Interesting Times

Real estate pricing is a function of supply and demand. Since each market has different underlying demand drivers and supply constraint characteristics, investment returns vary. Compared to the NCREIF Property Index (NPI), returns for some markets are historically more volatile than others.

Market volatility, defined as beta (β), is not necessarily a negative feature. Markets with higher volatility often outperform the NPI index in an upturn of the real estate cycle. However, like leverage, this characteristic can also accentuate a market decline.

Applying the financial concept of beta suggests a potential investment strategy during the anticipated real estate recovery, with an overweighting of high-beta property sectors and markets.

The total risk of a portfolio is comprised of market risk and asset specific risk. Asset specific risk can be diversified away while market risk cannot. Market risk is commonly measured as beta. Beta is a quantitative measure of the volatility of a market, a property sector or a portfolio relative to a broad market index.

Generally speaking, a beta of 1 indicates that the market’s returns move in line with the broad market index. A beta of 1.2 means that the asset’s return is likely 20% more volatile than the broad market index return, while a beta of 0.8 means that the asset’s return is 20% less volatile than the broad market index return.

The closer the connection to the economy, the higher the beta.

Using the above definition, we calculated beta for all five property sectors [Exhibit 1]. Despite having the highest average total return, the hotel sector also has the highest beta and is therefore considered the riskiest of the property types.

This makes sense because hotels rely on daily room rentals, which suffer immediately and dramatically during economic downturns, but generally recover more quickly as well.

Historically, demand for office space is also sensitive to economic conditions, as employers have historically tended to overreact by hiring and firing too quickly in good times and bad.

The retail sector has historically had a beta slightly lower than the NPI index, supported by resilient consumer spending and longer leases. This longstanding trend may be changing, however, as the retail sector is experiencing a severe dislocation in the current downturn.

The apartment sector has the lowest beta among the five property sectors, as steady demand for housing has typically made it less sensitive to the economic environment than the other sectors.

We also calculated betas for four major property sectors for each of the metro areas tracked by the NCREIF index. Typically, a market with a higher beta relative to the NPI index tends to have higher returns when the index is increasing and lower returns when the index is decreasing.

To illustrate this market behavior, in Exhibit 2 we compare historic returns of two office markets — New York, a high-beta market, and Washington, D.C., a low-beta market.

The New York office market has shown greater volatility than the D.C. office market. The employment characteristics in these two markets likely explain some of this difference. New York’s economy is heavily weighted to the relatively volatile financial services industry, while the D.C. metro area has a concentration in historically less volatile sectors such as government, health care, education, and the defense industry.

Total returns for the New York office market have been much lower than the D.C. office market during the last two downturns, but significantly higher during the upturn [Exhibit 3].

Who benefits from beta?

We believe that understanding beta behavior may be useful in identifying opportunistic markets as well as in managing portfolio risk. An investment strategy focused on beta would seek higher returns by timing the real estate market cycle and taking on calculated market risk, with the goal of out-performing the market benchmark NPI index [Exhibit 4].

The strategy requires a thorough understanding of market fundamentals and an estimate of future market performance. In the early part of a market recovery it may be desirable to be overweight in the high-beta sectors and markets to maximize portfolio return. As the market moves towards a peak, the portfolio would shift to overweight the low beta sectors and markets in order to minimize potential losses during the downturn.

Of course, a portfolio with a higher beta will inherently have higher risk, which could negatively impact portfolio returns. In addition, the calculated betas shown here are derived from historic data and may not be an accurate predictor of future performance.

By David Lynn, ING Clarion, National Real Estate Investor, 1-28-2010

When Lightstone Group bought Extended Stay Hotels Inc. in June 2007, it relied on more than $7 billion in debt financing to complete the $8 billion deal just weeks before the leveraged-buyout market imploded.

Today, Extended Stay’s creditors are battling each other after the company filed the largest bankruptcy case by a U.S. hotel owner. A company reorganization plan, which includes financing from Centerbridge Partners LP and Paulson & Co., may be challenged by a proposal from Starwood Capital Group LLC that is backed by some so-called mezzanine lenders.

Infighting among lenders with different classes of debt, called tranches, is on the rise in the hotel industry and throughout the $3.5 trillion market for commercial real estate loans after property prices fell more than 40 percent from their peak in 2007. Commercial mortgage defaults more than doubled to 3.4 percent in last year’s third quarter from a year earlier.

“I expect that we will see a lot more of this tranche warfare as you are seeing in the Extended Stay scenario,” said Patrick Campbell, principal at Greenwich, Connecticut-based Wheelock Street Capital LLC, a private-equity firm focused on real estate.

Underlying the conflicts are complex financing arrangements made at the top of the market, according to David Broderick, a partner in the real estate group of law firm Allen & Overy LLP in New York. Those deals divided lenders into multiple tranches, with varying degrees of seniority and risk.

‘Binary Relationships’

Mezzanine loans, which became more prevalent during the market’s peak in 2006 and 2007, got their name because they rank in the capital structure between secured debt such as mortgages and ownership equity, sharing attributes of both. They are seen by investors as riskier than a first mortgage and have higher interest rates.

“Borrowers and lenders had a more binary relationship a decade ago,” Broderick said. “Creditors in these complicated structures no longer have similar economic interests, especially with so many lenders underwater.”

Delinquencies on loans packaged into commercial mortgage- backed securities rose to a record high of more than 6 percent in December, according to Trepp LLC, a New York-based seller of commercial mortgage data. There were about $60 billion of CMBS that were in so-called special servicing for a workout or resolution at the end of September, data from Fitch Ratings show.

Bankruptcy Claims

Extended Stay, which Lightstone bought from New York-based private-equity firm Blackstone Group LP, filed for bankruptcy in June, citing decreased business-travel spending.

The case, in federal bankruptcy court for the Southern District of New York, has been complicated by creditor lawsuits, including claims that the Chapter 11 filing was a effort to push out junior debt holders and transfer control of the Spartanburg, South Carolina-based company. Mezzanine lenders Deuce Properties Ltd. and Line Trust Corp., both incorporated in Gibraltar, said in a June lawsuit in New York Supreme Court that Cerberus Capital Management LP and senior lenders were trying to take over the chain’s 680 properties.

Peter Duda, a spokesman for Cerberus, a New York-based hedge-fund and private-equity firm, declined comment.

“I think it’s fair to say these kinds of issues will come up more and more as additional CMBS cases are filed,” said Jacqueline Marcus, a lawyer for Extended Stay at Weil, Gotshal & Manges LLP in New York. She declined further comment.

Michael Beckerman, a spokesman for Lakewood, New Jersey- based Lightstone, didn’t return a message seeking comment.

“We’re proceeding with our action against the senior lenders who supported the original term sheet filed by Extended Stay,” said Stephen Meister, a lawyer for Line Trust and Deuce Properties.

Competing Plans

Now, Starwood Capital, the investment firm run by Barry Sternlicht that is owed about $266 million by Extended Stay, has put forward its own plan for the bankrupt chain, backed by some junior creditors.

Starwood, based in Greenwich, Connecticut, said its proposal will ease “widespread dissatisfaction” among Extended Stay’s creditors by providing a new $600 million equity investment, court filings show.

Starwood may end up competing with Extended Stay’s own plan, which includes $400 million in new financing from Centerbridge Partners and Paulson & Co., the hedge-fund firm run by John Paulson.

The firms, both based in New York, have agreed in principle on a $200 million equity investment and $200 million backstopped rights offering to support the hotel chain’s turnaround.

Tom Johnson, a spokesman for Starwood Capital, declined to comment. Leslie Armel, a Paulson spokesman, declined to comment, while a message left for Centerbridge officials wasn’t immediately returned.

Vacant Rooms

The hotel industry is struggling with falling occupancy rates caused by the recession. Occupancy last year through November dropped 8.9 percent in the top 25 U.S. markets as leisure and business travelers slashed spending, according to Smith Travel Research Inc. The rate probably will fall an additional 0.2 percent this year nationwide, according to Jan Freitag, a vice president at the Hendersonville, Tennessee-based firm.

About $28.2 billion in debt across 1,200 loans backed by 1,800 U.S. hotels was included on a performance watch list as of December 2009, according to data compiled by Realpoint LLC, a Horsham, Pennsylvania-based credit-rating company. Most of these loans are in default or close to default, according to Frank Innaurato, managing director of CMBS analytical services at Realpoint. Outstanding securitized hotel debt is $73 billion.

Stuyvesant Town

Earlier this month, real estate investor Tishman Speyer Properties LP and BlackRock Inc., the world’s largest money manager, missed a $16.1 million payment on Stuyvesant Town and Peter Cooper Village, the New York apartment complex they bought in 2006 for $5.4 billion with $1.4 billion of mezzanine debt and a $3 billion mortgage.

A group led by Boston-based Winthrop Realty Trust, holding about $300 million in senior mezzanine debt, last week took a step toward foreclosure by demanding payment from Tishman Speyer and BlackRock, both based in New York.

Fitch estimates the property’s value to be $1.8 billion today, making it worth less than the senior debt. Representatives of Tishman Speyer, Blackrock and Winthrop declined to comment.

Possible resolutions for the complex could include restructuring, sale of the debt or even the property itself, according to Ben Thypin, senior market analyst at New York-based research firm Real Capital Analytics Inc.

W Union Square

“One avenue for sale is an auction for mezzanine debt, which gives a way for all stake holders to participate in the transfer of ownership including bidding with money already owed in a so-called credit bid,” Thypin said. “Junior holders often have the incentive to move most quickly to salvage any return on their investment.”

That’s what happened with the W New York Union Square Hotel after Dubai World’s Istithmar investment unit, which bought the property in 2006 at the height of the market, missed a payment.

LEM, a Philadelphia-based affiliate of Lubert-Adler Real Estate Funds, won control of the 270-room property on Manhattan’s Park Avenue South in an auction last month by bidding $2 million for Istithmar’s equity interest, assuming the $97 million in mezzanine debt it didn’t already own and taking over the defaulted $115 million first mortgage. LEM was the most junior lender in the original $285 million deal.

Private Equity

In addition to its first mortgage, Istithmar financed the purchase of the W New York Union Square with $117 million in mezzanine debt. The loan was split into three tranches, with LEM’s $20 million piece the smallest and most junior.

The hotel could change hands again as the senior mezzanine lender, DekaBank Deutsche Girozentrale, considers foreclosing on LEM unless loan payments are brought up to date, said David Gutstadt, a senior vice president at New York-based Savills LLC. Savills is DekaBank’s adviser.

Rick Matthews, an LEM spokesman, declined to comment. Industry newsletter Real Estate Alert reported Dekabank’s plan yesterday.

“Tranche warfare will increase because of the capital that’s been raised targeting distressed commercial real estate,” said Thypin.

Real estate private-equity firms raised $6.8 billion in the fourth quarter of 2009, according to London-based Preqin Ltd., and more than $40 billion for the year. Sternlicht, the former chairman of U.S. lodging company Starwood Hotels, raised $930 million when he took Starwood Property Trust public in August.

“Private equity has been disappointed with opportunities available through senior debt so they’re looking to subordinated debt to get control of properties,” Thypin said.

By Nadja Brandt and Jonathan Keehner, Bloomberg, 1-20-10

Following a year that saw the near meltdown of the banking system and the sweeping impact of a global recession, 2010 could shape up to be a better year for investors, though perhaps not as robust as some would wish. According to John Levy, the new year has ushered in an uptick in market activity for commercial real estate investors, putting some in a position to secure stimulus bailout dollars.

“2009 started out with what I’d call the Armageddon trade,” says John Levy, founder of John B. Levy & Co., “with people predicting the collapse of not just individual banks, but the entire banking system. That mood has changed, and 2010 feels a lot better. The second half of the year promises to be better than the first. However, that doesn’t mean we’re through with the bank failure business,” Levy adds. “I see problems in areas from Arizona to Florida and California to Michigan, and the reasons can vary from cars to condos.”

Undergirding Levy’s muted optimism is what he sees as the rebirth of the market for commercial mortgage-backed securities (CMBS). While Levy believes the government definitely needed to step in last year with its TALF program, he predicts that improvements in the CMBS market will occur because of activity in third-party and public markets, not because of assistance from the government.

“The rebirth of the CMBS market is absolutely going to happen this year,” Levy says. “Last year, we had three CMBS deals, and that was three more than anyone predicted. The CMBS market in 2010 won’t resemble the one we knew and loved in 2007, but we will see a rebirth with reasonable and rational underwriting. I even think we’ll see the first multi-borrower CMBS deal this year.”

Levy is decidedly guarded about whether commercial real estate values will rebound in 2010. While some investors are optimistic about a resurgence in property values in 2010, Levy doesn’t share their sentiment. Rather, he believes the road to recovery for commercial real estate values will be protracted.

“Consider commercial real estate from the perspective of NASDAQ,” Levy explains. “As you recall, that index hit 5,000 in 2000. Here we are ten years later, and NASDAQ is still under 3,000. So will there be a resurgence in commercial real estate values? Yes, most likely in 2011. But returning to the levels we saw in 2007 will take time.”

In light of the huge bank bailouts we saw in 2009, there is one question on the minds of real estate developers and investors: “How can I get a piece of the stimulus pie?”

“When it comes to getting a slice of stimulus pie, some developers and investors have a place at the table,” Levy says. “Some don’t. If you own or invest in apartments, you’re in luck. When you get a real estate loan on your multifamily apartment from Freddie Mac or Fannie Mae, rates are one-half to one percent less than if you borrow from an insurance company. So if you happen to invest in multifamily housing, you get a direct bailout. That’s enough to make anyone’s 2010 look promising.”

National Real Estate Investor, 1-27-10

The relative lack of new developments in the pipeline from 2011 to 2013 suggests that multifamily properties may generate good returns in the near-term. Several sources project large rent increases during this period for metropolitan areas that have no new buildings planned for delivery. With pricing at attractive levels and financing still somewhat available via government-sponsored enterprises, today might be the time to invest in multifamily properties.

Distress creates opportunities, and last year was one of the worst periods on record for multifamily properties. The national vacancy rate hit 8% by the end of the year, up from a previous high of 7.8% in 1986. Similarly, asking and effective rents cratered at magnitudes previously unseen, both at the national and MSA levels. Asking rents fell by 2.3% through 2009, the largest annual decline on record. Effective rents fell by 3.0% for the year, more than triple the worst decline previously recorded in 2002.

Deterioration in loan performance for debt supported by multifamily properties reflected the pressure that the actual collateral was enduring. Data for securitized loans show that overall delinquency and default rates (CMBS loans that are 60 days or more past due) spiked from 2.32% at the end of 2008 to 7.22% by the end of 2009.

The latest data available from the FDIC show a similarly worrisome rise in default rates (90 days or more past due) for multifamily loans held by agricultural banks, regional banks and other FDIC-insured institutions, from 1.74% in the fourth quarter of 2008 to 3.58% in the third quarter of 2009.

As the economy recovers, investors must look beyond the deluge of bad news and consider the fact that financing constraints are preventing developers from building. Reis does not expect permit activity to rise until 2011, implying a dearth in new supply until at least 2012. If demand surges, this lack of new supply may result in above-average rent growth and tight vacancies. The table below summarizes data on overall delinquency and default rates for the top five metropolitan areas that are experiencing loan-level distress. Assuming financing is available for qualified investors, delinquency rates are indicative of where pricing might be attractive.

While there is much merit to this line of thinking, a little caution is always useful. Specifically, two factors must be examined.

First, just because there are no new projects in the near-term does not mean that rent growth if and when demand snaps back is a given. Rent growth may indeed surge in areas that did not experience overbuilding in the previous cycle.

Las Vegas, for instance, has no new projects slated for completion from 2011 to 2013, but will have to contend with an excess supply of apartment buildings as well as condos being rented out by individual owners. From 2002 onwards Las Vegas increased its rental stock by over 12%, almost 50% higher than nationwide averages. On top of this, over 16,000 apartments were converted into condominiums, leading to a large shadow supply of condos being rented out by owners who were unable to flip their units after the housing market crashed.

Second, just because there are no new projects right now doesn’t mean new buildings can’t be erected quickly. On average a multifamily building takes as little as nine to 18 months from start to completion with appropriate financing. If most projections augur for high rent growth because of a lack of supply, guess what will happen in areas like Texas, which typically sport an elastic supply curve? That’s right: developments will be initiated and prospects of high rent growth may vanish.

Multifamily buildings have endured much distress in 2009, but Reis as well as other data providers generally expect apartments to be one of the first sectors to rebound in commercial real estate. If there are indeed opportunities looming on the horizon commencing in 2011, this is the year that serious investors should begin scouring the landscape for good deals.

By Victor Calanog, National Real Estate Investor, 1-26-10

During the economic turmoil of the last few years, Nobel Prize-winning economist and Columbia University professor Joseph Stiglitz has been one of the most strident and incisive critics of the historic bailout of the banking sector.

We recently sat down with Professor Stiglitz to discuss his new book "Freefall: America, Free Markets And The Sinking of The World Economy", and how the Obama administration should go about reshaping our economy.

With so much talk of a recovery, where is our economy right now?

The way I put it is that, if you look back before the crisis, the American economy was basically supported by a housing bubble, which supported a consumption boom. In one year, we had $950 billion in mortgage equity withdrawals. That got reflected in the statistics and our savings rate went to zero.

The implication is that post-crisis, even if we have our banking system work, it is not likely that we will go back to a zero savings rate in the U.S. If we don't go back to a zero savings rate, it's going to be hard to have a robust recovery unless you find something else to fill in the gap.

A recovery is predicated on the financial sector working, but obviously the sector isn't working. And there is another set of problems: Small businesses can't get loans. We are in that dynamic process now, where some of the things that we did [to steady the economy] have the characteristics of stretching out our economy's adjustments. These steps buoyed the economy in the short run, but may be more likely to extend the length of the downturn.

Our response to the crisis was party based on a fundamentally flawed theory. The theory was that we were having a psychological problem, and that if we could only restore confidence then the economy would go back to normal. Of course, we had a psychological problem, which was the bubble, but we're back to reality now.

In your book "Freefall", you suggest that the U.S. economy needs structural changes, rather than just cosmetic changes. Do you get the sense that the Obama administration shares that sensibility?

I think there are differences of view among those in the administration, as in any administration. But I think that one can read the proposal last week of a tax imposed on large banks on the basis of leverage to be a recognition that there is need to do more than a cosmetic change.

I think most people would say the tax has enhanced the equity of the bailout. But it's also an efficiency measure in two ways: first NOT to have the banks pay is subsidizing the financial sector, and that leads to a bloated financial sector. Second, the fact that the tax focuses on liabilities means that the Obama administration recognizes that part of the problem is excess leverage.

Does it go far enough?

No, it doesn't go far enough in several respects. First, as I point out in my book, this is not the first bailout that's come at the expense of American taxpayers or at the expense of taxpayers abroad. The banks have had an impressive record of bad lending all around the world. So, it is clear that the sector has been subsidized and is over-bloated. But, secondly, it's also clear that the sector proposes large externalities on the economy and the incentives structures at the organizational and individual level are such as to exacerbate the problem.

The tax is backward looking and is just attempting to recover [the costs] of this particular crisis. It doesn't look at all the other crisis, past crises and it doesn't create a fund for future crises. And it doesn't stop other forms of excessive risk-taking, like over-the-counter derivatives.

You mention in your book that, before the crisis, as much as two-thirds of our GDP in America was housing-related. If the housing market is going to continue to languish, how do we replace that in our economy? How do we move away from that concentration?

There is plenty of need for investment with high-yield returns. This is where the financial sector failed -- it didn't channel funds to areas with the strongest social return. I think most people would say that we need to retrofit our economy for global warming, and that we need to change our capital structure in those markets and change transportation and infrastructure.

Other examples of very high returns include education, technology and infrastructure -- many of these areas are in the public sector.

The third area is clearly stronger exports. We've been borrowing abroad and we've had a trade deficit as much as 5 percent of GDP. Some would say it's a reflection of exchange rate policy, but many people say it's caused by a lack of industrial policy. What I mean is a a set of economic policies that would promote research and technology that would make America competitive. And it is not a function of our wages -- Germany has a robust export economy and high wages.

We haven't had those kind of policies that would make American more competitive. We had a banking sector that was one of our leading sectors. Some people think that was part of the problem. We diverted people who would have been talented in other areas into banking. It's not just capital resources problem, it's our human resources that were misused.

In your book, you criticize the Obama administration for lacking a clear vision for how we could recover from the financial crisis and reshape our economy. Do you still feel that the Obama administration lacks a larger vision for our economy?

It's hard to say whether they have a vision. They haven't articulated a vision in a very clear manner. They've identified two problems, which I agree are very important: carbon and health care. And they've talked about the problem in our education system.

The lack of vision that I'm critical of is particularly evidenced in the financial sector. My approach is to say, "Lets have a view of what the financial sector is supposed to do, and lets see if they're doing it, and how they need to change."

What we should have done is identified the banking institutions that are lending, we should have given them more money and given them money on the condition that they lend.

When we had our welfare reform of 1996 [when Stiglitz was in the Clinton administration], we made welfare conditional. That is to say, you got welfare payments but you had to go to training and look for a job.

We put the banks on welfare, but we didn't put any conditions. We said, "You can spend the money you gave them on a Florida vacation." It's ironic that we were more "strict" with our poor than our banks.

Currently the top four banks control 40 percent of American deposits. Isn't this concentration in our banking system terribly dangerous for our economy? And do you get the sense that the Obama administration thinks it's dangerous, or plans to do anything about it?

It is bad for three reasons. First, the conventional economist's reason is that this degree of concentration gives you monopoly power, and this monopoly power leads to higher than efficient prices. Second, as Teddy Roosevelt realized when he was considering anti-trust actions against the banks, it was a political argument, not just an economic argument. [He knew] that economic power was going to be associated with political power. And today, you see this in the [banks'] opposition to financial reform legislation.

Third, these big institutions have become too big to fail. I think the Obama administration is a little bit aware of the last problem, but not at all attentive to the first two.

We saved the big banks because we were afraid of the what would happen if we let them fail. It wasn't that the government didn't have the economic powers to let them fail. It was a problem of political will. I think that they are beginning to see the political argument behind the danger of big banking monopolies. You're beginning to see a little of Obama's frustration.

In a recent piece in the New Yorker, John Cassidy wrote about the "death of the Chicago School" of economic thought, which was championed by Alan Greenspan and values free markets and very little regulation. Are economists who missed the crisis rethinking their views? Do you think that the field of economics is going through a radical upheaval?

I think that a surprisingly large number of those who had previously believed that markets work perfectly, and are self-correcting still believe that. And that there are a variety of formulas with which they can reconcile what happened to those beliefs.

They can believe for instance that their theories are sound, and that every 75 years there is an event their theories can't yet explain. So, many economists say, "Our theory works almost always," as opposed to the view that I take, that it's the pathologies that tell you about how things work normally. When things are working well, you don't see the failures that are about to happen.

At the same time, among younger people and probably disproportionately outside of the U.S., there has been a big change. I teach the graduate macro [economics] course at Columbia. The course is divided into four quarters. We believe the students should know all the strands of thought. I teach the last quarter, and it deals with Keynesian concerns, how to deal with unemployment and recessions. The first half the course is operating under the hypothesis that there's no such thing as unemployment, which is the dominant view held by the Chicago school.

The students come up at the end of my section and say, "Why did we have to waste our time with the first part [of the course]?" Young people have been very strongly effected by the crisis.

[The crisis] has bolstered more of the critique of the efficient markets theory. But it hasn't been the revelation and hasn't been the seismic change that one would have hoped.

What stories do you think the financial news media has missed since the crisis? Is there one big story that you'd like to see covered?

The market coverage of the recovery and meltdown has been very much driven by the market, Wall Street and the [Obama] administration, all of whom have the incentive to talk up the economy. Do you remember the "green shoots" Bernanke mentioned in March? [Larry] Summers recently said every one agrees the recession is over -- well, except for the one out of six Americans who can't get a job.

The Huffington Post, 1-21-10

The rich world’s debt reduction has barely begun

DELEVERAGING is an ugly word for a painful process. But few things matter more for the world economy than whether, and how fast, the rich world’s borrowing is cut back. History suggests that severe financial crises are usually followed by long periods of debt reduction—in which credit falls relative to the size of the economy. This time, too, that process is under way. Banks have been furiously reducing leverage. Consumer credit in America has fallen for ten consecutive months, the largest and longest drop on record. But how much further is there to go?

A new report by the McKinsey Global Institute, a research arm of the consulting firm, tries to offer an answer. It begins by comparing the recent evolution of debt levels in ten big rich economies and four large emerging ones. Ratios of total debt to GDP (including debt owed by households, government, non-financial businesses and the financial industry) vary widely, with America’s, at just under 300%, lower than many others. But with a few exceptions, such as Germany and Japan, most rich countries saw a huge rise over the past decade. Britain and Spain were the most extreme, with an increase in their total-debt ratios of more than 150 percentage points apiece, to 465% and 365% respectively.

The debt piled up in different places in different countries. With the exception of Japan, which was dealing with the aftermath of its own earlier asset bust, government debt as a share of GDP was mostly flat or falling. Nor, with the exception of commercial property and leveraged buy-outs, did the rich world’s firms go on a debt binge. Corporate leverage, measured as debt to book equity, was stable or falling in most countries before the crisis. Financial-sector debt rose as a share of GDP in most countries, especially Britain and Spain, and some pockets of finance (such as investment banks) saw a huge increase in leverage. But outside Germany and Japan, where it fell, the most striking jump was in household debt. Most rich countries saw a rise of more than 40% in the ratio of household debt to disposable income. Even there, though, the rise was not uniform. In America middle-income households built up most debt. In Spain poorer people did.

The picture McKinsey paints is one of concentrated (albeit large) credit excesses rather than economy-wide debt binges. As a result, the debt-reduction process will differ by sector and by country. Judged by ratios of total debt to GDP, deleveraging has barely started. As of June 2009 these ratios had fallen only in America, Britain and South Korea, and not by much at that. But the composition of debt has shifted sharply, as government borrowing has soared while private debt has fallen. The financial sector has cut back the most. By mid-2009 financial leverage in most countries had fallen to around its average in the 15 years before the crisis.

To pinpoint where more squeezing is likely, the study examined how far the level and growth of debt in different sectors were out of line with other countries and with historical averages. It also looked at measures of borrowers’ capacity to service their debts and their vulnerability to income shocks. On this basis it could assess where the chances of more deleveraging over the next couple of years are high, moderate or low (see chart). Half of the ten rich countries in the report’s sample have one or more sectors that are “highly” vulnerable to more debt reduction. Not surprisingly, these include households in America, Britain, Spain and, to a lesser degree, Canada and South Korea, as well as commercial property in America, Britain and Spain. With a high risk of more corporate and financial deleveraging as well, Spain has the rockiest road ahead. No country in the sample has much chance of government-debt reduction over the next couple of years.

Changing gear

Assigning the odds of further deleveraging is not the same as gauging its likely economic impact. To do that, the study looks to history. It finds 32 examples of sustained deleveraging (at least three consecutive years in which ratios of total debt to GDP fell by at least 10%) in the aftermath of a financial crisis. In some cases the debt burden was reduced by default. In others it was inflated away. But in about half the cases—which the report regards as the most appropriate points of comparison—the deleveraging came through a prolonged period of belt-tightening, where credit grew more slowly than output. The message from these episodes is sobering. Typically deleveraging began about two years after the beginning of the financial crisis and lasted for six to seven years. In almost every case output shrank for the first two or three years of the process. (Countries which defaulted or inflated their debt away saw bigger recessions at first, but had higher output growth than the belt-tighteners by the end.)

Worse, there are several reasons why today’s mess could be more protracted than previous episodes. First, the scale of indebtedness is higher. The highest debt ratio in the report’s group of belt-tighteners was 286%, in Britain after the second world war. Today more than half the rich countries in the McKinsey sample have debt totalling more than 300% of GDP. Second, the number of countries afflicted simultaneously means that rapid expansions of exports, which have supported output in the past, are harder to achieve. Third, big increases in public debt, while cushioning demand in the short term, increase the overall debt reduction that will eventually be needed. Once private deleveraging is done, the public sector will need to cut back.

In theory that sounds simple. In practice it will be fiendishly hard to get the balance right. Investors may worry about the sustainability of public debt long before private-debt reduction is over, forcing a lot of belts to be tightened at once. The most painful bits of deleveraging could well lie ahead.

The Economist, 1-14-10

The following graph shows total housing starts and the percent vacant housing units (owner and rental) in the U.S. Note: this is a combined vacancy rate based on the Census Bureau vacancy rates for owner occupied and rental housing through Q3 2009 (Q4 will be released in early February).

Click on graph for larger image in new window.

It is very unlikely that there will be a strong rebound in housing starts with a record number of vacant housing units.

The vacancy rate has continued to climb even after housing starts fell off a cliff. Initially this was because of a significant number of completions. Also some hidden inventory (like some 2nd homes) have become available for sale or for rent, and lately some households have probably doubled up because of tough economic times.

The second graph shows single family housing starts and unemployment (inverted). (The first graph shows total housing starts)

You can see both the correlation and the lag. The lag is usually about 12 to 18 months, with peak correlation at a lag of 16 months for single unit starts. The 2001 recession was a business investment led recession, and the pattern didn't hold.

This suggests unemployment might peak in Summer 2010 since housing starts bottomed in April 2009. However, since I expect the housing recovery to be sluggish, I also expect unemployment to remain high throughout 2010 (I think double digits throughout 2010 is very likely without additional job related stimulus).

Until the large overhang of vacant housing is reduced, a significant rebound in housing starts is also very unlikely.

CalculatedRisk, 1/20/2010

Encino, Calif.-based Marcus & Millichap Real Estate Investment Services has completed its annual ranking of the top and bottom 15 markets for retail real estate.

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There is major representation from West Coast markets on both lists. Stronger markets include urban centers like San Francisco, San Diego, Orange County, Calif., Los Angeles, Portland, Ore. and Seattle-Tacoma, Wash. The lower projected vacancy rate in these cities underscores a trend of retailers eying urban sites when expanding.

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Weaker markets include some cities that had steep housing bubbles and where retail projects were built in anticipation of new rooftops that never materialized. Fizzling housing markets in Florida like Orlando and Fort Lauderdale along with California's Inland Empire, Las Vegas and Phoenix are all ranked in the bottom 15. Also on the bottom 15 markets list are struggling Midwestern markets plagued by high levels of unemployment including Detroit and a triumvirate of Ohio cities: Cincinnati, Cleveland and Columbus.

Marcus & Millichap included the list of markets in a Webcast entitled 2010 U.S. Economic, Capital Markets and Retail Market Overview and Outlook.

Aside from the market ranking, Marcus & Millichap Managing Director of Research Services Hessam Nadji provided an economic outlook and provided commentary on how the recovery is shaping up.

Nadji pointed to the Commerce Department's retail sales figures--which are now showing year-over-year gains--as one sign that the economy is strengthening.

Retail Traffic, 1-21-10

The start of 2010 is showing signs of growing investor demand in U.S. commercial real estate, and potentially in related secondary markets, despite the lagging performance of underlying collateral. The pick-up is also predicted to be mirrored in similar markets in Europe and Asia, areas expected to see comparatively better performance relative to the ailing U.S. market.

In a report from the rating agency Moody’s Investors Service, analysts project some pick-up in commercial real estate (CRE) demand after Q409, which would help markets after little movement for much of the year.

A majority of the commercial sectors, 51%, remain in poor-performing status in Q409, according to the report–but Moody’s notes that number is down from 53% in the previous quarter. All but hotels showed improvements from Q309, but despite the gain, all sectors but multifamily continue to hold at a medium performance.

The five best markets in the US, as ranked in the report are: Honolulu, Las Vegas, Pittsburgh, Newark and Raleigh. The five worst: Detroit, Phoenix, Atlanta, Charlotte and Indianapolis.

The credit rating agency Fitch had a bleaker outlook for commercial real estate, when it reported that the amount delinquencies in commercial mortgage-backed securities (CMBS) reached 4.71% at the end of 2009 and could climb as high as 12% at the end of 2012.

A report from the mortgage-data provider, Trepp, had the delinquency rate for CMBS above 6% in December 2009, and data from the credit-rating agency Realpoint showed a delinquent unpaid balance in CMBS climbing 16% in November 2009 to $37.93bn.

On a global scale, US commercial property lags behind. A report from the financial services provider Credit Suisse claims that capital values are currently bottoming in many global markets, and CRE valuations “look appealing” as initial property to government bond yield spreads remain high worldwide.

“Total returns turn positive considerably before rents find a floor since rental yields are always positive and may offset negative rental developments. This is especially true in times of high initial yields such as today,” according to the Credit Suisse report. “We therefore think that the year 2010 can finally mark a turning point for global direct commercial real estate investments.”

While demand is growing in US markets, it remains behind Western Europe and Asia, which posted positive returns. According to the report, structural adjustments in the consumer sector, weak occupancy and foreclosure sales caused by refinancing problems continue to hold back US CRE. Prime office vacancies rose 15% in every major city, according to the report.

But, according to Credit Suisse, there are some opportunities in the US. Average CRE prices declined by 40% since the middle of 2007 but stabilized to pre-bubble levels. Bargain prices could attract foreign investors like the Bank of China, which, according to the Financial Times, is actively seeking property in New York, Los Angeles and San Francisco. The Bank provided $120m for the New York Time building near Times Square.

This demand echoes a recent survey by the Association of Foreign Investors in Real Estate (AFIRE), which showed that 51% of respondents targeted US properties in 2009. In a sign of growing demand, the percentage increased from 37% in 2008.

Investors in the US are starting to sense an improvement on the way in 2010. John Levy, the founder of John B. Levy & Company, the real estate investment banking firm, said that 2009 started out with “Armageddon trade,” when predictions of a banking system collapse were prevalent. But, he said, the mood in 2010 has changed.

“The rebirth of the CMBS market is absolutely going to happen this year,” Levy said. “Last year, we had three CMBS deals, and that was three more than anyone predicted. The CMBS market in 2010 won’t resemble the one we knew and loved in 2007, but we will see a rebirth with reasonable and rational underwriting. I even think we’ll see the first multi-borrower CMBS deal this year.”

Jon Prior, Housing Wire, 1-20-10

More than 36% of the $270 billion in commercial real estate loans maturing in 2010 are under water, meaning the mortgage balance is greater than the value of underlying property, according to data from Oakland, Calif.-based research firm Foresight Analytics. And the worst is yet to come.

In 2011, 49% of maturing loans will be under water, followed by 63% in 2012, 61% in 2013, and 57% in 2014. In all, from 2010 through 2014, the total amount of maturing loans expected to be under water is a whopping $770 billion.

“The mortgage maturity issue was problematic for lenders already in 2009, so it’s really just going to get worse in 2010 — and it looks like beyond — unless you expect a meaningful rebound in prices,” says Matthew Anderson, a partner at Foresight Analytics. “The issue of the rising dollar volume of maturities that is more and more under water will become a greater problem for lenders of all types with the passing of each year.”

By contrast, only 16% of commercial mortgages that matured in 2009 were under water, Anderson estimates.

This year’s maturity issues may prove worse than Foresight’s figures suggest, because the projection of upside-down loans maturing, at 36%, doesn’t include loans that would have matured in 2009 and were simply extended for one year. That could add substantially to the volume of underwater maturities this year, based on Anderson’s estimate that 60% of mortgages with 2009 maturities were granted one-year extensions. “That’s obviously is just going to add to that [36%] figure.”

Kicking the can down the road

Banks hold the greatest number of the maturing loans through 2014, a total of $785 billion. Of that amount, 68%, or $535 billion, are projected to be under water over the same period. With little liquidity in the marketplace (yet no real pressure from the federal government to write down the problem debt), how will banks deal with their underwater loans?

According to Anderson, there are two likely scenarios. The rosiest picture entails banks extending the loans, adding to the next year’s already growing volume of underwater maturing loans.

The Armageddon scenario could go something like this: An unforeseen panic or event pressures banks and other lenders to unload problematic loans, taking hefty losses on maturing mortgages that are under water or otherwise unable to qualify for refinancing.

CMBS sector tires of distress

The longest commercial mortgage-backed securities (CMBS) loan extension to date has carried a two-year term. As of Dec. 8, the volume of all CMBS loans sent to special servicing for resolution had climbed to 9%, an all-time high, according to commercial real estate data and analytics firm Trepp LLC, which is based in New York.

Special servicers face a growing number of loans backed by properties with multiple problems, which may include a value that is under water, or insufficient cash flow to cover debt service or the special servicer’s mounting fees.

“For those loans headed into default, where the cash flow is insufficient and the value is low, it can be pretty costly for the special servicer to maintain payments on those loans,” notes Anderson. “I suspect what we’ll start to see with CMBS is an acceleration in resolving defaulted loans one way or another.”

A special servicer faced with the cost of air conditioning an empty building may opt to keep the AC off, even though that choice could result in a $30 million mold issue down the road. Without needed maintenance, experts predict that many of the properties piling on fees in special servicing will decline.

Life companies eke by

The $93 billion of commercial real estate loans held by the life companies slated to mature through 2014 is predominantly backed by institutional, Class-A properties that have few issues with cash flow.

“Life companies are not immune, but they’re in a somewhat different spot than most of the rest of the market,” Anderson explains. “Traditionally life company underwriting would be more conservative. The loan-to-values in the first place would be lower so the underwater loan proportion would be noticeably lower for the life companies.”

There’s one caveat to the above scenario. Unless life company loans were written to 60% loan-to-value ratios, the roughly 40% decline in commercial real estate valuations across the board may have those LTVs approaching the 100% mark.

The upshot of the problem? “As much as the regulators would like to press the banks even harder and force everyone to clean up their balance sheets and move on, they recognize that if they did that they would create much bigger losses in the near term and exacerbate the whole capital problem — or lack of capital — for banks.”

By Sibley Fleming, National Real Estate Investor, 1-15-10

Yields on the benchmark U.S. 10-year note will rise over the next six months, according to the Bloomberg Professional Global Confidence Index. The 5,437 respondents from New York to Tokyo to Paris were optimistic on the outlook for the global economy for a sixth consecutive month, pushing the index, which began in November 2007, to a record high.

Treasury yields will rise for a second consecutive year as U.S. debt sales climb above $2 trillion and the Federal Reserve unwinds stimulus programs, according to the 18 primary dealers that trade with the central bank. The survey shows sentiment is also the most pessimistic on record for the U.K., Spain and Switzerland, where governments also enacted measures to support their economies.

“The market will have to absorb a significantly greater amount of supply as the Fed steps away,” said Michael Pond, a survey participant and an interest-rate strategist in New York at Barclays Plc, one of the primary dealers required to bid on Treasury auctions. “We do expect yields to go higher. Bearishness across all sovereign issuers may be warranted.”

Bond Index

Expectations for an increase in 10-year Treasury note yields rose to 76.65 in January, the highest since Bloomberg began compiling the data in November 2007. The reading was 70.45 in December, and 55.93 a year ago. The measure is a diffusion index, meaning a reading above 50 indicates Bloomberg users expect bonds to decline.

Outstanding public Treasury debt has soared 60 percent to a record $7.27 trillion since the end of 2007 as the U.S. funded two fiscal stimulus programs totaling $955 billion and the $700 billion Troubled Asset Relief Program that bailed out banks. The deficit may be 9.2 percent of gross domestic product this year, according to a survey of economists by Bloomberg. While that is down from 10 percent last year, it’s up from 4.7 percent in 2008.

The Fed is near the end of its $1.75 trillion commitment to support debt markets. The central bank said in November 2008 that it would buy $300 billion of Treasuries and $600 billion of mortgage securities, which it later expanded to $1.45 trillion. It stopped buying Treasuries in October and has acquired $1.12 trillion of mortgages.

Yield Forecast

Yields on 10-year notes will end 2010 at 4.14 percent, the highest level since June 2008, according to a separate Bloomberg News survey. The yield on the benchmark 3.375 percent security due in November 2019 rose 4 basis points to 3.75 percent at 12:31 p.m. in New York, according to BGCantor Market data, after increasing from 2.21 percent at the end of 2008.

The Bloomberg Professional Global Confidence Index rose to 66.6 this month from 58.9 in December. While the outlook for bonds dimmed, sentiment toward the dollar increased for a fourth month, climbing to 53.11 from 51.99 in December. The index is the highest since March. A reading above 50 indicates Bloomberg users expect the dollar to strengthen.

The index covering the yen tumbled to a record low of 35.54 from 50.60. The replacement of Japan’s finance minister four months into the government’s term increases concern about the commitment to rein in budget deficits, Moody’s Investors Service said yesterday.

Sovereign Sentiment

Brazilian, French, German, Japanese, Mexican, Spanish, Swiss and U.K. bond yields will all rise, the Bloomberg user survey showed. A Bank of America Merrill Lynch index measuring returns on government debt shows that the securities lost 1.1 percent in December, the biggest decline since losing 1.53 percent in January 2009.

Speculation about eroding credit quality for European sovereign issuers has pushed yields higher in Greece, Spain and Ireland. The European Commission said yesterday that “severe irregularities” in Greece’s statistical data leave the accuracy of the European Union’s largest deficit in doubt.

Pessimism was the highest for U.K. debt, with the index rising to record 78.17 in January from 72.47 last month.

The Bank of England last week pledged to complete its bond- purchase program as policy makers gauged the strength of the economic recovery.

Improving Economy

Treasuries fell 3.7 percent in 2009 in their worst performance since at least 1978 when Bank of America Corp.’s Merrill Lynch indexes began tracking the debt, compared with a 20 percent gain for corporate bonds, the best since 1995. A year earlier Treasuries rallied 14 percent as investors sought a refuge in government debt as credit markets froze and the recession deepened.

John Lipsky, the first deputy managing director at the International Monetary Fund, said in a Bloomberg Radio interview on Jan. 6 that the agency may raise its 3.1 percent forecast for global growth.

“You’re not seeing the flight to quality that you did before,” said Sean Simko, a survey participant who oversees $8 billion at SEI Investments Co. in Oaks, Pennsylvania. The improving economy will continue to support demand for higher risk assets at the expense of Treasuries, he said.

Real estate research firm Reis Inc.’s data for the fourth quarter of 2009 shows continued erosion in fundamentals at neighborhood and community centers and regional malls. Vacancies at both property types rose. For shopping centers, vacancies are at their highest point since 1991 and for regional malls vacancies are at their highest point since Reis began tracking the figure at the end of 1999.

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The conditions have caused rents to fall to the point where asking and effective rents at neighborhood and community centers are now back to the levels they were in 2006 and 2007. Asking rents at regional malls have also dropped to 2006 levels. According to Reis, “This is also the first time in our 10 year history for regional malls that we’ve observed four straight quarters of asking rent declines, and the year-over-year decline of negative 3.6 percent is the largest magnitude of deterioration over a 12 month period on record as well.” More troubling, this is the first time in the 29 years it has been tracking neighborhood and community center trends that Reis has recorded effective rent drops in all 77 markets it covers.

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The numbers also indicate that community and shopping centers have had negative absorption for eight straight quarters, but the losses were much greater in 2009 than in 2008. Cumulatively, neighborhood and shopping centers have experienced negative absorption of 30.4 million square feet in the last eight quarters. Of that, 24.1 million square feet came off the books in 2009. The only bright spot in the data is that the losses were worse in the first half of 2009 (-15.7 million square feet) than the second (-8.4 million square feet). In fact, the pace of negative absorption has fallen for three straight quarters, indicating that perhaps a bottom is near.

Reis cautions, however, “[N]ote how completions have also slowed, with 1.8 million square feet of strip mall space coming online this period. Also note how negative net absorption outstripped the amount of newly completed space for every quarter in 2009.”

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Overall, the sector added 10.1 million square feet in new space in 2009—down from more than 25 million square feet in 2008 and 33.3 million square feet in 2007.

Going forward, Reis expects economic pressures to continue to affect consumers and businesses. Although the economy is growing again, high unemployment and inconsistent consumer spending patterns make for a difficult outlook for retail properties for another 18 to 24 months.

“Reis continues to project increasing vacancy levels and negative asking and effective rent growth for neighborhood and community centers through 2011. We have yet to observe any unexpected systematic resumption in hiring and strength in consumer spending that may lead us to revise our projections with a more optimistic bent,” the company wrote in its report.

Real Traffic Online, Jan 12, 2010

If only we’d had more power, we could have kept the financial crisis from getting so bad.

So let’s consider what an empowered Fed might have done during the housing bubble, based on the words of the people who were running it.

In 2004, Alan Greenspan, then the chairman, said the rise in home values was “not enough in our judgment to raise major concerns.” In 2005, Mr. Bernanke — then a Bush administration official — said a housing bubble was “a pretty unlikely possibility.” As late as May 2007, he said that Fed officials “do not expect significant spillovers from the subprime market to the rest of the economy.”

The fact that Mr. Bernanke and other regulators still have not explained why they failed to recognize the last bubble is the weakest link in the Fed’s push for more power. It raises the question: Why should Congress, or anyone else, have faith that future Fed officials will recognize the next bubble?

Just this week, Mr. Bernanke went to the annual meeting of academic economists in Atlanta to offer his own history of Fed policy during the bubble. Most of his speech, though, was a spirited defense of the Fed’s interest rate policy, complete with slides and formulas, like (pt - pt*) > 0. Only in the last few minutes did he discuss lax regulation. The solution, he said, was “better and smarter” regulation. He never acknowledged that the Fed simply missed the bubble.

This lack of self-criticism is feeding Congressional hostility toward the Fed. Mr. Bernanke is still likely to win confirmation for a second term, based on his aggressive and creative policies once the crisis began. But Congress hasn’t decided whether to expand his regulatory authority and is considering reining in the Fed’s other main mission — setting interest rates.

A once-marginal proposal — from Representative Ron Paul, the Texas Republican — that would give Congress the power to review interest rate decisions recently passed the House and will soon be considered by the Senate.

Economists are generally horrified by this idea. If Congress could force Fed officials to answer questions about every interest rate move, the process could easily become politicized. A politicized central bank is a first step toward runaway inflation.

But politicizing monetary policy isn’t the only mistake Congress could make. It also could end up going in the other direction and handing Fed officials more power without asking them to grapple with their failures.

When Mr. Bernanke is challenged about the Fed’s performance, he often points out that recognizing a bubble is hard. “It is extraordinarily difficult,” he said during his Senate confirmation hearing last month, “to know in real time if an asset price is appropriate or not.”

Most of the time, that’s true. Do you know if stocks will keep going up? Is gold now in the midst of a bubble? What will happen to your house’s value? Questions like these are usually an invitation to hubris.

But the recent housing bubble was an exception. By any serious measure, houses in much of this country had become overvalued. From the late 1960s to 2000, the ratio of the median national house price to median income hovered from 2.9 to 3.2. By 2005, it had shot up to 4.5. In some places, buyers were spending twice as much on their monthly mortgage payment as they would have spent renting a similar house, without even considering the down payment.

More than a few people — economists, journalists, even some Fed officials — noticed this phenomenon. It wasn’t that hard, if you were willing to look at economic fundamentals. You couldn’t know exactly when or how far prices would fall, but it seemed clear they were out of control. Indeed, making that call was similar to what the Fed does when it sets interest rates: using concrete data to decide whether some part of the economy is too hot (or too cold).

And Fed officials could have had a real impact if they had decided to attack the bubble. Imagine if Mr. Greenspan, then considered an oracle, announced he was cracking down on wishful-thinking mortgages, as he had the authority to do.

So why did Mr. Greenspan and Mr. Bernanke get it wrong?

The answer seems to be more psychological than economic. They got trapped in an echo chamber of conventional wisdom. Real estate agents, home builders, Wall Street executives, many economists and millions of homeowners were all saying that home prices would not drop, and the typically sober-minded officials at the Fed persuaded themselves that it was true. “We’ve never had a decline in house prices on a nationwide basis,” Mr. Bernanke said on CNBC in 2005.

He and his colleagues fell victim to the same weakness that bedeviled the engineers of the Challenger space shuttle, the planners of the Vietnam and Iraq Wars, and the airline pilots who have made tragic cockpit errors. They didn’t adequately question their own assumptions. It’s an entirely human mistake.

Which is why it is likely to happen again.

What’s missing from the debate over financial re-regulation is a serious discussion of how to reduce the odds that the Fed — however much authority it has — will listen to the echo chamber when the next bubble comes along. A simple first step would be for Mr. Bernanke to discuss the Fed’s recent failures, in detail. If he doesn’t volunteer such an accounting, Congress could request one.

In the future, a review process like this could become a standard response to a financial crisis. Andrew Lo, an M.I.T. economist, has proposed a financial version of the National Transportation Safety Board — an independent body to issue a fact-finding report after a crash or a bust. If such a board had existed after the savings and loan crisis, notes Paul Romer, the Stanford economist and expert on economic growth, it might have done some good.

Whether we like it or not, the Fed really does seem to be the best agency to regulate financial firms. (It now has authority over only some firms.) As the lender of last resort, it already has a vested interest in the health of those firms. The Fed’s prestige also tends to give it its pick of people who want to work on economic policy.

“The Federal Reserve has unparalleled expertise,” Mr. Bernanke told Congress last month. “We have a great group of economists, financial market experts and others who are unique in Washington in their ability to address these issues.”

Fair enough. At some point, though, it sure would be nice to hear those experts explain how they missed the biggest bubble of our time.

Had the labor force not decreased by 661,000 last month, the jobless rate would have been 10.4 percent, according to economists including David Rosenberg at Gluskin Sheff & Associates in Toronto and Harm Bandholz at UniCredit Research in New York.

“The actual unemployment rate is higher than shown by the official numbers,” Bandholz said yesterday after a Labor Department report released in Washington showed the economy unexpectedly lost 85,000 jobs in December while the jobless rate was unchanged.

About 1.7 million Americans opted out of the workforce from July through December, representing a 1.1 percent drop that marks the biggest six-month decrease since 1961, the Labor Department report showed. The share of the population in the labor force last month fell to the lowest level in 24 years.

December’s 10 percent unemployment rate matched the median forecast of economists surveyed by Bloomberg News. It was shy of the 26-year high of 10.1 percent reached two months earlier.

The so-called underemployment rate -- which includes part- time workers who’d prefer a full-time position and people who want work but have given up looking -- rose to 17.3 percent in December from 17.2 percent.

The number of discouraged workers, those not looking for work because they believe none is available, climbed to 929,000 last month, the most since records began in 1994.

Length of Unemployment

The backdrop to the disillusionment is that it’s taking longer and longer to find work, economists said. Workers were unemployed for 29.1 weeks on average last month, the most since records began in 1948.

“Longer-term unemployment is one of the biggest problems,” said Bandholz. “Payroll declines will come to a halt in the next couple of months, but the people who are unemployed are having problems getting a job and it’s getting tougher by the month.”

Revised figures showed payrolls climbed by 4,000 in November. The gain was the first since the economic slump began in December 2007.

“Workers seem to be particularly discouraged by this recession,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York.

Participation Rate

The participation rate, or the share of the population in the labor force, fell to 64.6 percent in December, the lowest level since 1985, from 64.9 percent.

The labor force will probably grow this year as the economy continues to expand and Americans believe jobs will be easier to get. That will mean the unemployment rate will head higher because there won’t be enough jobs available to satisfy the demand for work.

“The exodus from the labor force can’t contain the unemployment rate indefinitely,” said Ryan Sweet, a senior economist at Moody’s Economy.com in West Chester, Pennsylvania. “We expect unemployment to resume rising over the next few months, peaking near 10.5 percent in the third quarter.”

Federal Reserve policy makers, while noting stabilization in the labor market, have expressed concern about unemployment and poor job prospects. That’s one reason policy makers will keep the benchmark interest rate near zero longer than most anticipate, said John Ryding.

Fed ‘On Hold’

“We continue to believe that the Fed will leave monetary policy on hold throughout 2010 in light of the high level of un- and under-utilized labor resources,” Ryding, chief economist at RDQ Economics in New York, said in a note to clients. The median forecast of economists surveyed by Bloomberg News last month projected the first rate increase would come in the third quarter of this year.

Treasury two-year notes yesterday gained the most in three weeks following the worse-than-expected payroll numbers. The yield fell five basis points, or 0.05 percentage point, to 0.97 percent at 4:31 p.m. in New York.

President Barack Obama on Dec. 8 proposed additional spending on the nation’s transportation system, tax credits to spur hiring by small businesses and incentives to make homes more energy efficient in a second round of efforts to cut the jobless rate.

“We’re going to have to work harder to create jobs.” U.S. Labor Secretary Hilda Solis said in an interview on Bloomberg Television. “This is a very stubborn recession.”

With Apartment-Vacancy Rate at 30-Year High, Landlords Cut Prices 3% in 2009

Apartment vacancies hit a 30-year high in the fourth quarter, and rents fell as landlords scrambled to retain existing tenants and attract new ones.

Rents fell 3% last year, according to Reis, led by declines in San Jose, Calif., Seattle, San Francisco and other cities that had brisk growth until the recession.

In New York City, the vacancy rate improved by 0.1 percentage point for the second straight quarter, but around 60% of rental buildings dropped their rents in the fourth quarter from the previous quarter. Effective rents -- which include concessions such as one month of free rent -- fell 5.6% in New York last year, the worst since Reis began tracking the data in 1990.

Landlords now must entice tenants to renew leases. "We'll shampoo their carpets. We'll paint accent walls. We'll add Starbucks cards," said Richard Campo, chief executive of Camden Property Trust, a Houston-based real-estate investment trust that owns 63,000 units. He said the first half of 2010 should be "pretty ugly," but was optimistic the sector would pick up later in the year.

Few markets have been spared. During the fourth quarter, vacancies increased in 52 markets, while they improved in 17 and stayed flat in 10. Vacancies increased most sharply for the year in Tucson, Ariz.; Charlotte, N.C.; and Lexington, Ky.

Landlords were also hit last year by competition from a wave of new supply that hit the market. The 120,000 units that came onto the market last year, including some busted condo projects that had to be converted to rentals, represented the most new construction since 2003, according to Reis.

Many of those developments had secured financing before credit markets seized up. The credit crunch has frozen most new development, which means that new apartment completions should fall by half in 2011. That's one potential silver lining for apartment owners: The limited new supply should give them the ability to boost rents quickly whenever job growth returns.

Such oversupplied markets as Florida, Phoenix and Las Vegas are hurting, even though housing sales have picked up. "Landlords aren't benefiting because jobs aren't recovering," said Hessam Nadji, managing director at Marcus & Millichap, a real-estate firm.

Marcus & Millichap is to release a separate report on Friday that forecasts a further 2% to 3% drop in apartment rents over the next year, most of which will be concentrated over the next six months. The report forecasts Washington, D.C., will be the healthiest rental market in 2010 for the second straight year.

Thanks to falling home prices and record low mortgage rates, it now costs less to own than it has in the past decade on a mortgage-payment-to-rent basis. But falling rents are expected to offset some of the recent improvement in affordability, making renting more attractive than owning in some markets.

By NICK TIMIRAOS, Wall Street Journal, 1-7-09

But the statistics and stories over the last two years make a case that it is: Since the housing crisis began, this inland port city 80 miles east of San Francisco has had one of the worst foreclosure rates in the country – for most of the time, the worst.

At the height of it, about 1 in 10 houses fell to foreclosure. Houses that sold for more than $500,000 before the crash now go for $200,000. In some neighborhoods, fixer-uppers cost less than a new Honda Fit – under $20,000.

To spend time in Stockton, a plain-jane city of single-family home neighborhoods edged by freeways and lingering farms, is to begin to understand the calamitous effects of the nation's foreclosure crisis, which has devastated so many once-booming places.

Stockton is the San Joaquin County seat. And according to the Associated Press Economic Stress Index, a month-by-month scoring of U.S. counties' rates of unemployment, bankruptcy and foreclosures, San Joaquin had a score of 23.55 in November, making it the fourth-most stressed of counties with a population over 25,000. Its foreclosure rate of 6 percent was exceeded only by metro Las Vegas, metro Fort Myers, Fla., metro Orlando, Merced County, Calif., and Kendall County, Ill.

An outsider might not notice immediately how Stockton has suffered. It boasts a downtown mall, a mix of handsome, century-old and modern architecture, a new sports stadium, even a promenade overlooking the city's canal.

But two years into the housing crisis, Stockton is a changed place. Whole neighborhoods have been decimated by the mortgage disaster. The tax base has shrunken. City services and municipal jobs have been cut. Unemployment hovers at about 16 percent. Economists predict it will take years for Stockton to recover from the housing bust.

Locals say the same about the city's reputation.

Since the housing meltdown began, journalists from around the world have parachuted in to see the city felled by sub-prime mortgages, which enticed new homeowners priced out of the San Francisco Bay area with low interest rates that reset to levels they could not afford.

"Welcome to Foreclosureville, U.S.A." wrote the Los Angeles Times. "America's Most Miserable City," declared the London Independent. That headline was inspired by Forbes' "most miserable cities" index, which ranked Stockton No. 1.

City officials say they fully expect Stockton to shake the title in 2010 (it's recently dropped to No. 4 or 5). But how far away from the top can it go? The population of 290,400 is strapped. Up to two-thirds of homeowners owe more on their properties than the houses are now worth. Housing values have dropped more than 60 percent since the height of the boom four years ago, more than any other city.

Housing developments built for commuters have been hit the hardest, since they were the ones to attract newcomers fleeing the huge spike in prices closer to the Bay area. Those whose livelihoods depend on a healthy housing environment – real estate brokers, contractors, day laborers – are barely holding on here.

Probably the happiest people are the ones scooping up foreclosures. Speculators are back, of course, but the other bargain hunters include people who only dreamed of being able to afford a house. They're now living the dream in Stockton.

By the time the whole foreclosure phenomenon is done, Stockton may well look less like the bedroom community for commuters to the Bay Area that it was becoming and more like the working-class, immigrant community ringed by Central Valley farm country that it was before.

For now, residents just hope the worst is over.

The heart of Foreclosureville, U.S.A. – the Stockton subdivision that had more bank repossessions than any other place in the country for much of the last two years – is starting to look like its old self again.

The "For Sale" signs that overwhelmed Weston Ranch are mostly gone, and the lawns where weeds grew like corn stalks are shorn.

Foreclosure businesses that sprang up, including one that spray-painted brown lawns green and another that offered a foreclosure bus tour, have folded. Every time a foreclosure hits the market, bargain hunters snap it up.

But looks are deceiving. In Weston Ranch, financial devastation struck like a natural disaster and the ground has not yet settled. Speculators are buying houses to rent out. On streets where everyone knew everyone, no one knows anyone.

Orlando Mixon and his family – wife, son and daughter – are typical Weston Ranch settlers. They moved here eight years ago from Union City, east of San Francisco, after a search for an affordable house sent them farther and farther down the freeway.

In those boom times, the Mixons paid $175,000 for a new four-bedroom, three bath split-level, more than they would have paid just five days earlier. But they were excited. They didn't know Stockton, but the subdivision of 5,000 homes was like a town unto itself, built for easy access to and from a long commute. Beige and boxy, the houses made up in size what they lacked in style.

Now, the Mixons are hanging on by their fingers. Their house, they think, is worth just over $200,000, though some on the next street sold recently for $150,000. Still, with two mortgages, they owe more than that (they won't say how much). Until last month, Mixon spent four months out of work, pushing the family toward financial ruin.

"I try not to think about that," Mixon said. He spoke while washing his blackened work clothes in the driveway: He now works on an oil rig in Los Angeles when there is work, drives the 340 miles every other week to his job, seven days on, seven off. His wife Sharon's commute is 60 miles each way, five days a week in rush hour traffic, for her job as a manager in a hospital in Hayward.

Stockton residents on average commute 46 miles each way.

___

The biggest bargain in Stockton stands on a street most people would choose to avoid. Old men drinking from bottles in brown paper bags lean against an empty brick building. Younger ones loiter on the corners, wearing puffy parkas, selling ... something.

Rudy Willey, a real estate broker who knows his turf, had had no great expectations for the house. But the property was worse than he had imagined: more like a package store than a single-family home. It had no land, no porch, no stoop.

Squatters had had their way with the place. Its small, low-ceilinged rooms looked lopsided. All the fixtures were gone. The bathroom, the kitchen – the whole place – needed a do-over.

"$15,000?" Willey said, locking the front door. "I think they're asking too much."

He smiled at the irony of it. Twenty-seven years of selling real estate in Stockton had not fully prepared him for what has happened to his city, his vocation and his livelihood.

At 58, nearing retirement, or so he thought, Willey is working twice as hard and making half as much as he did two years ago. In two months, he has taken just two days off.

Not three years ago, Willey couldn't keep up with the demand for half-million-dollar starter homes springing up within a 30-mile radius of Stockton. Commuters were buying in; locals were trading up.

Having seen his share of boom and bust cycles, Willey knew the times were too good to last. A wave of selling in Elk Grove, a town half an hour away that had been the fastest growing in the country in 2007, became a sign.

"When I saw the 'For Sale' signs, I thought: 'Something's happening,'" Willey said. "I thought we were due for a correction – maybe a 15 percent drop."

Now, Willey is selling houses for less than half of what they sold for then. Even so, it is harder to close a deal.

A few brokers have acquired most of the foreclosure listings. Most no longer take phone calls to hear offers. Half the time, they don't return e-mails. In some cases, Willey suspects the broker simply does not want to share a commission.

Time to work on a Plan B: Willey is taking a multimedia course at San Joaquin Delta College, a two-year school where he also teaches real estate classes. He hopes to start a Web site.

At night, he works on a book, a guide for would-be homebuyers.

And each day, he tries to look on the bright side. On an afternoon's outing to see houses below $35,000, he kept remarking on the "wonderful opportunities" working people have to own a home.

"Not bad, not bad," he said, going through an $18,000 house that had decent bones. It was in a homely neighborhood of aging bungalows. But there were no drug dealers on the corners. "Redone," Willey said, "this could be a nice little home."

___

Among all the bargains in Stockton, Jason Ramey had his heart set on one.

It was not on the market yet. But on its window and door was the sign of the times: an eviction notice.

This was early 2009, the height of Stockton's foreclosure boom. More than 90 percent of the houses for sale in the city were foreclosures or short sales – where the lender lets borrowers sell a property for less than they owe on it, forgiving the balance, to avoid foreclosure.

Ramey, a 31-year-old insurance agent, knew what he wanted. He had been looking at real estate listings for years. But when the market was high, he could not afford to buy. Even "shacks," as he likes to say, cost $300,000 – well above his price range.

Then came the housing disaster, and opportunity.

Ramey began scouting houses on the San Joaquin County foreclosure listings. As soon as he saw The One, a corner property in a coveted new development, he decided to wait for it.

The house had an arched entrance that reminded Ramey of a French chalet. Neighbors showed pride of place – planting rose gardens, flowering fruit trees, dooryard bougainvillea. It wasn't as big as other foreclosures in the mid-$200,000 range. But Ramey, a local boy, knows Stockton inside and out. This house had location, location, location, besides its four bedrooms, three baths. This was a place where he could see staking roots, growing a family.

Ramey waited four months for the house to come on the market. Meanwhile, he and his girlfriend took a real estate class for first-time homebuyers. Their instructor: Rudy Willey.

He taught them how to research properties, find the right mortgage, make a deal. The very morning the house showed up on the real estate listing site he'd been checking every day, Ramey called Willey.

"We put an offer in that night," Ramey said, smiling widely, then adding: "Sure enough, our offer was accepted."

They bought the house, which had sold for more than $500,000 three years earlier, for $233,000.

"Every day, we can't wait to get home," Ramey said, while giving a tour of the house. Everything in it, stainless steel appliances, tile floors, paint, looked brand spanking new. A koi pond and above-ground pool shared space in the backyard with magnolia trees and hibiscus plants.

The family that lost that house had put love and money into it. Ramey said the solar panels – which have cut their utility bills to $30 from $250 when they were renting – were appraised at over $100,000.

"You hear all these horrible stories," Ramey said. "There are so many other aspects to this. This market, the way it is, gave us the opportunity to live the American dream."

EVELYN NIEVES, Huffington Post, 01/10/10

The credit binge has been over for years, but the real hangover starts in 2010 for banks holding a lot of commercial real estate loans.

During the easy lending days of 2005 to 2008, banks extended a wave of such loans to retailers, office building owners, hotels and other businesses. But business profits have plummeted since then, and with vacancy rates soaring and rents falling, real estate values have plunged as well.

Refinancing and retiring these credits could be a nightmare; a majority of loans due through 2014 may be underwater, industry experts say, meaning more banks will be forced to restructure loans to avoid costly foreclosures.

"For a lot of community and regional banks that have a concentration in real estate, it's gotta be problem No. 1," said Matthew Anderson, a partner with Foresight Analytics LLC, a market research firm in Oakland, Calif. "For the largest banks, actually, commercial real estate isn't as big an exposure as consumer lending. But for a lot of those regional and community banks, commercial real estate is their main focus. At a minimum, it's going to be a drag on earnings."

U.S. banks had a historic $1.3 trillion of commercial mortgages outstanding as of Sept. 30, with about $60.5 billion of them delinquent, Foresight estimated.

About $650 billion in banks' boom-time CRE loans are coming due over the next four years, with more than $150 billion maturing in 2010. About 43% of the loans due next year exceed the current value of the properties they cover, Foresight said. The percentage of underwater loans due in 2011 is 60%, and the figure rises for each year thereafter.

"Everyone's view is pretty much consistent on this: there are significant numbers of commercial mortgage loans that are underwater because real estate property values have dropped significantly," said Robert Gordon, a partner at the law firm Mayer Brown LLP. "Even for loans that are performing on a cash-flow basis, when they hit maturity, it is going to be difficult to refinance them without additional equity."

But is CRE due for a meltdown akin to the home mortgage crisis? Market watchers have been describing CRE as the proverbial next shoe to drop in the credit crisis for at least a year now. Gordon and others say that may be overblown, though banks are certainly in for a period of extended pain.

"Everything is dependent on the economy and how quickly do we see a recovery taking place," said Keith Leggett, the senior economist at the American Bankers Association. "That will be a key factor affecting the commercial real estate market. Because [when] you have high levels of unemployment, you're probably also going to see higher vacancy rates. This is going to put pressure on rents."

CRE stress is already doing plenty of damage. It's been a key factor at a number of the 140 banks that had failed in this cycle through Monday. Though CRE losses have not been as severe as losses on construction and development credits, they are accelerating. The CRE delinquency rate of 4.63% at Sept. 30 was up from 4.1% in the prior quarter and 2.1% a year earlier, according to Foresight. It could spike to 5.6% for the last three months of the year.

While a full-blown CRE crisis is conceivable, the more likely scenario is that small and midsize banks are just beginning a long slog through billions of dollars in commercial real estate losses.

Helping banks avoid the worst: CRE loans are not all coming due at the same time, and the loans that are the deepest underwater — issued at the credit bubble's peak — do not mature for another couple of years. CRE loans tend to have a lifetime of five years or more.

"A lot of our deals were done on 10-year maturities, with five-year price resets," said Steve Rice, executive vice president of commercial banking with Umpqua Holdings Corp. in Portland, Ore. "The greater challenge for the entire market and entire industry is when the hard maturities come due."

Catherine Mealor, a banking analyst with KBW Inc.'s Keefe, Bruyette & Woods Inc., noted that with CRE loans tending to carry longer-dated maturities than other kinds of commercial loans, banks have more time to grow earnings and cover their CRE losses.

And the favorable terms borrowers got at the height of the credit boom mean it is relatively easy for them to keep making interest payments, even if retiring the loan is an issue.

"Losses will come, but the burn will be slow," Richard Ramsden, an analyst with Goldman Sachs & Co., said in a CRE research note earlier this year. "Commercial mortgages will be an issue, but given the cash flow on the properties coupled with a zero-interest rate environment, banks can deal with the issue slowly as there is debt service coverage flexibility" even if the borrowers' properties "are way underwater."

That means borrowers can stay solvent as long as they do not have to retire the loan. Recognizing this, regional lenders like Susquehanna Bancshares Inc. in Lititz, Pa., and Umpqua have been giving more extensions and other concessions to worthy commercial borrowers that have fallen on hard times. The trend should accelerate after regulators issued a policy statement in October that essentially gave banks their blessing to work out loans with borrowers that are earning money and making payments, even if their properties are underwater.

Whether this guidance is good for the industry remains a subject of debate.

Supporters of workouts say they let banks stave off losses while building goodwill with borrowers that have the potential to survive the recession. They also buy time for lenders to improve earnings and raise more capital to absorb future losses.

Detractors say workouts can be abused to mask banks' true health and may draw out the downturn by enabling lenders to "extend and pretend." Mealor said the flexibility regulators have granted banks comes with a price: They will keep a closer eye on CRE books, and may require bankers to raise reserves to cover troubled loans, even if the bankers avoid having to charge them off.

"It's kind of a race against time," Anderson said. "Whether the economic recovery is strong enough or fast enough to prop up the commercial real estate [market] remains to be seen."

I finished my indoctrination on how to overthrow the government last weekend. Specifically, I attended a grass roots meeting of activists in Berkeley, California planning to collect 450,000 signatures by April to put the “California Democracy Act of 2010” on the November ballot.

The measure seeks to amend California’s broken constitution by permitting passage of budget and tax measures with a simple majority. The current two thirds requirement, which California shares only with the miniature states of Rhode Island and Delaware, is widely blamed for the legislative impasse in Sacramento that has driven the state to financial ruin.

Overdependence on capital gains—up to 40% of revenues in good years—enabled  the state to just barely balance the budget at stock and real estate market tops, but to death spiral into hemorrhaging  deficits during the inevitable busts that followed. Furthermore, since proposition 13 capped real estate taxes at 1.25% in 1978, the state’s population has grown by 16 million to 38 million, placing a backbreaking strain on all services.

Our hulking, language mangling, steroid injecting  governator, viewed by both parties as a complete failure in his seven years in office, blames it all on Washington. There is some merit to what Arnold claims. The Internal Revenue Service is basically a giant machine devilishly designed to suck money out of California and spend it everywhere else. The Golden State is far and away the largest revenue generator for the federal government, but only gets back 78 cents out of every dollar it forks over. The rest is blown in the Midwest, the South, and Alaska—huge net recipients of tax dollars—and usually the first and loudest to complain about free government handouts. The second biggest net payer into the system is, surprise, surprise, New York. This has been going on for decades.

Only six obstinate legislators from the farm belt and the Deep South (Orange County) are holding hostage the world’s sixth largest economy, right after France. During the frequent 24 hour debates over the budget, they show up with Costco sized bags of Cheetos, soggy baloney sandwiches, and six packs of Diet coke so they can camp out, and if necessary, sleep at their desks in order to cast a “no” vote at every opportunity.

Decades of relentless gerrymandering have made virtually every seat in the state safe, so elections offer no solutions. Daryl Steinberg, president of the California Senate, told me that voters of all political stripes are fed up to the gills. Once boasting the best public education system in the country, California now ranks 47th in spending/pupil and 49th in pupils/teacher. The University of California, the top public university in the world, and a veritable PhD and Nobel Prize factory, has endured two 20% back to back budget cuts. Students are rioting, and for good cause. Schools, police and fire departments, parks and aid agencies are closing throughout the state. My local high school had to cancel its sports and music programs to keep class sizes from rising above 40.

Antiquated infrastructure is falling apart, with the San Francisco Bay Bridge closed for five days in November, forcing the local economy to take a huge hit. The barbaric prison system, which has been ruled by a federal judge as inflicting “cruel and unusual punishment,” is letting 24,000 prisoners out early, since it can’t afford to house or feed them. The public outrage is so violent the initiative will almost certainly pass.

When it does, taxes are going to go up a lot. Target numero uno: property taxes and the top 5% of income earners. Expect a battle royal, as the top 1% of taxpayers already pay a marginal state tax rate of 10.3%, the second highest in the country after Vermont, generating 50% of state revenues. This will make our sunshine the world’s most expensive.

That will be great news for the Golden State’s beleaguered bond holders, who will love to see new sustainable sources of revenue. Take a look at the California municipal bond funds (VCV), (NCP), and the (NVX). Any hint that the Land of Fruits and Nuts is about to make a major dent in this year’s anticipated $21 billion budget deficit will cause the yields on its long dated tax free paper to shed its distressed premium very quickly, sending prices soaring.

If California were a stock, I’d be buying it now, but you can do the next best thing with bonds.  If you want to join the revolution, or just learn more about the issue, go to www.CAMajorityRule.com

By www.madhedgefundtrader.com, 1/7/10

FOR many Japanese the boom years are still seared on their memories. They recall the embarrassing prices paid for works by Van Gogh and Renoir; the trophy properties in Manhattan; the crazy working hours and the rush to get to the overcrowded ski resorts at the weekend, only to waste hours queuing at the lifts.

The bust, when it came, was less perceptible. The world did not come crashing down after December 29th 1989, the last trading day of that decade, when the stockmarket peaked. The next year Japanese buyers were still paying record prices for Impressionist art at Christie’s. It was not until 1991 that the property bubble burst. There was no Lehman-style collapse or Bernie Madoff-type fraud to hammer home the full extent of the hubris.

But once the Nikkei 225 hit 38,916 points 20 years ago this week, life began to leach out of the Japanese economy. In the third quarter of 2009 nominal GDP—though still vast by global standards—sank below its level in 1992, reinforcing the impression of not one but two lost decades. Deflation is back in the headlines. On December 29th the Nikkei stood at 10,638, 73% below its peak, though an expansionary budget drafted on December 25th has given it a recent lift. Urban property prices have fallen by almost two-thirds. Some ski apartments are worth just one-tenth of what the “bubble generation” paid for them.

What effect has this steady erosion of value had on the psychology of Japanese people? The bust did not lay waste to Japan, after all, as the Depression did to America in the 1930s. Homelessness and suicide have risen, and life has got much harder for young people seeking good jobs. But Japan still has ¥1,500 trillion ($16.3 trillion) of savings, its exporters are world-class, and many of its citizens dress, shop and eat lavishly. As a senior civil servant puts it: “Japanese people have never really felt that they are in crisis, even though the economy is slowly withering away.”

For individuals the damage lies below the surface. One of the first bubbles to pop, says Peter Tasker of Arcus Research, who has written several books on the bust, was a psychological one: confidence. Instead of getting angry, people lost faith in Japan’s economic prowess. “It became all about declining expectations and how society coped with it,” Mr Tasker says.

The mood among investors swiftly turned risk-averse. Remarkably, retail investors were among the first to get out of the stockmarket and were net sellers of equities from 1991 to 2007, says Kathy Matsui, chief strategist for Goldman Sachs in Japan. Though there have been four bear-market share-price rallies since 1989, they have all been driven by foreigners.

The Japanese parked their money instead in government-backed shelters such as the post office, which in turn invested in safe bonds. The result has been a 78% rally in ten-year government bonds since their trough in 1990 (see chart). “Fixed income has been one of the longest-duration bull markets in the world,” Ms Matsui notes.

A deflationary mindset started to take hold. With prices falling, even inert money in the bank or post office earned, in real terms, a small tax-free return. Once the banking system began to look frail, there was a boom in the sale of safes for people to keep their cash at home. A long period of zero interest rates led a few to hunt for higher yields abroad. The mythical figure of Mrs Watanabe—housewives in Japan manage the family money—invested in New Zealand dollars and Icelandic kronur. These days she is placing large bets on Brazilian bonds, leading to the quip that although Tokyo failed to secure the 2016 Olympics, the Japanese will finance the games in Rio de Janeiro anyway. Yet individual Japanese investors are still only gingerly returning to their own stockmarket.

The most pernicious effects of the bust, economists say, have been transmitted via banks and businesses. Banks found themselves loaded down with non-performing loans. Belatedly they faced up to many of their losses, restructured and consolidated. But according to Takuji Aida, an economist at UBS in Japan, long-term yields remained very low because of deflationary expectations, thereby flattening the yield curve (the difference between short- and long-term interest rates). That prevented banks from earning their way out of crisis, so lending remains weak.

Companies, meanwhile, have been focused on paying down debt, as well as coping with deflation in the domestic economy and competition from cut-price imports. Large exporters were forced to restructure and enjoyed a long boom from 2002 to 2007. But firms in more protected areas of the domestic economy have fared badly: profitability, wages and investment have declined in the past decade.

This has fed back to households. As firms cut back, the proportion of full-time contract jobs has fallen from almost 80% of the labour force in 1990 to 66% in 2007, according to the OECD. The proportion of lower-paid non-regular jobs has risen correspondingly. This is partly down to the increasing role of women in the workforce, as declining wages and benefits force families to rely on two incomes. But there are long-term social costs to this extended income drought. “The slow wear-and-tear of the recession has made people much less confident of their ability to finance children,” Mr Tasker says.

A weak culture of consumer borrowing means that people have been forced to rely even more on their savings—or those of their parents. But as society ages, growth in the stock of savings has dwindled. Savings are bound to fall as more people retire. For the younger generation the next decade may be even tougher than the past two.

The Economist, 12-30-09

Here are his two slides about exotic mortgages:

Click on graph for larger image in new window.

Slide 7 also shows initial monthly payments for some alternative types of variable-rate mortgages, including interest-only ARMs, long-amortization ARMs, negative amortization ARMs (in which the initial payment does not even cover interest costs), and pay-option ARMs (which give the borrower considerable flexibility regarding the size of monthly payments in the early stages of the contract). These more exotic mortgages show much more significant reductions in the initial monthly payment than could be obtained through a standard ARM. Clearly, for lenders and borrowers focused on minimizing the initial payment, the choice of mortgage type was far more important than the level of short-term interest rates.

The availability of these alternative mortgage products proved to be quite important and, as many have recognized, is likely a key explanation of the housing bubble. Slide 8 shows the percentage of variable-rate mortgages originated with various exotic features, beginning in 2000. As you can see, the use of these nonstandard features increased rapidly from early in the decade through 2005 or 2006. Because such features are presumably not appropriate for many borrowers, Slide 8 is evidence of a protracted deterioration in mortgage underwriting standards, which was further exacerbated by practices such as the use of no-documentation loans. The picture that emerges is consistent with many accounts of the period: At some point, both lenders and borrowers became convinced that house prices would only go up. Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages.

Pimco managing director Bill Gross not only oversees the world's biggest bond fund, his views often sway markets. In a late December interview with TIME's John Curran, Gross pointed to the second half of 2010 as a period when investors large and small will reckon with a new reality of poor economic growth and a Federal Reserve that is hard pressed to offer much help.

TIME: Where do you see the economy going over the next 6 to 12 months?
Bill Gross: The economy should be relatively strong in the first half of 2010 then weaken in the second half. That's not to say we'll return to recession but we'll see weakness as opposed to a continuation of what will probably be a decent first half.

What will make the first half of 2010 so good?
The first half will be dominated by government stimulus and by inventory accumulation or a lack of [inventory] liquidation among businesses. I expect nothing from consumer [spending] and nothing really from housing or really any of the standard cyclical leading sectors. It's hard to put a number on GDP growth rates, but let's say 4% in the first half and then 2% in the second half, which would basically call for some additional help. (See TIME's 2009 Person of the Year: Federal Reserve Chairman Ben Bernanke.)

You're talking about a second shot of federal stimulus?
Yes, something else is probably needed if the [government's] thrust is really reducing unemployment below double digits and re-normalizing the economy.

What does this say about the Federal Reserve's hopes to start pulling its added liquidity out of the markets, either by raising short-term rates or just getting out of buying bonds, which has been keeping long rates low?
I think the Fed's statements suggest that they really want to exit in some fashion from the buying program. The first step in that direction, logically, would be to stop buying and our sense is that they're at least going to try that. But based on our forecasts for the second half of the year they may have to re-initiate it, and that will be difficult to do once they stop because it then becomes a political hot potato.

All that said, I think they'll stop buying mortgage agency securities, and the trillion-and-a-half dollar check that's been written over the past 9 to 12 months basically disappears. It's significant from the standpoint of interest rates and interest rate spreads in certain sectors. And I would even go so far as to say it might be a mistake. (See the best business deals of 2009.)

Because they might have to restart the buying program later?
Yes, I think the Fed wonders about this as well. But you have to understand that the Fed's probably under political pressure — such as the hearings for new regulation of the Fed, the growing public unease about the supersized Fed balance sheet, etc.. The Fed's expanded balance sheet is not something that I consider to be a problem, but I think the market does — and so the Fed will probably be working in the direction of pulling some of the liquidity out of the marketplace. They won't sell — it's a near impossibility to unload what they've purchased over past 12 months. But they'll at least stop buying. (See the worst business deals of 2009.)

Won't that put upward pressure on interest rates?
I think it will. I mean the mortgage market would be your first place to look in terms of something that's overvalued that would become normalized. Nobody knows what the Fed's buying is worth — we think about half a percentage point on rates, but we don't know.

But secondly, there's a ripple affect. Just speaking about Pimco's general portfolio strategy, we've sold our agency mortgage securities, Fannie and Freddie, in the billions to the willing check of the Fed. They're buying a trillion dollars of them, or have over the past 9-12 months, and so we sold them a lot of ours. Now, what did we do with the money? We bought Treasuries, we bought corporate bonds, and so the bond markets in general have benefited, as have stocks because this available money effectively flows through the capital markets. So it's a trillion-and-a-half dollar check that won't be there as the Fed withdraws from the market. How that affects the markets, I just don't know. I'm not eagerly anticipating the answer, but I think it holds some surprises in 2010, not just in mortgage securities but stocks as well. We could miss the money, put it that way.

IT seems so distant, 1999. Bill Clinton had survived impeachment, his popularity hardly dented, Sept. 11 was just another date and music fans were enjoying a young singer named Britney Spears.

But there was a particular unease in the air. The so-called Y2K problem, the inability of computers to read dates beyond 1999 threatened to turn Jan. 1, 2000 into a nightmare. The issue had first been noticed by programmers in the 1950s, but had been ignored. As the turn of the century loomed, though, it seemed that humankind faced a litany of horrors.

Haywire navigation controls might cause aircraft to fall from the skies. Electricity grids, water systems and telephone networks would be knocked out, while nuclear power plants would be subject to meltdown. Savings and pension accounts would be wiped out in a general bank failure. A cascade of breakdowns in communication and commerce would create vast shortages of food and medicine, which would, in turn, produce riots, lawlessness and social collapse. Even worse, ICBMs might rise from their silos unbidden, spreading death across the globe.

Y2K problems would not be limited to mainframe computers that governed the information systems of the modern world, but were going to affect millions of tiny computer chips found everywhere. Thanks to these wonky microprocessors, elevators would die, G.P.S. devices would stop working and dishwashers would dry the food onto the plates before trying to rinse it off. Even ordinary cars might spontaneously accelerate to fatal, uncontrollable speeds, with brakes failing to respond.

The Y2K catastrophe was promoted with increasing shrillness toward century’s end: headlines proclaimed a “computer time bomb” or “a date with disaster.” Vanity Fair’s January 1999 article “The Y2K Nightmare” caught the sensationalist tone, claiming that “folly, greed and denial” had “muffled two decades of warnings from technology experts.”

Among the most reviled of the Y2K deniers was Bill Gates, who not only declared that Microsoft’s PCs would take the date turnover in stride, but had the audacity to blame those who “love to tell tales of fear” for the worldwide anxiety. Mr. Gates’s denialism was ignored as governments and corporations set in place immensely expensive schemes to immunize systems against the Y2K bug.

They weren’t the only ones keen to get in on the end-time spirit. The Rev. Jerry Falwell suggested that Y2K would be the confirmation of Christian prophecy, “God’s instrument to shake this nation, to humble this nation.” The Y2K crisis might incite a worldwide revival that would lead to “the rapture of the church.” Along with many survivalists, Mr. Falwell advised stocking up on food and guns.

So the scene was set here in New Zealand for midnight on Dec. 31, 1999. We are just west of the dateline, and thus would be the first to experience not only popping Champagne corks and fireworks, but the Y2K catastrophe, if any. As clocks hit midnight, Champagne and skyrockets were the only explosions of interest, since telephones, ATMs, cars, computers and airplanes worked just fine. The head of the government’s Y2K Readiness Commission declared victory: “New Zealand’s investment in planning and preparation has paid off.”

Confident that our millions were well spent, we waited for news of the calamities sure to hit countries that had ignored Y2K. Asia, a Deutsche Bank official had predicted, was going to be “burnt toast” on New Year’s Day — not just the lesser-developed areas of Vietnam and China, but South Korea, which by 1999 was a highly computer-dependent society. South Korea, one computer expert told me, had a national telephone system similar to British Telecom’s. But where the British had wisely sunk millions of pounds into Y2K remediation, South Korea had done next to nothing.

However, exactly 10 years ago today, as the date change moved on through the Far East, India, Russia, the Middle East and Europe, it became apparent that it made little difference whether you lived in Britain, which at great expense had revamped many of its computer systems, or the lackadaisical Ukraine, which had ignored the issue.

With minor glitches that would have gone unnoticed any other day of the week, the world kept ticking on. It must have been galling for computer-conscientious Germans to observe how life continued its pleasurable path for feckless Italians, who had generally paid no attention to Y2K. There were problems, to be sure: in Australia, a bus-ticket machine stamped the wrong date, while in Britain a tide gauge in Portsmouth Harbor failed. Still, the South Korean phone system came through unscathed.

By the time midnight reached the United States, where upward of $100 billion had been spent on Y2K fixes, there was little anxiety. Indeed, the general health of American information systems, fixed and not, became clearer in the new year. The Small Business Administration calculated that 1.5 million businesses had undertaken no Y2K remediation. On Jan. 3, it received about 40 phone calls from businesses that had experienced minor faults, like cash registers that misread the year “2000” as “1900” (which seemed everywhere the single most common error caused by Y2K).

KNOWING our computers is difficult enough. Harder still is to know ourselves, including our inner demons. From today’s perspective, the Y2K fiasco seems to be less about technology than about a morbid fascination with end-of-the-world scenarios. This ought to strike us as strange. The cold war was fading in 1999, we were witnessing a worldwide growth in wealth and standards of living, and Islamic terrorism was not yet seen as a serious global threat. It should have been a year of golden weather, a time for the human race to relax and look toward a brighter, more peaceful future. Instead, with computers as a flimsy pretext, many seemed to take pleasure in frightening themselves to death over a coming calamity.

No doubt part of the blame must go to those consultants who took businesses and governments for an expensive ride in the lead-up to New Year’s Day. But doom-laden exaggerations about Y2K fell on ears that were all-too receptive. The Y2K fiasco was about more than simple prudence.

Religions from Zoroastrianism to Judaism to Christianity to U.F.O. cults have been built around notions of sin and the world’s end. The Y2K threat resonated with those ideas. Human beings have constructed an enormous, wasteful, unnatural civilization, filled with sin — or, worse in some minds, pollution and environmental waste. Suppose it turned out that a couple of zeros inadvertently left off old computer codes brought crashing down the very civilization computers helped to create. Cosmic justice!

The theme of our fancy inventions ultimately destroying us has been a favorite in fiction at least since Mary Shelley’s “Frankenstein.” We can place alongside this a continuous succession of spectacular films built on visions of the end of the world. Such end-time fantasies must have a profound, persistent appeal in order to keep drawing wide-eyed crowds into movie theaters, as historically they have drawn crowds into churches, year after year.

Apocalyptic scenarios are a diversion from real problems — poverty, terrorism, broken financial systems — needing intelligent attention. Even something as down-to-earth as the swine-flu scare has seemed at moments to be less about testing our health care system and its emergency readiness than about the fate of a diseased civilization drowning in its own fluids. We wallow in the idea that one day everything might change in, as St. Paul put it, the “twinkling of an eye” — that a calamity might prove to be the longed-for transformation. But turning practical problems into cosmic cataclysms takes us further away from actual solutions.

This applies, in my view, to the towering seas, storms, droughts and mass extinctions of popular climate catastrophism. Such entertaining visions owe less to scientific climatology than to eschatology, and that familiar sense that modernity and its wasteful comforts are bringing us closer to a biblical day of judgment. As that headline put it for Y2K, predictions of the end of the world are often intertwined with condemnations of human “folly, greed and denial.” Repent and recycle!

In response to the depressed state of the real estate and capital markets, large amounts of capital are now chasing opportunities to purchase defaulted commercial real estate loans at a discount. Not since the savings and loan crisis in the late 1980s has the market expected a comparable volume of loans to be sold.

For savvy buyers, this is a chance to earn enviable returns. However, it also is an opportunity for those who do not fully understand the nature of what they are buying to lose money — lots of money.

Depending on the quality of the loan documents and the history of the loan, the borrower may have defenses and claims that can seriously delay a foreclosure on the collateral and reduce the ultimate return to the loan buyer.

Discussions at industry trade shows and seminars that focus on buying distressed mortgage debt often only address the need to price and evaluate the underlying real estate. While the real estate asset securing the loan ultimately is the source of repayment, a buyer of these loans must realize that he is not buying the real estate collateral.

Instead, the buyer is literally acquiring a stack of paper comprising the loan documents that embody certain legal obligations and rights of the lender and borrower. That is a fundamentally different asset from the real estate.

Assuming there is no fatal flaw in the loan documents, the rights of the lender will include the right to foreclose on the mortgage and become the owner of the real estate. But depending on the facts and circumstances, that may be an easy path or a long hard road.

Modeling the masters

A valuation methodology for purchasing defaulted mortgage loans should take into account, on a net present value basis or capitalization rate basis, both the cash flow and liquidation value of the real estate, as well as the expense and length of time it will take to convert the loan into ownership of the real estate collateral.

In the early 1990s, the Resolution Trust Corporation developed a valuation methodology, the Derived Investment Value (DIV) methodology. The DIV took into account all of the unique attributes of distressed debt that make valuing it different from valuing the underlying real estate.

Such factors included the length of time required to complete a mortgage foreclosure and the widely differing mortgage foreclosure procedures from state to state, depending on whether the process is judicial or non-judicial foreclosure.

Other important factors that the DIV methodology took into account included the length of time to recover the collateral out of a borrower bankruptcy proceeding, the time period to market and sell the real estate after foreclosure, assumptions regarding the availability of interim cash flow to the lender, and expenses that would be incurred by the lender in the entire process. These basic principles contained in the DIV methodology largely remain valid today.

Similarly, discussions of due diligence in connection with purchasing defaulted mortgage loans all too often focus only on the attributes of the underlying real estate and not the mortgage loan itself. Ultimately, the length of time and the cost of converting the paper into owning the real estate will depend on the specific attributes of the mortgage loan.

For example, are there material flaws in the loan documentation? Have events occurred since the loan was originated that have provided the borrower defenses and claims that can be used to contest a foreclosure? Are there title problems such as liens prior to the mortgage?

Most of these due diligence issues can be addressed by careful review and analysis of the loan documents and loan servicing files, including the relevant correspondence files, and through public record searches.

Bankruptcy risk

One unique and important loan documentation consideration is whether there is a “carve-out guaranty,” also known as a “springing guaranty.” In effect, this is a guaranty under which the person controlling the borrower has agreed that he or she will become liable on a recourse basis for the loan, if certain “bad” actions are taken by the borrower. Typically, the guarantor under such a guaranty will become personally liable for the loan if the borrower files bankruptcy.

A bankruptcy filing by the borrower is generally something the lender wants to avoid. The bankruptcy imposes an immediate prohibition, an automatic stay, against the pursuit by any creditors of their claims against the borrower, including a mortgage foreclosure by the lender.

At a minimum, the borrower bankruptcy will cause the lender to incur significant additional legal costs and may materially delay recovery by the lender of its collateral. Carve-out guaranties are behavior control devices that are intended to impose the adverse consequence of recourse liability on the person controlling the borrower so as to make it less likely that they will choose to put the borrower in bankruptcy.

These kinds of guaranties have been found to be enforceable by the courts and have proven to be an effective deterrent to bankruptcy filing and enhance the value of the mortgage loan.

Gauging the risk of whether the borrower will file bankruptcy is an important part of pricing a distressed debt purchase, and knowing whether or not you will have an effective carve-out guaranty as part of your loan documents is very important.

Of course, due diligence of loan documentation and files can only be conducted to the extent such items are made available by the seller for review. Hopefully, deficiencies in this regard can be addressed with adequate seller representations and warranties.

The loan seller should, at a minimum, confirm the outstanding balance of the principal and interest of loan and should identify the specific instruments that constitute the loan documents, including any loan document amendments.

Additionally, the loan seller should confirm the completeness of the due diligence file and identify any material correspondence to or from the borrower and to or from governmental entities regarding the real estate.

It certainly appears that 2010 will present great opportunities in the distressed debt marketplace for those who invest wisely. However, as with all strategic investments, buying at the right price is everything, and to do that you have to know what it is you are buying: a stack of paper comprising the loan documents that needs to be carefully evaluated.

Patrick M. McGeehan, National Real Estate Investor, 12-18-09

When it comes to market bubbles and how they are created, very little, if anything, has changed. This is because human psychology has not changed. Massive bubbles are created when large numbers of people buy into "new era" stories that exaggerate how much the world has improved. For example, in the past few years the global equities and housing bubbles were driven by a giddy faith that world markets were on a tear and prices would go up indefinitely. Our animal spirits are sparked by these tales; we find them irresistible. And since as animals we're also given to a herd mentality, in a bubble we tend to invest too much in the most popular stories—and continue to do so even after the bubble bursts.

As I wrote in my book irrational exuberance in 2000, one of the key stories of our time is the triumph of capitalism. This theme was underscored by the disintegration of the Soviet Union and China's shift to a market economy. But many true believers got the details wrong—and became convinced, for example, that capitalism means market prices will always go up.

In the several decades since the worldwide rise of market economies, our perceptions of ourselves have changed greatly—while young people back then might have become hippies, deeply skeptical of business, today's young people are very concerned with making money. They might have temporarily questioned the idea of capitalism after the financial crisis, but quickly shrugged off their qualms. People still largely believe in the ownership society and in markets. They believe in the importance of doing business, and they generally believe that we all have a responsibility to take care of ourselves. So much for the idea that we're all socialists now; while many countries do take care of society's losers to a significant extent, we don't idealize doing so, as we once did. And this unadulterated belief in capitalism helped to fuel the bubbles that led to the crash.

Yet old ideas about markets—especially the notion that they always go up—have changed far less than you'd think. My partner, Karl Case, and I (founders of the S&P/Case-Shiller home-price index) recently conducted a survey of people's expectations of the U.S. housing market and found that, despite all the problems of the past few years, Americans still expect prices to rise over the mid- and long term—even though my data show that between 1890 and 1990 real home prices actually didn't increase.

Bubbles are also encouraged by the Internet and by high-speed data transmission. People pick up ideas in newspapers, via TV, or online, then spread them via word of mouth. Anyone who's ever played the children's game of telephone knows that, once started, a story or idea takes on a life of its own. It's probably no accident that the tulip mania of the early 1600s occurred around the time the first newspapers and pamphlets began circulating, and that the crash of 1921 coincided with the first mass radio broadcasts. The Internet helped fuel the tech bubble and the financial crisis. I have no doubt that new social media like Twitter or Facebook will contribute to the next craze, or that the Internet will have other, unexpected effects on markets as well.

Still, shouldn't we learn something from our past mistakes? The good news is that some of us do. In some cases, it's generational—there's evidence to suggest that people learn best from seismic events that happen to them in their youth (which is why the Great Depression resulted in lifelong behavioral shifts for many people). In other cases, however, people simply don't pay attention to the right information—or it may take them a while to come to it. Economics is an imperfect science, and it often goes off on tangents. For example, a few years back, economists were enamored with the efficient-markets theory—the idea that the markets always know best. Now, post-crisis, that's finally changing, and even the G20 recently issued a warning about bubbles. But while this awareness may help keep them in check for a few years, it won't eradicate them.

Nor will it be the end of the world when we go through the next one. The triumph of capitalism remains a powerful story, and no matter the shocks to come, we're unlikely to forget it.