The Bubble Asks for a Bail Out

Last Monday the front page of the Wall Street Journal headlined a story  which outlined why the most powerful real estate developers in the U.S. have formally asked for a bailout loan from the Federal Government. A drop in asset values from to the real estate bubble, rising vacancies and dropping rents in the commercial markets have depressed cash flows so much that many of these large developers cannot meet their debt obligations.  These developers cannot look to banks for additional credit because they are already over leveraged; they are left to turn to the government for help. 

The depressed rents and a sudden depreciation in assets that the developers are describing should not be a surprise to anyone. When Bernanke and Paulson said the real estate market would be entering an adjustment period, this is exactly what they were talking about! 

To understand how dangerous it would be to extend government credit to real estate developers, it is important to first take a step back and restate the causes of the "real estate bubble" which is considered the impetus of the 2008 recession. The real estate market is like any other free market, driven by supply and demand forces. In its most simplistic and fundamental form, the real estate bubble was created by artificial demand side changes. An extremely lax credit environment created artificially¹ high demand for real estate, (more borrowers qualified for loans = more demand) which in turn led to an artificially high valuation for real estate. Credit was then extended based on this artificially high valuation of real estate assets.² The bubble "popping" was the realization that all the underlying assets were, in fact, overvalued, which meant many of the properties purchased within the bubble had mortgages based on a value higher than asset’s actual worth. The bubble was simply a difference between an artificial inflation and reality. This recession is an adjustment period for the credit markets, where all of the mortgages will somehow adjust or unwind to meet pre-bubble prices.

Offering government issued loans to developers would slow or reverse this market adjustment, which must happen for the real estate market to find a firm footing and for credit to start flowing again. If the government extends loans to real estate developers they could only do so by ignoring the deflated value of the underlining assets. (This is inherently true in the request to the Government. The market has deemed these assets unfit to extend additional credit, forcing developers to ask the Government for a loan.) To issue a new loan on these deflated assets the Government would have to repeat the mistakes of the past and secure a loan based on an inflated asset value. The Government would essentially be reinflating the bubble by allowing Real Estate Developers to continue to over leverage their depreciated assets. This will continue to fuel the artificial demand that caused this recession and prevent the market from finding a bottom from which to rebuild. 

The recovery of the credit markets is hinged on a return to a realistic (pre-bubble) valuation for real estate. Proper underwriting depends heavily on being able to comfortably assign an applicable risk premium within the interest rate, and this can only be done if the lender is comfortable with the stability of the securtized asset. If the Developers received a bail out their assets will not undergo the market adjustment, it would artificially keep real estate prices high, and prevent the market from finding a bottom.   

There is no solution that will help troubled Real Estate Developers, they are probably extremely over leveraged now that their assets have lost so much value. As the economy contracts real estate rents will need to come down to meet demand changes. It may also pose the scenario where an asset manager may need to offer space at a loss to cover at least a portion of fixed costs. The riskiest of the real estate developers, those who took on the most debt based on inflated values, will probably not survive the adjustment, but this is a necessary process. 

If left uninhibited, the market forces that are driving real estate values downward are the path to economic recovery. Inexpensive space decreases the barrier to entry for emerging businesses. New and more conservative Real Estate Developers will now have a greater opportunity to expand by capitalizing on the bad bets made by riskier developers. The worst over valued properties will be defaulted, and then resold at more realistic values at auction and lenders will be insulated by auction losses by Government backing already guaranteed through TARP. This process will eventually lead to the bottom of the market, where prices become stable. This stability will allow credit to start flowing again by solidifying confidence in the value of real estate, which will once again be used to leverage new loans.  

This new request will prove to be a real test for the Federal Government. The Developers' problems are a description of the natural market forces adjusting in the wake of a real estate bubble. Depressed rents, and depreciated assets are a necessary evil as our economy searches for a firm footing. I can only hope that congress has the sense not to hand out money to everyone that asks, and instead analyzes the impacts of their stimulus. This will be an opportunity to either show a true understanding of the causes of this recession by denying the developer loans, or show true ignorance by granting them. 

 

1.   Demand was "artificial" because borrowers received loans they should not have qualified for in a normal credit environment. This is a widely accepted cause of the real estate bubble. 

2.   To understand the crisis in more detail please see two articles I wrote in October, "Truly Understanding the Credit Crisis..." and "You Would Have Been an Idiot Not to Take a Teaser Rate..."