It May be DeJa Vu All Over Again

February 11, 2010: Elizabeth Warren (1), the Chairwoman appointed by Harry Reid in the fall of 2008 to lead the Congressional Oversight Panel formed to oversee the Seven Hundred Billion Dollar ($700,000,000,000) Toxic Asset Relief Program (TARP), has been an advocate and champion for the “middle class working family” for the past ten years or so. Early this decade, she completed a study of how a family composed of a married couple and two children have actually become poorer during the period from 1970 to 2003. She has predicted the bankruptcy of the Middle Class family unless the problem of the “rich getting richer” and the middle and underclass becoming poorer is solved. This is called “redistribution of wealth” folks.

Looking strictly at the data she offers and the absolute changes therein, adjusted for inflation, it is difficult to dispute her conclusion. But, when you look at the real value of the progression of this so called middle class family’s struggle during this same period, there has been a ratcheting up of the quality of life. They enjoy the availability of everyday higher and higher advancements in technology that has given them automobiles and unparalled efficiencies in transportation, advances in media-entertainment communication, medical and pharmaceutical discoveries, better trained providers of health care services, improved opportunities for education, and of course the ability to see the whole world at your desktop computer through the Internet, etc., I believe her conclusion may be flawed. Nevertheless, I think we will be hearing a lot from Ms. Warren about how financial institutions requested by the consumer to fund these goodies are exploiting the middle class, notwithstanding their voluntary leveraging into more expensive housing. transportation and the questionable pursuit of life styles of the rich and famous.

In her new role as Chairman of the COP Committee, she is holding monthly hearings on the results of TARP and has begun to focus on the condition of the Commercial Real Estate Market and the potential threat that a new wave of foreclosures may be upon us beginning later this year unless someone (the Government) does something about it. This is almost certainly going to be the recommendation of her committee.

Here are some of the facts: According to Jon Greenlee, Associate Director of the Division of Bank Supervision and Regulation of the Board of Governors of the Federal Reserve System, Federal Reserve examiners are reporting sharp deterioration in the credit performance of loans in bank portfolios and loans in Commercial Mortgage Backed Securities (CMBS). Of the approximately $3.5 trillion of outstanding debt associated with Commercial Real Estate, including loans for multifamily housing developments, about $1.7 trillion was held on the books of banks and thrifts and an additional $900 billion represented collateral for commercial mortgage-backed securities, with other investors holding the remaining balance of $900 billion. More than $500 billion will mature each year over the next few years. In addition to losses caused by declining property cash flows (rents and lease income, etc.) and deteriorating condition for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. These losses will continue to put pressure on bank’s earnings especially those of smaller regional and community banks that have a high concentration of them.

Before the 2007-2009 financial industry meltdown, securitization markets were an important conduit of credit to the household and business sectors. This market essentially shut down in mid 2008 causing the Treasury and Federal Reserve to create a program called “Term Asset-Backed Securities Loan Facility” (TALF). Entities in the financial industy were having to mark their assets to market under financial company operating regulations. Whether the loan was current or not the high leverage common in financial companies was causing capital to shrink if not disappear even among what were considered the more stable and successful banks or other financial institutions. TALF was an idea that if you could shift the so called “toxic ” assets requiring Mark to Market from the regulated financial institution to the portfolio holdings of large institutional or individual investors willing to take the risk inherent in the loans, this would go a long way toward stopping the technical implosion of the financial and banking system. The Treasury saw this as a plan by which they could guarantee or indemnify the TALF eligible investors from major loss by providing the financing for the purchase along with certain buy back guarantees for a percentage of the face value of the loan and the banks woul then be able to fund new auto loans, student loans, credit card borrowing, small business loans and even loans to larger businesses thus stimulate economic activity. If a loan purchased by the investor was not paid off or was sold below a certan minimum percent discount of face value thereafter, the investor would receive a high percentage of their loss paid to them by the Treasury. If the loan was paid, their wold enjoy a very high return. While the government guarantees in the TALF program did stimulate buying in TALF eligible securities holding these CMBS, the banks have been reluctant to loan the monies they received until they have a better understanding of what future risks are going to be. Now, market participants anticipate that CMBS delinquency rates will climb higher in the near term, driven not only by negative fundamentals, but by borrowers’ having difficulty rolling over those loans that are maturing.

What does all this mean? If we can believe Ms. Warren, the pending rising defaults in commercial real estate loans are going to cause another earthquake in the financial markets. The question then becomes, “will the Federal government step in with new guarantees or the funding of massive new programs designed to provide liquidity or simply will they fund a bailout of the 3000 plus small banks and the TALF investors that are holding these securities on their balance sheets”. Will the “too big to fail” concept be extended to the small and community bank? If it’s true that over 50% of the Commercial Real Estate loans are under water, I suspect that we will soon begin to hear about a new trillion dollar program that must be instigated before the November elections to save the financial system again. Perhaps it will even be a recommendation by Ms Warren who seems to have little confidence in capital market economics or just believes they are too punitive to those who are willing to take risks if they make a profit but cry for help when they fail.

Here is my take. If the Government thinks it is manageable to create another Trillion or so of Treasury debt to keep the small and midsized banks from failure and make good on their guarantees caused by the continued necessity to mark to market their assets to levels that cause their equity capital to fall below that required to be sustained by regulations, why wouldn’t it be in the American taxpayer’s best interest to just have the bank regulators go ahead and let the banks fail, go through bankruptcy, sell their remaining assets to new investors and reorganize with capital loans totally or partially guaranteed by the same partnership (Federal Reserve Bank and U.S. Treasury)? Given that these banks are going to fail because of poor due diligence and poor risk management, why should we be concerned that their current shareholders or owners have to suffer the consequences caused by their misjudgments?

One Man’s Opinion—Bud Brewer

(1) Elizabeth Warren (born 1949) is an American attorney and law professor. She is the Leo Gottlieb Professor of Law at Harvard Law School — where she teaches contract law, bankruptcy, and commercial law — and has devoted much of the past three decades to studying the economics of middle class families. In the wake of the 2008-9 financial crisis, she became the chair of the Congressional Oversight Panel created to investigate the U.S. banking bailout (formally known as the Troubled Assets Relief Program). In that role, she has provided a critical check on the U.S. Department of the Treasury and has been a leading advocate for accountability and transparency. In 2007, she also first developed the idea to create a new Consumer Financial Protection Agency, which President Barack Obama has advocated and Congress is now considering.[