November 2007 Archives

November 1, 2007

Fed Delivers / Credit Woes Persist

Posted by Noah Rosenblatt on November 1, 2007 at 1.27 PM

A: Drug dealer Ben Bernanke & co. delivered a 1/4 pt rate cut to the addicted markets and all but declared, "NO MORE DRUGS FOR YOU"; let the hangover begin! Future actions are now entirely data dependent as the fed views current policy as balanced between inflation risks in the pipeline and slowing economic growth. The knee jerk rally on wall street was not surprisingly short-lived, especially as the deeper problems of credit woes began to resurface! This credit crunch is not over, and the news about foreclosures rising and expected delinquencies going into 2008 is not news at all if your on top of macro economy and reading your stuff!

First, I want to say one thing about the fed. The action taken yesterday is a preventative insurance policy for the economic weakness expected as the spillover of a nationwide housing slump and credit crunch hits the consumer in 2008! As I said in my post in mid August regarding 2008 ARM resets:

"It's 2008 that we have to worry about and how that may or may not further change the lending environment and ultimately housing."

Expect things to get worse before it gets better and the environment to be ripe pickings for contrarian investors whose eyes light up when an asset class gets to be really 'down & out'. I expect 2008 to be the year for these opportunities, possibly continuing into early 2009.

As far as the credit woes coming back to haunt the markets, it shouldn't be surprising to any readers of this site that foreclosures spiked higher & ARM rates rose! After all, the plunge in the ABX indices and the freefall in the mortgage insurers have been predicting this for weeks now. According to CNN Money:

Foreclosure filings climbed during the third quarter of 2007 with no relief in sight, according to a report released Thursday. The report by RealtyTrac, an online marketer of foreclosure properties, showed the number of filings rose 30 percent from the previous quarter and nearly doubled from a year earlier. More than 635,000 foreclosure filings were reported nationwide - one for every 196 households. The filings include everything from default notices to auction sale notices to actual bank repossessions.

"August and September were the two highest monthly foreclosure filing totals we've seen since we began issuing our report in January 2005," said Saccacio.

On to those that hold these dysfunctional loans turned into mortgage backed securities. There are billions and billions of dollars in bad assets held by banks, brokerages and lenders whose market value is virtually impossible to figure out. Even the holders of these notes don't know what they are worth. All we know is that the markets to buy these assets are in distress and selling at such unfavorable levels is extremely undesirable. So, you write down the losses without physically selling the assets; and this is what is happening. The problem with this is it doesn't cure the disease! Here is an idea of what we found out in the past week alone:

Citibank (NYSE: C) - It took more than $3 billion in writedowns in the third quarter on its exposure to leveraged loan commitments, subprime mortgages and fixed-income trading. Citi's total credit costs jumped by $3 billion, as the bank recognized $780 million in credit losses and took a net charge of $2.24 billion to increase loan-loss reserves.

"For Citi to re-establish an average tangible capital ratio of over 4.25%, Citi will need to raise over $30 billion of equity," she writes. "To do that Citi could cut its dividend, raise capital, sell assets, or a combination thereof. ... We believe such a catalyst will pressure the stock."

Merrill Lynch (NYSE: MER) - What is the balance sheet of Merrill Lynch really worth? Wednesday, Merrill reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations (CDOs), which are complex debt securities, and junk mortgages. What shocked the market was that only three weeks ago Merrill estimated losses of $4.5 billion on these sorts of assets. One cause was that Merrill gave the job of valuing these securities to a group of people who turned out to have a much more conservative view on these assets' true worth.

Credit Suisse (NYSE: CS) - Credit Suisse reported a 31% drop in third-quarter net profit Thursday after the credit market crisis wiped around 2.2 billion francs ($1.9 billion) off the value of its mortgage book and leveraged loan commitments.

We knew there was trouble in creditville and expectations of increasing foreclosures and delinquencies by monitoring what is going on in the ABX indices. I started reporting on this weeks ago, with posts and my statements below. While you read those over, glance at how the ABX 'AA' market is continuing to plunge, indicating investor expectations of more carnage to come before this credit mess can be declared over. Notice where the two red lines intersect indicating the point where the index blew past the low level reached when the credit crunch first hit us in August!

OCT 16th ---> "It was clear that equities were drunk on rate cuts, as I posted last week, and I think the street is yet to adapt fully to a world of credit restrictions, solvency issues, global inflation and higher rates. The first credit blip was an 'awakening' of sorts, and for those that think it's completely over, well, stop hitting the snooze button!"

OCT 18th ---> "Just a lot going on under the surface here folks that could lead to another round of credit woes when it reaches the top; that is mass media and consumers. In a sign that investor sentiment is plunging for mortgage backed securities, the ABX markets are getting whacked again. It's entirely possible that this leads to another round of seizing up of the secondary mortgage markets."

OCT 20th ---> "Now, I don't know how all this will end, but I do know that investors are pulling bids fast from the ABX markets and the mortgage insurance companies. These are NOT normal moves people and it's clear something is going on! Expect another round of uncertainty and media reports on the credit crunch, and the secondary mortgage markets to seize up again leaving no place for holders of these distressed assets to sell positions; which leads me to be very concerned about those entities that are forced to sell to meet debt requirements! I would also expect to hear more bad news from brokerages, hedge funds, banks, and other entities with uncertain exposure to these markets."

So, whats going on here? Other than uncertainty regarding the depth of the credit squeeze, I'm not sure! It's clear the fed is trying their best to eliminate the delusion from the tradable markets that their policy actions are taken to meet their demands. In other words, they don't want to be wall street's bitch anymore. But its also clear that the side effects of a nationwide housing slump are yet to hit full force. As for the credit squeeze, expect the secondary mortgage markets to continue to be in distress and for lending rates to behave independently of fed action and 10YR bond yields; as yield premiums rise for higher perceived mortgage risk. As long as there is no normal functioning market to unwind bad asset holdings, lenders will be very cautious to whom they hand out their capital via loans to and will demand high premiums for riskier borrowers, or not loan to these borrowers at all. They need to clean up their books and the end result of that is tighter lending / underwriting standards for new loans.

Ratings Farce Hurts Credit Markets

Posted by Noah Rosenblatt on November 1, 2007 at 4.39 PM

A: I want to quickly discuss one more aspect of why the carnage in the CDO markets and other structured credit markets are getting killed. It lies in the rating agencies! What once was thought to be AAA rated securities, actually are NOT! As rating agencies adjust their criteria for rating these assets, and downgrade the ratings, the investment opportunities shrinks as many hedge funds and other institutions have restrictions on purchases of junk rated holdings. Let me explain.

A very big portion of the problem lies in the ratings of these CDO's, CMO's. Although many were and still are rated AA and AAA, they really are more like junk! We just don't know and neither do the investment banks that hold the assets!

The rating agencies are in the process of fixing their mistake; by adjusting their ratings criteria. Moodys already cut the ratings of about $35B worth of CDO's, but they are in the process of reviewing a hell of a lot more of these instruments. Once they get downgraded to basically junk status, investments in them become restricted by hedge funds and the like! That exponentially will hurt this problem of illiquidity as there already is no market for valuing these instruments. So how do you mark these assets to market value if there is no market? You can't? You have to try to value them and that is what is being adjusted by many of these large banks as the original valuations are way off!

According to Bloomberg:

Moody's Investors Service cut the ratings of collateralized debt obligations tied to $33 billion of subprime mortgage securities it downgraded this month, a decision that may force owners to mark down the value of their holdings.

Securities with ratings as high as AAA from at least 45 CDOs were either cut or put on review for a downgrade, according to individual statements distributed today by the New York-based ratings company.

"They're going down now and they're likely to go down further in the future," said Dan Ivascyn, a managing director at Pacific Investment Management Co. in Newport Beach, California, manager of the world's largest bond fund. "This is just one step in aligning ratings with where the market is trading bonds."

Almost 480 tranches of CDOs had been downgraded, according to an Oct. 5 report by Morgan Stanley structured credit analysts. That included 69 AAA securities and 106 with AA ratings.

This is another reason why the ABX indices are plunging as the insiders buy credit protection and bet that more carnage is coming in foreclosure world. I hope this helps those desperately trying to understand what is going on in this very complicated, and un-transparent world! Expect many more ratings downgrades to come as the review process continues! Also expect the pool of buyers for these distressed assets to shrink as the rating downgrades limits investments in these instruments as they don't pass what is 'allowable' by funds previously looking to buy them at cheap prices!

November 2, 2007

Developer Incentives Avoid Price Cut

Posted by Christine Toes on November 2, 2007 at 11.24 AM

I can feel the new development slowdown - can you feel it? I know Elliman superstar Doug Heddings feels it as he recently reported on "Broker Incentives" two days ago on his blog TrueGotham.com:

I couldn't resist blogging about something I just heard. Avonova, one of the latest condo conversions on the Upper West Side located at 81st and Broadway is launching a new program offering broker and buyer incentives for upcoming sales. Buyers will receive a $10,000 gift certificate towards the purchase of California Closets and their agents will receive a full 4% commission and an additional $2500 American Express gift card at closing. The reason I share is that incentives are rarely seen in a hot market where demand outweighs supply. Perhaps this is a sign that the Fall market isn't providing the demand that sellers and developers had hoped for.

My new development buyers are just not in the game right now. They're looking, but no one is buying anything. They're worried about their jobs and their bonuses. They're concerned about a recession. They anticipate a market downturn in the first quarter of 2008.

Unfortunately, I don't have a crystal ball and I don't know how long it will last. All I can tell my buyers is that if they buy now there are some good deals and incentives out there. Thanksgiving to New Years is generally a dead time for sales and is probably a big reason why developers want to stimulate sales before year end. Since we aren't expecting record bonuses this year, sales are probably going to be fairly weak until people at least find out what their bonus is going to be and whether they still have a job.

My low end buyers are buying, but they are resale buyers since new development basically starts at $900K. The $1M+ new development buyer seems to have gone into hibernation. The buyers I have over $1M right now are looking for "value". They want the worst house on the best block or a great price per sq ft.. As long as they are getting a "good deal", they are buying - but right now, that means they are buying resales.

Developers must be feeling the slowdown because I can hear a hint of desperation in the voices of their salespeople. Salespersons at new developments and conversions are quietly dropping hints that the developer "might" negotiate the transfer taxes or throw in a storage unit. They are encouraging customers to "make an offer", whereas a few months ago, they would flat out tell you there was no negotiating on prices. This is definitely a new tune from the spring when the same sales agents practically laughed me out of the room when I asked if the developer would pay part of the closing costs or was offering concessions of any kind.

And although I'm not seeing prices come down yet, the developers must be feeling a crunch. They are doing everything they can to move apartments without reduce prices. In the past month, I have been invited to more catered broker's open house tours and cocktail parties at new developments than I can possibly schedule into my blackberry. Suddenly vacations, AmEx gift cards, and offers of higher commissions are coming out of the woodwork! My prediction is that there are more incentives come over the next few months.

So who's offering?

The Chatham at 464 W 44th street is offering the following incentives to brokers:

A $15K AmEx giftcard to the broker that sells PHC, a 2bed 2bath, 1576sf, E and W exposure for $2.5M.
A $5K AmEx giftcard to the broker that sells PHA, a 1bed 1.5bath, 828sf apt for $1.25M

Commission Incentives:
(Toll Brothers frequently pays 2% commission but most new developments pay 3%. Some developers, such as Related, usually pay 4% commission, but in general, 3% is the norm to the broker bringing the buyer).

45 Park Avenue is offering 5% commission to brokers to help them sell the last 10% of their units

Avonova is offering a $10K California Closets gift certificate for buyers and their e-flyer says to "ask about additional broker incentives." They are also offering 4% commission.

SohoMews is offering to pay 50% of the commission to the buyer's broker at the contract signing instead of at the closing.

Other incentives:

865 UN Plaza - Developer paying closing costs (this isn't new, they have offered this since they opened)
517 W 46th - Paying transfer taxes & attorney's fees
75 Wall - Offering 18 month rate lock
Twenty9th - Developer offering long term rate locks and rate buy-downs
The Clement Clark is offering to pay the developer's transfer taxes, which will save you 1.8% of the sales price in closing costs.
Morgan Court was offering to pay the buyer's transfer taxes for the next 5 apartments that sell.
Loft 14 - paying transfer taxes (1.8% of sale price)

Here are some other events appearing in my inbox. Brokers are fairly easily bribed into attending new development events when free food and an open bar are involved.

** You're Invited to a SOUTH STAR Event at the Hotel Gansevoort - Wednesday, November 7 **
** Your Invited to Mohawk Atelier for a Preview of our Astonishing Penthouse - Thursday, November 1 from 5-7:30pm **

I will keep you posted periodically with where the incentives are! You never know where the next "great deal" will appear! :)

November 3, 2007

Level 3 Assets: Credit's Next Concern

Posted by Noah Rosenblatt on November 3, 2007 at 10.17 PM

A: I want to discuss what will soon be in the media alot, as round 2 of the credit crunch already is underway! First off, I don't care what CEO's get fired or how many rate cuts printing press Ben Bernanke does, the credit crisis problems lie so deep that these actions will not cure the disease; it will only provide some temporary relief as the problem phases itself out. What we need to look out for now, is what round 3 of the credit crunch may be caused by. I think it will be lowered valuations for Level 3 Assets. On November 15th, a new accounting rule will require the disclosure of these assets whose market valuations were assigned by in-house models, as the market where they trade in are illiquid and in distress.

LEVEL 3 ASSETS (via Marketwatch.com) - Level 3 assets are those that trade so infrequently that there is virtually no reliable market price for them, and valuations for these assets are based on management assumptions.

Problems people! I've discussed many times in the past few months how the markets for these CDO's, CMO's, and other mortgage backed securities have seized up. There are just no bids and no volume, making no market!

Now, what we do know is that brokerages, banks, hedge funds, and other institutions are holding very complicated assets whose actual value has virtually vanished. The key word here is actual, or real market value. But these level 3 assets are NOT being marketed to the real market! They are being held, hidden on the books of major corporations and institutions, as management places their best-guess valuations that are almost always grossly overvalued!

Round 3 of the credit crunch will be the 'coming out' of sorts of the adjusted valuations of these level 3 assets leading to the uncovering of major losses to the most exposed corporations and institutions. I think this process will take months to play out and we are heading right into the heart of storm as November 15th approaches.

RULE SFAS157 (via PrudentBear.com):

From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks' balance sheets. The new US accounting rule SFAS157 requires banks to divide their tradable assets into three "levels" according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks' own models.

To get an idea of the potential size of this problem, here is what I was able to find that is somewhat fresh news.

GOLDMAN SACHS - said Wednesday (OCT 10th) the size of its level 3 assets at the end of third quarter increased to $72.05 billion from $54 billion at the end of the second quarter.

In terms of percentage, the New York-based investment bank's third-quarter level 3 assets amounted to 7% of the total assets, compared with about 6% at the end of the second quarter.

PrudentBear.com continues:

Figures that have been disclosed show Lehman with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with $20 billion, 155% of capital, and J P Morgan Chase with about $60 billion, 50% of capital. However those figures are almost certainly low; the border between Level 2 and Level 3 is a fuzzy one and it is unquestionably in the interest of banks to classify as many of their assets as possible as Level 2, where analysts won't worry about them, rather than Level 3, where analyst concern is likely.

So far, subprime mortgages and the derivative products associated with them has caused round 1 and round 2 of the credit crunch. We saw what effect it has on the markets when Merill, Wells Fargo, Citigroup, Bear Sterns, Bank of America, and Washington Mutual write down losses far exceeding original estimations. But there are far more assets out there whose valuations have been guessed at and will soon be classified under the level 3 category. As the PrudentBear.com article points out, these include:

a) Alt-A & Prime Mortgage Backed Securities - As home prices fall, debt-to-equity ratios rise. As ratios pass 100% of original loan-to-value, the mortgage becomes "uncovered", and the securities related to them become unmarketable level 3 classified assets whose value gets assigned by management
b) Securitized Credit Card Obligations - $915B credit card debt outstanding
c) Leveraged Buyout Bridge Loans
d) Asset Backed Commercial Paper - Slowing market from $1.2Trillion to $900Billion in past 3 months
e) Credit Default Swaps - Hello ABX Indices; we discussed the plunge here
f) Complex Derivative Contracts - Interest Rate & Currency swaps

According to The Business:

It's the level 3 assets that must concern investors more than ever as they are marked to in-house models. Those models are more art than science and are subject to the banks' judgment.

Much of the attention of such Level 3 assets has been focussed on mortgage-related assets. But they also include complex derivative contracts, credit card receivables, loans linked to leveraged buyout loans and asset backed commercial paper. From Nov. 15, the Level 3 disclosures will be accompanied by details of the basis on which they are classified.

It's the balance sheets that will define round 3 of the credit crunch as the value of level 3 assets gets disclosed to investors. Hard to imagine how the assigned valuations of these un-tradable assets rise; instead, expect to see significant write-downs and more distress as we work through this process.

November 5, 2007

Expect Surprise Fed Rate Cut

Posted by Noah Rosenblatt on November 5, 2007 at 8.11 AM

A: I'm going with my gut on this one. I think the credit crunch has matured to the point where we could see Ben Bernanke & Co., surprise with an inter-meeting cut. I know, I know, this goes against everything I said only a week ago when I didn't want the fed to cut. Fact is, I don't! We have enough problems with pipeline inflation, weak dollar, and rising commodity and energy prices. But there is a big difference between what I want, and what will happen. I think the credit crunch is getting so bad, that it wouldn't shock me to see the fed use the element of surprise before years end to try and restore some confidence via a stimulative inter-meeting rate cut.

The problem is the rate cut will not be a cure, it will only dampen the effect that the credit crunch has on the overall economy in the months to come.

Here are my concerns:

a) Nov. 15th accounting change; level 3 assets set stage for more widespread write downs
b) Citigroup & Merrill announce pain & management shakeup
c) Mortgage insurers whacked; should insurance availability for CDO's & CMO's shrink or outright disappear, or claims can't get paid out, we'll have major problems for those holding these bad assets
d) Ratings agency downgrades will lead to more credit pain
e) Nationwide housing slump continues; foreclosures & delinquencies rise predicted by ABX Indices

Again, I think the best way to get out of this mess is for our economy to go through a nasty recession that penalizes those that made these bets, without aggressive easing by our fed that may cause a moral hazard, weaken our dollar further, and buildup pipeline inflation. The recession itself will flush out the problems, clean off the balance sheets, and help ease inflation pressures. But, I doubt the fed will stand idle and let this scenario play out like that. They will most likely take action and cut rates to limit the severity of any recession, at the expense of:

a) bail outs; creating a moral hazard
b) weakening our US dollars further
c) rising energy prices
d) rising commodity prices
e) pipeline inflation

Thoughts?

Monday's Links

Posted by Noah Rosenblatt on November 5, 2007 at 5.13 PM

A: Some good stuff out there in the blogosphere that I would like to share with readers.

Quitest October in a Decade (truegotham.com)

That said, if the October and first week of November activity are any indication of what's on the horizon for the New York City real estate market, that correction may indeed be just around the corner. I'm not prophesying by any stretch here as that always gets me into trouble but this has been the quietest October I have seen in the past 10 years.

Citigroup: $134.8 Billion in 'Level 3' Assets (Marketwatch.com via calculated risk)

Citigroup Inc. ... said its so-called level 3 assets as of Sept. 30 were $134.84 billion. Level 3 assets are holdings that are so illiquid, or trade so infrequently, that they have no reliable price, so their valuations are based on management's best guess.

Lara Meyer: I'd Be a Dove on This Fed (realtimeeconomics.com)

But Mr. Meyer, now a Fed watcher at his old firm, Macroeconomic Advisers, feels like a soft-money inflationist next to the current crew running the central bank.

The Fed, he says, left last week's meeting, at which it cut rates by a quarter point, "with even more resolve" not to cut rates again. "The markets may have pushed the FOMC into a cut in October, but we think the message is: 'Push us once, you win. Push us twice, you pay!' This is one of the most hawkish Committees that I can recall … Put it this way: I would be the dove on this committee today, and I don't usually do even a good imitation of a dove."

Credit & Financial Bloodbath Will Continue (Prof. Nouriel Roubin's Blog)

The amount of losses that financial institutions have already recognized - $20 billion - is just the very tip of the iceberg of much larger losses that will end up in the hundreds of billions of dollars. But calling this crisis a sub-prime meltdown is ludicrous as by now the contagion has seriously spread to near prime and prime mortgages. And it is spreading to subprime and near prime credit cards and auto loans where deliquencies are rising and will sharply rise further in the year ahead.

Valuation of illiquid assets is a most complex issue; but starting with the November 15th adoption of FASB 157 the leeway that financial institutions have used so far for creative accounting will be much more limited. Valuation of illiquid assets is a most technical issue. But new regulations will limit the ability of financial institutions to put "illiquid" asset in "level 3" securities, i.e. securities where the lack of market prices allows them to use dubious "valuation models" and "unobservable inputs" to value such assets.

Fitch May Downgrade Bond Insurers After New Test (bloomberg.com)

Fitch Ratings may lower the AAA credit ratings on one or more bond insurers after a new review of the companies' capital takes into account downgrades of collateralized debt obligations that they guarantee.

Fitch said it will spend the next six weeks reviewing the capital of insurers including MBIA Inc., Ambac Financial Group Inc., CIFG Guaranty and Financial Guaranty Insurance Co. to ensure they have enough capital to warrant an AAA rating. Any guarantor that fails the new test may be downgraded within a month unless the company is able to raise more capital, New York- based Fitch said today in a statement.

Fitch said it decided to review the bond insurers after "broader and deeper' downgrades of "CDOs, which package debt such as subprime mortgage securities and loans.

The bond insurance industry has guaranteed more than $1 trillion of bonds issued by U.S. cities and states as well as bonds backed by mortgages, credit cards and other assets, and the guarantee allows borrowers to use the insurers' AAA rating.

November 6, 2007

Wall Street Bonus Update

Posted by Noah Rosenblatt on November 6, 2007 at 9.36 AM

A: Would love some reader participation here, especially if you are in financial industry and need to post comment anonymously. Most of my contacts I have surveyed STILL expect to get paid their full bonuses come early 2008; in fact 90% of the friends / clients / colleagues I talked to about this said they expect a satisfying bonus season. But I wonder if it will turn out this way. Manhattan real estate is seasonal and it's normally the JAN-APRIL bonus season that turns out to be the most active time of year for sales volume, inventory declines, and bidding wars. What will happen this year given the carnage in the financial sector?

This is going to be the first big test for Manhattan real estate. I'm somewhat relieved to hear the positive words from those I keep in touch with about these topics, but I have to wonder whether these people are a good representation of the whole industry? I'm not so sure; given the generally positive nature of the self. It's very hard for me to imagine a bonus season where everyone gets their expected bonus. The write-downs in the brokerage and banking world have been in the tens of billions so far, and with some 8 weeks or so left in the year, and the Nov. 15th accounting change, it's all but guaranteed that more write-downs of losses will come. It's still too early too tell how the bonus season will be, with such uncertainty in this sector.

With Bill Gross of Pimco declaring this credit crisis as a "$1 Trillion Problem", and predicting "$250 billion of subprime and Alt-A mortgage loans to default and those defaults will fall to the balance sheets of investment stalwarts such as Merrill Lynch and Citigroup", it's hard to ignore the side effects to bonus pool. That would mean we have some $200+ Billion of losses yet to be reported.

My sentiment for a great bonus season has certainly declined in the past 3-4 weeks. No question about it. When I was interviewed for the OpenHouseNY segment, back in mid September, we didn't know how bad the credit crunch was getting. Needless to say, the credit environment has deteriorated significantly in the 5-7 weeks after that taping. I'd be a fool to stick to what I said in the past when the environment has changed so drastically.

As I reported a few times over the past 3 months or so, buyer confidence has dipped and sales volume seemed to have slowed. This combination helped to build inventory slightly from the month of August to September, as noted by Jonathan Miller's reporting. While the changes are small and not enough to base any trends on, they are worth noting given the change in buyer confidence.

I expect bonuses to come in, but not as widespread (in total bonuses handed out) and not as high (in size of bonus) as some may expect with stocks just off record highs. The financial sector has felt a lot of pain, and management knows the level of toxic waste still on their books. I would go far as to say that 2009's bonus season looks to be the real problem, not this years, as we still have some time to get the full depth of losses off the books.

For Manhattan inventory trends, this bonus season will be especially important! We must monitor the sales pace during these normally frenzy months to see if the deals come through as expected, or not. If they don't, and volume is light, we will have much more inventory heading into next summer than we did in previous years.

FINANCIAL SECTOR WORKERS ---> What is your feeling about your upcoming bonus?

November 7, 2007

Today's Crunchy Headlines & Thoughts

Posted by Noah Rosenblatt on November 7, 2007 at 12.31 PM

A: More of the same today as GM's insurance segment and other businesses led to an astounding $39B loss. I really hope with this new accounting changing for Level 3 Assets coming Nov. 15th, we are not entering the next version of Enron, Worldcom, & Tyco type surprises. Here are some headlines validating the continuing credit crunch, the falling dollar, and $100 oil. The story is still being written.My thoughts at the end.

WaMu: Expected "Soft Landing" Becomes "Severe Downturn" (Reuters via Calculated Risk)

"The soft landing we were anticipating quickly transitioned to a severe downturn," Chief Executive Kerry Killinger said in a presentation to investors in New York. "This process is painful."

Stocks Pull Back As Dollar Tumbles (Yahoo Finance)

Stocks fell sharply and bonds jumped Wednesday after the dollar sank further amid speculation that China will seek to diversify some of its foreign currency stockpiles beyond the greenback. The 13-nation euro hit a fresh record against the dollar -- rising to $1.4729 -- before falling back. The dollar fell not only against the euro but in Asia following a report that a senior Chinese political figure said China should diversify its $1.43-trillion foreign exchange reserves into the euro and other strong currencies.

GM Reports $39Billion Loss on Deferred Tax Charge (Bloomberg)

General Motors Corp., the world's largest automaker, reported a record $39 billion quarterly loss after three money-losing years forced the company to write down the value of future tax benefits.

The Detroit-based automaker signaled that it won't generate enough earnings to use the benefits, citing defaults on subprime mortgage loans at GMAC LLC and "more challenging" auto-market conditions in the U.S. and Germany.

Bottomless Banking (Forbes)

As Citigroup faces another massive quarterly write-down of credit derivative assets, questions remain about other banks' exposures, and when the crisis goes from a trading book issue into an industrywide credit quality problem. Morgan Stanley may be on the hook for another $6 billion in write-downs for collateralized debt obligations and other mortgage exposure, according to Fox-Pitt Kelton analyst David Trone. And rumors continue to circulate about Goldman Sachs, which so far is the least scathed of all the Wall Street firms.

Traders are intensely focused on level 3 reported by the banks, because new accounting rules changing the way assets are valued kick in later this month and could fuel a new wave of write-downs. To hear executives from the banks talk in recent weeks, Wall Street is going through another one of those unprecedented moments where the models that perform so well in good times prove utterly useless when things go haywire.

Within Fed: Resistance To More Rate Cuts (NY Times)

In an unusually blunt interview, the president of the Federal Reserve Bank of Philadelphia said he already expected growth to slow to an annual pace of 1.5 percent or less. But he said he would not support another rate cut unless the slowdown appeared to be even sharper than that.

Mr. Plosser suggested that he disagreed with the Fed's decision to lower the benchmark federal funds rate last week, its second rate cut in two months. "I happen to think this decision was a close call," he said.

Crude Oil = $98; Gold = $845 (The Big Picture)

The Fed recklessly abandons their price stability mandate, and this is what it has wrought: Dollar at record lows, oil and gold near all time highs.

It is the first rule of economics, yet so many idiots pundits cannot seem to to remember it: THERE IS NO FREE LUNCH.

In physics, the corollary is that "every action has an equal and opposite reaction." Why this is too complex for their little frontal lobes is beyond me. It is simple. It is basic. It is easily understood by even supply siders.

Think about all of the brainiacs who have been begging for rate cuts -- and from historically moderate rates -- over the past 2 years. Be sure to thank them for the reckless disregard for your wallet.

Wow, just a lot of crazy things going on right now. I think the biggest concern right now should be the magnitude of write-downs as the truth makes its way to the surface AFTER the accounting rule change takes place on Nov. 15th! I discussed Level 3 Assets on Saturday and told you to expect chatter about this in the media as we near the deadline.

What we need to look out for now, is what round 3 of the credit crunch may be caused by. I think it will be lowered valuations for Level 3 Assets. On November 15th, a new accounting rule will require the disclosure of these assets whose market valuations were assigned by in-house models, as the market where they trade in are illiquid and in distress.

It's the balance sheets that will define round 3 of the credit crunch as the value of level 3 assets gets disclosed to investors. Hard to imagine how the assigned valuations of these un-tradable assets rise; instead, expect to see significant write-downs and more distress as we work through this process.

Even Rick Santelli, talking from the bond pits in Chicago, mentioned how the blogosphere was ripe with talk about the upcoming FASB 157 accounting change! He's right, and its the unknown that worries me. How many more surprises are out there and how many quarters of earnings will be adjusted as the truth comes out? All of a sudden the P/E's of companies that appeared so attractive from a valuation standpoint, will rise significantly as earnings disappear!

The ABX indices have correctly predicted the carnage in the mortgage markets starting back on October 11th; I first talked about it on Oct. 16th. R-E-S-P-E-C-T the ABX! Investors are STILL pulling bids and its clear the demand for credit protection is high as the ongoing credit crisis threatens holdings that cannot be sold on the secondary mortgage markets. Expect:

a) lending capital to be used for highest quality borrowers
b) lending rates to continue to be disconnected from falling bond yields and fed funds rates
c) risk to continue to be re-priced for residential mortgage backed securities
d) lower quality borrowers to find higher rates
e) very tight lending & underwriting standards
f) secondary mortgage markets to be seized up restricting available capital for loans

...to continue until this situation clears up! I really wish all the news would just come out so we can get through this quicker, but that won't happen. I think the idea of a recession w/out future easing in fed funds rates is the sleeper call to get through this conglomerate of problems. A recession helping to ease the credit problems / weed out bad bets, national housing inventory problem, higher oil prices, higher commodity prices, weakening dollar, avoid bail out / moral hazard, pipeline inflation is becoming clearer each day.

We need to clean the slate as stagflation becomes a very real possibility; recall my post back on April 19th:

What you need to know is that right now we very well could be heading into a period of stagflation; that is high inflation and slowing economic growth via rising unemployment or a recession. The problem with this scenario is that if the fed tries to control one problem they can make the other problem much worse!

November 8, 2007

'AAA' ABX Index Plunges

Posted by Noah Rosenblatt on November 8, 2007 at 9.54 AM

A. I've been waiting and watching the higher rated ABX index for sharp movements, and it finally came yesterday. The 'AAA" ABX index absolutely plunged yesterday falling from 80.17 to 71.88, a plunge of over 10%! To put that into perspective, it would be like the DOW falling 1,340 points in one day; if that happened do you think people would notice? The blogosphere has been successful in analyzing and interpreting the ABX indices for some time now, so it's no surprise that I need to bring this up after yesterday's move. As the contagion hits higher rated paper and investors desperately try to buy credit protection for these holdings, is it only a matter of time for alt-a and prime mortgage backed securities to get their day at the confessional? Needless to say, alt-a & prime make up a significant larger portion of total loans outstanding than subprime.

First, lets look at the chart courtesy of Markit:

Wow. Quite a move. In fact, all of the ABX Indices got whacked again yesterday. The only difference today is that it now means something to people who normally would never monitor trends of these indices. It's just a clear sign that deeper problems still exist in creditville.

For those that are a bit more educated regarding these trades, or are employed in or around this industry, here is how the ABX trade works (courtesy of anonymous source right in the middle of this derivative trading action at a hedge fund). WARNING - This is not easy to understand and I don't fully get it, so don't ask:

Here is how an ABX trade works:

I want to buy protection on 100mm. The ABX coupon is 70 bps and the price is 95. I pay (1 - 0.95) * 100 mm = USD 5mm upfront. Every month (different compounding on ABX) I pay 70bps/12 * 100 mm = $58,000

1% of the pool defaults and I get paid USD 1mm. Going forward I pay the 70 bps on 99mm. In fixed income when 'spreads widen' then 'bonds gets cheaper' because you are discounting future cashflows at a higher rate.

When ABX spreads widen the bond price drops and I can close out the trade at say 85 by selling protection. I will receive (1 - 0.85) * 99mm = $15mm making a P&L of about 10 million, minus whatever coupons I paid plus whatever default payments I received.

You should recognize that this discounting of future cash flows assumes you know WHEN these cash flows will take place --> duration is critical.

Over the life of the trade the price will drift to 100. Imagine it with one day left - how much upfront would you pay for 1 day of protection ? = none.

Prepayments reduce the notional but don't trigger protection payments which is why you need to get the duration right initially. Quoting in bond points removes the need to agree on a duration - it's implied in the price. If we agree on a price we're done - you could have gotten to that price with different spread and duration assumptions than me.

KEY POINTS - there is a lot more to pricing an asset backed instrument than meets the eye - interest rates, mechanics, prepays, defaults, timing, carry all have to factor in and there is no simple answer. You need to put it all into some sort of model and your intuition is often wrong. There is a lot more to it than "I think there will be more defaults so spreads should go wider". Remember that when yields or spreads go up you are discounting future cash flow at a higher interest rate so the present value of a future dollar is less and the present value of the sum of these cash flows is less so the price is lower. This is the inverse relationship between bond prices and interest rates.

Don't say I didn't warn you in advance how the ABX trade works! Here are my concerns:

1. The FASB 157 accounting change will adjust how Level 3 assets are classified and how they get disclosed to investors. This is a major problem. What used to be able to be classified as tier 2, may now need to be adjusted to tier 3. Needless to say, banks & brokerages used this gray area to underestimate the exposure of assets considered under level 3 accounting disclosures.

2. The problem is no longer contained to subprime. The plunge in AAA ABX is consistent with what my sources were telling me for past 10 days or so. Investors are buying credit protection for alt a and prime mbs holdings. You can imagine the worry if its no longer just a subprime illness. Of course there were problems making AAA paper from subprime junk, but what if this spreads to higher quality paper before its securitized?

3. Ratings downgrades will have a two pronged effect. First, it will restrict who can buy the distressed assets as many pensions accounts and even hedge funds have restrictions on junk purchases. Second, level 3 accounting adjustments due to downgrades of holdings to markets that are untradable?

November 9, 2007

Sizing Up Level 3 Assets

Posted by Noah Rosenblatt on November 9, 2007 at 9.02 AM

A: Another day, another bite from the credit monster. Lets keep the credit discussions going as this is by far the most important macro economic news going on right now, with $95 oil a close second, and the free falling US dollar an even closer third. Here are todays credit crunch headlines as well as the latest 'level 3 assets' disclosures as filed to the Securities & Exchange Commission.

First, lets size up what we know (which is already outdated) as disclosed in filings to the SEC for level 3 assets exposure by major banks and brokerages; again, this is important because these numbers will likely have to be revised higher once the new accounting change takes place on Nov. 15th.

Source: FACTBOX: Sizing Up Banks' Hard To Value Assets (Reuters)

MORGAN STANLEY (NYSE: MS) -----> $88.21B as of August 31st
GOLDMAN SACHS (NYSE: GS) ------> $72.05B as of August
LEHMAN BROTHERS (NYSE: LEH) ---> $34.68B as of August 31st
BEAR STEARNS (NYSE: BSC) --------> $20.25B as of August 31st
CITIGROUP (NYSE: C) --------------> $134.84B as of September 30th
MERRILL LYNCH (NYSE: MER) ------> $15.39B as of September 28th
BANK OF AMERICA (NYSE: BAC) ----> $21.64B as of June 30th
----------------------------------------------------------------------
TOTAL = $387.06 Billion of Level 3 Assets Known So Far

Now, the $250 Billion dollar question is how will these numbers be revised in future filings after the accounting change takes place on November 15th? Note that these are not losses, they are the total assets deemed by the company to fit into the category of un-tradable assets because not enough liquidity exists in the marketplace to get a true price value on the securities; so instead of marking them to market they are marking the asset values to models. In other words, the firms use these in-house valuation models to put a price tag on what these assets might be worth if they could be traded. Needless to say, you can see the problem with certainty here and why future write downs and losses are likely as the secondary mortgage markets continue to be seized up!

Today's credit crunch headlines:

Wachovia Sets $1.1B in OCT Losses (AP)

Wachovia Corp. said Friday the value of collateralized debt obligations in its portfolio fell about $1.1 billion in October, making it the latest financial institution to warn of sharp losses last month in the credit markets. The company also said it plans to boost its allowance for loan losses in the fourth quarter due to expected credit deterioration in the housing market in certain regions. The provision is pegged at $500 million to $600 million in excess of charge-offs in the quarter.

Barclays Denies Speculation About Write-Downs (Bloomberg)

Barclays Plc, Britain's third-biggest bank, denied speculation that it will announce a substantial writedown in the value of its assets after its stock fell as much as 9.1 percent.

"There is absolutely no substance in these rumors," spokesman Alistair Smith said. He also denied speculation that Chief Executive Officer John Varley may step down.

HSBC Exits Mortgage Securities (NY Times)

HSBC Holdings, the British bank, said it had stopped sales and trading of mortgage-backed securities in the United States after the collapse of the subprime market forced it to close two lending units.

The bank will keep its asset-backed business both globally and in the United States, Mr. Goad said, including securities backed by non-United States mortgages.

On The Subprime Endangered List (BusinessWeek)

Which CEO will be catching subprime heat next now that Citigroup's Chuck Prince is out? It will likely come down to whose losses are biggest. Bear Stearns' James E. Cayne may be the most vulnerable CEO.

Bear's biggest problem may be its so-called Level 3 assets. That risky group includes all securities that require a lot of guesswork to value - such as mortgage-related debt and assorted corporate loans. Those hard-to-trade assets are susceptible to markdowns - and Bear has $20 billion worth. Bear has offered little hint about the type of Level 3 assets it holds, but analysts think the bulk are mortgage-related. In its recent conference call, Bear said it had $2.4 billion in subprime exposure.

For a company of Bear's size - its market value is roughly $15 billion, vs. $165 billion for Citi and $45 billion for Merrill - a $3 billion-plus hit would be disastrous. It would be nearly triple the $1.1 billion in net income Bear generated in the first nine months of the year. And it would likely tarnish its credit rating, signaling to lenders that the firm has a thinner cushion against potential losses. That, in turn, could make it harder and costlier for Bear to borrow the money it needs to run its day-to-day operations.

Those last two sentences are why I included this in today's discussion! Especially the very last sentence: "That, in turn, could make it harder and costlier for Bear to borrow the money it needs to run its day-to-day operations." Keep in mind that as this credit crunch evolves to future phases, ratings downgrades become more and more likely and that in itself can cause more problems. The vicious credit cycle feeds on itself.

November 11, 2007

The NEW UrbanDigs.com

Posted by Noah Rosenblatt on November 11, 2007 at 7.40 PM

A: As you guys probably noticed by the type of content I have been publishing the past 6-12 months, the new urbandigs will be a blog dedicated to "MACRO ECONOMIC DISCUSSIONS & INVESTMENT STRATEGIES FOR MANHATTAN REAL ESTATE". The goal will always be to maintain an open discussion forum to analyze and talk about what macro events are occurring that may have a delayed impact on Manhattan real estate. I will post articles based on my thoughts for the day, that are fresh and pertinent to the near term economy and our local Manhattan real estate marketplace. If you are new, its probably best for you to search the archives for past discussions on tips for buyers & sellers. For regulars, I hope you find use from the new tools and consider participating as much as possible on comment threads and the new discussion forum. Here's a breakdown of features the new urbandigs will offer. Enjoy and as always, THANKS for reading!!

1. REAL-TIME MANHATTAN HOUSING DATA - Finally! I am very excited to have partnered with the great people at Streeteasy.com to bring real time data for us to easily track. The main tool will allow you to track TODAY's, 7-DAY, & 30-DAY raw snapshots of activity in the Manhattan real estate market. All data is provided by Streeteasy.com for this snapshot and is the data used for the charting system I'll get to in a moment.

How It Works: Streeteasy's systems update once a day, in the early hours. Once we grab the daily update, the raw data won't change again until the following morning. I worked with the streeteasy team to fine tune data collection and provide:

a) only listings for the island of Manhattan
b) only co-ops, condos, and townhomes
c) excluding any listing without exact address
d) only exclusive listings
e) duplicates removed

You may notice the 30-DAY isn't there yet! Thats because the finished product with all rules in place to clean data used for these stats, is only 3 weeks old or so. Once 30-DAYS of data is received, the # will display on the widget. We will continue efforts to fine tune and enhance these tools as we go. We have reached a point where I'm confident enough to get it live, but consider it in BETA for an additional 6 months or so.

2. DISCUSSION FORUM - This has been the most requested new feature. From now on, if you have a question, problem, thought, service needed, opinions wanted, advice needed, whatever, just post a new discussion in the TALK REAL ESTATE tab above. It is dynamic, so there is no moderating for new discussions and I decided not to install a 'create account' requirement. The discussion forum is open to all at any time.

I plugged in a batch of categories that I thought covered most areas related to real estate, but if I left something out you can always email me the suggestion and I'll add it. I only ask that you keep it clean as I will have to remove any discussion that may pose as a liability for me.

To start a new discussion, simply click on the appropriate link, type in your name or screen name, select a category, type your main question in the subject line, and then the actual question in the comment box. The Category, Subject line, & # Comments will be displayed on the main discussion forum. The system will place the 'last replied to' discussion at the very top.

3. CHART MANHATTAN INVENTORY TRENDS - My favorite new feature is taking a bit longer than thought to build. We will launch the charting system by next Monday, November 18th. Please check back here soon.

When the charting software is activated, it will only display data recorded when we finished the charting database, which is at 12 days right now or so. Needless to say, consider the future charting section to be in BETA for the next 3-5 months as we fine tune the visual features and collect enough data to start discussing trend changes.

4. AUTOMATED COMMENT PUBLISHING - Write a comment, type in the security work, publish, and reload page. Bam, your comment is up. Sorry it took so long! Hopefully this will entice more to participate and share their thoughts on comment threads!!

5. BOOKMARKING - Feel free to add any article you want to share publicly to any or all of the following bookmarking / social media sites. Account may be required.

6. CREATIVE ADS - It's been just over 2 years and I've said no to all advertising requests thus far, with exception of Google text ads that pay for my health insurance. Thanks Google, but inflation is a bitch! I hope you don't mind, but I installed a simple ad system that has 3 spots under the real time housing data widget at the top right. I tried to make it as unobtrusive as possible, so that it doesn't distract form the content and tools this site strives to offer. There will be no flash or pop ups allows; only still creative ads and slow animated gif's. If you are an advertiser, you can learn more.

UrbanDigs on FOX Business News

Posted by Noah Rosenblatt on November 11, 2007 at 7.55 PM

A: Last minute notice that I will be a guest contributor on Fox Business tomorrow at 7AM's 'Money For Breakfast' segment on FOX Business Channel. Try to catch it if you can!

Among the topics that will be discussed:

Foreign Buyer Demand / Weak US Dollar: Continuing Impact?

State of the Market

Wall Street Bonus Season Expectations

Still A Buy?

Of course, it's out of my hands what actually gets discussed on air.

November 12, 2007

The ABCs of Appraisal

Posted by Jeff Bernstein on November 12, 2007 at 10.35 AM

The property appraisal business has been coming under the spotlight lately. I expect the lights to get a lot hotter. This has implications for the real estate market overall, NYC in particular and it has implications for how you the buyer may want to approach your real estate transaction.

First a few disclaimers. I am not an appraiser (so all of you who are please cut me some slack on the particulars). Second I have nothing against appraisers, in fact I think they are among the most highly trained professionals in the art of valuing real estate. Thirdly, my apologies for being late on this story. In my piece on asset cycles a couple of months back I did mention that appraisers and bond rating agencies were apt to come in for some severe criticism during this real estate down cycle. But honestly, I should have written about this subject earlier in keeping with Noah's practice of being ahead of the crowd in spotting trends that will be important to you the real estate buyer and investor. That said here goes.

The cover of last Thursday's Wall Street Journal read "Probe Widens on Inflated Home Appraisals"; online version has free preview only.

The bottom line is that N.Y. State Attorney General Andrew Cuomo wants Fannie Mae and Freddie Mac to look into how well they helped protect mortgage investors from losses due to faulty appraisals on loans that should not have been made. This follows on the heels of The Governator of California signing a law in October trying to prevent lenders from pressuring appraisers into making the numbers work on deals. The issue of mortgage fraud - and faulty appraisals being behind 80% of these scams - was raised as far back as early 2005 in the articles below. Now remember fraud follows assets that are in bull markets because as Willie Sutton said "That's where the money is". It's not a characteristic of all the professionals who work as stock or rating agency analysts or appraisers to commit fraud, but these people's opinions are very important to how money is raised and invested and there is great potential for them to abuse their positions or aide and abet others who do.

Certain loans secured by real property fall under the purview of the Federal Institutions Reform, Recovery and Enforcement Act of 1989 (FIREA) and require a written appraisal of the value of the real property asset. Read the law here.

As can be noted from the name of the law this is one of those great pieces of after the fact legislation written in the wake of the last real estate debacle - the S&L crisis. As in all bear markets bad underwriting (assessment of risk) was at fault and FIRREA tried to address this after it was too late.

So Jeff? Why do I care?

1) Expect more properties not to appraise at levels buyers and sellers hoped for - As I opined in my asset cycles piece:

Virtuous cycles where real estate or other asset prices rise for several years tend to condition the professional evaluators like stock analysts to bias their assumptions and adjustments up. On the other side when the asset cycles turn vicious assumptions and adjustments start to be biased down.

Often times the government moves this process along by beating up on the evaluators. For example, after a decade long bull market, stock analysts had buy ratings on everything in sight, some ended up being quasi investment bankers. Their positive ratings helped companies' stocks rise helping them pay themselves and raise money. When the boom ended regulators asked why no one had sell recommendations on stocks that appeared to a reasonable person to be overvalued. Wall Street complied and in the teeth of the bear market with stocks getting cheaper daily, analysts came out with tons of sell recommendations. In fact research departments, though they hadn't been given a quota by the SEC, voluntarily decided it was only reasonable to have 20 or 30% of their recommendations be sells. This is a good article on the conflicts of interest in stock ratings and one on the new rules the SEC adopted soon after to prevent future problems.

My prediction is now that the heat is being placed on appraisers they to will adopt some kind of unspoken quota system on how many properties "don't hit the number". This will just put more pressure on the downward move in home prices. According to Jim Gannon of Guild Partners (a trained appraiser):

"Some lenders may appreciate this trend and hide behind more conservative appraisals when telling good customers they can't make a loan that they would rather avoid extending anyway."

2) In New York City two of the three appraisal methodologies are typically not used for valuing coops and condos. Coops are leased fee, not fee simple interests. You own shares in a corporation and a right to use an apartment, you don't own the asset, therefore replacement cost can't be used to value these assets. Condos are fee simple interests (you actually own the apartment), but you don't own the building and replacing a single condo is un-realistic. (Note that in the suburbs replacement cost is looked at for home valuations which may put a floor on appraisals if sky rocketing building costs offset the inevitable decline in land values). Secondly, you can't sub-let coops easily, therefore you can't equate them to rentals and value them on an "if rented" income capitalization basis. In general, although Manhattan is dominated by rentals and you should do your own rent vs. buy analysis, appraisers don't try to look at what the cash flows on a condo would be if it were sub let and equate that with value of the condo. So in general appraisers have to rely on one valuation technique, which is comparable sales. With comparable sales prices likely to start to soften, it will be harder to get an appraiser to sign off on your paying up for an apartment. It may even be hard to get them to sign off on a purchase in line with comps from a few months ago if prices have been generally falling.

3) If your dream apartment doesn't appraise don't panic ...RENEGOTIATE. It ain't gonna appraise for anyone else who is trying to buy it. So if the seller wants to sell, its a perfect reason for you to get them to knock down the price.

I love happy endings!

Just a few more details for you macro mavens.

The tools of real estate appraisal. There are three accepted methods to valuing a piece of real estate of any kind - below are some vast simplifications of what they are and why they are very subjective.

1) The income or yield capitalization method - What are the potential cash flows the property can produce and what are they worth in today's dollars. This includes the cash generated by the sale of the property five or ten years out. These future values must be quantified and brought back to today based on a discount rate for the cash flows and a reversion rate for the future sale price. What discount and reversion rates to use are a subjective judgement by the appraiser and the only way to actually get an idea of what rates are being used in the market are by surveys or using historical transaction data (which tends to be a bit stale). FYI nothing says that investors will still apply these same rates to a property in the future...or even next week.

2) The replacement cost method - If you had to build this home or building today, what would it cost, then add on the value of the land (which can be determined from comparable land sales, which can be somewhat stale depending on the market) and subtract any depreciation due to the age of the building being valued versus a new one. For this analysis the appraiser needs to have a good sense of what current construction costs are for different types of buildings, despite the rapid rates of increase and swings in commodity prices in recent years.

3) Comparable sales method - What are comparable properties selling for in the market today, adjusted for any differences in location, size, utility (does it have a pool etc.) and ownership structure (condo vs. coop etc.) and when the sale took place. In a rising market appraisers adjust upward the value of comps that were sold a while ago to account for market appreciation. In a falling market they will have to adjust them down This is often a very good indicator of the current market value of a property, particularly for real estate that trades a lot (its harder to use for valuing things like golf courses that have a serious land value but don't turn over that much). Comp information for residential real estate is reasonably available, and tends to be fresh in large markets, but must be adjusted as no group of four or five properties are that alike.

In many cases more than one technique can and should be used for the appraisal process and an average or median of the values is used to determine a value judgment. Sometimes its weighted towards one or other method, which looks like it should be more accurate in particular case. This along with all assumptions and adjustments mentioned above is where the art of appraisal comes in. Just like valuing a stock, its not a science. There is no absolute correct answer. Only future trading will tell you how far off an appraisal was from the eventual sale value of a property as an appraisal values a property only on a particular date, because market conditions are ever changing.

Billions of dollars of consumer wealth and borrowing power - on paper at least- depend on appraisals. As appraisers start to get less sanguine about valuing properties, there will be less wealth in the nation....how much less is an open question. Due to the additional appraisal methods available to evaluate commercial real estate the impact of changing sentiment among appraisers may be less of an issue.

Other related posts from the blogosphere:

Fannie & Freddie Get Appraised (Matrix)

Appraisers: Pushers & Pressures (Matrix)

What's Wrong with Approved Appraiser Lists (Calculated Risk)

Price is NOT Right: Appraisals Sink Home Sales (Boston Herald)

November 13, 2007

Credit Downgrades / Blackstone / Commercial

Posted by Noah Rosenblatt on November 13, 2007 at 10.00 AM

A: Lets enjoy what looks like will be a nice Walmart induced bounce today, even as credit concerns continue under the surface. Yesterday, Fitch downgraded some $37 Billion worth of structured finance CDO's, Blackstone President warns of a mortgage black hole, and a spillover into the bonds backed by US commercial mortgages which shrank some 84% in the past 8 months. On to the discussion.

Just the facts people as we try to assess the continuing damage bubbling under the surface before it reaches the good people of creditville; a not so nice place to live. A few things are worthy of discussion on a day that will seem like a nice relief rally from the credit selloff.

FITCH DOWNGRADES $37.2 Bln WORTH OF CDO's

As the rating agencies scramble to fix the mistakes they made by dropping the ball on what used to be 'AAA' rated securities, more downgrades were announced.

According to Forbes:

Derivative Fitch said it has downgraded 37.2 bln usd of structured finance collateralized debt obligations (SF CDOs) across 84 tranches.

Ratings on 66 US cash and hybrid SF CDOs remain on negative watch pending resolution on or before Nov 21, 2007. It said the actions are based on the continued credit deterioration of the underlying collateral, as well as changes to the default forecasting assumptions.

Nothing new here folks. In my post about "Ratings Farce Hurts credit Markets" I discussed how:

What once was thought to be AAA rated securities, actually are NOT! As rating agencies adjust their criteria for rating these assets, and downgrade the ratings, the investment opportunities shrinks as many hedge funds and other institutions have restrictions on purchases of junk rated holdings.

Quite simply, its much harder to RAISE CAPITAL if your assets are getting downgraded to JUNK status; which is currently happening.

CREDIT MARKET SPILLS OVER TO COMMERCIAL MORTGAGES

Ugh. It was logical to think it's just a matter of time until the credit problems start to infect the securitization of commerical mortgages. Well, that time has come.

According to FT.com's article "Hysterical US Bond Investors Threaten Commercial Property":

Global credit turmoil has spilled over into the market for bonds backed by US commercial mortgages, threatening to push down property prices and scuttle deals.

Issuance of US commercial-mortgage-backed securities fell to $6.3bn in October, down 84 per cent from a record $38.5bn in March, according to Commercial Mortgage Alert, a trade publication. The decline in CMBS issuance is crucial because such securities have provided an estimated 40 to 60 per cent of financing for new commercial property purchases in recent years.

Moody's index of commercial real estate prices is expected to show that prices flattened or fell in September, after rising nearly 14 per cent in the 12 months to August. RBS Greenwich Capital predicts that US commercial property prices will fall 10-15 per cent next year. Market turbulence is also raising the cost of commercial mortgage borrowing.

What I worry about in this commercial sector, is that many banks have loosened their terms in order to get more business in the past 12 months or so. The story mentioned this too.

In the past six to 12 months, banks have scrambled to attract borrowers by agreeing to looser terms - making loans that exceed the value of properties and accepting more interest-only repayments. Loans rose to 118 per cent of the value of commercial properties in the last quarter, Moody's says.

Ramifications of those looser terms is my main fear in this sector.

BLACKSTONE PRESIDENT WARNS OF MORTGAGE BLACK HOLE

Ok, so their CEO got questioned on his exit strategy and the stock has floundered since going public. But the Blackstone Group still has some very smart people, and when the President publicly states something like this, it's worth listening to.

According to FT.com:

The US mortgage crisis is "deeper" and "scarier" than anyone expected, Tony James, president of Blackstone, said on Monday. Mr James, also Blackstone’s chief operating officer, said that deal flow was rebounding but the market for private equity buy-outs would be constrained by the reluctance of big banks to lend during the mortgage crisis.

"The mortgage black hole is, I think, worse than anyone saw. Deeper, darker, scarier. [The banks] are now looking at new reserves and my sense . . . is they don’t have a clear picture of how this will play out and confidence is low."

However, he said that subprime mortgage prices were reaching a point where they offered "real value". Blackstone is more interested in buying mortgages themselves than home lenders, he said.

Scary, but perhaps a silver lining? That note referencing the fact that subprime mortgage prices (the bonds) are reaching a point of 'real value' could hint that the Blackstone Group is beginning to nibble on some distressed assets? The one big thing I'm waiting for is liquidity to come back into the secondary mortgage markets to signal that value is being picked on by longer term investors. So far, it hasn't happened but this is an interesting thing to hear.

Also, we need to keep an eye on any forced liquidation of assets that may need to occur in the near future due to ratings changes, unwinding of Yen carry trade, or credit market deterioration. Keep an eye on commodity prices for any signal of major liquidations to meet debt requirements.

Live Chat

Posted by Noah Rosenblatt on November 13, 2007 at 9.09 PM

A: You guys want the live chat back?

November 14, 2007

ABX 'AAA' Index Gets Bids

Posted by Noah Rosenblatt on November 14, 2007 at 9.59 AM

A: A noticeable uptick in the ABX 'AAA' index yesterday, although lower rated indices held at their lows. Also, it seems the financial stocks are starting to react favorably to negative news (HSBC, BAC, & BSC), a good sign. This doesn't mean the total write-downs are over or that the credit crunch is over! It simply means confidence is trickling back into the sector, and that's worth noting. All that is needed to destroy that is another negative surprise or a new phase of the credit crunch cycle unveiling itself.

First, the ABX 'AAA" move yesterday. While its not anything to cause major celebration, it is a good sign to see some bids coming in. You can see on the chart to the right that there was a nice little rebound after the steep selloff over the past week or so. After hearing news of Blackstone & Oaktree rallying up funds to start nibbling on distressed assets, I've been watching the ABX indices for any bids to come. Hopefully we will see a more pronounced rebound in all of these indices which will signal renewed confidence in the distressed secondary mortgage markets.

OakTree Capital Raises $10Bln For Fire Sales (via Reuters)

Investment firm Oaktree Capital Management L.P. is armed with over $10 billion to pick up assets during fire sales as the credit crisis continues to roil financial markets, said chairman Howard Marks on Tuesday. "An enormous part of what lies ahead depends on confidence ... I think it unwise to take actions today on the assumption the worst is over." With three to five years of aggressive investing behind us, it's unrealistic to expect the last four months to have unwound all of that, he said.

This year Oaktree has raised two funds that could invest in leveraged buyout debt that has been marked down because of the credit crisis. One is Oaktree's $3.5 billion Opportunities Fund VII which is expected to pick up a chunk of LBO debt and the other the $4 billion Oaktree Loan Fund which is primarily for the purpose of buying bridge loans related to LBOs.

On a side note, here is the credit news out since yesterday:

HSBC Takes $3.4 Billion Charge (NY Times)

Bear Stearns Takes $1.2 Billion Write Down; Says Worst Over (USA Today)

Bank of America Sees $3 Billion Loss on CDO's (Reuters)

...yet the market shrugged off the negative credit news and focused on the near term future and what Bear Stearns said about the worst being over. Personally, I don't buy it and I worry there will be a new phase of the credit cycle to reveal itself as ratings downgrades continue. But, the market has its own way of interpreting things, and I'm not going to argue a positive reaction. Its a sign of confidence trickling in a bit as these write downs are now embedded in the mindset of investors. I question how many more it will take to change that sentiment? For now, just expect more write downs and losses to be reported, and more ratings downgrades from Fitch & Moodys.

As Howard Marks of Oaktree Capital said, "With three to five years of aggressive investing behind us, it's unrealistic to expect the last four months to have unwound all of that!"

I agree.

Comments: Be Sure To Add Security Word

Posted by Noah Rosenblatt on November 14, 2007 at 10.58 AM

A: It's a new site, with new functionality and tools, so I just want to point out to all that the comment system is now automatic! No more moderating before publishing. But I have found 7 comments in the JUNK folder because the commenter forgot to add the security word before posting their comment.

Consider this just a friendly reminder moving forward! If you write a comment and DO NOT see it published after you RELOAD THE PAGE, then chances are you forgot the security code or typed it incorrectly. I get like 600+ spam comments daily and don't have time to go through it for mis-junked comments. Here is what the security system looks like:

THANKS ALL!

Commercial Market - Players Getting Nervous

Posted by Jeff Bernstein on November 14, 2007 at 12.05 PM

Noah's piece yesterday titled, "Credit / Downgrades / Commercial" talks about the shutdown of the commercial CMBS market and predictions of a decline in commercial real estate prices. Up until now the commercial construction market has been very strong and commercial construction has done much to pick up slack from the implosion in residential construction.

According to an August 13th Wall Street Journal article commercial construction was growing at a 17% year-to-year rate over the summer and was cushioning the effects of the residential construction slump. However, the tightening of credit seems like it could very well throw cold water on this trend.

According to Bloomberg.com :

U.S. commercial real estate prices may fall as much as 15 percent over the next year in the broadest decline since the 2001 recession as rising borrowing costs force property owners to accept less or postpone sales.

And Calculated Risk discussed yesterday how Countrywide's Commercial real estate loan pipeline is down significantly; check out this chart:

The chart says it all. I have been attending a weekly real estate seminar in Manhattan for the last few weeks with my partner. Many of the city's biggest and best developers come to speak on various sub-markets around town and segments from retail to multi-family rentals. For the first few weeks the panels started out very ebullient. Each developer in turn waxed poetic about the subject of the day be it prospects for downtown or Coney Island developments, or $2,000 per square foot CondoTel prices, "Main Street" retail rents of $350 per square foot or $100++ per square foot office rents. Somewhere towards the end of the talk, the very talented moderator would finally ask the tough questions about financing, end buyer/user demand for product, absorption rates etc. My partner would comment to me that the panel would visibly slump when the discussion reached these topics and the ebullience would immediately cease. Still people spoke of potential eventual downturns, etc.

Last week the discussion, which was about one of the boroughs, started similarly but quickly got to the tough questions. This time a prominent New York City developer (names withheld to protect the innocent) launched into a monologue about New York's real estate cycles and how long it has been since a downturn. This gray beard averred that cycles had not been revoked and that we were heading into a downturn. He added that this particul