Beautiful Burnout

First things first. My dear friend and regular correspondent Sadia, a music and arts film producer of some repute, has saved me from my musical fixation with Everlast by helping me change the channel to a band called Underworld, whose song Beautiful Burnout you can listen to here.

It’s a bit “New Age,” but certainly qualifies for inclusion in anyone’s library of dramatic music. Just the thing for energetically typing on topics related to the economy and whatever else might catch one’s attention in the wee hours.

Speaking of beautiful burnouts, it came across the wires this morning that the first batch of commercial mortgage bonds to be successfully liquidated in the UK since the crisis kicked off changed hands at a 56% discount to their peak value.

This, of course, is no surprise to readers of The Casey Report, who were warned about the coming wave of commercial real estate defaults since our September 2, 2008 lead article “Real Problems for Real Estate,” which included a lengthy and downright prescient interview with professional real estate investor Andy Miller.

(Subscribers can read the issue by logging in at CaseyResearch.com and clicking on the archives link. Not yet a subscriber? Easily fixed, with a three-month, no-risk trial… click here.)

Today’s news, as reported on Bloomberg, included the following notations that are very applicable to the situation that will soon be faced in extremis here in the United States (and elsewhere)…

Bank lenders have been willing to extend loans to help borrowers avoid default, while commercial mortgage bond issuers must repay investors by a set deadline.

“If they’re not nervous now, then they’ve been hiding under a rock,” said Hans Vrensen, interviewed in his role as head of European securitization research at Barclays Capital Inc, which he left last week.

Loans against hundreds of buildings were securitized throughout Europe, with more than 60 percent packaged near the market’s peak. They include Paris’s Coeur Defense, the largest office complex in Europe; London’s city hall; German apartment blocks; and British hospitals and care homes.

“There’s very little appetite among banks to recognize losses on their property loans, but CMBS doesn’t have that luxury,” said Jeffrey Rubinoff, a London-based real estate finance lawyer at Freshfields Bruckhaus Deringer LLP. “If maturity is looming, you’re up against a hard date.”

Earlier in the week, Andy Miller tipped me to the latest Fitch Ratings report on the state of the U.S. commercial real estate market. Or, more specifically, their expectations for the losses to be suffered by the sector this year and next. Some highlights… (lowlights?)

Fitch expects loss severities in 2009 and 2010 to “rise markedly over 2008,” and that disposition time – the time it takes to work out terms on a troubled loan – will increase to between 24 and 36 months. This is due to the limited financing available and a record backlog of loans now in the hands of special servicers – a backlog that has grown 300% since the beginning of 2009. Special servicers are the folks hired to do the loan workouts.

By digging a bit further, I learned that between January and the end of June 2009, the number of unresolved commercial loans in the hands of special servicers rose to 4,504, “a 33% increase by loan count and a more dramatic 134% rise by unpaid principal balance compared with the prior six-month period.” Further, the size of the average loan now entering special servicing has nearly doubled from 2008, to $14.8 million. During the first six years of 2009, just 814 loan restructurings were completed, of which only 156 involved a full payout.

And the real fun begins in the first quarter of next year and then continues throughout the year, and into the next, and the next, as hundreds of billions of dollars of commercial loans reach maturity.

While it’s still too early to assess the potential damage, we can gain some useful perspective by looking over the 2008 Commercial Mortgage Backed Securities (CMBS) Loss Study that Fitch also released earlier this week. That study showed that 22.1% of the loans resolved by special servicers were disposed with a loss. And that the average loss of loans experiencing losses was -42.9%, further broken down as follows by property type:

The mainstream press is starting to catch on to the idea that all is not well in commercial real estate, evidenced by a report titled “Commercial Real Estate Bust Looms” on NBC’s Los Angeles affiliate. In that report, a member of one of the nation’s leading families of real estate had the following to say…

“I have never seen anything this bad,” said Dan Tishman, CEO of Tishman Construction, one of the nation's leading construction and management firms, comparing the current slide to major commercial real estate busts in the 1980s and '90s.

Now that pretty much everyone can see what’s coming, what also comes next is easy to anticipate. Namely, a quick bugle call to bring the federal cavalry at a trot. An article on CoStar Group’s website yesterday was appropriately titled “Feds Ready to Start Pushing Banks Toward CRE Loan Workouts.” Some useful snippets…

With the Federal Deposit Insurance Corp. (FDIC) probably within days of shutting down its 100th troubled bank of 2009, bank regulators are getting ready to issue new workout guidelines that will push banks to restructure troubled commercial construction and mortgage loans to head off massive foreclosures that some economists believe could threaten the fragile economic recovery. 

And this…

One of the biggest current sources of that risk is losses on deteriorating commercial real estate mortgage, with small- and medium-sized banks particularly overweight in CRE loans, FDIC Chairman Sheila Bair and other federal regulators said in testimony last week before the U.S. Senate Banking, Housing and Urban Affairs Committee.

Bair, Comptroller of the Currency John Dugan and Office of Thrift Supervision deputy director of examinations, supervision and consumer protection Timothy Ward testified they are close to finalizing new guidelines for banks on how to modify troubled commercial real-estate loans to reduce defaults and foreclosures, and how to account for losses from those loans. Some analysts say the "extend and pretend" practices of lenders who extend loan maturities because they're unwilling to seize properties from borrowers and take the losses are prolonging the slump in transaction activity and delaying the process of price discovery. 

Unlike a boo-boo, where a kiss is thought to make it all better, even the most strident smooch will not improve a deeply underwater $14.8 million commercial loan – or a securitized bundle of such loans. Therefore, unless the new guidelines include some sort of firm government guarantee against loss that significantly changes the nature of the loans (by putting you, dear taxpayer, on the firing line), the banks and property companies are going to ultimately have to take it in the neck.

As are the many insurance companies, pension funds, and mutual funds that were previously ardent fans of CMBS paper.

While the Wizards of Washington can pull any number of rabbits out of cone-shaped hats, dictating that commercial real estate valuations should rise by almost 100% from today’s levels, the amount loosely needed to make this particular boo-boo all better, isn’t one of them.

So, what’s to be done? First and foremost, stay away from real estate and hotel stocks, many of which have staged surprising recoveries this year. You might also want to take a closer look at the portfolio holdings of your mutual funds, insurance companies, and banks.

Download on Net Neutrality

By Alex Daley, Casey’s Extraordinary Technology

David here. Today, Thursday, October 22, the FCC is scheduled to vote on new regulations to insure “net neutrality.” The handicappers have it that they will soon become (the latest in a long list of additions to) the law of the land. What to make of it all? For help on that front, we turn to our own Alex Daley, former top tech exec at Microsoft and now the editor of our Casey’s Extraordinary Technology service. Here’s Alex…

I am not a big net neutrality fan. But as a free market guy, it cuts both ways for me. To start, net neutrality (as a concept, not as legislation) is an important component of why the Internet works as well as it does. If I am on a Road Runner cable modem, or a FiOS connection, or my iPhone, I can access the same sites no matter which ISP I choose and expect roughly the same quality of service, relative to the amount of bandwidth on my connection. That is because if I bring up http://failblog.org/, they are paying their ISP to serve up the pages, I am paying my ISP to let me download it, and these two providers agree to distribute each other's content. Each side gets paid by only the party on their end, and thus neither has any control over what can and cannot pass over the network.

But of course the ISPs hate that arrangement. It effectively kills their business model. Lately ISPs, especially cable companies, which are used to having near unlimited control over their own networks, have been hemming and hawing that they want to start charging content providers for the right to send data to their customers. For example, by making Google pay Comcast (and Time Warner Cable and Cablevision, etc...) some indeterminate fee for the right to deliver their content to the customers of those ISPs.

Right now, for instance, when you get Cable TV, Comcast gets paid both by you for delivering a television network, and by the network themselves for the privilege of being carried. The cable company also gets a share of the network’s advertising inventory to sell on to local advertisers. 

If, however, I watch a show on Hulu.com, Comcast gets paid just by me. Hulu doesn't have to pay Comcast -- they only have to pay their own ISP wherever they originate their content (which allows them to shop around for the best place to put their datacenter and get a good bulk price on bandwidth). And Hulu gets to sell all its own ads. It flips the whole model of a cable company upside down, transforming them from a powerful intermediary that controls access to a market of millions to a dumb pipe – easily substituted by any other faster or cheaper dumb pipe – through which flows any content you want, and they have no control over it any longer. Of course they want to resist that.

Cable companies and phone companies have a lot more competition these days, even off the web, in the local video market. But make no mistake, they are still in large part government-sponsored oligopolies. For instance, local municipalities control whether or not more than one company can operate within their territory. As further proof, consider the war being fought in order for FiOS to get rights to build out in this city or that. 

Verizon has been lobbying for states to be able to control franchise rights, instead of individual counties and cities – and of course cable has been lobbying against it, rallying individual municipalities to fight state-level franchising. The reason they can do this, of course, is that the cable companies pay significant fees to municipalities in exchange for the right to use public poles to run their wires. Local governments don't want to lose that revenue, but states want a bigger share and more control of it. Even so, the tide has begun to shift. Between satellite, fiber optic, IPTV from legacy telephone providers, and the world wide web, video is quickly becoming a commodity business.

If I were a shareholder in a cable company, I would want management to fight tooth and nail against the trend of becoming a substitutable commodity. And I would want the company to cut its costs to the bone and recognize that the trend is a virtually unstoppable force – all it can do is delay it a bit and scramble to find a new business model.

All of this, from the onslaught of competition from more video providers, to the way the Internet flips the business model of the cable companies on its head, is causing these companies to flail around desperately for new ways to add growth or even just stem the bleeding. This is why Comcast is trying to buy NBC. And why it is producing unique content – the Golf Channel, G4, Versus, and lots of other niche programming – that is only available through the Comcast service.

Net neutrality legislation – which requires the cable companies and ISPs to treat all content the same, as opposed to actively blocking or slowing down the delivery of some content, in favor of content that they are paid to carry or give preference to – is the final nail in the coffin of the cable business model, which is a dead man walking regardless. It won’t happen overnight, and it make take decades for the cable companies to succumb, but with the legislation, it will be completely inevitable.

So, is net neutrality the government compelling a specific business model? Sure. But so was the entire cable and phone industry to begin with. At least with this business model, there is no party with enough power to charge every side of the market, raise its rates at twice the rate of inflation every year for over a decade, and exercise a large amount of discretionary control over what kind of media you can and cannot have access to.

So, why do I have a problem with it, then? Well, the cable companies have been doing a fine job destroying themselves and don't need government help to accelerate the process. As a free-market kind of guy, I say, "Go ahead Comcast – make Google pay to get on your service. Keep raising my rates with no improvement to my service. Stop innovating again like for the first 30 years or so." It won't destroy the Internet. I'll just switch to using my wireless carrier as an ISP, or to Clearwire, or to FiOS. And even if it does, something even better will pop up to replace it. After all, the Internet – and IPTV, and the digital video recorder, etc. – was born in an age where cable and phone monopolies were even more powerful. The government granted them monopolies and the market took them away from them. With net neutrality, the government is taking away some of that monopoly power, but it is also granting a bit of it to the Internet and its largest players. The well-connected Google, for instance.

The problem with net neutrality legislation is, it assumes that it doesn't get any better than this and tries to keep things the way they are today. I say, let the companies fight it out, destroy each other, destroy themselves. Deregulate more, not less. Let the market come up with an even better invention than the Internet. 

[For the latest developments in technology and how to position yourself to profit, check out Casey’s Extraordinary Technology – which combines a monthly overview with specific in-between-editions Alerts to keep you ahead of the crowd in the single most important sector of the U.S. economy. Check out our risk-free three-month trial subscription by clicking here. ]
 

They’re Coming

The skyrocketing interest of U.S. investors in gold, silver, oil, and other tangible commodities, and the falling dollar that makes international assets even more appealing, should translate into an increasing number of U.S. brokerage firms trying to get in on the action by building global trading platforms for their customers. Scottrade has already done so, as has E-Trade, though both offerings are still relatively rudimentary.

At first glance, it appears that the new international trading service announced by Fidelity Investments today takes things to a new and improved level, opening the door for their millions of customers to join the worldwide party.

In addition to allowing stock trades in 12 foreign markets and eight currencies, the new Fidelity platform also allows you to decide whether you want to settle your foreign trades in U.S. dollars or the local currencies.

It is, of course, the Canadian market that interests us the most – as that is where many of the best resource companies are found. The physical proximity of the Canadian market, its homogeneity with the U.S., and its heavy weighting on gold and energy companies will make it especially attractive to the new wave of U.S. resource investors – especially now that they have increasingly more efficient and easy ways to trade the shares.

Of course, the size of the Canadian market vis-à-vis potential U.S. investment demand could create a situation akin to trying to force Niagara Falls through a garden hose. The total value of the Canadian equities market, where many of our favorite resource companies are to be found, is estimated to be about $2 trillion. By comparison, the U.S. equities markets ring in somewhere around $18 trillion.

In making the announcement of its new trading service, Fidelity reaffirmed its recommendation that clients should have 30% of their portfolios invested in foreign issues. Fidelity currently has on the order of $2.9 trillion under management -- a lot of smackers, to use an industry term.

If this trend toward buying international issues remains in motion, as we very much expect it to, it can only help to improve liquidity and to push up the values of the resource companies subscribers to the International Speculator are already well positioned in.

And that, dear readers, is that for today. I know I promised to get into the topic of natural gas today, and I have some notes to share with you on that corner of the energy sector – but time has slipped away, and so I will endeavor to deliver on same tomorrow.

Speaking of tomorrow… until tomorrow, thanks for reading and for being a subscriber to a Casey Research service. We couldn’t work for a nicer group of folks…

David Galland
Managing Director
Casey Research