Global Economic Crisis

“Commercial real estate is the next shoe to drop.”

James Helsel, Treasurer of the U.S. National Association of Realtors

 
Pennsylvania realtor and U.S. National Association of Realtors official James Helsel joined with other concerned parties in meeting with a congressional committee last week, conveying a collective message that was saturated with gloom and doom. A commercial real estate implosion has been predicted for months by many observers, including this writer. There is now mounting evidence that this sector of the economy is indeed in the grips of a severe contraction, with all indicators pointing to an accelerating price deflation spiral over a period that may extend to several years.

It has all happened before. In the early 1990s speculators drove the valuations on commercial space far beyond the bounds of prudence. When reality caught up, the worst crash in real estate prices ensued. It now seems increasingly clear that this early 90`s disaster is about to be eclipsed by the commercial real estate crash of the current Global Economic Crisis. In fact, commercial real estate prices have already fallen from their 2007 peak valuation by a greater figure than that which has crippled the U.S. residential housing market. As with the housing market, the commercial real estate contraction will adversely affect the balance sheets of the nation’s banks. However, the dynamics of that impact will be qualitatively different.

The subprime debacle in the housing market overwhelmingly impacted the largest U.S. banks and financial institutions. With commercial real estate, however, the pyramid becomes inverted. The bulk of the exposure to commercial real estate mortgages is held by financial institutions of small to medium size. Deutsche Bank real estate analyst Richard Parkus told the same congressional committee addressed by James Helsel that the four largest American banks have an average exposure of 2 percent to commercial real estate on their balance sheets. In contrast, the banking institutions that ranked between 30 to 100 in order of size had on average a 12 percent exposure to commercial real estate mortgages. What these figures suggest is that a massive collapse in the U.S. commercial real estate market will cripple a large number of regional and community banks, in comparison to a few “too large to fail“  institutions stricken by the subprime housing disaster.

Though publicly quiet on this gathering storm, behind the scenes the economic policymakers in the Obama administration are deeply worried by this growing danger of a wider banking crisis brought on by a massive collapse in commercial real estate. The Federal Reserve is also in a state of high anxiety, for the same reasons. By June of this year, there were already 5,315 commercial properties in default, a figure that is more than double the number of commercial real estate defaults in all of 2008.

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Many loans initiated when the prices of commercial properties were at their peak will be coming due over the next 3 years, including $400 billion by the end of 2009, and nearly $2 trillion by 2012. With unemployment skyrocketing, real disposable income shrinking and nearly 7% of income now being saved by the chastened American consumer, it is a foregone conclusion that a greater proportion of these loans will become non-performing. In the current economic climate, there are simply no options available in terms of refinancing and securitization. As with housing, a glut of foreclosed commercial properties will further depress prices, creating a vicious concentric circle of financial doom.

Ultimately, the coming collapse in the U.S. commercial real estate market is not only inevitable; it is round two of the banking crisis. Having barely escaped alive from the consequences of the subprime housing collapse due to trillions of dollars in taxpayer aid and quantitative easing from the Federal Reserve, combined with Timothy Geithner’s stage-managed “Stress Test,“ it is difficult to see an escape route for the American banking sector once the ravages of the commercial real estate storm have hit with gale force. That must be what the Obama administration and the Fed are frantically consulting on behind the scenes, hoping against hope that they have a TARP 2 ready in time. In the final analysis, a very large number of small to medium sized banks in trouble can pose just as great a systemic risk to the global financial system as was the case with a small number of banking giants. What happens to the concept of “too big to fail“  in that scenario?

A few weeks before these antics a more sober assessment of America’s banking health was delivered at the National Press Club in Washington by Dr. Martin D. Weiss, the head of Weiss Research, a global investment research firm. Previously, Weiss had accurately forecast the demise of Bear Stearns and the implosion of the U.S. investment-banking sector. However, at the National Press Club he offered a more chilling prediction: 1,568 U.S. banks and thrifts risk failure. Included in that number are several of the largest American banks, including J.P. Morgan Chase, Goldman Sachs, Citigroup, Wells Fargo, Sun Trust Bank and HSBC Bank USA. The numbers and depth of the banking problem highlighted by Dr. Weiss are far larger and much more ominous than has been portrayed by the Federal Reserve, Treasury Department and FDIC. He backed up his dire analysis with documentation and precise mathematical modeling. For example, he refers to the government’s justification for a hideously expensive taxpayer bailout of AIG, based on the firm’s exposure to the fragile investment vehicles known as Credit Default Swaps, or CDS. The policymakers maintain that AIG’s $2 trillion in CDS exposure represented an unacceptable systemic risk, meaning AIG was “too big to fail.” However, Weiss points out that Citigroup alone holds a portfolio of $2.9 trillion in Credit Default Swaps, while J.P. Morgan Chase possesses a staggering $9.2 trillion of these toxic instruments, about five times the exposure that led AIG to demand that the government rescue it, or see the global financial system implode.

The essential point Dr. Weiss made at his press conference is that the degree of exposure U.S. banks have to a variety of toxic assets is beyond what the U.S. government and, by extension, the American taxpayer is financially capable of rescuing. Continued bailouts of insolvent banking institutions will not repair a broken financial order, but may very well cripple the overall economy.

Earlier, NYU economics professor Nouriel Roubini had already gone on record as declaring that much of the U.S. banking sector was functionally insolvent, and that bailing out zombie financial institutions would only replicate the Japanese “lost decade” of the 1990s, when Tokyo’s preference for keeping alive insolvent banks instead of closing them down led to a prolonged L-shaped recession. Roubini and other critics of both Bush and Obama administration policies on bank bailouts have looked to the Swedish model for resolving a profound banking crisis, which involved temporary short-term nationalization, closing down insolvent banks, while those banks that can be salvaged are cleaned up of their toxic assets, recapitalized and then sold back to the private sector. “You have to take them over and you have to split them up into three or four national banks, rather than having a humongous monster that is too big to fail,” Nouriel Roubini has argued.

According to the International Monetary Fund, the global financial and economic crisis has already created more than $4 trillion in credit losses due to toxic assets. If nothing else, the IMF estimate on the scale of the economic and financial disaster thus far should compel the Washington political establishment to face the painful yet necessary truths regarding America’s precarious situation. However, it appears that fantasy is preferred over reality within the corridors of power.

The procrastination of policymakers in Washington in facing dark reality, and preference to avoid any public takeover of troubled banking institutions while simultaneously subsidizing these financial dead men walking with almost unlimited taxpayer funds, at the same time maintaining the fiction, as Timothy Geithner has just done, that all is basically fine with the “vast majority” of U.S. banks, is to insure the inevitability of a systemic banking collapse in the United States. The conglomeration of reckless, greed-induced banking practices by the oligarchs of finance and inept, reality-denying policymakers is sending much of the American banking sector on a Wagnerian death ride into a financial apocalypse. Many of the U.S. banks are in fact doomed to fail, and no contrived stress test or Geithner speech can alter that outcome. And that isn’t even the worst part. For when mass banking failures occur in the United States and overseas, a global economic depression will be an irreversible outcome.