Are Huge Real Estate Defaults Coming in 2010?

David Galland interviews Andy Miller about the next downturn in the real estate market and its impact on financial institutions.

I hope Andy Miller is wrong but I fear he is right.

An Insider’s View of the Real Estate Train Wreck – John Mauldin, Outside the Box

David Galland: Andy Miller has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects – such as shopping centers, apartment communities, office buildings, and warehouses – from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming.

Back in 2007, Andy was almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people that think they know what’s going on, and those who actually know – Andy very much belongs in the latter category.

As you’ll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation’s biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate.

No one has been more right on the housing market in recent years. So, what’s coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well?

MILLER: I don’t think so.

For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the U.S. were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

If it’s true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn’t help a homeowner whose property is worth less than the mortgage. So when the supply of government-facilitated loans dries up, it’s going to put the home market in a very, very bad place.

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.

The public doesn’t have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It’s huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can’t get people to focus on it, and it’s very esoteric, it’s very hard to understand. But it’s not something the bond market won’t notice. The government can’t keep doing what it has been doing to support mortgage lending without pushing interest rates way up.

Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that’s exactly where they’re headed. So anyone who’s comforted by current statistics on single-family homes should look beyond the data and into the dynamics of the market. What they’ll find is very alarming.

On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money.

MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the U.S. Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that they were going to remove all the caps on the agencies.

Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash?

MILLER: I think the first thing that changed was that people learned that prices don’t go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don’t think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate. But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in fantasy land for 10 years. And that was the first change – a mental adjustment from Alice in Wonderland to reality. Today it’s clear that commercial properties are not performing and that values have gone down, although I’ve got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is.

Right now there are an awful lot of banks that do an awful lot of commercial real estate lending, and for about a year now you’ve been telling me that you saw the first and second quarter of 2010 as being particularly risky for commercial real estate. Why this year, and what do you see happening with these loans and the banks holding them?

MILLER: It’s an educated guess, and it hasn’t changed. I still think that it’s second quarter 2010. The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there’s some alternative in place, it’s going to be a very hideous picture for the bond market and the banking system. The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I’ll give you an example. In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn’t have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital. That’s very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they’ll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that’s horribly destructive.

Just to be clear on this, let’s say I own an apartment building and I’ve been making my payments, but I’m having trouble and the value of the property has fallen by half. I go to the bank and say, “Look, I’ve got a problem,” and the bank says, “Okay, let’s work something out, and instead of you paying $10,000 a month, you pay us $5,000 a month and we’ll shake hands and smile.” Then, even though the property’s value has dropped, as long as we keep smiling and I’m still making payments, then the bank won’t have to reserve anything against the risk that I’ll give the building back and it will be worth a whole lot less than the mortgage.

MILLER: I think what you just described is accurate. And it’s exactly a Japanese-style solution. This is what Japan did in ’89 and ’90 because they didn’t want their banking system to implode, so they made it easier for their banks to sit on bad assets without owning up to the losses. And what’s the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it’s not going to sell them. Why is that bad? Well, the money tied up in the loans the bank is sitting on is idle. It is not being used for anything productive.

Wouldn’t banks know that ultimately the piper must be paid, and so they’d be trying to build cash – trying to build capital to deal with the problem when it comes home to roost?

MILLER: The more intelligent banks are doing exactly that, hoping they can weather the storm by building enough reserves, so when they do ultimately have to take the loss, it’s digestible. But in commercial real estate generally, the longer you delay realizing a loss, the more severe it’s going to be. I can tell you that because I’m out there servicing real estate all day long. Not facing the problems, and not writing down the values, and not allowing purchasers to come in and take these assets at discounted prices – all the foot-dragging allows the fundamental problem to get worse. In the apartment business, people are under water, particularly if they got their loan through a conduit. When maintenance is required, a borrower with a property worth less than the loan is very reluctant to reach into his pocket. If you have a $10 million loan on a property now worth $5 million, you’re clearly not making any cash flow. So what do you do when you need new roofs? Are you going to dig into your pocket and spend $600,000 on roofing? Not likely. Why would you do that? Or a borrower who is sitting on a suburban office property – he’s got two years left on the loan. He knows he has a loan-to-value problem. Well, a new tenant wants to lease from him, but it would cost $30 a square foot to put the tenant in. Is the borrower going to put the tenant in? I don’t think so. So the problems get bigger.

Why would the owner bother going through a workout with the bank if he knows he’s so deep underwater he’s below snorkel depth?

MILLER: It’s always in your interest to delay an inevitable default. For example, the minute you give the property back to the bank, you trigger a huge taxable gain. All of a sudden the forgiveness of debt on your loan becomes taxable income to you. Another reason is that many of these loans are either full recourse or part recourse. If you’re a borrower who’s guaranteed a loan, why would you want to hasten the call on your guarantee? You want to delay as long as possible because there’s always a little hope that values will turn around. So there is no reason to hurry into a default. None.

So that’s from the borrower’s standpoint. But wouldn’t the banks want to clear these loans off their balance sheets?

MILLER: No. The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against their capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. Remember, you suffer if the bank succumbs and turns around and liquidates that asset, then you really do have to take a write-down because then your capital is gone.

So here we are, we’ve got the federal government again, through its agencies and the FDIC, ready to support the commercial real estate market. They’ve taken one step, in allowing banks to use a very loose standard for loss reserves. What else can they do?

MILLER: Well, obviously nobody knows, but I can guess at what’s coming by extrapolating from what the federal government has already done. I believe that the Treasury and the Federal Reserve now see that commercial real estate is a huge problem. I think they’re going to contrive something to help assist commercial real estate so that it doesn’t hurt the banks that lent on commercial real estate. It’ll resemble what they did with housing. They created a nearly perfect political formula in dealing with housing, and they are going to follow that formula. The entire U.S. residential mortgage market has in effect been nationalized, but there wasn’t any act of Congress, no screaming and shouting, no headlines in the Wall Street Journal or the New York Times about “Should we nationalize the home loan market in America.” No. It happened right under our noses and with no hue and cry. That’s a template for what they could do with the commercial loan market. And how can they do that? By using federal guarantees much in the way they used federal guarantees for the FHA. FHA issues Ginnie Mae securities, which are sold to the public. Those proceeds are used to make the loans. But it won’t really be a solution. In fact, it will make the problems much more intense.

Don’t these properties have to be allowed to go to their intrinsic value before the market can start working again?

MILLER: Yes. Of course, very few people agree with that, because if you let it all go today, there would be enormous losses and a tremendous amount of pain. We’re going to have some really terrible, terrible years ahead of us because letting it all go is the only way to be done with the problem.

Do you think the U.S. will come out of this crisis? I mean, do you think the country, the institutions, the government, or the banking sector are going to look anything like they do today when this thing is over?

MILLER: I know this is going to make you laugh, but I’m actually an optimist about this. I’m not optimistic about the short run, and I’m not optimistic about the severity of the problem, but I’m totally optimistic as it relates to the United States of America.

This is a very resilient place. We have very resilient people. There is nothing like the American spirit. There is nothing like American ingenuity anywhere on Planet Earth, and while I certainly believe that we are headed for a catastrophe and a crisis, I also believe that ultimately we are going to come out better.

Andy Miller is the co-founder of the Miller Frishman Group (,which includes three companies serving different sectors of the real estate market – from mortgage brokerage and banking, to the building, management, and marketing of commercial real estate across the United States. His firm is currently deeply involved in the distressed real estate business, assisting lenders across the nation with their growing portfolios of non-performing loans.


Are Lower Gold Prices a Buying Opportunity?

Paul Brodsky at QB Asset Management Co. warns:

There are more American net-debtors than net-savers and US federal and state governments are deeply indebted. Thus, it is politically expedient for policy makers to inflate away the burden of existing and future US debt repayment (which will grow as the burden shifts from private and state debtors to the government).

Link: Is Gold a Crowded Trade? by Paul Brodsky

Investing in gold is tough because it challenges the investor to come to terms with the faults of his or her government, and then to act upon them. It requires the admission that there is risk in holding cash. This is counter-intuitive to this generation’s vintage of financial asset investor accustomed to thirty years of a credit build-up alongside declining interest rates.

There is certainly much more chatter in the press than in years past surrounding gold, and there certainly is more US retail investment (through ETFs) than there has been. That has been reflected to some degree in its rising price, no doubt. An ounce of gold has risen from about $250 in 1999 to current levels, having moved higher in each year and making it one of the best performing assets over the last ten years. So then, is a person that pays $1,100 an ounce today top-ticking the market by entering a crowded trade that has little upside and great downside?

We don’t think so.

Do your own research. Call your investment advisers and ask them what percentage, if any, they recommend investors allocate towards precious metals. Ring up prominent friends with substantial portfolios and ask them how much gold they have as a percentage of their portfolios. What about your fund managers overseeing, say $50 billion? Are they actually long $2.5 billion to $5 billion in precious metal plays? Our guess is that the figures in both cases will be very small, say 5% to 10% (if any at all).

Let’s extend this thinking. If people you know have only dipped their toes in the water and are doing more watching than investing in gold, then the past ten years of price appreciation must have come from elsewhere. Did it come from institutional investors? No, not in any great way. Most mutual and pension funds that report their holdings don’t own any gold – zip – other than very minor positions in precious metal mining stocks (and these stocks usually comprise less than 1% of their holdings). Hedge funds? Yes, it seems hedge funds have been buying gold but of those that have, most have less than 10% of their holdings in precious metals.

What about foreign central banks, Middle-East sheiks, Russians, ultra-wealthy families around the world? Yes, we would argue they “get the joke” and have been diversifying their wealth out of their home currencies and fiat currency-denominated assets into this scarcer currency.

Currently there is about $55 billion in global gold and silver ETFs – that’s it. (Does that qualify to be in the top ten of the any single issue in the DJIA?) It is estimated that all the gold mined in the last 5000 years is about 130,000 metric tons (each tonne converts into about 35,274 ounces). It’s a cube that would be roughly the size of a tennis court.

So let’s say there are 4.6 billion ounces of gold above ground, which means that at about $1,100/oz, the total global market value of all mined gold is currently worth a little over $2 trillion. By comparison, US Treasury debt was approaching $13 trillion, last we looked and we believe total US equity market capitalization is about $11 trillion. And then there are other bond markets (at least $8 trillion) money market funds, etc. There is also real estate.

In the US alone there is estimated to be about $65 trillion in present value private sector credit outstanding and trillions more in unfunded government obligations. And then there are the financial assets (stocks and bonds), real estate and public sector obligations for the rest of the world.

Global central banks are trying to keep it all afloat by printing even more money (by making more debt). The response by central banks to declining velocity has been and will continue to be the same as their responses to credit deflation – they will continue to print money. They may give it to their fractionally reserved banks that may then use the money multiplier to distribute more credit and in turn raise systemic velocity, or they may give it directly to debtors in the hope they will spend like drunken sailors again.

There is enormous embedded inflation already and more to come. The high-powered money has already been created; it is leveragable and it is there to increase velocity. Higher prices must follow.

Will the Fed and other central banks withdraw liquidity? No, never. They never have and they never will regardless of how many tools they proclaim are in their toolbox to do so. If money velocity picks up leading to rising consumer prices, it will also lead to rising market-priced interest rates. They may decide to cut back their monetization, but they will not drain money.

We can look at price inflation contemporaneously or we can throw the ball ahead of the receiver. The result will be the same. The defense is blitzing; Jerry Rice is standing all alone in the end zone; Joe Montana is going to get sacked….but the ball is already in the air.


At current valuations the gold market is a tiny speck in relation to where perceived global wealth is being housed. The fundamental issue is one of ratios and relative future value. Our bet is that the gold-to-everything-else spread will narrow substantially. We are indifferent to whether gold rises to $10,000/oz. while the DJIA stays at 10,000 or gold stays at $1,100 while stocks and bonds crater. (In fact, we would love it if gold stayed at current levels while financial assets fell because then we would greatly increase our purchasing power vis-à-vis the rest of humanity and wouldn’t owe any capital gains tax!)

Further, we think that fundamentally gold is worth many multiples of its current price. Remember, it rose from $35/oz to $880/oz in a matter of nine years from 1971 to 1980, and the piece de resistance came in the last few months when everyone had to own it and its price went parabolic (it became a bubble).

There is chatter and there are fundamentals. (Consider that 250,000 people watch CNBC on a good day and 10 million people regularly watch Good Morning America. And remember CNBC and most business media focus on financial assets, not commercial business.) We think the gold chatter is a bunch of financial asset predators talking up their businesses. Needless to say, we don’t think gold is a crowded trade.

Conclusion: Future global US dollar-based claims are now estimated to be above $100 trillion versus a current US dollar monetary base of about $2 trillion. Global markets, policy makers and politicians are beginning to recognize that existing US dollar-denominated public and private credit (claims) cannot be settled with current USDs outstanding. Either far more USDs must be manufactured or credit must deflate far more.

2. Expectations: Three “Flations”

– Price Inflation/Deflation: Price deflation is a natural economic function (through competition, economies of scale and innovation); price inflation (though monetary/credit inflation) is a political construct meant to offset the natural tendency of prices to decline

– Credit Inflation/Deflation: Credit inflation temporarily warps pricing structure of goods, services and wages, which leads to broad economic and asset mal-investment

– Monetary Inflation/Deflation: The only true inflation/deflation metric (“inflation is always and everywhere a monetary phenomenon…”), the growth or decline in a currency’s monetary base best defines the increase or decrease in that currency’s purchasing power over time.

Conclusion: In the current lexicon, “deflation” is commonly and mistakenly confused with economic contraction. They are very different dynamics that may not correlate. Monetary growth/contraction may cause rising/falling nominal prices over time independent of changes in supply/demand fundamentals (see Zimbabwe). Thus, money and credit growth from an economy’s political dimension could synthesize nominal output growth while real (inflation-adjusted) output and real asset values may contract. Real output and assets are produce sustainable economic capital and employment over time.

3. US Monetary Base

– M0 = Money in circulation plus bank reserves held at the Fed
– High-powered money => May be leveraged further through fractionally-reserved banking system
– M0 just increased 135% in last 18 months

4. Reflexive Cause & Effect
– Output contraction => central bank generated monetary inflation
– Monetary Inflation in the form of M0 (new money given to the banking system) unaccompanied by a further bank system multiplier effect and/or by an increase in monetary velocity (thereby increasing M1, M2, M3) will effectuate a different form of monetary inflation
– Will checks be sent to homeowners (debtors, not creditor banks) made out to their servicers?

In a global paper currency monetary regime, where banking systems do not multiply their new high-powered money and where velocity does not rise (i.e. today’s environment), price inflation is a lagging consequence of monetary inflation. Demand-led output growth does not matter; indeed contracting demand is likely to push prices higher because it engenders more aggressive policy intervention.

Q: So what has been the true rate of inflation already experienced?

A: Something closer to 135% than popular price baskets. Of course, this may not be manifest through price inflation in any discrete year and it is likely the goal of policy makers to drag it out.

Q: Will policy makers withdraw the inflation they have already created?

A: Yes, if they don’t mind economic contraction. No, if they do not want to witness substantial credit deflation leading to output contraction and rising unemployment.

Q: What will be the ultimate outcome of global central bank monetary inflation?

A: It seems inevitable that there will be a new global monetary regime. That is not as radical as it sounds, given the current one is only 39 years old and no paper money system has ever lasted throughout millennia.

Q: Would Americans suffer from a new global regime?

A: American debtors would benefit from inflation because the burden of their debts would be inflated away vis-à-vis their higher nominal wages and asset prices. American dollar holders would suffer because they would lose future purchasing power, as would dollar-denominated bondholders because the purchasing power from their coupon interest and principal repayment would be inflated away.


Lessons from the Crisis – John Mauldin

Greek debt AAA, and banks could use massive leverage (almost 40 times in some European banks) and buy these bonds and make good money in the process. (Don’t ask Dad why people still trust rating agencies. Some things just can’t be explained.)

Except, now that Greek debt is risky. Today, it appears there will be some kind of bailout for Greece. But that is just a band-aid on a very serious wound. The crisis will not go away. It will come back, unless the Greeks willingly go into their own Great Depression by slashing their spending and raising taxes to a level that no one in the US could even contemplate. What is being demanded of them is really bad for them, but they did it to themselves.

But those European banks? When that debt goes bad, and it will, they will react to each other just like they did in 2008. Trust will evaporate. Will taxpayers shoulder the burden? Maybe, maybe not. It will be a huge crisis. There are other countries in Europe, like Spain and Portugal, that are almost as bad as Greece. Great Britain is not too far behind.

The European economy is as large as that of the US. We feel it when they go into recessions, for many of our largest companies make a lot of money in Europe. A crisis will also make the euro go down, which reduces corporate profits and makes it harder for us to sell our products into Europe, not to mention compete with European companies for global trade. And that means we all buy less from China, which means they will buy less of our bonds, and on and on go the connections. And it will all make it much harder to start new companies, which are the source of real growth in jobs.

And then in January of 2011 we are going to have the largest tax increase in US history. The research shows that tax increases have a negative 3-times effect on GDP, or the growth of the economy. As I will show in a letter in a few weeks, I think it is likely that the level of tax increases, when combined with the increase in state and local taxes (or the reductions in spending), will be enough to throw us back into recession, even without problems coming from Europe. The research was done by Christina Romer, who is Obama’s chairperson of the Joint Council of Economic Advisors.

And this next time, we won’t be able to fight the recession with even greater debt and lower interest rates, as we did this last time. Rates are as low as they can go, and this week the bond market is showing that it does not like the massive borrowing the US is engaged in. It is worried about the possibility of “Greece R Us.”

Bond markets require confidence above all else. If Greece defaults, then how far away is Spain or Japan? What makes the US so different, if we do not control our debt? As Reinhart and Rogoff show, when confidence goes, the end is very near. And it always comes faster than anyone expects.

The good news? We will get through this. We pulled through some rough times as a nation in the ’70s. No one, in 2020, is going to want to go back to the good old days of 2010, as the amazing innovations in medicine and other technologies will have made life so much better. You guys are going to live a very long time (and I hope I get a few extra years to enjoy those grandkids as well!). In 1975 we did not know where the new jobs would come from. It was fairly bleak. But the jobs did come, as they will once again.