What is Plan C and How Will They Solve the CRE Conundrum

The Washington Post has a good article on the Treasury Department’s new task force charged with closing the barn door now that the horses are long gone. It’s called Plan C and their job is to figure out where the next disaster might be lurking in the financial system.

That’s how the Post describes their job. I, on the other hand would suggest that we pretty much know where the problems lie, it’s simply an issue of figuring out how to cope with them. The list includes all the usual suspects, consumer loans, credit cards and of course the elephant in the room, commercial real estate.

The article does a good job highlighting the looming disaster that is CRE:

The officials in charge of Plan C — named to allude to a last line of defense — face a particular challenge in addressing the breakdown of commercial real estate lending.

Banks and other firms that provided such loans in the past have sharply curtailed lending.

That has left many developers and construction companies out in the cold. Over the next few years, these groups face a tidal wave of commercial real estate debt — some estimates peg the total at more than $3 trillion — that they will need to refinance. These loans were issued during this decade’s construction boom with the mistaken expectation that they would be refinanced on the same generous terms after a few years.

The credit crisis changed all of that. Now few developers can find anyone to refinance their debt, endangering healthy and distressed properties.

General Growth Properties, which owns the Tysons Galleria mall in Northern Virginia, one of the most profitable shopping centers in the nation, filed for bankruptcy this spring after it could not roll over its loans. The John Hancock Tower in Boston, one of the city’s most famous landmarks, was auctioned off after its owner defaulted on its debt.

“There’s going to be a lot of these stories where people relied very heavily on this high-leverage cheap availability of debt,” said Kevin Smith of Blackwell Advisors, a financial consultancy.

Kim Diamond, a managing director at Standard & Poor’s, said the trend is expected to accelerate over the next few years, further depressing prices on some of the nation’s most valuable properties.

“It’s not a degree to which people are willing to lend,” she said. “The question is whether a loan can be made at all.”

The problem affects not just the recipients of the loans but also the institutions that lend, many of them small community banks and regional firms.

Thousands of these institutions wrote billions of dollars in mortgages on strip malls, doctors offices and drive-through restaurants. These commercial loans required a lot of scrutiny and a leap of faith, and, for much of the decade, the smaller banks that leapt were rewarded with outsize profits.

In doing so, many took on bigger and bigger risks. By the beginning of the recession in December 2007, the median midsize bank held commercial real estate loans worth 3.55 times its capital cushion — its reserve against unexpected losses — according to the Federal Deposit Insurance Corp.

Borrower defaults increasingly are draining capital from many of those banks, forcing some to close. Financial analysts said losses on commercial real estate loans are now the single largest cause of bank failures.

A lot of that is probably of no surprise to you if you read this blog or those of others who are following the slow motion destruction of CRE. But one thing in the piece I excerpted really hit me between the eyes. Look at it outside of the article:

In doing so, many took on bigger and bigger risks. By the beginning of the recession in December 2007, the median midsize bank held commercial real estate loans worth 3.55 times its capital cushion — its reserve against unexpected losses — according to the Federal Deposit Insurance Corp.

The first thing I asked myself when I read this was where have the regulators been. No matter what the asset or how exotic it might be, the one thing that will kill a bank quicker than anything else is an over concentration of loans in one asset class. How could they have allowed the banks to build up such a dangerous concentration of loans? We talking about small to medium-sized banks here, not the behemoths. They’re not that difficult to examine, there isn’t that much complexity.

In reality, the exposure to commercial real estate is probably understated. It’s not at all uncommon that the security backstopping what might appear to be commercial loans to small businesses and entrepreneurs is in fact some form of real estate. Sometimes a personal residence, but often raw land, the physical plant for the business or other commercial real estate that the borrower might have picked up for investment and pledged to secure the loan.

By allowing this concentration to develop the regulators have left themselves with very little room to solve the problem. Given the deterioration in the value of commercial real estate any event that forces the banks to value the property at current prices would surely exhaust their loan loss reserves and begin eating into capital. Smaller banks don’t have the earnings capacity of larger banks, particularly in this economy, so growing out of their problems is not nearly so viable a recapitalization alternative.

Private equity might recapitalize some of the more attractive banks but that will cover a small fraction. It seems unlikely that a PPIP or anything of that nature will work because the writedowns will fracture the banks’ balance sheets. There’s just too much exposure.

The Plan C boys have their work cut out for them trying to untie this Gordian Knot. My guess is that they have to use a lot of taxpayer dollars to work out the problem.

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