The Next Financial Explosion

A weird quiet seems to have settled over the country. We're in the midst of the financial crisis, yet it feels like the whole thing has somehow passed. In fact, the ionized air around us suggests we're in the eye of this hurricane—experiencing a moment of calm before the storm whips up again.

Which is to say we are probably experiencing a rolling recession. And some analysts believe the crisis has yet to fully ripple across the myriad types of assets held by banks and investors. The failure of residential mortgage-backed securities was just the first ripple of this much larger wave. Asset types that didn't exist on the same scale in 1929—like credit cards, industrial loans, and commercial real estate—still hold the force to wreak more havoc. And on the tip of Wall Street's and Washington's tongues are commercial mortgage-backed securities. They sure look like the tsunami in this financial storm. But it might just be the Geithner plan that halts the wave and saves our shopping malls from looking as dead as some suburbs.

So first, why do CMBS have to blow up? Like residential mortgages, the premise behind commercial loans was faulty. And that premise is, of course, that the market would never go down. Commercial loans, which are packaged into CMBS, are given to owners of buildings that have multiple streams of income, like apartment complexes and shopping malls. Unlike residential mortgages, their terms are as short as five years with a lump-sum payment due at the end. In residential mortgages, only savvier homeowners—well, they seemed so at the time—thought to treat their homes like cash machines and take out equity in the form of refinancing. But in the commercial market, especially the crazed one of 1993-2006, it was de rigueur to refinance loans and pull out equity before the big payout came due.

Thanks to that practice, America's $6.5 trillion commercial real estate market, of which nearly 50 percent was financed, may be in dire straits, too. More than half a trillion dollars in commercials mortgages are coming due between now and 2011 (which is five years out from the market's 2006 peak). And just like the homeowners who never expected to actually face their balloon payments, the frozen credit markets are leaving commercial loan holders unable to pay off their loans. Delinquencies in CMBS loans are already up 246 percent over this quarter last year, and analysts say they could go much higher.

Real estate investment trusts are built on commercial loans, which are often packaged into CMBS. REITs are a special type of company that allows investors to avoid corporate income taxes if they distribute 90 percent of their profits back to investors, usually as a dividend. Which is why it was scary for many of those investors to watch General Growth Properties, the largest REIT in the country, declare bankruptcy last week. The company, which owns 200-plus malls, faces $5.5 billion in commercial real estate loans due in two years. Basically, it was hugely overleveraged. It has been a dead REIT walking for months—Sam Zell predicted the bankruptcy at a REIT conference in New York three weeks ago. But General Growth was holding out hope that it could convince its investors to simply hang in there—to give them an additional year to pay off their loans with no penalty either in a moratorium or a forbearance. Ultimately, investors said no, and here's why.

Analysts, media, and investors are lashing the commercial real estate sector with their tongues. Zell called it Darwinian. Stock values of public REITs, despite a recent upswing, have been routed, according to the Wall Street Journal. REITs are wrecks and have turned to the tenets of religion to survive: faith, hope, and charity. Their future is clouded, according to one unusually sanguine headline writer. Commercial Property Faces Crisis, says another.

A strip mall, the quintessential piece of commercial real estate, is only as valuable as the rent it earns its landlords. When tenants, i.e., stores, stopped making money, they stopped paying rent. Commercial landlords were faced with two unsavory choices: allow stores to leave or lower their rents. (Several stores, from Circuit City to Steve and Barry's, gave their landlords no choice at all; they went out of business, leaving large vacant holes in malls and balance sheets.) Landlords are now allowing down-market stores into previously off-limits malls and investing in gimmicks like the Flowrider, an indoor wave-surfing machine, to draw people back in the hope that they might purchase a latte or T-shirt before leaving. Needless to say, when landlords are hanging ten to avoid a wipeout, the times, they are a-changing.

But what's puzzling is that several of the largest public REITs, though not General Growth, have lately been raising cash through secondary stock offerings—and have found willing investors. One plausible explanation for why real estate moguls like Zell, Steve Roth, and William Mack are bemoaning the fate of their industry while REITs are padding their bank accounts is that REITs were prepping for General Growth's and other weak REITs' liquidations. It is a Darwinian sector, then, and everyone in it is trying to avoid looking like the dodo bird. As General Growth's 200-plus shopping malls hit the auction block, stronger REITs will become the latest vulture capitalists, buying up the distressed properties and assuming their debts. But here is where, unlike last time, the carnage stops. Those debts, commercial mortgages, are probably about to be a lot safer, as they are likely soon to be protected by the Geithner Public-Private Investment Plan.

The PPIP, as has been explained here among other places, protects investors to an absurd degree against losses in assets they buy in the coming distressed asset auctions. An investor with government protection can potentially make 45 cents on a dollar of investment, according to a Credit Suisse analysis, while a theoretical unprotected one would make only 15 cents per dollar invested. The mortgages on those empty strip malls and shopping centers full of wave-surfing, unemployed, nonshopping shoppers will magically become sound investments! Therefore, REITs that have extra cash in hand may find a way, working with the government's handpicked PPIP managers, to bail themselves out of their own mortgages, mostly on Uncle Sam's dime.

So while commercial real estate values could indeed be headed for collapse, savvy REITs are already putting aside money for umbrellas and galoshes. And Obama and Geithner are hoping they have built a weather-changing machine for the entire economy in the form of the PPIP. Of course, the PPIP has promised only up to $1 trillion in investor protection across all asset-backed securities, not just CMBS, so far. Yet the blog REIT Wrecks estimates that up to $1.8 trillion may be required for complete investor prophylacticism in the CMBS market alone.

The REITs that survive this extinction are going to be on sounder financial footing than even the strongest REITs now. After overleveraging their holdings in reckless pursuit of profit, they are positioned to swoop in and buy up, in the form of auctioned distressed assets, well, themselves. And their weaker brethren. At a discount. With government backing. Welcome to Bailout Economics.

If all of this smarts a bit, consider what the collapse of the residential mortgage market has shown us about not providing a government safety net in times like these. If our options are bank collapses, shotgun mergers, and investor panic versus a mild form of economic socialism, then call me comrade. (Though there is still no reason for the administration to privatize the gains from what can fairly be called the CMBS bailout and socialize only the potential losses.)