An Alternative To F&F And Ugly Developments With Commercial Mortgages

I had a busy day, so I’m just beginning to catch up on everything. As I bounce around I’m realizing that a day I thought was mild from the point of a lot of dramatic news had some pretty interesting things going on. Here are a couple that just caught my attention.

The first one from the WSJ goes under the heading “It’s about time.” I’ve been looking for someone to stand up and start taking a leadership role. Anyone! Just speak truth to power. Who would have thought that a Southern banker like Ken Lewis might do just that? Mr. Lewis has proposed a solution to the future of the mortgage industry that won’t sit well with the power brokers of Washington.

Lewis bucks the trend to centralized control of the mortgage markets by suggesting that in fact the country should migrate to a system of private financing of mortgages. Basically, he calls for scrapping the Fannie/Freddie system. He acknowledged that in the short-term it would be necessary for the government to use its control of the two to push down rates but argued for a system that moves away from that system eventually. Props to him for at least having the courage to stand up and suggest that even though the Emperor may be clothed, he at has at least inappropriately revealing socialist attire.

The second one, also from the WSJ, is not comforting. It confirms what a lot of people have been whispering among themselves concerning the prospects for commercial mortgage backed securities. Two big commercial mortgage backed securities were said by Credit Suisse to be likely to default. These loans were just packaged in the last year. The loans involve a $209 million loan on two Westin hotels in Tucson and Hilton Head and a $125 million loan in Corona, California.

The fact that these are recent loans is particularly discomfiting. Commercial loans generally contain an interest reserve (sort of a negative amortization feature) that lets the borrower and lender pretend that with time all things will be fine. It works so long as either property values increase and you can refinance or the economy booms and your revenues exceed by a large margin your projections. Neither of those circumstances currently exist, hence the loans are likely to go bad.

The commercial mortgage market has largely flown mostly under the radar so far. Partly because the concepts are more arcane and not easily conveyed by the mass media and partly because of the ability of the lenders to keep zombie projects alive via interest reserves and other concessions. The rubber, as it always does, is going to hit the road sooner or later. It appears from this report it may be sooner and when that happens, look for a lot more strain on the banking sector, particularly the regionals. Though this is an event that effects the CMBS market, it has repercussions for the banking sector given their appetite for commercial real estate loans.

If Obama and company are at a loss with what to do with the TARP money that Paulson is leaving them, they might want to start looking at this sector.

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