Everything Works in Reverse - Asset Cycle II

Posted by jeff

Thu Dec 13th, 2007 11:16 AM

It can be very hard for investors to adjust their psychology to new market conditions - I have the scars on my back to prove it. For one thing markets tend to go up over the long-term. If you are a true investor and have a holding period of 10 years or more -Warren Buffet has been quoted as saying his favorite holding period is "forever"- over any ten year period the worst that usually happens to you is you get bored. Obviously if you are not properly diversified, if you buy the most speculative areas...when they are hot, trade in and out, or use leverage, a lot worse can happen.

100_year_dow_bull_bear_periods.jpgLooking at these longer-term charts, I am sure you can see how in the long periods of appreciation in different asset classes you can get pretty "long-term" optimistic. In fact since businesses can't trade the markets and have to gear themselves to their long-term competitive positions, they almost have to adopt the "long-term bullish" mentality. Of course this is where the seeds of down cycles are planted. Imagine that you were a large mortgage lending entity...say Freddie Mac....and you were losing share to many alternative sources of financing. Meanwhile real estate prices were marching inexorably higher and competitors were figuring this appreciation trend into their calculus for loan to value ratio requirements. It is likely that you would respond, even just to maintain market share. In fact according to the CFO this is exactly what happened "The underwriting standards declined," said Anthony Piszel, chief financial officer of Freddie Mac. "That was across the board." This according to a Floyd Norris article in the Times Herald Tribune, he writes "A kinder way to look at it is that competition forced the company to lower its standards. Either way, Freddie this week released data showing how its standards eroded. None of the loans on its books from 2003 or earlier call for payments of interest only. Almost a quarter of the loans it bought this year had that characteristic."

Home%20prices.jpgSo these days Freddie is no longer buying the NINA (no income no asset) loans they were before the credit crunch - and they are raising capital to butress their balance sheet. So what's my point? In order to adjust to the transition from bull to bear market you have start thinking in reverse....once you start doing it, its actually pretty easy. Just think about all the things that people did and realize they will do the opposite when the market turns down. Think about all the positive data and how it underpinned the decisions of appraisiers, lenders, rating agencies, buyers and sellers and realize the bad data will have the opposite impact.

This month's Real Deal has a cover article on "The Commercial Slowdown - How Deep Will the Dip Be" in New York City. Interestingly, it parallels the Freddie Mac example. According to Adrian Zuckerman, the head of the real estate practice for Epstein Becker and Green P.C. and head of the firm's Real Estate Steering Committee. "Lending standards over the past few years were speculation-based, not performance-based". Now although the headlines are coming out now, I have been hearing for at least 6 months about how difficult it was to be a commercial real estate investor/developer and acquiring property in NYC - "Going long the market". But folks were doing it anyway...why? They are in the business of buying and developing real estate and prices usually go up. Zuckerman comments further in the article "There's still a relatively strong leasing market in New York, but if the leasing market drops , or even remains stable, the projected rents won't be there - estimated performance projections won't be met". The article goes on to talk about an increasing number of commercial buildings that are in technical default....they have not stopped paying their mortgages, but they don't have the required interest coverage ratios and other measures of financial health that banks insist they maintain. We have many projects particularly in the boroughs that are coming out of the ground to beat the 421A expiration and I have heard about several deals that are already having financing issues. The current stalemate of buyers and sellers may be broken, when banks join the ranks of sellers. This is a particular risk in the boroughs.

Things working in reverse...thats why they say you can't un-pop a bubble. Pervasive declines in underwriting standards...we are now finding out that they were not just in loans to individuals for residential real estate, they were in loans to developers and commercial real estate buyers to. It is the natural cycle of things - like in the bible 7 fat years...