercial real
estate may pose to the financial system and the public. An
extended severe recession and continuing high levels of
unemployment can drive up the LTVs, and add to the difficulties
of refinancing for even solidly underwritten properties. But
delaying write-downs in advance of a hoped-for recovery in mid-
and longer-term property valuations also runs the risk of
postponing recognition of the costs that must ultimately be
absorbed by the financial system to eliminate the commercial
real estate overhang.
It should be understood that not all banks are the same.
There are ``A'' banks, those who have operated on the most
prudent terms and have financed only the strongest projects.
There are ``B'' banks, whose commercial real estate portfolios
have weakened but are largely still based on performing loans.
There are ``C'' banks, whose portfolios are weak across the
board. The key to managing the crisis is to eliminate the C
banks, manage the risks of the B banks, and to avoid
unnecessary actions that force banks into lower categories.
Any approach to the problem raises issues previously
identified by the Panel: the creation of moral hazard,
subsidization of financial institutions, and providing a floor
under otherwise seriously undercapitalized institutions. That
should be balanced against the importance of the banks involved
to local communities, the fact that smaller banks were not the
recipients of substantial attention during the administration
of the TARP, and the desire that any shake-out of the community
banking sector should proceed in a way that does not repeat the
pattern of the 1980s. The alternative, illustrated by recent
actions of the FDIC, is to accept bank failures, and, when
write-downs are no longer a consideration, sell the assets at a
discount, and either create a partnership with the buyers to
realize future value (as was done in the Corus Bank situation)
or absorb the losses.
There appears to be a consensus, strongly supported by
current data, that commercial real estate markets will suffer
substantial difficulties for a number of years. Those
difficulties can weigh heavily on depository institutions,
particularly mid-size and community banks that hold a greater
amount of commercial real estate mortgages relative to total
size than larger institutions, and have--especially in the case
of community banks--far less margin for error. But some aspects
of the structure of the commercial real estate markets,
including the heavy reliance on CMBS (themselves backed in some
cases by CDS) and the fact that at least one of the nation's
largest financial institutions holds a substantial portfolio of
problem loans, mean that the potential for a larger impact is
also present.
There is no way to predict with assurance whether an
economic recovery of sufficient strength will occur to reduce
these risks before the large-scale need for commercial mortgage
refinancing that is expected to begin in 2011-2013. The
supervisors bear a critical responsibility to determine whether
current regulatory policies that attempt to ease the way for
workouts and lease modifications will hold the system in place
until cash flows improve, or whether the supervisors must take
more affirmative action quickly, as they attempted to do in
2006, even if such action requires write-downs (with whatever
consequences they bring for particular institutions). And, of
course, they must be especially firm with individual
institutions that have large portfolios of loans for projects
that should never have been underwritten.
The stated purpose of the TARP, and the purpose of
financial regulation, is to assure financial stability and
promote jobs and economic growth. The breakdown of the
residential real estate markets triggered economic consequences
throughout the country. Treasury has used its authority under
the TARP, and the supervisors have taken related measures in
ways they believe will protect financial stability, revive
economic growth, and expand credit for the broader economy.
The Panel is concerned that until Treasury and bank
supervisors take coordinated action to address forthrightly and
transparently the state of the commercial real estate markets--
and the potential impact that a breakdown in those markets
could have on local communities, small businesses, and
individuals--the financial crisis will not end.
Annex I: The Commercial Real Estate Boom and Bust of the 1980s
As indicated in the main text,\495\ the initial boom of the
1980s was so great that between 1980 and 1990 the total value
of commercial real estate loans issued by U.S. banks tripled,
representing an increase from 5.8 percent to 11.0 percent of
banks' total assets.\496\ Several factors converged to cause
the real estate crash of the late 1980s: growth in demand,
economic conditions, tax incentives, a descent into faulty
practices, and lax regulatory policies.
---------------------------------------------------------------------------
\495\ See Section B.
\496\ This does not include the quantities being loaned by credit
unions or thrift institutions. See History of the Eighties, supra note
36, at 153.
---------------------------------------------------------------------------
Although the commercial real estate market was not the only
market suffering a downturn at this time, and therefore cannot
be labeled as the only cause of these failures, an analysis of
bank assets indicates that those institutions which had
invested heavily in commercial real estate during the preceding
decade were substantially more likely to fail than those which
had not.
The majority of lending institutions that failed were from
specific geographic regions: ones which had been economically
prosperous in the early 1980s and had therefore attracted the
greatest levels of investment and generated the most inflated
real estate prices. The failing banks and thrifts also tended
to be small, regional institutions. These, unlike their
national counterparts, could not hedge their bets by lending in
multiple regions; their loans were made in a more concentrated
and inflated property market. Furthermore, in the interest of
economic stability, the federal banking and savings and loan
deposit insurance agencies, the Federal Deposit Insurance
Corporation, and the Federal Home Loan Bank Board, seemed
willing to extend protections to large banks that it would not
offer to local thrifts. For example, they agreed to extend
coverage to the uninsured depositors of certain large banks but
would not offer similar treatment to regional savings and
loans.\497\ This is not to say that the large institutions were
unharmed; the large banks and thrifts had thrown themselves
into commercial real estate lending with greater vigor than the
smaller ones and had allowed these loans to account for a far
greater proportion of their assets. As a result, and in spite
of their advantages, many large banks came to the brink of
collapse as well.
---------------------------------------------------------------------------
\497\ See History of the Eighties, supra note 36, at 151 (Dec.
1997).
FIGURE 43: TOTAL VALUE OF COMMERCIAL REAL ESTATE LOANS BY U.S.
COMMERCIAL BANKS \498\
---------------------------------------------------------------------------
\498\ See Cole and Fenn, supra note 43, at 21. A comparable chart
for current values of commercial real estate loans by U.S. banks is
provided in Section E on page 46.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 44: TOTAL VALUE OF COMMERCIAL REAL ESTATE LOANS BY U.S.
COMMERCIAL BANKS \499\
---------------------------------------------------------------------------
\499\ See Cole and Fenn, supra note 43, at 21.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
1. Demand for Office Space and Regional Impact
During the 1970s, increasing rates of inflation made real
estate a popular investment.\500\ Furthermore, with the United
States shifting away from manufacturing toward a more services-
based economy, there was a growing demand for additional office
space. From the late 1970s until the end of the 1980s (with the
exception of 1982), the number of people working in offices
grew by more than four percent every year.\501\ Existing office
space was fully absorbed, and by 1980, the office vacancy rate
had fallen to 3.8 percent.\502\ There was, therefore,
significant demand for the construction of new workspace in
most major U.S. markets.\503\
---------------------------------------------------------------------------
\500\ See Lynn E. Browne and Karl E. Case, ``How the Commercial
Real Estate Boom Undid the Banks,'' in Real Estate and the Commercial
Real Estate Crunch, at 61 (1992) (online at www.wellesley.edu/
Economics/case/PDFs/banks.pdf) (hereinafter ``Browne and Case
Article'').
\501\ See History of the Eighties, supra note 36, at 92.
\502\ See History of the Eighties, supra note 36, at 93.
\503\ See Garner Economic Review Article, supra note 34, at 93-94.
---------------------------------------------------------------------------
Despite this high demand, the increase in supply that was
forthcoming proved to be excessive. All sectors of commercial
real estate experienced a boom in the early 1980s, but
investments in office space were the ones yielding the highest
returns, and the majority of new construction loans were for
the building of office space.\504\ Office construction
increased by 221 percent between 1977 and 1984,\505\ meaning
that in spite of steadily increasing demand, office vacancy
rates rose rapidly.\506\ Although investment began to level off
in 1986, office vacancy rates reached 16.5 percent and then
began climbing toward 20 percent during the credit crunch of
the early 1990s.
---------------------------------------------------------------------------
\504\ See History of the Eighties, supra note 36, at 141, 145.
\505\ See History of the Eighties, supra note 36, at 143.
\506\ See Garner Economic Review Article, supra note 34, at 93.
---------------------------------------------------------------------------
Demand for office space was a driving factor for the boom
and is one of the reasons why the majority of lending
institution failures are centered on specific regions. Although
most of the country saw fluctuations in commercial real estate
values and the whole country suffered from the fallout of the
crisis, the most significant swings in property values occurred
in states or regions which had comparatively prosperous
economies in the early 1980s, such as Arizona, Arkansas,
California, Florida, Kansas, Oklahoma, Texas, and the
Northeast.\507\ These areas' strong economies had more growing
businesses and investors, which heightened their demand for
office space, and therefore increased both the amount of
overbuilding and the amount of real estate investment that
occurred there during the 1980s.\508\
---------------------------------------------------------------------------
\507\ See History of the Eighties, supra note 36, at 13-26.
\508\ See History of the Eighties, supra note 36, at 13-26.
---------------------------------------------------------------------------
FIGURE 45: OFFICE VACANCY RATE FROM 1979-1990 \509\
---------------------------------------------------------------------------
\509\ See Garner Economic Review Article, supra note 34, at 93.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
FIGURE 46: INCREASE IN OFFICE EMPLOYMENT FROM 1979-1990 \510\
---------------------------------------------------------------------------
\510\ See History of the Eighties, supra note 36, at 146.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
2. Tax Law Changes
The Economic Recovery Tax Act of 1981 (ERTA) incentivized
investment in commercial real estate by introducing an
Accelerated Cost Recovery System (ACRS) which dramatically
improved the rate of return on commercial properties.\511\
During the 1970s, the high rate of inflation had reduced the
value of depreciation tax deductions on commercial
buildings.\512\ The ACRS resolved this by shortening building
lives from 40 years to 15 and by allowing investors to use a
175 percent declining-balance method of depreciation rather
than simple straight-line depreciation.\513\ These measures
increased the tax deductions which were available in the early
years of a property's holding period. The ACRS also made
commercial real estate investments a useful tax shelter for
high-income individuals. A commercial property could be
financed largely by debt (which conferred additional tax
advantages), depreciated at an accelerated rate, and then sold
for a capital gain to others who wished to repeat the
process.\514\ Furthermore, the passive losses which an investor
suffered prior to the resale could be deducted from ordinary
income for tax purposes.\515\ Not surprisingly, the period
after 1981 saw a sharp increase in investments in commercial
real estate.\516\
---------------------------------------------------------------------------
\511\ See Joint Committee on Taxation, General Explanation of the
Economic Recovery Tax Act of 1981, at 68-69 (Dec. 19, 1981) (online at
www.archive.org/stream/generalexplanati00jcs7181#page/n1/mode/2up)
(hereinafter ``Economic Recovery Tax Act of 1981'').
\512\ See Browne and Case Article, supra note 500, at 63.
\513\ See Economic Recovery Tax Act of 1981, supra note 511, at 68-
69.
\514\ See James R. Hines, ``The Tax Treatment of Structures,'' in
The Effects of Taxation on Capital Accumulation (1987).
\515\ See Browne and Case Article, supra note 500, at 64.
\516\ See Garner Economic Review Article, supra note 34, at 93.
---------------------------------------------------------------------------
The Tax Reform Act of 1986 eliminated many of the
advantages which ERTA had created for commercial real estate
investors.\517\ The ACRS was removed, and losses from passive
activities, such as real estate investment could no longer be
deducted from active sources of income. These developments
limited the profitability of commercial real estate
development, curtailing investor interest and prompting a
general softening of property prices.\518\
---------------------------------------------------------------------------
\517\ See Andrew A. Samwick, ``Tax Shelters and Passive Losses
after the Tax Reform Act of 1986,'' in Empirical Foundations of
Household Taxation, at 193-223 (1996).
\518\ See Garner Economic Review Article, supra note 34, at 93.
---------------------------------------------------------------------------
3. Inflation, Interest Rates, and the Deregulation of Thrift
Institutions
During the late 1970s, the unexpected doubling of oil
prices helped drive inflation into the double digits.\519\ The
Federal Reserve moved under Chairman Paul Volcker to break the
inflation cycle by dramatically increasing the federal funds
rate in 1979, which in turn caused a sharp increase in interest
rates in general.\520\ The funding liabilities of lending
institutions (the amount of interest they had to pay on their
short-term loans) increased sharply as well. This put thrifts
in a bind because they specialized in residential mortgages,
which meant that their main source of income was the repayments
on long-term mortgages with low, fixed interest rates.\521\
With the revenue from these low-interest loans now being
surpassed by their losses on high-interest borrowing, many
thrifts faced an unsustainable asset-liability gap that put
them on the path to insolvency.\522\ The situation was
exacerbated when Regulation Q--which had placed ceilings on the
interest rates which saving institutions could offer to
depositors--was phased out between 1980 and 1982.\523\ In order
to remain competitive, thrifts therefore had to start offering
interest rates to savers which matched or bettered inflation,
which increased their funding liabilities even further.\524\
This higher interest rate environment was also highly
detrimental to the ability of borrowers, such as real estate
investors, to refinance their loans, further exacerbating the
economic contraction that was then underway.
---------------------------------------------------------------------------
\519\ There is now general agreement that the surge in inflation in
the late 1970s resulted from both excessive fiscal stimulus (fiscal
deficits over this period were -2.7 percent in 1977 and 1978, 1.6
percent in 1979, and 2.7 percent in 1980) and loose monetary policy.
The budget deficits in the 1970s were the largest since the end of
World War II. Congressional Budget Office, A 125 Year Picture of the
Federal Government's Share of the Economy, 1950 to 2075 (online at
www.cbo.gov/doc.cfm?index=3521&type=0) (accessed Feb. 9, 2010). See
also Congressional Budget Office, Budget and Economic Outlook:
Historical Budget Data, January 2010 (online at www.cbo.gov/ftpdocs/
108xx/doc10871/historicaltables.pdf) (accessed Feb. 9, 2010).
\520\ See Federal Reserve Bank of St. Louis, The Reform of October
1979: How It Happened and Why, remarks by D.E. Lindsey, A. Orphanides,
and R.H. Rasche at the Conference on Reflections on Monetary Policy 25
Years after October 1979 (Oct. 2004) (online at
research.stlouisfed.org/conferences/smallconf/lindsey.pdf).
\521\ See Rob Jameson, Case Study/US Savings & Loan Crisis (Aug.
2002) (online at erisk.com/learning/casestudies/
ussavingsloancrisis.asp) (hereinafter ``Jameson Case Study'').
\522\ See Jameson Case Study, supra note 521.
\523\ See Jameson Case Study, supra note 521.
\524\ See Jameson Case Study, supra note 521.
---------------------------------------------------------------------------
Rather than allow the thrifts to fail, Congress decided to
loosen the regulations on these institutions' lending practices
so that they would be able to experiment with new methods of
generating revenue. The Depository Institutions Deregulation
and Monetary Control Act of 1980, followed by the Garn-St
Germain Depository Institutions Act of 1982, significantly
reduced the amount of capital which thrifts had to keep in
their mandatory reserve accounts at Federal Reserve Banks and
increased the proportions of their total assets which could be
used for consumer and commercial loans. They also increased the
amounts which the FDIC would guarantee from $40,000 per account
to $100,000, meaning that even if a thrift's financial future
was uncertain, the average saver would not feel he were taking
as much risk by maintaining an account there. Further, the
thrift industry's regulator, the Federal Home Loan Bank Board,
set regulatory standards that allowed savings and loans broad
latitude in the resources that could be counted as capital.
Thrifts now had the opportunity to engage in riskier lending
and investing with the hope of achieving increased
profitability in new and uncertain markets, with the added
confidence of knowing that they would not lose depositors by
doing so.
4. Competition Among Lending Institutions and Lax Lending Practices
Thrifts were not the only lending institutions which felt
pushed to take greater risks. The 1980s had brought challenges
to banks' profitability. The high interest rates and
elimination of Regulation Q had affected banks as well as
thrifts, increasing their costs of doing business.
Simultaneously, the number of lenders was on the rise; in
addition to the thrifts moving into new markets, approximately
2,800 new banking charters were granted in the 1980s, and the
rapid growth of the commercial paper market had taken a
sizeable proportion of banks' commercial and industrial lending
business.\525\ In the face of this increased competition, banks
became more willing to take risky investments on the principle
that ``if we don't make the loan, the institution across the
street will.'' \526\
---------------------------------------------------------------------------
\525\ See History of the Eighties, supra note 36, at 154.
\526\ See History of the Eighties, supra note 36, at 154.
---------------------------------------------------------------------------
In this difficult lending environment, commercial real
estate loans were an attractive revenue earner. The booming
commercial real estate market made nonperformance seem
unlikely, and commercial real estate lending involved large,
up-front fees.\527\ For struggling institutions--both banks and
thrifts--this sort of immediate income could be essential.
---------------------------------------------------------------------------
\527\ See Garner Economic Review Article, supra note 34, at 93.
---------------------------------------------------------------------------
Competition for commercial real estate loans rapidly
intensified. In order to secure the largest possible share of
this booming market, lending institutions started to engage in
risky business practices. Many lowered their maximum LTV
ratios, decreasing the amount of borrowers' equity at risk and
increasing the potential loss to the lender.\528\ Some became
less rigorous in enforcing principal payment schedules, and
would allow principal payments to be renewed repeatedly or
unpaid interest simply to be added to the unpaid principal
(practices which were uncommon prior to the 1980s).\529\
Perhaps most significantly, underwriting standards in some
cases became laxer. Traditionally, the decision to extend a
loan collateralized by commercial real estate was made by
evaluating whether the project in which the borrower wished to
invest was likely to generate sufficient earnings to cover the
debt payments. As a backup measure, lenders would evaluate the
value of the collateralized investment property and whether it
would cover the value of the loan if the borrower defaulted.
From the late 1970s onward, lenders started to place increasing
emphasis on the backup criterion and less on whether the
project was likely to succeed.\530\ This might not have been
dangerous were it not for the fact that property valuations
were being increasingly inflated as well. Once the market began
to decline in the late 1980s, lenders found not only that their
borrowers were defaulting but that the sale of foreclosed
properties would not recoup their loan principal.
---------------------------------------------------------------------------
\528\ See History of the Eighties, supra note 36, at 155.
\529\ See History of the Eighties, supra note 36, at 155.
\530\ See History of the Eighties, supra note 36, at 155.
---------------------------------------------------------------------------
5. Faulty Appraisals
Before committing funds to a real estate loan, federally
insured deposit institutions are required to hire an outside
appraiser to deliver an independent opinion on the collateral
value of the property in question. This is to ensure that an
informed but impartial individual is present who can assess the
project's viability and hopefully steer the lender away from
risky loans.\531\ However, prior to 1987, federal bank
examiners had very few guidelines for how to assess an
appraiser's credibility, and state licensing standards for
appraisers were practically non-existent.\532\ A federal review
of appraisal practices in the mid-1980s revealed that many
appraisers had embraced the flawed belief that the real estate
boom was sustainable and had tended to over-value properties as
a result.\533\ Since there were no mechanisms by which
appraisers could be held accountable for faulty appraisals,
they had never had sufficient motivation to analyze whether
their assumptions were accurate.\534\ Furthermore, the
commercial real estate market was growing so rapidly in the
early 1980s that many appraisal offices had to hire new and
inexperienced appraisers, who were less likely to question the
prevailing wisdom that commercial property values would
continue to increase.\535\ For all these reasons, appraisals
failed to provide a reliable check on risky lending in the
early 1980s and helped contribute to the severity of the bust
which followed.
---------------------------------------------------------------------------
\531\ See History of the Eighties, supra note 36, at 156.
\532\ See History of the Eighties, supra note 36, at 157.
\533\ See History of the Eighties, supra note 36, at 157.
\534\ See History of the Eighties, supra note 36, at 157.
\535\ See History of the Eighties, supra note 36, at 157.
---------------------------------------------------------------------------
It should be noted that the economic recession of 1990-1991
affected the multifamily sector in a similar fashion.
Overbuilding in this sector ultimately led to a collapse in
values, which in turn led to tighter underwriting standards.
Fortunately, with inflation under control and with the fall in
interest rates during the 1980s, borrowers took advantage of
the opportunity to refinance, and the multifamily market began
to loosen substantially by 1992.\536\
---------------------------------------------------------------------------
\536\ Rent Guidelines Board, 1996 Mortgage Survey Report (online at
tenant.net/Oversight/RGBsum96/msurv/96msurv.html) (accessed Feb. 7,
2010).
SECTION TWO: UPDATE ON WARRANTS
On Tuesday, January 19, 2010, the Office of Financial
Stability (OFS) issued a Warrant Disposition Report detailing
the Department of the Treasury's approach to warrant
dispositions related to TARP CPP investments.\537\ The Panel
has performed its own analysis of Treasury's warrant
disposition process using an internally created model,
beginning with its July report. Based upon 11 initial warrant
sales of relatively small institutions, Treasury received only
66 percent of the Panel's estimated value of warrants
sold.\538\ Subsequently, Treasury's return on warrant sales has
improved to 92 percent of Panel estimates.\539\ In its July
report, the Panel recommended that Treasury be more forthcoming
on the details of its disposition process and valuation
methodology. The July report also recommended that Treasury
provide periodic written reports on its warrant fair market
value determinations and subsequent disposition rationale.\540\
---------------------------------------------------------------------------
\537\ Warrant Disposition Report, United States Department of the
Treasury--Office of Financial Stability (online at
www.financialstability.gov/docs/
TARP%20Warrant%20Disposition%20Report%20v4.pdf) (hereinafter ``Warrant
Disposition Report'').
\538\ See COP August Oversight Report, supra note 5, at 54-57.
\539\ See Warrant table at Figure 47.
\540\ Warrant Disposition Report, supra note 537.
---------------------------------------------------------------------------
Upon repayment of Treasury's CPP investment, a financial
institution has the right to repurchase its warrants at an
agreed-upon fair market value.\541\ The repurchase process
follows a set timeline that includes bid submission(s),
Treasury bid evaluation, and a final appraisal option.\542\
This Warrant Disposition Report provides Treasury's first
comprehensive and systematic public explanation of its internal
procedures and specific details for each warrant sale.
---------------------------------------------------------------------------
\541\ Warrant Disposition Report, supra note 537.
\542\ Under the repurchase through bid process, financial
institutions have 15 days from CPP preferred repayment to submit an
initial bid. Then, Treasury has 10 days to accept or reject the bid.
Additional bids may be submitted at any time, even if an agreement on
fair market value is not reached within the 25-day timeframe.
Under the repurchase through appraisal process, Treasury or the
repaying financial institution may invoke an appraisal procedure within
30 days following Treasury's response to the institution's first bid if
no agreement on fair market value has been reached. In this scenario,
both parties select independent appraisers who conduct their own
valuations and work toward fair market value agreement. If both
appraisers are in agreement, that valuation becomes the repurchase
basis. If they are not in agreement, a third appraiser creates a
composite valuation of the three appraisals to establish the fair
market value (subject to some limitations). However, this process has
yet to be used to date.
---------------------------------------------------------------------------
Treasury utilizes three sources in its determination of the
fair market value of warrants and subsequent evaluation of an
institution's bid to repurchase its warrants: market quotes;
independent, third-party valuations; and internal model
valuations.\543\
---------------------------------------------------------------------------
\543\ Warrant Disposition Report, supra note 537.
---------------------------------------------------------------------------
Market quotes: Though warrants are similar in
structure to options, there is little market data for long-
dated options that is comparable in length and terms to those
of the warrants held by Treasury. Accordingly, Treasury
collects what market pricing information is available from
various market participants who are active in the options and/
or convertible securities markets and uses this data to
estimate warrant valuations. In the future, Treasury plans to
use the market values from the trading of recently auctioned
CPP warrants as some indication of the market's expectations
for long-term volatility (in addition to continuing to collect
valuation estimates from market participants).
Independent valuation: Outside consultants and
external asset managers provide estimated valuation and a range
of values to Treasury for use as a third-party valuation
source.
Internal modeling: Treasury uses a binomial option
model adjusted for American-style options as its primary
internal valuation model.\544\ Treasury uses the 20-trading day
trailing average stock price of a company in its valuations and
updates this data if negotiations continue over an extended
period of time. A binomial option pricing model values a
warrant based on how the price of its underlying shares may
change over the warrant's term. The binomial model allows for
changes to input assumptions (e.g., volatility) over time.\545\
---------------------------------------------------------------------------
\544\ Dr. Robert Jarrow, an options expert and professor at Cornell
University, reviewed Treasury's internal valuation model and concluded
that it is consistent with industry best practice and the ``highest
academic standards.''
\545\ Congressional Oversight Panel, July Oversight Report: TARP
Repayments, Including the Repurchase of Stock Warrants (July 10, 2009)
(online at cop.senate.gov/documents/cop-071009-report.pdf).
---------------------------------------------------------------------------
The OFS Warrant Committee, comprised of Treasury officials
within OFS, makes a recommendation to the Assistant Secretary
for Financial Stability regarding acceptance or rejection of a
bank's bid based on these three valuation sources. In the event
that there is no fair market value agreement between parties
and no invocation of the appraisal process, Treasury seeks to
sell the warrants to third parties ``as quickly as
practicable'' and, when possible, through public auction.\546\
Treasury has conducted the three warrant auctions to date as
public modified ``Dutch'' auctions registered under the
Securities Act of 1933 and administered by Deutsche Bank.\547\
In a ``Dutch'' auction, bidders submit one or more independent
bids at different price-quantity combinations and have no
additional information on others' bids. Bids must be greater
than the minimum price set by Treasury. The warrants are then
sold at a uniform price that clears the auction.\548\
---------------------------------------------------------------------------
\546\ Warrant Disposition Report, supra note 537.
\547\ As auction agent, Deutsche Bank Securities Inc. has received
fees equal to approximately 1.5 percent of gross proceeds ($16.6M).
This is a haircut to the typical average secondary equity offering fees
of 3.5 to 4.5 percent.
\548\ Warrant Disposition Report, supra note 537. It is generally
accepted that, compared to discriminating price auctions in which a
bidder pays what he bids, uniform price auctions increase how
aggressively participants bid in an auction, thus increasing the amount
of proceeds from the auction. This occurs because uniform price
auctions decrease the so called ``winner's curse,'' which is a bidder's
fear that an auction win means he overpaid. A uniform price auction is
the same type of auction used to sell Treasury debt.
---------------------------------------------------------------------------
By comparison, the Panel's warrant valuation methodology
employs a Black-Scholes model modified to account for the
warrants' dilutive effects on common stock and the dividend
yield of the stock. A Black-Scholes model and binomial model
share similar underlying assumptions but differ in the
variability of those assumptions. In its use of Black-Scholes,
the Panel assumed that the risk-free rate, the dividend yield,
and the stock price volatility of each financial institution
would be constant over time.\549\ The binomial model, on the
other hand, includes inherent variability in assumptions at
various time intervals. This model is generally more complex
and time-intensive, whereas Black-Scholes is, by comparison,
more transparent and reproducible.
---------------------------------------------------------------------------
\549\ Congressional Oversight Panel, July Oversight Report: TARP
Repayments, Including the Repurchase of Stock Warrants (July 10, 2009)
(online at cop.senate.gov/documents/cop-071009-report.pdf).
---------------------------------------------------------------------------
Congress has addressed the receipt and disposition of TARP
warrants in three separate legislative actions: EESA, American
Recovery and Reinvestment Act of 2009 (ARRA), and Helping
Families Save Their Homes Act of 2009 (HFSA). EESA was
authorized on October 3, 2008, and provided that, in exchange
for the purchase or commitment to purchase a troubled asset:
(1) in the case of a financial institution whose securities are
traded on a national securities exchange, Treasury is to
receive a warrant giving the right to receive nonvoting common
stock or preferred stock, or (2) in the case of all other
financial institutions, Treasury is to receive a warrant for
common or preferred stock or a senior debt instrument.\550\
---------------------------------------------------------------------------
\550\ Warrant Disposition Report, supra note 537.
---------------------------------------------------------------------------
This legislation was followed by ARRA, enacted on February
17, 2009, which stated that when TARP assistance is repaid by a
financial institution, ``the Secretary of the Treasury shall
liquidate warrants associated with such assistance at the
current market price.'' \551\ On May 20, 2009, HFSA amended
section 7001(g) of ARRA by striking ``shall liquidate warrants
associated with such assistance at the current market price''
and inserting ``at the market price, may liquidate warrants
associated with such assistance.'' \552\ This effectively
reversed the limitations on the Secretary's discretion to
dispose of TARP warrants as set forth in ARRA. Given the
timing, the ``shall liquidate'' language may have created a
greater sense of urgency in Treasury's initial warrant
dispositions and may have ultimately influenced the lower bid
prices received in those warrant repurchases.
---------------------------------------------------------------------------
\551\ Warrant Disposition Report, supra note 537.
\552\ Warrant Disposition Report, supra note 537.
---------------------------------------------------------------------------
The following table includes both data previously published
by the Panel and new data provided by Treasury in its January
19th Warrant Disposition Report. In prior reports, the Panel
has provided a table detailing warrant repurchases by financial
institutions to date, repurchase/sale proceeds, the Panel's
best estimate of warrant fair market value,\553\ and the
internal rate of return for each institution's CPP repayment,
which is also a Panel staff calculation.\554\ To allow for
comparison between Panel estimates and the data Treasury has
utilized in its disposition decisions, this table has been
expanded to include the best estimates of warrant market value
from Treasury's three valuation methods discussed above (noted
in columns headed ``Market Quotes Estimate,'' ``Third-Party
Estimate,'' and ``Treasury Model Valuation''). The ``Price/
Estimate Ratio'' column displays the number of cents on the
dollar that Treasury has received for warrant dispositions
compared to the Panel's best estimate of warrant value.
---------------------------------------------------------------------------
\553\ The Panel's modified Black-Scholes model produces a low
estimate, high estimate, and ``best'' estimate of warrant value.
\554\ The Internal Rate of Return (IRR) is effectively the interest
rate received for an investment (i.e., Treasury's TARP CPP investment)
consisting of payment(s) (i.e., Treasury's initial investment in the
financial institution) and income (i.e., dividends, TARP CPP preferred
repayment, warrant redemption) at discrete points in time. For
Treasury's TARP investments in a financial institution, the IRR is
calculated from the initial capital investment and subsequent dividends
and warrant repayments/sale proceeds over time.
FIGURE 47: WARRANT DISPOSITIONS FOR FINANCIAL INSTITUTIONS WHICH HAVE FULLY REPAID CPP FUNDS AS OF FEBRUARY 2, 2010 555
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Panel's Best
Investment Warrant Market Quotes Third Party Treasury Model Warrant Valuation Price/ IRR (Percent)
Institution Date QEO Repurchase Estimate Estimate Valuation Repurchase/Sale Estimate at Estimate
Date Amount Repurchase Date Ratio
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Old National Bancorp........................................... 12/12/2008 No 5/8/2009 $1,353,000 $3,054,000 $1,326,000 $1,200,000 $2,150,000 0.5581 9.30
Iberiabank Corporation......................................... 12/5/2008 Yes 5/20/2009 1,566,000 2,334,000 1,421,000 1,200,000 2,010,000 0.5970 9.40
Firstmerit Corporation......................................... 1/9/2009 No 5/27/2009 4,918,000 6,485,000 5,400,000 5,025,000 4,260,000 1.1796 20.30
Sun Bancorp, Inc............................................... 1/9/2009 No 5/27/2009 2,096,000 4,028,000 2,252,000 2,100,000 5,580,000 0.3763 15.30
Independent Bank Corp.......................................... 1/9/2009 No 5/27/2009 2,104,000 2,885,000 2,345,000 2,200,000 3,870,000 0.5685 15.60
Alliance Financial Corporation................................. 12/19/2008 No 6/17/2009 762,000 990,000 818,000 900,000 1,580,000 0.5696 13.80
First Niagara Financial Group.................................. 11/21/2008 Yes 6/24/2009 1,646,000 4,221,000 2,807,000 2,700,000 3,050,000 0.8852 8.00
Berkshire Hills Bancorp, Inc................................... 12/19/2008 No 6/24/2009 611,000 1,494,000 971,000 1,040,000 1,620,000 0.6420 11.30
Somerset Hills Bancorp......................................... 1/16/2009 No 6/24/2009 266,000 447,000 276,000 275,000 580,000 0.4741 16.60
SCBT Financial Corporation..................................... 1/16/2009 No 6/24/2009 1,159,000 2,888,000 1,281,000 1,400,000 2,290,000 0.6114 11.70
HF Financial Corp.............................................. 11/21/2008 No 6/30/2009 424,000 753,000 563,000 650,000 1,240,000 0.5242 10.10
State Street................................................... 10/28/2008 Yes 7/8/2009 33,000,000 55,000,000 57,000,000 60,000,000 54,200,000 1.1070 9.90
U.S. Bancorp................................................... 11/14/2008 No 7/15/2009 127,000,000 144,000,000 140,000,000 139,000,000 135,100,000 1.0289 8.70
The Goldman Sachs Group, Inc................................... 10/28/2008 No 7/22/2009 826,000,000 993,000,000 902,000,000 1,100,000,000 1,128,400,000 0.9748 22.80
BB&T Corp...................................................... 11/14/2008 No 7/22/2009 36,000,000 62,000,000 67,000,000 67,010,402 68,200,000 0.9826 8.70
American Express Company....................................... 1/9/2009 No 7/29/2009 219,000,000 309,000,000 285,000,000 340,000,000 391,200,000 0.8691 29.50
Bank of New York Mellon Corp................................... 10/28/2008 No 8/5/2009 94,000,000 136,000,000 135,000,000 136,000,000 155,700,000 0.8735 12.30
Morgan Stanley................................................. 10/28/2008 No 8/12/2009 731,000,000 900,000,000 855,000,000 950,000,000 1,039,800,000 0.9136 20.20
Northern Trust Corporation..................................... 11/14/2008 No 8/26/2009 69,000,000 86,000,000 84,000,000 87,000,000 89,800,000 0.9688 14.50
Old Line Bancshares Inc........................................ 12/5/2008 No 9/2/2009 102,000 254,000 214,000 225,000 500,000 0.4500 10.40
Bancorp Rhode Island, Inc...................................... 11/21/2008 No 9/30/2009 1,166,000 1,476,000 1,423,000 1,400,000 1,400,000 1.0000 12.60
CVB Financial Corp............................................. 12/5/2008 Yes 10/28/2009 917,000 1,110,000 1,349,000 1,307,000 1,230,279 1.0624 -26.30
Centerstate Banks of Florida Inc............................... 11/21/2008 No 10/28/2009 125,000 236,000 206,000 212,000 220,000 0.9636 5.90
Manhattan Bancorp.............................................. 12/5/2008 No 10/14/2009 34,000 50,000 56,000 63,364 140,000 0.4526 9.80
Bank of the Ozarks............................................. 12/12/2008 No 11/24/2009 2,210,000 2,480,000 2,509,000 2,650,000 3,500,000 0.7571 9.00
Capital One Financial.......................................... 11/14/2008 No 12/3/2009 30,000,000 124,000,000 108,000,000 148,731,030 232,000,000 0.6411 12.00
JP Morgan Chase & Co........................................... 10/28/2008 No 12/10/2009 658,000,000 1,063,000,000 998,000,000 950,318,243 1,006,587,697 0.9441 10.90
TCF Financial Corp............................................. 1/16/2009 No 12/16/2009 15,900,000 16,200,000 14,300,000 9,599,964 11,825,830 0.8118 11.00
LSB Corporation................................................ 12/12/2008 No 12/16/2009 446,000 605,000 569,000 560,000 535,202 1.0463 9.00
Wainwright Bank & Trust Company................................ 12/19/2008 No 12/16/2009 532,000 632,000 541,000 568,700 1,071,494 0.5308 7.80
Wesbanco Bank, Inc............................................. 12/5/2008 No 12/23/2009 577,000 643,000 851,000 950,000 2,387,617 0.3979 6.70
Union Bankshares Corporation................................... 12/19/2008 Yes 12/23/2009 448,000 424,000 410,000 450,000 1,130,418 0.3981 5.80
Trustmark Corporation.......................................... 11/21/2008 No 12/30/2009 7,601,000 9,014,000 9,704,000 10,000,000 11,573,699 0.8640 9.40
Flushing Financial Corporation................................. 12/19/2008 Yes 12/30/2009 742,000 1,007,000 850,000 900,000 2,861,919 0.3145 6.50
--------------------------------------------------------------------------------------------------------------------------
Total...................................................... .............. ............ .............. $2,870,705,000 $3,935,710,000 $3,683,442,000 $4,025,635,703 $4,367,594,154 0.9217 14.40
----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
555 ``Market Quotes Estimate,'' ``Third party Estimate,'' and ``Treasury Model Valuation'' are from the OFS Warrant Disposition Report. ``Panel's Best Valuation Estimate at Repurchase Date'' is from the Panel's internal valuation
model.
In sum, warrant repurchases and auction sales have
generated proceeds of $2.9 billion and $1.1 billion,
respectively. Treasury notes that these warrant dispositions
have produced an absolute return--the ratio of actual proceeds
to the CPP preferred investment amount--of 3.1 percent from
dividends and 5.7 percent from sale of warrants for total
absolute return of 8.8 percent.\556\ The Panel agrees with this
simple calculation but prefers to use an internal rate of
return (IRR) calculation, which is an annualized measure and
therefore allows for comparison with other investment
alternatives in the economy. The Panel's latest IRR for the
TARP CPP, based on all warrant sales and repurchases to date,
is 14.4 percent.\557\
---------------------------------------------------------------------------
\556\ Warrant Disposition Report, supra note 537.
\557\ Warrant Disposition Report, supra note 537. The ``QEO''
column in the table above notes whether a financial institution
completed a qualified equity offering before December 31, 2009, in
which case, according to the terms of CPP contracts, the institution
was allowed to reduce by half the number of warrants owned by Treasury
and available for its disposition. A QEO is an offering of securities
that qualifies as Tier 1 capital.
---------------------------------------------------------------------------
The proceeds from warrant sales/repurchases of larger
financial institutions were from 86 to over 100 percent of the
Panel's best estimate, with the only significant outlier being
Capital One Financial, whose auction results reflected only 64
percent of the Panel's best estimate. This result may have been
due to several factors, including: (1) market uncertainty
surrounding Treasury's warrant auctions, as Capital One's
warrants were the first to go to auction; (2) the significant
portion of Capital One's earnings derived from its credit card
business, which given recent regulatory changes may be viewed
as a less desirable investment option; and (3) the decline in
implied volatility of Capital One's stock price in the months
preceding the auction (a higher volatility suggests the
potential for greater returns in the future, leading to higher
valuations of the associated stock's warrants).
For smaller institutions, the ratio of actual proceeds
received to the Panel's best estimates tended to be lower than
that for larger institutions, possibly reflecting the fact that
the market for trading of the underlying stock of these smaller
institutions is less liquid.
Some trends in estimates versus actual sales prices emerge
when reviewing the pattern of warrant repurchases over time.
The first five repurchase bids came in below Treasury's
internal model ``best estimate'' and well below the third-party
valuation ``best estimate.'' Treasury attributed this to the
warrant liquidation language in ARRA, as discussed above, and
to the fact that Treasury initially relied on financial
modeling consultants for third-party input as opposed to
external asset managers.\558\ The remaining accepted warrant
repurchase bids came in above or just below Treasury's internal
model ``best estimate,'' well above most of the market quote
valuations, and close to the third-party valuations. Overall,
the gross proceeds of $2.9 billion from warrant repurchases to
date--although only 94 percent of the Panel's best estimated
value for these warrants of $3.1 billion--were greater than
Treasury's internal model valuation of these warrants of $2.6
billion.
---------------------------------------------------------------------------
\558\ Warrant Disposition Report, supra note 537.
FIGURE 48: VALUATION OF OUTSTANDING WARRANTS AS OF FEBRUARY 2, 2010
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Warrant Valuation
Stress Test Financial Institutions with Warrants Outstanding -----------------------------------------------
Low Estimate High Estimate Best Estimate
----------------------------------------------------------------------------------------------------------------
Wells Fargo..................................................... $354.41 $1,836.20 $817.62
Bank of America Corporation..................................... 578.94 2,581.34 965.46
Citigroup, Inc.................................................. 10.04 921.63 175.81
The PNC Financial Services Group Inc............................ 99.66 540.64 251.21
SunTrust Banks, Inc............................................. 14.85 238.42 110.90
Regions Financial Corporation................................... 7.36 185.20 90.87
Fifth Third Bancorp............................................. 87.22 359.91 201.68
Hartford Financial Services Group, Inc.......................... 510.11 863.18 619.91
KeyCorp......................................................... 16.77 151.28 78.41
All Other Banks................................................. 751.70 2,890.27 1,921.43
-----------------------------------------------
Total....................................................... $2,431.06 $10,568.07 $5,233.30
----------------------------------------------------------------------------------------------------------------
As the above table shows, the Panel's best estimate of
Treasury's outstanding warrants is $5.2 billion, with a minimum
valuation estimate of $2.4 billion and a maximum estimate of
$10.6 billion. Bank of America and Wells Fargo, both of whom
repaid their CPP investment in December 2009, will likely be
the next high-valued warrants to be auctioned.\559\ Combining
the best estimate of warrants outstanding with the warrant
redemption receipts received so far shows that the Panel's best
estimate of the total amount Treasury will receive from the
sale of TARP warrants now stands at $9.3 billion.
---------------------------------------------------------------------------
\559\ Treasury Transaction Report, supra note 450.
SECTION THREE: ADDITIONAL VIEWS
A. J. Mark McWatters and Paul S. Atkins
We concur with the issuance of the February report and
offer the additional observations below. We appreciate the
spirit with which the Panel and the staff approached this
complex issue and incorporated suggestions offered during the
drafting process.
There is little doubt that much uncertainty exists within
the present commercial real estate, or CRE, market. Broad based
recognition of CRE related losses has yet to occur, and
significant problems are expected within the next two years.
The bottom line is that CRE losses need to be recognized--
hiding losses on balance sheets is not good for financial
institutions, for investors, or for the economy. Just as in the
residential real estate market, the CRE market needs freedom to
engage in price discovery in order for investors to have
confidence and transparency to resume investing risk capital in
CRE.
In order to suggest any ``solution'' to the challenges
currently facing the CRE market, it is critical that market
participants and policymakers thoughtfully identify the sources
of the underlying difficulties. Without a proper diagnosis, it
is likely that an inappropriately targeted remedy with adverse
unintended consequences will result.
Broadly speaking, it appears that today's CRE industry is
faced with both an oversupply of CRE facilities and an
undersupply of prospective tenants and purchasers. In addition
to the excess CRE inventory created during the 2005-2007 bubble
period, it appears that there has been an unprecedented
collapse in demand for CRE property. Many potential tenants and
purchasers have withdrawn from the CRE market not simply
because rental rates or purchase prices are too high, but
because their business operations do not presently require
additional CRE facilities. Over the past few years while CRE
developers have constructed a surplus of new office buildings,
hotels, multi-family housing, retail and shopping centers, and
manufacturing and industrial parks, a significant number of end
users of such facilities have suffered the worst economic
downturn in several generations. Any posited solution to the
CRE problem that focuses only on the oversupply of CRE
facilities to the exclusion of the economic difficulties facing
the end users of such facilities appears unlikely to succeed.
The challenges confronting the CRE market are not unique to
that industry, but, instead, are generally indicative of the
systemic uncertainties manifest throughout the larger economy.
In order to address the oversupply of CRE facilities,
developers and their creditors are currently struggling to
restructure and refinance their CRE portfolio loans. In some
instances creditors with sufficient regulatory capital are
acknowledging economic reality and writing their loans down to
market value with, perhaps, the retention of an equity
participation right. In other cases lenders are merely
``kicking the can down the road'' by refinancing problematic
credits on favorable terms at or near par so as to avoid the
recognition of book losses and the attendant reductions in
regulatory capital. With respect to the most problematic
credits, lenders are foreclosing on their CRE collateral
interests and are either attempting to manage the properties in
a depressed market or disposing of the facilities at
significant discounts. While these approaches may offer
assistance in specifically tailored instances, none directly
addresses the challenge of too few tenants and purchasers of
CRE facilities.
Until small and large businesses regain the confidence to
hire new employees and expand their business operations, it
remains doubtful that the CRE market will sustain a meaningful
recovery. As long as businesses are faced with the multiple
challenges of rising taxes, increasing regulatory burdens, and
enhanced political risk associated with unpredictable
governmental interventions in the private sector (including
government actions that will affect health care and energy
costs), it is unlikely that they will enthusiastically assume
the entrepreneurial risk necessary for protracted business
expansion at the microeconomic level and thus a recovery of the
CRE market at the macroeconomic level. It is fundamental to
acknowledge that the American economy grows one job and one
consumer purchase at a time, and that the CRE market will
recover one lease, one sale, and one financing at a time. With
the ever-expanding array of less-than-friendly rules,
regulations and taxes facing businesses and consumers, we
should not be surprised if businesses remain reluctant to hire
new employees, consumers remain cautious about spending, and
the CRE market continues to struggle.
It is indeed ironic that while Treasury is contemplating a
plan to fund another round of TARP-sourced allocations for
``small'' financial institutions (including targeting funds to
certain favored groups, including CDFIs), the Administration is
also developing a plan to raise the taxes and increase the
regulatory burden of many financial institutions and other CRE
market participants. The Administration seems reluctant to
acknowledge that such actions may raise the cost of capital to
such financial institutions and decrease their ability to
extend credit to qualified CRE and other borrowers. More
significantly, the Administration appears indifferent to the
dramatic level of uncertainty that such actions have injected
into an already unsettled marketplace.
It is also troublesome that Treasury would contemplate
another round of bailouts to rescue financial institutions that
placed risky bets on the CRE market. Over the years many of
these institutions have profited handsomely by extending credit
to CRE developers, and it is disconcerting that these same
institutions and their CRE borrowers would approach the
taxpayers for a bailout. We should also note that during the
bubble era, these institutions and the CRE developers were
almost assuredly managed by financial and real estate experts
and advised by competent counsel and other professionals who
were thoroughly versed in the risks associated with CRE lending
and development.\560\
---------------------------------------------------------------------------
\560\ Sophisticated securities products, including CDSs, also were
developed to provide for hedging and risk management for CRE and CMBS
exposure, among other things. Some have mistakenly likened these
products to ``insurance,'' because some market participants viewed them
in that sort of role. It is a facile comparison, because they differ in
significant ways from ``insurance.'' Thus, they properly are not
treated as such.
---------------------------------------------------------------------------
Although some financial institutions may struggle or even
fail as a result of their ill-advised underwriting decisions
and the resulting overdevelopment of the CRE market, any
taxpayer-funded bailouts of these institutions will inject
unwarranted moral hazard risk into the market and all but
establish the United States government as the implicit
guarantor of any future losses arising from distressed CRE
loans.\561\ Such actions will also encourage private sector
participants to engage in less-than-prudent economic behavior,
confident in the expectation--if not an emerging sense of
entitlement--that the taxpayers will yet again offer a bailout
if their CRE portfolios materially underperform. Since CRE
market participants reaped the benefits from the run-up to the
CRE bubble, they should equally shoulder the burdens from the
bursting of the bubble. The Administration--through TARP, a
program similar to the Resolution Trust Corporation (RTC),\562\
or otherwise--should not force the taxpayers to subsidize these
losses and underwrite the poor management decisions and
analysis of such CRE lenders and developers. A market economy
by necessity must cull or marginalize the products and services
of the weakest participants so that those who have developed
innovative and competitive ideas may prosper on a level playing
field. Any attempt by the Administration to prop up the
financial institutions and developers who contributed to the
oversupply of CRE property is not in the best interests of the
more prescient and creative market participants or the
taxpayers. The opportunity for entrepreneurs to succeed or fail
based upon their own acumen and judgment must survive the
current recession and the implementation of the TARP program.
---------------------------------------------------------------------------
\561\ The results of any additional ``stress tests'' conducted by
the applicable banking supervisors should not be used by Treasury as an
excuse for the allocation of additional TARP funds to capital-deficient
financial institutions. Instead, such financial institutions should
seek capital from the private markets or be liquidated or sold through
the typical FDIC resolution process.
\562\ The RTC responded to the failure of a significant number of
financial institutions within specific geographic areas. Without the
RTC, some have argued that the affected areas would have been
``materially under-banked.'' It is not apparent that the same situation
manifests itself today as a result of distressed CRE loans or
otherwise. Some banks will fail (and will be liquidated or sold through
the typical FDIC resolution process), but a substantial majority should
survive and will be better off by not having to compete with their
mismanaged former peers. Because these banks are not systemically
significant financial institutions, the failure of which might
materially impair the U.S. economy, Treasury's potential use of the
TARP program to recapitalize them stretches the intent of EESA and
would create risks of moral hazard and implicit government guarantees.
In addition, an RTC-type approach raises the potential for unintended
enrichment of some participants at the taxpayer's expense.
---------------------------------------------------------------------------
In addition, as the Report notes, Treasury has realized
that financial institutions increasingly consider TARP to be a
stigma of weakness. This perception is inevitable after almost
a year and a half of TARP and is a healthy development. In
fact, banks that accept TARP funds at this point of the
economic cycle should be branded as weaker institutions. A
question for policymakers is whether they should be allowed to
fail rather than be propped up further at taxpayer expense.
Finally, as Treasury considers its actions in using TARP
funds in the context of CRE or other areas, it must be mindful
not only of political realities, but also funding realities. As
the Report indicates, there are substantial ``uncommitted''
funds available to Treasury under the TARP. Some of these funds
have never been allocated out of Congress's original
authorization of $700 billion under EESA. However, if Treasury
exceeds the original $700 billion in total allocations under
the TARP, it then would rely on its interpretation that EESA
allows ``recycling'' of TARP funds; that is, amounts returned
to the Treasury create more ``headroom'' for Treasury to use
TARP funds up to a maximum outstanding at any time of $700
billion. We find Treasury's legal analysis regarding this
interpretation of EESA unconvincing and disagree with
Treasury's assertion that these returned amounts become
``uncommitted'' funds again, which may be re-committed.
SECTION FOUR: CORRESPONDENCE WITH TREASURY UPDATE
Secretary of the Treasury Timothy Geithner sent a letter to
Chair Elizabeth Warren on January 13, 2010,\563\ in response to
a letter from the Chair regarding the assistance provided to
CIT Group, Inc. under the Capital Purchase Program.
---------------------------------------------------------------------------
\563\ See Appendix I of this report, infra.
SECTION FIVE: TARP UPDATES SINCE LAST REPORT
A. TARP Repayments
No additional banks have repaid their TARP investments
under the CPP since the Panel's most recent oversight report. A
total of 59 banks have repaid their preferred stock TARP
investments provided under the CPP to date. Treasury has also
liquidated the warrants it holds in 40 of these 59 banks.
B. CPP Monthly Lending Report
Treasury releases a monthly lending report showing loans
outstanding at the top 22 CPP recipient banks. The most recent
report, issued on January 15, 2010, includes data through the
end of November 2009. Treasury reported that the overall
outstanding loan balance of the top CPP recipients declined by
0.2 percent between the end of October 2009 and the end of
November 2009. The total amount of originations at the end of
November 2009 was five percent below what it was when EESA was
enacted.
C. CPP Warrant Disposition Report
As part of its investment in senior preferred stock of
certain banks under the CPP, Treasury received warrants to
purchase shares of common stock or other securities in those
institutions. At the end of 2009, Treasury held warrants in 248
public companies as part of the CPP. In December 2009, Treasury
began the public sale of warrants to third parties, in addition
to original issuers, through a standardized process that,
according to Treasury, is designed to ensure that taxpayers
receive fair market value whether the warrants are purchased by
the issuer or a third party.
On January 20, 2010, the Treasury released a report showing
that as of December 31, 2009, the government had received $4
billion in gross proceeds on the disposition of warrants in 34
banks. These proceeds consisted of $2.9 billion from
repurchases by the issuers and $1.1 billion from auctions. See
Section Two for a detailed discussion of the report.
D. TARP Initiative to Support Lending to Small Businesses
On February 3, 2010, Treasury announced the final terms of
a TARP initiative to invest capital in CDFIs that lend to small
businesses. Under the program, eligible CDFIs will have access
to capital at a two percent rate, compared with a five percent
rate under the CPP. CDFIs that are already participating in
TARP will be able to transfer those investments into this
program. Further, CDFIs will not be required to issue warrants
to take part in the initiative.
E. Term Asset-Backed Securities Loan Facility (TALF)
At the January 20, 2010 facility, investors requested $1.5
billion in loans for legacy CMBS. Investors did not request any
loans for new CMBS. By way of comparison, investors requested
$1.3 billion in loans for legacy CMBS at the December facility
and $1.4 billion at the November facility. Investors did not
request any loans for new CMBS at the December facility but did
request $72.2 million in loans for new CMBS at the November
facility. These have been the only loans requested for new CMBS
during TALF's operations.
At the February 5, 2010 facility, investors requested $987
million in loans to support the issuance of ABS collateralized
by loans in the auto, credit card, equipment, floor plan,
servicing advances, small business, and student loan sectors.
No loans were requested in the premium financing sector. By way
of comparison, at the January 7, 2010 facility, investors
requested $1.1 billion in loans collateralized by the issuance
of ABS in the credit card, floor plan, and small business
sectors.
F. Legacy Securities Public-Private Investment Program (PPIP)
On January 29, 2010, Treasury released its initial
quarterly report on PPIP for the quarter ending December 31,
2009. The report indicates that PPIP, which Treasury intends to
support market functioning and facilitate price discovery in
the mortgage-backed securities markets through the purchase of
eligible assets, has created $24 billion in purchasing power
for public-private investment funds. As of the end of the
quarter, these funds had drawn down $4.3 billion in total
capital which was invested in eligible assets or cash
equivalents pending investment.
G. Home Affordable Modifications Program (HAMP) Updated Requirements
On January 28, 2010, Treasury and the Department of Housing
and Urban Development (HUD) released guidance regarding
documentation requirements and procedures for servicers
participating in the HAMP. Under these new terms, all
modifications with an effective date on or after June 1, 2010,
will require an initial standard package of three documents
before evaluation. Treasury and HUD also clarified procedures
by which borrowers may be converted from trial modifications to
permanent modifications.
H. Metrics
Each month, the Panel's report highlights a number of
metrics that the Panel and others, including Treasury, the
Government Accountability Office (GAO), Special Inspector
General for the Troubled Asset Relief Program (SIGTARP), and
the Financial Stability Oversight Board, consider useful in
assessing the effectiveness of the Administration's efforts to
restore financial stability and accomplish the goals of EESA.
This section discusses changes that have occurred in several
indicators since the release of the Panel's January report.
Interest Rate Spreads. Interest rate spreads have
continued to contract since the Panel's January report, further
reflecting signs of economic stability. The mortgage rate
spread, which measures the difference between the conventional
30-year mortgage rate and 10-year Treasury bills, was 1.3
percent at the end of January.\564\ This represents a 45
percent decrease since the enactment of EESA.
---------------------------------------------------------------------------
\564\ Board of Governors of the Federal Reserve System, Federal
Reserve Statistical Release H.15: Selected Interest Rates: Historical
Data (Instrument: Conventional Mortgages, Frequency: Weekly) (online at
www.federalreserve.gov/releases/h15/data/Weekly_Thursday_/
H15_MORTG_NA.txt) (hereinafter ``Federal Reserve Statistical Release
H.15: Selected Interest Rates: Historical Data'') (accessed Jan. 27,
2010); Board of Governors of the Federal Reserve System, Federal
Reserve Statistical Release H.15: Selected Interest Rates: Historical
Data (Instrument: U.S. Government Securities/Treasury Constant
Maturities/Nominal 10-Year, Frequency: Weekly) (online at
www.federalreserve.gov/releases/h15/data/Weekly_Friday_/
H15_TCMNOM_Y10.txt) (hereinafter ``Federal Reserve Release H.15'')
(accessed Jan. 27, 2010).
FIGURE 49: INTEREST RATE SPREADS
------------------------------------------------------------------------
Percent Change Since
Indicator Current Spread Last Report (12/31/09)
(as of 1/29/10) (Percent)
------------------------------------------------------------------------
TED spread \565\ (in basis 17 -10.5
points)....................
Conventional mortgage rate 1.32 0.76
spread \566\...............
Corporate AAA bond spread 1.62 3.8
\567\......................
Corporate BAA bond spread 2.57 -3.4
\568\......................
Overnight AA asset-backed 0.13 -0.25
commercial paper interest
rate spread \569\..........
Overnight A2/P2 nonfinancial 0.13 -0.16
commercial paper interest
rate spread \570\..........
------------------------------------------------------------------------
\565\ TED Spread, SNL Financial.
\566\ Federal Reserve Release H.15, supra note 564 (accessed Jan. 27,
2010); Federal Reserve Release H.15, supra note 564 (accessed Jan. 27,
2010).
\567\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release H.15: Selected Interest Rates: Historical Data
(Instrument: Corporate Bonds/Moody's Seasoned AAA, Frequency: Weekly)
(online at www.federalreserve.gov/releases/h15/data/Weekly_Friday_/
H15_AAA_NA.txt) (accessed Jan. 27, 2010); Federal Reserve Release
H.15, supra note 564 (accessed Jan. 27, 2010).
\568\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release H.15: Selected Interest Rates: Historical Data
(Instrument: Corporate Bonds/Moody's Seasoned BAA, Frequency: Weekly)
(online at www.federalreserve.gov/releases/h15/data/Weekly_Friday_/
H15_BAA_NA.txt) (accessed Jan. 27, 2010); Federal Reserve Release
H.15, supra note 564 (accessed Jan. 27, 2010).
\569\ Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release: Commercial Paper Rates and Outstandings: Data
Download Program (Instrument: AA Asset-Backed Discount Rate,
Frequency: Daily) (online at www.federalreserve.gov/DataDownload/
Choose.aspx?rel=CP) (hereinafter ``Federal Reserve Release: Commercial
Paper'') (accessed Jan. 27, 2009); Board of Governors of the Federal
Reserve System, Federal Reserve Statistical Release: Commercial Paper
Rates and Outstandings: Data Download Program (Instrument: AA
Nonfinancial Discount Rate, Frequency: Daily) (online at
www.federalreserve.gov/DataDownload/Choose.aspx?rel=CP) (accessed Jan.
27, 2010). In order to provide a more complete comparison, this metric
utilizes a five-day average of the interest rate spread for the last
five days of the month.
\570\ Federal Reserve Release: Commercial Paper, supra note 569
(accessed Jan. 27, 2010). In order to provide a more complete
comparison, this metric utilizes a five day average of the interest
rate spread for the last five days of the month.
Commercial Paper Outstanding. Commercial paper
outstanding, a rough measure of short-term business debt, is an
indicator of the availability of credit for enterprises. The
amount of asset-backed commercial paper outstanding decreased
by 11 percent in January. Financial and non-financial
commercial paper outstanding both increased in January by 4 and
11 percent, respectively.\571\ Total commercial paper
outstanding has continued to decrease since the enactment of
EESA. Asset-backed commercial paper outstanding has declined
nearly 40 percent and nonfinancial commercial paper outstanding
has decreased by 43 percent since October 2008.\572\
---------------------------------------------------------------------------
\571\ Federal Reserve Release: Commercial Paper, supra note 569
(accessed Jan. 27, 2010).
\572\ Federal Reserve Release: Commercial Paper, supra note 569
(accessed Jan. 27, 2010).
FIGURE 50: COMMERCIAL PAPER OUTSTANDING
[Dollars in billions]
------------------------------------------------------------------------
Percent Change Since
Indicator Current Level Last Report (12/31/09)
(as of 1/27/10) (Percent)
------------------------------------------------------------------------
Asset-backed commercial $431 -11.3
paper outstanding
(seasonally adjusted) \573\
Financial commercial paper 601 4.03
outstanding (seasonally
adjusted) \574\............
Nonfinancial commercial 115 11.2
paper outstanding
(seasonally adjusted) \575\
------------------------------------------------------------------------
\573\ Federal Reserve Release: Commercial Paper, supra note 569
(accessed Jan. 27, 2010).
\574\ Federal Reserve Release: Commercial Paper, supra note 569
(accessed Jan. 27, 2010).
\575\ Federal Reserve Release: Commercial Paper, supra note 569
(accessed Jan. 27, 2010).
Lending by the Largest TARP-recipient Banks.
Treasury's Monthly Lending and Intermediation Snapshot tracks
loan originations and average loan balances for the 22 largest
recipients of CPP funds across a variety of categories, ranging
from mortgage loans to commercial real estate to credit card
lines. The data below exclude lending by two large CPP-
recipient banks, PNC Bank and Wells Fargo, because significant
acquisitions by those banks since October 2008 make comparisons
difficult.\576\ In November, these 20 institutions originated
$186.5 billion in loans, a decrease of 14 percent compared to
October 2008.\577\ The total average loan balance for these
institutions decreased by 2.5 percent to $3.3 trillion in
November.\578\
---------------------------------------------------------------------------
\576\ PNC Financial and Wells Fargo purchased large banks at the
end of 2008. PNC Financial purchased National City on October 24, 2008
and Wells Fargo completed its merger with Wachovia Corporation on
January 1, 2009. The assets of National City and Wachovia are included
as part of PNC and Wells Fargo, respectively, in Treasury's January
lending report but are not differentiated from the existing assets or
the acquiring banks. As such, there were dramatic increases in the
total average loan balances of PNC and Wells Fargo in January 2009. For
example, PNC's outstanding total average loan balance increased from
$75.3 billion in December 2008 to $177.7 billion in January 2009. The
same effect can be seen in Wells Fargo's total average loan balance of
$407.2 billion in December 2008 which increased to $813.8 billion in
January 2009. The Panel excludes PNC and Wells Fargo in order to have a
more consistent basis of comparison across all institutions and lending
categories.
\577\ U.S. Department of the Treasury, Treasury Department Monthly
Lending and Intermediation Snapshot: Summary Analysis for November 2009
(Jan. 27, 2010) (online at www.financialstability.gov/docs/surveys/
Snapshot_Data_November_2009.xls) (hereinafter ``Treasury Snapshot for
November 2009'').
\578\ Treasury Snapshot for November 2009, supra note 577.
FIGURE 51: LENDING BY THE LARGEST TARP-RECIPIENT BANKS (WITHOUT PNC AND WELLS FARGO) \579\
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Percent Change Since Percent Change Since
Indicator Most Recent Data October 2009 (Percent) October 2008 (Percent)
(November 2009)
----------------------------------------------------------------------------------------------------------------
Total loan originations.............. $186,556 -0.25 -14.5
Total mortgage originations.......... 55,227 1.07 24.7
Small Business Originations.......... 4,586 -15 \580\ -10.3
Mortgage refinancing................. 32,519 6.9 73.3
HELOC originations (new lines & line 1,954 -12.2 -58.9
increases)..........................
C&I renewal of existing accounts..... 49,614 4.1 -13.6
Total Equity Underwriting............ 30,600 4.8 58.3
Total Debt Underwriting.............. 262,719 -13 -27
----------------------------------------------------------------------------------------------------------------
\579\ Treasury Snapshot for November 2009, supra note 577.
\580\ Treasury only began reporting data regarding small business originations in its April Lending Survey, this
number reflects the percent change since April 2009. Treasury Snapshot for November 2009, supra note 577.
Housing Indicators. Foreclosure filings increased
by fourteen percent from October to November, and are 25
percent above the October 2008 level. Housing prices, as
illustrated by both the S&P/Case-Shiller Composite 20 Index and
the FHFA House Price Index, increased slightly in November.
FIGURE 52: HOUSING INDICATORS
----------------------------------------------------------------------------------------------------------------
Percent Change From
Most Recent Monthly Data Available at Time Percent Change Since
Indicator Data of Last Report October 2008 (Percent)
(Percent)
----------------------------------------------------------------------------------------------------------------
Monthly foreclosure filings \581\.... 349,519 14 25
Housing prices--S&P/Case-Shiller 145.5 0.24 -7.1
Composite 20 Index \582\............
FHFA Housing Price Index \583\....... 200.4 0.07 -1.3
----------------------------------------------------------------------------------------------------------------
\581\ RealtyTrac, Foreclosure Activity Press Releases (online at www.realtytrac.com//ContentManagement/
PressRelease.aspx) (hereinafter `` Foreclosure Activity Press Releases'') (accessed Jan. 27, 2010). Most
recent data available for December 2009.
\582\ Standard & Poor's, S&P/Case-Shiller Home Price Indices (Instrument: Seasonally Adjusted Composite 20
Index) (online at www.standardandpoors.com/prot/servlet/BlobServer?blobheadername3=MDT-Type&blobcol
=urldata&blobtable=MungoBlobs&blobheadervalue2=inline%3B+filename%3DSA_
CSHomePrice_History_012659.xls&blobheadername2= Content-
Disposition&blobheadervalue1=application%2Fexcel&blobkey =id&blobheadername1=content-
type&blobwhere=1243643617751 &blobheadervalue3=UTF-8) (hereinafter ``S&P/Case-Shiller Home Price Indices'')
(accessed Jan. 27, 2010). Most recent data available for November 2009.
\583\ Federal Housing Finance Agency, U.S. and Census Division Monthly Purchase Only Index (Instrument: USA,
Seasonally Adjusted) (online at www.fhfa.gov/webfiles/15368/MonthlyIndex_ Jan1991_to_Latest.xls) (accessed
Jan. 27, 2010). Most recent data available for November 2009.
FIGURE 53: FORECLOSURE FILINGS AS COMPARED TO THE CASE-SHILLER 20 CITY
HOME PRICE INDEX (AS OF NOVEMBER 2009) \584\
---------------------------------------------------------------------------
\584\ Foreclosure Activity Press Releases, supra note 581 (accessed
Jan. 27, 2010); S&P/Case-Shiller Home Price Indices, supra note 582
(accessed Jan. 27, 2010). Most recent data available for November 2009.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Small Business Lending. On February 5, 2010,
federal and state financial agencies, including the Federal
Reserve and FDIC, issued a statement highlighting the
importance of prudent and productive small business lending.
This statement urged institutions to focus their decision on a
small business owner's business plan rather than basing the
decision solely on economic and portfolio manager models.
Furthermore, it stated that regulators will not adversely
classify loans solely due to a borrower's specific industry or
geographic location.\585\ As figure 54 illustrates, new small
busi-
---------------------------------------------------------------------------
\585\ Board of Governors of the Federal Reserve System, Federal
Deposit Insurance Corporation, National Credit Union Administration,
Office of the Comptroller of the Currency, Office of Thrift
Supervision, Conference of State Bank Supervisors, Interagency
Statement on Meeting the Credit Needs of Creditworthy Small Business
Borrowers (Feb. 5, 2010) (online at www.fdic.gov/news/news/press/2010/
pr10029a.pdf) (``As a general principle, examiners will not adversely
classify loans solely due to a decline in the collateral value below
the loan balance, provided the borrower has the willingness and ability
to repay the loan according to reasonable terms. In addition, examiners
will not classify loans due solely to the borrower's association with a
particular industry or geographic location that is experiencing
financial difficulties'').
---------------------------------------------------------------------------
ness lending by the largest TARP participants has decreased
more than 10 percent since Treasury began tracking this metric
in April 2009.
FIGURE 54: SMALL BUSINESS LENDING BY LARGEST TARP-RECIPIENT BANKS (WITHOUT PNC AND WELLS FARGO) \586\
[Dollars in millions]
----------------------------------------------------------------------------------------------------------------
Percent Change from
Most Recent Data Available at Time Percent Change
Indicator Monthly Data of Last Report Since April 2009
(November 2009) (Percent) (Percent)
----------------------------------------------------------------------------------------------------------------
Small Business Lending Origination............... $4,586 -15 -10.3
Small Business Lending Average Loan Balance...... 179,131 -0.4 -4.1
----------------------------------------------------------------------------------------------------------------
\586\ Treasury Snapshot for November 2009, supra note 577.
I. Financial Update
Each month, the Panel summarizes the resources that the
federal government has committed to economic stabilization. The
following financial update provides: (1) an updated accounting
of the TARP, including a tally of dividend income, repayments
and warrant dispositions that the program has received as of
February 1, 2010; and (2) an updated accounting of the full
federal resource commitment as of December 31, 2009.
1. TARP
a. Costs: Expenditures and Commitments
Treasury has committed or is currently committed to spend
$519.5 billion of TARP funds through an array of programs used
to purchase preferred shares in financial institutions, offer
loans to small businesses and automotive companies, and
leverage Federal Reserve loans for facilities designed to
restart secondary securitization markets.\587\ Of this total,
$298.3 billion is currently outstanding under the $698.7
billion limit for TARP expenditures set by EESA, leaving $403.3
billion available for fulfillment of anticipated funding levels
of existing programs and for funding new programs and
initiatives. The $298.3 billion includes purchases of preferred
and common shares, warrants and/or debt obligations under the
CPP, AIGIP/SSFI Program, PPIP, and AIFP; and a $20 billion loan
to TALF LLC, the SPV used to guarantee Federal Reserve TALF
loans.\588\ Additionally, Treasury has allocated $36.9 billion
to the Home Affordable Modification Program, out of a projected
total program level of $50 billion.
---------------------------------------------------------------------------
\587\ EESA, as amended by the Helping Families Save Their Homes Act
of 2009, limits Treasury to $698.7 billion in purchasing authority
outstanding at any one time as calculated by the sum of the purchase
prices of all troubled assets held by Treasury. Pub. L. No. 110-343,
Sec. 115(a)-(b); Helping Families Save Their Homes Act of 2009, Pub. L.
No. 111-22, Sec. 402(f) (reducing by $1.26 billion the authority for
the TARP originally set under EESA at $700 billion).
\588\ Treasury Transaction Report, supra note 450.
---------------------------------------------------------------------------
b. Income: Dividends, Interest Payments, and CPP Repayments
As of February 1, 2009, a total of 59 institutions have
completely repurchased their CPP preferred shares. Of these
institutions, 37 have repurchased their warrants for common
shares that Treasury received in conjunction with its preferred
stock investments (including six institutions for whom warrants
were exercised at the time of the initial Treasury investment);
Treasury sold the warrants for common shares for three other
institutions at auction.\589\ For further discussion of
Treasury's disposition of these warrants, see Section Two of
this report. In January, Treasury received partial repayments
from two institutions, totaling $57.2 million.\590\ In
addition, Treasury receives dividend payments on the preferred
shares that it holds, usually five percent per annum for the
first five years and nine percent per annum thereafter.\591\ In
total, Treasury has received approximately $189.5 billion in
income from repayments, warrant repurchases, dividends,
payments for terminated guarantees, and interest payments
deriving from TARP investments,\592\ and another $1.2 billion
in participation fees from its Guarantee Program for Money
Market Funds.\593\
---------------------------------------------------------------------------
\589\ Treasury Transaction Report, supra note 450.
\590\ Treasury Transaction Report, supra note 450.
\591\ See, e.g., U.S. Department of the Treasury, Securities
Purchase Agreement: Standard Terms (online at
www.financialstability.gov/docs/CPP/spa.pdf) (accessed Jan. 4, 2010).
\592\ See U.S. Department of the Treasury, Cumulative Dividends and
Interest Report as of December 31, 2009 (Jan. 20, 2010) (online at
www.financialstability.gov/docs/dividends-interest-reports/
December%202009%20Dividends%20and%20Interest%20Report.pdf) (hereinafter
``Treasury Dividends and Interest Report''); Treasury Transaction
Report, supra note 450.
\593\ U.S. Department of the Treasury, Treasury Announces
Expiration of Guarantee Program for Money Market Funds (Sept. 18, 2009)
(online at www.treasury.gov/press/releases/tg293.htm).
---------------------------------------------------------------------------
c. TARP Accounting
Figure 55: TARP ACCOUNTING (AS OF FEBRUARY 1, 2010) \594\
[Dollars in billions]
----------------------------------------------------------------------------------------------------------------
Total
Anticipated Actual Repayments/ Funding Funding
TARP Initiative Funding Funding Reduced Outstanding Available
Exposure
----------------------------------------------------------------------------------------------------------------
Capital Purchase Program (CPP) \595\.... $204.9 $204.9 $122 $82.9 $0
Targeted Investment Program (TIP) \596\. 40.0 40.0 40 0 0
AIG Investment Program (AIGIP)/ 69.8 \597\ 46. 0 46.9 22.9
Systemically Significant Failing 9
Institutions Program (SSFI)............
Automobile Industry Financing Program 81.3 81.3 3.2 78.1 0
(AIFP).................................
Asset Guarantee Program (AGP) \598\..... 5.0 5.0 \599\ 5.0 0 0
Capital Assistance Program (CAP) \600\..
Term Asset-Backed Securities Lending 20.0 20.0 0 20.0 0
Facility (TALF)........................
Public-Private Investment Partnership 30.0 30.0 0 30.0 0
(PPIP) \601\...........................
Supplier Support Program (SSP).......... \602\ 3.5 3.5 0 3.5 0
Unlocking SBA Lending................... 15.0 0 N/A 0 15.0
Home Affordable Modification Program 50.0 \603\ 36. 0 35.5 14.5
(HAMP)................................. 9
Community Development Financial
Institutions Initiative \604\..........
Total Committed......................... 519.5 468.5 - 298.3 51
Total Uncommitted....................... 179.2 N/A 170.2 N/A \605\ 349.4
Total............................... $698.7 $468.5 $170.2 $298.3 $400.4
----------------------------------------------------------------------------------------------------------------
\594\ Treasury Transaction Report, supra note 450.
\595\ As of December 31, 2009, the CPP was closed. U.S. Department of the Treasury, FAQ on Capital Purchase
Program Deadline (online at www.financialstability.gov/docs/
FAQ%20on%20Capital%20Purchase%20Program%20Deadline.pdf).
\596\ Both Bank of America and Citigroup repaid the $20 billion in assistance each institution received under
the TIP on December 9 and December 23, 2009, respectively. Therefore the Panel accounts for these funds as
repaid and uncommitted. U.S. Department of the Treasury, Treasury Receives $45 Billion in Repayments from
Wells Fargo and Citigroup (Dec. 22, 2009) (online at www.treas.gov/press/releases/20091229716198713.htm)
(hereinafter ``Treasury Receives $45 Billion from Wells Fargo and Citigroup'').
\597\ In information provided by Treasury in response to a Panel request, AIG has completely utilized the $40
billion made available on November 25, 2008 and drawn down $5.3 billion of the $29.8 billion made available on
April 17, 2009. This figure also reflects $1.6 billion in accumulated but unpaid dividends owed by AIG to
Treasury due to the restructuring of Treasury's investment from cumulative preferred shares to non-cumulative
shares. Treasury Transaction Report, supra note 450.
\598\ Treasury, the Federal Reserve, and the Federal Deposit Insurance Company terminated the asset guarantee
with Citigroup on December 23, 2009. The agreement was terminated with no losses to Treasury's $5 billion
second-loss portion of the guarantee. Citigroup did not repay any funds directly, but instead terminated
Treasury's outstanding exposure on its $5 billion second-loss position. As a result, the $5 billion is now
accounted for as available. Treasury Receives $45 Billion from Wells Fargo and Citigroup, supra note 596.
\599\ Although this $5 billion is no longer exposed as part of the AGP and is accounted for as available,
Treasury did not receive a repayment in the same sense as with other investments.
\600\ On November 9, 2009, Treasury announced the closing of this program and that only one institution, GMAC,
was in need of further capital from Treasury. GMAC received an additional $3.8 billion in capital through the
AIFP on December 30, 2009. U.S. Department of the Treasury, Treasury Announcement Regarding the Capital
Assistance Program (Nov. 9, 2009) (online at www.financialstability.gov/latest/tg_11092009.html); Treasury
Transaction Report, supra note 450.
\601\ On January 29, 2010, Treasury released its first quarterly report on the Legacy Securities Public-Private
Investment Program. As of that date, the total value of assets held by the PPIP managers was $3.4 billion. Of
this total, 87 percent as non-agency Residential Mortgage-Backed Securities and the remaining 13 percent was
Commercial Mortgage-Backed Securities. U.S. Department of the Treasury, Legacy Securities Public-Private
Investment Program (Jan. 29, 2010) (online at www.financialstability.gov/docs/External%20Report%20-%2012-
09%20FINAL.pdf).
\602\ On July 8, 2009, Treasury lowered the total commitment amount for the program from $5 billion to $3.5
billion. This action reduced GM's portion from $3.5 billion to $2.5 billion and Chrysler's portion from $1.5
billion to $1 billion. On November 11, 2009, there was a partial repayment of $140 million made by GM Supplier
Receivables LLC, the special purpose vehicle created to administer this program for GM suppliers. This was a
partial repayment of funds that were drawn down and did not lessen Treasury's $3.5 billion in total exposure
to the ASSP. Treasury Transaction Report, supra note 450.
\603\ This figure reflects the total of all the caps set on payments to each mortgage servicer and not the
disbursed amount of funds for successful modifications. In response to a Panel inquiry, Treasury disclosed
that, as of Jan 10, 2010, $32 million in funds had been disbursed under the HAMP. Treasury Transaction Report,
supra note 450.
\604\ On February 3, 2010, the Administration announced a new initiative under TARP to provide low-cost
financing for Community Development Financial Institutions (CDFIs). Under this program, CDFIs are eligible for
capital investments at a 2 percent dividend rate as compared to the 5 percent dividend rate under the CPP.
Currently, the total amount of funds Treasury plans on investing has not been announced.
\605\ This figure is the sum of the uncommitted funds remaining under the $698.7 billion cap ($179.2 billion)
and the repayments ($170.2 billion).
FIGURE 56: TARP REPAYMENTS AND INCOME
[Dollars in billions]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Repayments/ Other
Reduced Dividends \606\ Interest \607\ Warrant Proceeds
TARP Initiative Exposure (as (as of 12/31/ (as of 12/31/ Repurchases (as of 2/1/ Total
of 2/1/10) 09) 09) (as of 2/1/10) 10)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total.......................................................... $170.1 $12.5 $0.38 $4.03 $2.51 $189.5
CPP............................................................ 121.9 8.3 0.02 4.03 -- 134.3
TIP............................................................ 40 3 N/A 0 -- 43
AIFP........................................................... 3.2 0.94 0.34 N/A -- 4.48
ASSP........................................................... N/A N/A 0.01 N/A -- 0.01
AGP............................................................ \608\ 5 0.28 N/A 0 \609\ 2.23 7.5
PPIP........................................................... N/A N/A .002 N/A -- 0.002
Bank of America Guarantee...................................... -- -- -- -- \610\ 0.28 .28
--------------------------------------------------------------------------------------------------------------------------------------------------------
\606\ Treasury Dividends and Interest Report, supra note 592.
\607\ Treasury Dividends and Interest Report, supra note 592.
\608\ Although Treasury, the Federal Reserve, the FDIC, and Citigroup have terminated the AGP, and although Treasury's $5 billion second-loss position
no longer counts against the $698.7 TARP ceiling, Treasury did not receive any repayment income.
\609\ As a fee for taking a second-loss position up to $5 billion on a $301 billion pool of ring-fenced Citigroup assets as part of the AGP, Treasury
received $4.03 billion in Citigroup preferred stock and warrants; Treasury exchanged these preferred stocks and warrants for trust preferred
securities in June 2009. Following the early termination of the guarantee, Treasury cancelled $1.8 billion of the trust preferred securities, leaving
Treasury with a $2.23 billion investment in Citigroup trust preferred securities in exchange for the guarantee. Treasury Transaction Report, supra
note 450.
\610\ Although Treasury, the Federal Reserve, and the FDIC negotiated with Bank of America regarding a similar guarantee, the parties never reached an
agreement. In September 2009, Bank of America agreed to pay each of the prospective guarantors a fee as though the guarantee had been in place during
the negotiations. This agreement resulted in payments of $276 million to Treasury, $57 million to the Federal Reserve, and $92 million to the FDIC.
U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Bank of America
Corporation, Termination Agreement, at 1-2 (Sept. 21, 2009) (online at www.financialstability.gov/docs/AGP/BofA%20-%20Termination%20Agreement%20-
%20executed.pdf).
2. Other Financial Stability Efforts
a. Federal Reserve, FDIC, and Other Programs
In addition to the direct expenditures Treasury has
undertaken through TARP, the federal government has engaged in
a much broader program directed at stabilizing the U.S.
financial system. Many of these initiatives explicitly augment
funds allocated by Treasury under specific TARP initiatives,
such as FDIC and Federal Reserve asset guarantees for
Citigroup, or operate in tandem with Treasury programs, such as
the interaction between PPIP and TALF. Other programs, like the
Federal Reserve's extension of credit through its section 13(3)
facilities and SPVs and the FDIC's Temporary Liquidity
Guarantee Program, operate independently of TARP.
Figure 57 below reflects the changing mix of Federal
Reserve investments. On February 1, 2010, four temporary
Federal Reserve programs aimed at increasing liquidity in the
financial system expired: the Primary Dealer Credit Facility
(PDCF), the Term Securities Lending Facility (TSLF), the Asset-
Backed Commercial Paper Money Market Mutual Fund Liquidity
Facility (AMLF), and the Commercial Paper Funding Facility
(CPFF). As the liquidity facilities established to face the
crisis have been wound down, the Federal Reserve has expanded
its facilities for purchasing mortgage-related securities. The
Federal Reserve announced that it intends to purchase $175
billion of federal agency debt securities and $1.25 trillion of
agency mortgage-backed securities.\611\ As of January 28, 2010,
$162 billion of federal agency (government-sponsored
enterprise) debt securities and $973 billion of agency
mortgage-backed securities have been purchased. The Federal
Reserve has announced that these purchases will be completed by
April 2010.\612\
---------------------------------------------------------------------------
\611\ Board of Governors of the Federal Reserve System, Minutes of
the Federal Open Market Committee, at 10 (Dec. 15-16, 2009) (online at
www.federalreserve.gov/newsevents/press/monetary/
fomcminutes20091216.pdf) (``[T]he Federal Reserve is in the process of
purchasing $1.25 trillion of agency mortgage-backed securities and
about $175 billion of agency debt'').
\612\ Board of Governors of the Federal Reserve System, FOMC
Statement (Dec. 16, 2009) (online at www.federalreserve.gov/newsevents/
press/monetary/20091216a.htm) (``In order to promote a smooth
transition in markets, the Committee is gradually slowing the pace of
these purchases, and it anticipates that these transactions will be
executed by the end of the first quarter of 2010''); Board of Governors
of the Federal Reserve System, Factors Affecting Reserve Balances (Feb.
4, 2010) (online at www.federalreserve.gov/Releases/H41/Current/).
---------------------------------------------------------------------------
FIGURE 57: FEDERAL RESERVE AND FDIC FINANCIAL STABILITY EFFORTS \613\
---------------------------------------------------------------------------
\613\ Federal Reserve Liquidity Facilities include: Primary credit,
Secondary credit, Central Bank Liquidity Swaps, Primary dealer and
other broker-dealer credit, Asset-Backed Commercial Paper Money Market
Mutual Fund Liquidity Facility, Net portfolio holdings of Commercial
Paper Funding Facility LLC, Seasonal credit, Term auction credit, Term
Asset-Backed Securities Loan Facility. Federal Reserve Mortgage Related
Facilities Include: Federal agency debt securities and Mortgage-backed
securities held by the Federal Reserve. Institution Specific Facilities
include: Credit extended to American International Group, Inc., and the
net portfolio holdings of Maiden Lanes I, II, and III. Board of
Governors of the Federal Reserve System, Factors Affecting Reserve
Balances (H.4.1) (online at www.federalreserve.gov/datadownload/
Choose.aspx?rel=H41) (accessed Feb. 4, 2010). For related presentations
of Federal Reserve data, see Board of Governors of the Federal Reserve
System, Credit and Liquidity Programs and the Balance Sheet, at 2 (Nov.
2009) (online at www.federalreserve.gov/monetarypolicy/files/
monthlyclbsreport200911.pdf). The TLGP figure reflects the monthly
amount of debt outstanding under the program. Federal Deposit Insurance
Corporation, Monthly Reports on Debt Issuance Under the Temporary
Liquidity Guarantee Program (Dec. 2008-Dec. 2009) (online at
www.fdic.gov/regulations/resources/TLGP/reports.html).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
3. Total Financial Stability Resources (as of December 31, 2009)
Beginning in its April report, the Panel broadly classified
the resources that the federal government has devoted to
stabilizing the economy through myriad new programs and
initiatives as outlays, loans, or guarantees. Although the
Panel calculates the total value of these resources at nearly
$3 trillion, this would translate into the ultimate ``cost'' of
the stabilization effort only if: (1) assets do not appreciate;
(2) no dividends are received, no warrants are exercised, and
no TARP funds are repaid; (3) all loans default and are written
off; and (4) all guarantees are exercised and subsequently
written off.
With respect to the FDIC and Federal Reserve programs, the
risk of loss varies significantly across the programs
considered here, as do the mechanisms providing protection for
the taxpayer against such risk. As discussed in the Panel's
November report, the FDIC assesses a premium of up to 100 basis
points on TLGP debt
guarantees.\614\ In contrast, the Federal Reserve's liquidity
programs are generally available only to borrowers with good
credit, and the loans are over-collateralized and with recourse
to other assets of the borrower. If the assets securing a
Federal Reserve loan realize a decline in value greater than
the ``haircut,'' the Federal Reserve is able to demand more
collateral from the borrower. Similarly, should a borrower
default on a recourse loan, the Federal Reserve can turn to the
borrower's other assets to make the Federal Reserve whole. In
this way, the risk to the taxpayer on recourse loans only
materializes if the borrower enters bankruptcy. The only loan
currently ``underwater''--where the outstanding principal
amount exceeds the current market value of the collateral--is
the loan to Maiden Lane LLC, which was formed to purchase
certain Bear Stearns assets.
---------------------------------------------------------------------------
\614\ Congressional Oversight Panel, Guarantees and Contingent
Payments in TARP and Related Programs, at 36 (Nov. 11, 2009) (online at
cop.senate.gov/documents/cop-110609-report.pdf).
FIGURE 58: FEDERAL GOVERNMENT FINANCIAL STABILITY EFFORT (AS OF DECEMBER 31, 2009)
[Dollars in billions]
----------------------------------------------------------------------------------------------------------------
Treasury Federal
Program (TARP) Reserve FDIC Total
----------------------------------------------------------------------------------------------------------------
Total........................................... $698.7 $1,518.6 $646.4 $2,863.7
Outlays \i\................................. 286.8 1,136.1 69.4 1,492.3
Loans....................................... 42.7 382.6 0 425.3
Guarantees ii............................... 20 0 577 597
Uncommitted TARP Funds...................... 349.2 0 0 349.2
AIG............................................. 69.8 68.2 0 138.5
Outlays..................................... \iii\ 69.8 0 0 69.8
Loans....................................... 0 iv 68.2 0 68.7
Guarantees.................................. 0 0 0 0
Bank of America................................. 0 0 0 0
Outlays..................................... v 0 0 0 0
Loans....................................... 0 0 0 0
Guarantees.................................. 0 0 0 0
Citigroup....................................... 25 0 0 25
Outlays..................................... vi 25 0 0 25
Loans....................................... 0 0 0 0
Guarantees.................................. 0 0 0 0
Capital Purchase Program (Other)................ 58 0 0 58
Outlays..................................... vii 58 0 0 58
Loans....................................... 0 0 0 0
Guarantees.................................. 0 0 0 0
Capital Assistance Program...................... N/A 0 0 viii N/A
TALF............................................ 20 180 0 200
Outlays..................................... 0 0 0 0
Loans....................................... 0 x 180 0 180
Guarantees.................................. ix 20 0 0 20
PPIP (Loans) xi................................. 0 0 0 0
Outlays..................................... 0 0 0 0
Loans....................................... 0 0 0 0
Guarantees.................................. 0 0 0 0
PPIP (Securities)............................... xii 30 0 0 30
Outlays..................................... 10 0 0 10
Loans....................................... 20 0 0 20
Guarantees.................................. 0 0 0 0
Home Affordable Modification Program............ 50 0 0 xiv 50
Outlays..................................... xiii50 0 0 50
Loans....................................... 0 0 0 0
Guarantees.................................. 0 0 0 0
Automotive Industry Financing Program........... xv78.2 0 0 78.2
Outlays..................................... 59 0 0 59
Loans....................................... 19.2 0 0 19.2
Guarantees.................................. 0 0 0 0
Auto Supplier Support Program................... 3.5 0 0 3.5
Outlays..................................... 0 0 0 0
Loans....................................... xvi3.5 0 0 3.5
Guarantees.................................. 0 0 0 0
Unlocking SBA Lending........................... xvii 15 0 0 15
Outlays..................................... 15 0 0 15
Loans....................................... 0 0 0 0
Guarantees.................................. 0 0 0 0
Temporary Liquidity Guarantee Program........... 0 0 577 577
Outlays..................................... 0 0 0 0
Loans....................................... 0 0 0 0
Guarantees.................................. 0 0 xviii 577 577
Deposit Insurance Fund.......................... 0 0 69.4 69.4
Outlays..................................... 0 0 xix 69.4 69.4
Loans....................................... 0 0 0 0
Guarantees.................................. 0 0 0 0
Other Federal Reserve Credit Expansion.......... 0 1,270.4 0 1,270.4
Outlays..................................... 0 xx 1,136 0 1,136.1
Loans....................................... 0 xxi 134.4 0 134.4
Guarantees.................................. 0 0 0 0
Uncommitted TARP Funds.......................... 349.2 0 0 349.2
----------------------------------------------------------------------------------------------------------------
\i\ The term ``outlays'' is used here to describe the use of Treasury funds under the TARP, which are broadly
classifiable as purchases of debt or equity securities (e.g., debentures, preferred stock, exercised warrants,
etc.). The outlays figures are based on: (1) Treasury's actual reported expenditures; and (2) Treasury's
anticipated funding levels as estimated by a variety of sources, including Treasury pronouncements and GAO
estimates. Anticipated funding levels are set at Treasury's discretion, have changed from initial
announcements, and are subject to further change. Outlays used here represent investment and asset purchases
and commitments to make investments and asset purchases and are not the same as budget outlays, which under
section 123 of EESA are recorded on a ``credit reform'' basis.
\ii\ Although many of the guarantees may never be exercised or exercised only partially, the guarantee figures
included here represent the federal government's greatest possible financial exposure.
\iii\ This number includes investments under the AIGIP/SSFI Program: a $40 billion investment made on November
25, 2008, and a $30 billion investment committed on April 17, 2009 (less a reduction of $165 million
representing bonuses paid to AIG Financial Products employees). As of January 5, 2010, AIG had utilized $45.3
billion of the available $69.8 billion under the AIGIP/SSFI and owed $1.6 billion in unpaid dividends. This
information was provided by Treasury in response to a Panel inquiry.
\iv\ This number represents the full $35 billion that is available to AIG through its revolving credit facility
with the Federal Reserve ($24.4 billion had been drawn down as of January 28, 2010) and the outstanding
principal of the loans extended to the Maiden Lane II and III SPVs to buy AIG assets (as of December 31, 2009,
$15.5 billion and $17.7 billion respectively). Income from the purchased assets is used to pay down the loans
to the SPVs, reducing the taxpayers' exposure to losses over time. Board of Governors of the Federal Reserve
System, Federal Reserve System Monthly Report on Credit and Liquidity Programs and the Balance Sheet, at 17
(Oct. 2009) (online at www.federalreserve.gov/monetarypolicy/files/monthlyclbsreport200910.pdf). On December
1, 2009, AIG entered into an agreement with FRBNY to reduce the debt AIG owes the FRBNY by $25 billion. In
exchange, FRBNY received preferred equity interests in two AIG subsidiaries. This also reduced the debt
ceiling on the loan facility from $60 billion to $35 billion. American International Group, AIG Closes Two
Transactions That Reduce Debt AIG Owes Federal Reserve Bank of New York by $25 billion (Dec. 1, 2009) (online
at phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MjE4OD18Q2hpbGRJRD0tMXxUeXB1PTM=&t=1).
\v\ Bank of America repaid the $45 billion in assistance it had received through TARP programs on December 9,
2009. U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending
February 1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\vi\ As of February 4, 2009, the U.S. Treasury held $25 billion of Citigroup common stock. U.S. Department of
the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending February 1, 2010 (Feb. 2,
2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\vii\ This figure represents the $204.9 billion Treasury has disbursed under the CPP, minus the $25 billion
investment in Citigroup ($25 billion) identified above, and the $121.9 billion in repayments that are
reflected as available TARP funds. This figure does not account for future repayments of CPP investments, nor
does it account for dividend payments from CPP investments. U.S. Department of the Treasury, Troubled Asset
Relief Program Transaction Report for Period Ending February 1, 2010 (Feb. 2, 2010) (online at
www.financialstability.gov/docs/transaction-reports/2-3-10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\viii\ On November 9, 2009, Treasury announced the closing of the CAP and that only one institution, GMAC, was
in need of further capital from Treasury. GMAC, however, received further funding through the AIFP, therefore
the Panel considers CAP unused and closed. U.S. Department of the Treasury, Treasury Announcement Regarding
the Capital Assistance Program (Nov. 9, 2009) (online at www.financialstability.gov/latest/tg_11092009.html).
\ix\ This figure represents a $20 billion allocation to the TALF SPV on March 3, 2009. However, as of January
28, 2010, TALF LLC had drawn only $103 million of the available $20 billion. Board of Governors of the Federal
Reserve System, Factors Affecting Reserve Balances (H.4.1) (Jan. 28, 2010) (online at www.federalreserve.gov/
Releases/H41/Current/); U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for
Period Ending February 1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-
3-10%20Transactions%20Report%20as%20of%202-1-10.pdf). As of January 28, 2010, investors had requested a total
of $65.7 billion in TALF loans ($10.7 billion in CMBS and $55 billion in non-CMBS) and $64 billion in TALF
loans had been settled ($10 billion in CMBS and $54 billion in non-CMBS). Federal Reserve Bank of New York,
Term Asset-Backed Securities Loan Facility: CMBS (accessed Feb. 4, 2010) (online at www.newyorkfed.org/markets/
CMBS_recent_operations.html); Federal Reserve Bank of New York, Term Asset-Backed Securities Loan Facility:
non-CMBS (accessed Feb. 4, 2010) (online at www.newyorkfed.org/markets/talf_operations.html).
\x\ This number is derived from the unofficial 1:10 ratio of the value of Treasury loan guarantees to the value
of Federal Reserve loans under the TALF. U.S. Department of the Treasury, Fact Sheet: Financial Stability Plan
(Feb.10, 2009) (online at www.financialstability.gov/docs/fact-sheet.pdf) (describing the initial $20 billion
Treasury contribution tied to $200 billion in Federal Reserve loans and announcing potential expansion to a
$100 billion Treasury contribution tied to $1 trillion in Federal Reserve loans). Because Treasury is
responsible for reimbursing the Federal Reserve Board for $20 billion of losses on its $200 billion in loans,
the Federal Reserve Board's maximum potential exposure under the TALF is $180 billion.
\xi\ It is unlikely that resources will be expended under the PPIP Legacy Loans Program in its original design
as a joint Treasury-FDIC program to purchase troubled assets from solvent banks. See also Federal Deposit
Insurance Corporation, FDIC Statement on the Status of the Legacy Loans Program (June 3, 2009) (online at
www.fdic.gov/news/news/press/2009/pr09084.html) and Federal Deposit Insurance Corporation, Legacy Loans
Program--Test of Funding Mechanism (July 31, 2009) (online at www.fdic.gov/news/news/press/2009/pr09131.html).
The sales described in these statements do not involve any Treasury participation, and FDIC activity is
accounted for here as a component of the FDIC's Deposit Insurance Fund outlays.
\xii\ As of February 4, 2010, Treasury reported commitments of $19.9 billion in loans and $9.9 billion in
membership interest associated with the program. U.S. Department of the Treasury, Troubled Asset Relief
Program Transaction Report for Period Ending February 1, 2010 (Feb. 2, 2010) (online at
www.financialstability.gov/docs/transaction-reports/2-3-10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\xiii\ U.S. Government Accountability Office, Troubled Asset Relief Program: June 2009 Status of Efforts to
Address Transparency and Accountability Issues, at 2 (June 17, 2009) (GAO09/658) (online at www.gao.gov/
new.items/d09658.pdf). Of the $50 billion in announced TARP funding for this program, $36.9 billion has been
allocated as of February 4, 2010. However, as of January 10, 2010, only $32 million in non-GSE payments have
been disbursed under HAMP. Disbursement information provided in response to Panel inquiry on February 4, 2010;
U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending February
1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\xiv\ Fannie Mae and Freddie Mac, government-sponsored entities (GSEs) that were placed in conservatorship of
the Federal Housing Finance Agency on September 7, 2009, will also contribute up to $25 billion to the Making
Home Affordable Program, of which the HAMP is a key component. U.S. Department of the Treasury, Making Home
Affordable: Updated Detailed Program Description (Mar. 4, 2009) (online at www.treas.gov/press/releases/
reports/housing_fact_sheet.pdf).
\xv\ See U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending
February 1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
10%20Transactions%20Report%20as%20of%202-1-10.pdf). A substantial portion of the total $81 billion in loans
extended under the AIFP have since been converted to common equity and preferred shares in restructured
companies. $19.2 billion has been retained as first lien debt (with $6.7 billion committed to GM, $12.5
billion to Chrysler). This figure ($78.2 billion) represents Treasury's current obligation under the AIFP
after repayments.
\xvi\ See U.S. Department of the Treasury, Troubled Asset Relief Program Transaction Report for Period Ending
February 1, 2010 (Feb. 2, 2010) (online at www.financialstability.gov/docs/transaction-reports/2-3-
10%20Transactions%20Report%20as%20of%202-1-10.pdf).
\xvii\ U.S. Department of the Treasury, Fact Sheet: Unlocking Credit for Small Businesses (Oct. 19, 2009)
(online at www.financialstability.gov/roadtostability/unlockingCreditforSmallBusinesses.html) (``Jumpstart
Credit Markets For Small Businesses By Purchasing Up to $15 Billion in Securities'').
\xviii\ This figure represents the current maximum aggregate debt guarantees that could be made under the
program, which, in turn, is a function of the number and size of individual financial institutions
participating. $309 billion of debt subject to the guarantee has been issued to date, which represents about
54 percent of the current cap. Federal Deposit Insurance Corporation, Monthly Reports on Debt Issuance Under
the Temporary Liquidity Guarantee Program: Debt Issuance Under Guarantee Program (Dec. 31, 2009) (online at
www.fdic.gov/regulations/resources/tlgp/total_issuance12-09.html) (updated Feb. 4, 2010). The FDIC has
collected $10.5 billion in fees and surcharges from this program since its inception in the fourth quarter of
2008. Federal Deposit Insurance Corporation, Monthly Reports on Debt Issuance Under the Temporary Liquidity
Guarantee Program (Nov. 30, 2009) (online at www.fdic.gov/regulations/resources/TLGP/fees.html) (updated Feb.
4, 2010).
\xix\ This figure represents the FDIC's provision for losses to its deposit insurance fund attributable to bank
failures in the third and fourth quarters of 2008 and the first, second and third quarters of 2009. Federal
Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF Income Statement
(Fourth Quarter 2008) (online at www.fdic.gov/about/strategic/corporate/cfo_report_4qtr_08/income.html);
Federal Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF Income
Statement (Third Quarter 2008) (online at www.fdic.gov/about/strategic/corporate/cfo_report_3rdqtr_08/
income.html); Federal Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF
Income Statement (First Quarter 2009) (online at www.fdic.gov/about/strategic/corporate/cfo_report_1stqtr_09/
income.html); Federal Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF
Income Statement (Second Quarter 2009) (online at www.fdic.gov/about/strategic/corporate/cfo_report_2ndqtr_09/
income.html); Federal Deposit Insurance Corporation, Chief Financial Officer's (CFO) Report to the Board: DIF
Income Statement (Third Quarter 2009) (online at www.fdic.gov/about/strategic/corporate/cfo_report_3rdqtr_09/
income.html). This figure includes the FDIC's estimates of its future losses under loss-sharing agreements
that it has entered into with banks acquiring assets of insolvent banks during these four quarters. Under a
loss-sharing agreement, as a condition of an acquiring bank's agreement to purchase the assets of an insolvent
bank, the FDIC typically agrees to cover 80 percent of an acquiring bank's future losses on an initial portion
of these assets and 95 percent of losses of another portion of assets. See, for example Federal Deposit
Insurance Corporation, Purchase and Assumption Agreement Among FDIC, Receiver of Guaranty Bank, Austin, Texas,
FDIC and Compass Bank at 65-66 (Aug. 21, 2009) (online at www.fdic.gov/bank/individual/failed/guaranty-
tx_p_and_a_w_addendum.pdf). In information provided to Panel staff, the FDIC disclosed that there were
approximately $132 billion in assets covered under loss-sharing agreements as of December 18, 2009.
Furthermore, the FDIC estimates the total cost of a payout under these agreements to be $59.3 billion. Since
there is a published loss estimate for these agreements, the Panel continues to reflect them as outlays rather
than as guarantees.
\xx\ Outlays are comprised of the Federal Reserve Mortgage Related Facilities. The Federal Reserve balance sheet
accounts for these facilities under Federal agency debt securities and mortgage-backed securities held by the
Federal Reserve. Board of Governors of the Federal Reserve System, Factors Affecting Reserve Balances (H.4.1)
(online at www.federalreserve.gov/datadownload/Choose.aspx?rel=H41) (accessed Feb. 4, 2010). Although the
Federal Reserve does not employ the outlays, loans and guarantees classification, its accounting clearly
separates its mortgage-related purchasing programs from its liquidity programs. See Board of Governors of the
Federal Reserve, Credit and Liquidity Programs and the Balance Sheet November 2009, at 2 (online at
www.federalreserve.gov/monetarypolicy/files/monthlyclbsreport200911.pdf) (accessed Dec. 7, 2009).
\xxi\ Federal Reserve Liquidity Facilities classified in this table as loans include: Primary credit, Secondary
credit, Central bank liquidity swaps, Primary dealer and other broker-dealer credit, Asset-Backed Commercial
Paper Money Market Mutual Fund Liquidity Facility, Net portfolio holdings of Commercial Paper Funding Facility
LLC, Seasonal credit, Term auction credit, Term Asset-Backed Securities Loan Facility, and loans outstanding
to Bear Stearns (Maiden Lane I LLC). Board of Governors of the Federal Reserve System, Factors Affecting
Reserve Balances (H.4.1) (online at www.federalreserve.gov/datadownload/Choose.aspx?rel=H41) (accessed Feb. 4,
2010); see id.
SECTION SIX: OVERSIGHT ACTIVITIES
The Congressional Oversight Panel was established as part
of EESA and formed on November 26, 2008. Since then, the Panel
has produced 14 oversight reports, as well as a special report
on regulatory reform, issued on January 29, 2009, and a special
report on farm credit, issued on July 21, 2009. Since the
release of the Panel's January oversight report, which assessed
Treasury's exit strategy for the TARP, the following
developments pertaining to the Panel's oversight of the TARP
took place:
The Panel held a field hearing in Atlanta, Georgia
on January 27, 2010, discussing the state of commercial real
estate lending, the potential effect of commercial real estate
problems on the banking system, and the role and impact of the
TARP in addressing that effect. The Panel heard testimony from
regulators at the FDIC and the Federal Reserve as well as from
a number of participants in the commercial real estate
industry. An audio recording of the hearing, the written
testimony from the hearing witnesses, and Panel members'
opening statements all can be found online at http://
cop.senate.gov/hearings.
Upcoming Reports and Hearings
The Panel will release its next oversight report in March.
The report will address the assistance provided to GMAC under a
wide array of TARP initiatives as well as the approach taken by
GMAC's new management to return the company to profitability
and, ultimately, return the taxpayers' investment.
The Panel is planning a hearing in Washington on February
25, 2010 to discuss the topic of the March report. The Panel is
hoping to ask Treasury officials to explain their approach to
and reasons for providing assistance to GMAC and to hear
details from GMAC executives about their plans for the future
of the company.
SECTION SEVEN: ABOUT THE CONGRESSIONAL OVERSIGHT PANEL
In response to the escalating financial crisis, on October
3, 2008, Congress provided Treasury with the authority to spend
$700 billion to stabilize the U.S. economy, preserve home
ownership, and promote economic growth. Congress created the
Office of Financial Stability (OFS) within Treasury to
implement the Troubled Asset Relief Program. At the same time,
Congress created the Congressional Oversight Panel to ``review
the current state of financial markets and the regulatory
system.'' The Panel is empowered to hold hearings, review
official data, and write reports on actions taken by Treasury
and financial institutions and their effect on the economy.
Through regular reports, the Panel must oversee Treasury's
actions, assess the impact of spending to stabilize the
economy, evaluate market transparency, ensure effective
foreclosure mitigation efforts, and guarantee that Treasury's
actions are in the best interests of the American people. In
addition, Congress instructed the Panel to produce a special
report on regulatory reform that analyzes ``the current state
of the regulatory system and its effectiveness at overseeing
the participants in the financial system and protecting
consumers.'' The Panel issued this report in January 2009.
Congress subsequently expanded the Panel's mandate by directing
it to produce a special report on the availability of credit in
the agricultural sector. The report was issued on July 21,
2009.
On November 14, 2008, Senate Majority Leader Harry Reid and
the Speaker of the House Nancy Pelosi appointed Richard H.
Neiman, Superintendent of Banks for the State of New York,
Damon Silvers, Director of Policy and Special Counsel of the
American Federation of Labor and Congress of Industrial
Organizations (AFL-CIO), and Elizabeth Warren, Leo Gottlieb
Professor of Law at Harvard Law School, to the Panel. With the
appointment on November 19, 2008, of Congressman Jeb Hensarling
to the Panel by House Minority Leader John Boehner, the Panel
had a quorum and met for the first time on November 26, 2008,
electing Professor Warren as its chair. On December 16, 2008,
Senate Minority Leader Mitch McConnell named Senator John E.
Sununu to the Panel. Effective August 10, 2009, Senator Sununu
resigned from the Panel, and on August 20, 2009, Senator
McConnell announced the appointment of Paul Atkins, former
Commissioner of the U.S. Securities and Exchange Commission, to
fill the vacant seat. Effective December 9, 2009, Congressman
Jeb Hensarling resigned from the Panel and House Minority
Leader John Boehner announced the appointment of J. Mark
McWatters to fill the vacant seat.
ACKNOWLEDGEMENTS
The Panel wishes to acknowledge Richard Parkus, head of
Commercial Real Estate Debt Research, and Harris Trifon,
analyst, Deutsche Bank; Gail Lee, managing director at Credit
Suisse; Matthew Anderson, partner, Foresight Analytics LLC;
Nick Levidy, managing director, Moody's Investor Services;
Robert White, president, Real Capital Analytics, Inc.; Jeffrey
DeBoer, president and chief executive officer, The Real Estate
Roundtable; and David Geltner, director of research,
Massachusetts Institute of Technology Center for Real Estate
for the contributions each has made to this report.
APPENDIX I: LETTER FROM SECRETARY TIMOTHY GEITHNER TO CHAIR ELIZABETH
WARREN, RE: PANEL QUESTIONS FOR CIT GROUP UNDER CPP, DATED
JANUARY 13, 2010
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