October 13, 2010 – Can the economy improve without a recovery in real estate values? This question was addressed today by FDIC Chairman Sheila Bair, in a speech to the Urban Land Institute in Washington, D.C. Despite optimistic forecasts by various analysts, Ms. Bair cited the daunting challenges that must be overcome in order to restore stability to the real estate and financial system.
Ms. Bair noted that economic recovery has been slow and is likely to remain so due to high unemployment. Much work remains to be done to repair the financial system and “the health of the real estate sector will be crucial in determining the path of the entire economy. After three long and difficult years for the housing sector, we’ve begun to see positive signs…The Case-Shiller 10-city home price index, which declined by some 33 percent from the height of the crisis, has risen by just over 4 percent in the past year.”
Whether or not this small rebound is significant remains to be seen. Oversold markets will periodically rebound and then continue downward.
The statistics on mortgage foreclosures and delinquencies remain extremely bleak and are likely to add to the large number of vacant homes and distressed sales. A huge inventory of homes for sale along with buyer reluctance to purchase in a declining market indicate that the imbalance between supply and demand is likely to restrain a recovery in housing prices.
Chairman Bair noted that:
Some 2.4 million mortgages remained in the foreclosure process at the end of June, while another 2.7 million mortgages were at least 60 days past due. As of June, an estimated 11 million homeowners, or nearly 1 in 4 of those with mortgages, were underwater, owing more than their homes are worth. Not only are these borrowers generally unable to take advantage of today’s record low mortgage rates to refinance, but they become more likely to walk-away from their mortgages.
The typical mortgage that is 60 days delinquent has a very low probability of being brought current. In addition, as economic conditions remain poor and if home values continue to decline, the number of additional homeowners that become delinquent and face foreclosure could increase considerably. In a worst case scenario, we presently have a total of 5.1 million homes facing foreclosure, adding huge inventory to an already weak real estate market.
The ultimate default nightmare looming over the US financial system comes from the 25% of homeowners who are underwater on their mortgages. If home prices continue to decline, the incentive for underwater homeowners to strategically default becomes financially compelling. According to the Federal Reserve, as of the second quarter 2010, there is total mortgage debt outstanding of $14 trillion. Commercial banks and savings institutions currently hold $4.3 trillion dollars of outstanding mortgage debt, with the balance held primarily by Federal and related agencies. In a worse case scenario, if the 25% of homeowners underwater on their mortgages default, this would be equivalent to $3.5 trillion dollars of defaulted mortgages.
The prospect of another wave of massive mortgage defaults may be one of the primary factors behind the Federal Reserve’s obsession to increase the rate of inflation via quantitative easing (QE) – the outright printing of money. A still fragile financial system could not handle another major financial crisis if trillions of dollars in mortgage debts default. The prospect of Fed QE has already lead to large increases in the asset values of stocks, bonds and commodities. Will the Federal Reserve’s risky experiment with quantitative easing lead to a recovery in housing prices as well?
The risks to the financial system extend beyond the continuing huge defaults on residential mortgages. Commercial real estate (CRE) loans remain a major problem as well, especially with FDIC insured institutions holding approximately $1.75 trillion in CRE loans. Chairman Bair makes it clear that the default risk on CRE loans remains high.
We also face significant challenges in commercial real estate. Average CRE prices are down by 30 to 40 percent or more from their peak levels of 2007, and rents continue to drop for most property types and in most geographic markets.
Credit availability has also been limited as lenders have tightened standards, issuers have virtually stopped offering commercial mortgage-backed securities, and the credit standing of many borrowers has declined. FDIC-insured institutions hold about half of the $3.5 trillion in CRE loans outstanding, which means we’ve been focused on commercial real estate for a very long time. Lenders will continue to face some tough choices when loans come up for renewal with collateral values that have declined significantly from peak levels.
The federal regulatory agencies issued guidance last Fall designed to provide more clarity to banks on how to report those cases where they had restructured problem loans. This was an important step to reduce uncertainty as to how restructuring efforts would be viewed and reported for regulatory purposes.
Some have criticized these loan workouts as a policy of “extend and pretend.” But, as on the residential side, the restructuring of commercial real estate loans around today’s cash flows and today’s low interest rates may be preferable to the alternative of foreclosure and the forced sale of a distressed property. And going forward, as is the case with residential mortgage lending, we need better risk management and stronger lending standards for bank and nonbank originators to help prevent a recurrence of problems in commercial real estate finance.
Chairman Bair concludes by noting that recovery of the U.S. real estate sector “will take time”, and “problem loans will need to be worked out or written off”. Those expecting a rapid recovery in real estate and the banking system should carefully consider the Chairman’s frank assessments of the substantial risks to the financial system that still exist.