Lending, the FDIC, and Liquidation Selling

It's becoming more and more obvious that the real estate market in much of the
country has turned ugly. In places like California, Florida and Nevada prices
have dropped rapidly, largely because the exotic loan programs that fueled the
boom there have dried up.

The weakest buyers--those with low or no down payments and marginal credit who
bought in the last three years--have been weeded out to some extent. In any
pyramid scheme, which is what the residential real estate market amounted to
during the boom, the last in are usually those who are burned the worst.


Weak Lenders Equals Lower Prices

Almost all residential real estate transactions depend directly or indirectly on
lending. Those who pay cash for a property usually sold a previous property to
someone who used financing to buy their property. 

Houses in the US are generally worth what a lender will lend. If the lender
can't or won't lend, they aren't worth much. If lenders have become weakened by
previous reckless lending, other things being equal, they will be forced into
lending lower amounts on properties, since they have much less capital to risk,
and are forced to be far more conservative with what they do have left. 

It's also becoming more clear how weak the GSEs are (Fannie Mae and Freddie
Mac). Fannie and Freddie have taken on most of the mortgage market since
securitization ground to a standstill. The problem is that both Fannie and
Freddie have bit off more than they can chew, and are only afloat now because of
lenient accounting rules and an implied government guarantee.

If Fannie and Freddie begin to take on more water, the mortgage market will
really have nowhere else to turn for financing. Most of the bigger lenders who
keep loans on their books--Washington Mutual, Wachovia, Wells Fargo, etc--aren't
in great shape either.

The bottom line is that there is nowhere to hide in the mortgage market.
California dropped close to 35% in one year just because the exotic loan
programs were removed. How much would it drop if Fannie and Freddie quit buying
mortgages? 


FDIC, Receivership and Liquidation Selling

When the FDIC steps in and takes over a bank or thrift, a number of things
normally happen.

First, lending is ordinarily greatly curtailed. Loans to insiders are often
called in, weak borrowers who could previously borrow are turned away, and new
borrowers usually find it's easier to borrow money elsewhere. Most banks go
under because of sloppy lending, so the FDIC normally stops this kind of lending
right away.

Second, the FDIC normally seeks to clean up the balance sheet by getting rid of
collateral on the books that isn't generating any money. This normally involves
selling foreclosed houses, commercial property, equipment, etc. Lots of banks
and thrifts out there won't say how much real estate they are already holding on
their books, since if they did they might already be technically insolvent.
There are no doubt plenty of loans that are non-performing that are being listed
as performing, just to make the books look better. 

The FDIC is in the business of cleaning things up and getting on with business,
and, at least in the past, their normal pattern has been to try to sell most of
the collateral in target banks for whatever they can get. Also known as
liquidation selling.

The problem has gotten so big this time around that it's possible that the FDIC
may pursue a different course (due to political interference, no doubt).
However, the pattern the last time around--late 1980s and early 1990s--was to go
in and clear everything rotten out, liquidate collateral for whatever they could
get, for often dimes or even pennies on the dollar. 

The FDIC takeover of failed institutions alone will tend to depress real estate
prices in parts of the country. Heavy selling of foreclosed houses and
commercial property by FDIC-controlled banks and thrifts will make it worse. 

Understand that the FDIC doesn't have to please the stock market or the
shareholders, and they are often trying to clear up problems in a year or so
that have been building for most of a decade.

When a bank goes into receivership with the FDIC, what basically remains are the
depositor's accounts and the existing book of loans, many of which are rotten.
The collateral is often worth a lot less than it's book value in the first
place, and the FDIC policy of quick resolution often leads to drastic losses in
value, at least locally and on a short term basis. 

Liquidation of assets by the FDIC will probably lead to some of the biggest
losses (to the previous owners) and the biggest gains (to the buyers who buy at
the bottom from the FDIC-controlled institutions). The FDIC will likely be
setting the local market price in areas where they do heavy selling, but when
the liquidation selling is over, prices will tend to stabilize. 


Decrease in Local Money Supply and the FDIC

When banks or thrifts are taken over by the FDIC, the local lending climate
tends to change, and the local money supply often drops. Even in local banks
which are not taken over by the FDIC, in areas where other banks go under FDIC
receivership, lending tends to become much more conservative, for a number of
reasons. 

Commercial real estate is actually a much larger issue for most local banks than
residential, but all of the negative news so far has concentrated on
residential. Many of the same wild lending practices also went on in commercial
real estate, but in this case the loans tend to be held on the books of local
banks to a much larger degree, rather than being sold to outside investors.

As commercial real estate enters the train wreck, it's possible that liquidation
selling may extend there as well. Additionally, when local banks find that their
commercial loans are failing and collateral values are dropping, they will have
no alternative but to reduce lending to non-real estate customers. Many of these
local business customers have no other ready source of financing apart from
their local banks, so the downturn that begins in real estate will tend to bring
down many businesses which would have been able to weather the storm had they
had access to other financing. 

It's obvious that few cities need more strip malls, more big box stores, more
car lots, etc, and that this sector of the economy has become grossly overbuilt
in many areas. The most logical outcome is that a long period of liquidation,
falling values, and contraction would occur in many parts of the country. Square
footage of retail space has roughly doubled in the US since 1990, whereas
population and incomes have lagged far behind.