Wednesday, August 25, 2010

52 is Not a Pretty Number!

Reading an article in the Wall Street Journal this morning I was hit twice by the number 52. (For those that are looking for signs it can be noted that you can reverse today’s date and get 52 as well!)

The first sighting, Robert Taubman, chief executive of Taubman Centers, Inc. decided earlier this year to stop covering interest payments on it $135 million mortgage on the Pier Shops at Caesars in Atlantic City, N. J. “Taubman, which estimates the mall is now worth only $52 million, gave it back to its mortgage holder. (See

The second sighting: “Of the $1.4 trillion of commercial-real-estate debt coming due by the end of 2014, roughly 52% is attached to properties that are underwater, according to debt-analysis company Trepp LLC.”

The question raised in this article: is it a smart economic decision for commercial real estate firms to just stop making mortgage payments on properties whose values have fallen FAR BELOW the mortgage amounts?

This discussion parallels the discussions that took place many months ago about whether or not it was a smart economic decision for homeowners to just walk away from mortgages on properties whose values have fallen FAR BELOW the mortgage amounts.

The burning issue is between morality and economic incentives. And, what does the economist say about this? Well, everyone has a price. One of the rules I frequently hear is “Don’t say that you wouldn’t sell out for a particular price until you have actually been faced with the decision in real life and actually decided that you wouldn’t sell out for that price.” It’s easy NOT to walk away from a property if you have never been faced with the temptation!

This situation raises concerns relating to two major interpretations of the current economic situation.

First, debates are raging about whether or not we are in a deflationary period. For the last nine months the Consumer Price Index has shown a positive year-over-year rate of increase reaching about 3.0% during this time. For July the year-over-year growth rate was 1.3%.

Yet, the value of real properties seems to be going down and down.

But, isn’t this the same problem that existed in the early 2000s only on the other side of the coin? Then the Consumer Price Index was showing very little inflation, yet the value of real properties was increasing in the 10% to 15% range.

The problem was that the Consumer Price Index measured the price of “flow” goods and services and not the value of the “stock”, the value of the asset. Rent is what is measured in the Consumer Price Index and this is an “imputed” figure. Much concern was raised at the time about the validity of the estimates for rental prices used in the index. Perhaps the same issue should be raised now.

Second, this brings up the issue about whether or not we are in a period of debt deflation. This is the other side of the problem of the early 2000s when we had a credit inflation. In a period of credit inflation the problem is that there is too much credit chasing too few goods and services around. The credit keeps “the music playing” and as long as the music is playing, according to Chuck Prince, Chairman and CEO of Citigroup at the time, you have to keep dancing. A credit inflation is cumulative.

The problem with a debt deflation is that there is too much debt around. When there is too much debt around people have to de-leverage. And, de-leveraging takes a long time and is very, very painful.

One remedy to a debt deflation is for the government to re-flate the economy. This is what many economists, politicians, and pundits would like to see happen. If the government can cause prices to rise again the real value of the debt will go down and guess what? The music starts playing again.

The problem with this solution is that there are historical periods when the amount of debt outstanding becomes unsustainable. People have to accept the fact that “credit bubble” they lived in for so long, no longer exists. And, when this happens, people have to get their balance sheets back in order and live more practically within their means. In times like these, governments and others find it more and more difficult to push them back into profligate habits of spend, spend, spend.

The realization of this hit Europe earlier this year and the pain is evident.

Yet the fundamentalist ministers of “inflationary finance” like Paul Krugman, like many fundamentalist ministers when they are not being listened to, cry out that those who do not respond to their teachings are just members of a cult. These people that oppose them have been misled to a false teaching and are heretics.

The United States (and Europe and some other areas in the world) has a debt problem. And, a great deal of this debt is connected with real estate. And, a great deal of this debt rests on the balance sheets of depository institutions. (See my “Where is Banking Headed? Not up!

What does a financial institution do when it is holding a mortgage for $135 million and the underlying property is given to them and the value of this underlying property is only $52 million? What does the banking system do knowing that 52% of the $1.4 trillion in commercial real estate debt coming due by the end of 2014 is underwater, and, by all we know, a lot of it is substantially underwater? What does the Federal Reserve and the FDIC and the Treasury Department do when they know that a very large number of the depository institutions in the United States have assets on their balance sheets that are substantially underwater?

This is what happens in a debt deflation. The economy, in a sense, implodes. But, it takes time for everything to happen because it is cumulative. First, there is the panic phase which we have gone through. Now, we are in the un-winding phase because a large number of people know what is happening, they are not surprised anymore, and are trying to work out the problems as smoothly as they can.

The best evidence I can give to support the idea that this implosion is happening is what I presented in the post cited above: on December 31, 2002 there were more than 7,888 commercial banks in the United States. As of March 31, 2010 there were only 6,772 commercial banks. In the next three to five years, many analysts expect this number to drop to 4,000 or so. Note that if the number of banks fell to 4,102 banks, this would be 52% of the number of banks that existed at the end of 2002.


Pradeep said...

very great..

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