Provisions & Reserves at Banks

You would be forgiven for thinking that banks are not lending any money right now. Some actually are - you just need to know which ones. Luckily for clients of Mulcahy Capital, we know which banks are lending!

Among the topics I discuss in this Blog Post is the fact that most banks are not lending. Please take a look at the other topics in this Post that may interest you.

Provisions and Reserves at Banks

I have been pointing out the commercial real estate time bomb for some time and I am perplexed that we have not witnessed a substantial write down or provisioning of commercial real estate loans as of yet. The impending problems are no secret now and it seems to me that banks are buying time in an effort to earn their way out of the residential hangover before dealing with the next problem.

Provisioning is being made for loan losses by the banks, but these provisions seem hopelessly inadequate given where market prices for commercial real estate are today. Admittedly it's tough to call this a market with such few transactions taking place while cash rich investors keep their powder dry deciding on the right time to pounce in when they think the market has bottomed. Nonetheless this is the market we are living with, and as such, provisions should be made accordingly.

We will not find any regulators or government officials pushing the banks to provision appropriately for fear of a fresh round of bailouts. One way the government is helping banks earn their way out of their current problems is by providing the banks with very cheap credit. One extreme example of this is Goldman Sachs who reported that in Q3 the interest rate on their long term borrowings was a mere 0.92% on $203 billion of debt, down from 3.53% in Q3 2008. It's not hard to see how the likes of Goldman can earn their way out of problems and pay back TARP money. With cost of funds so low the spreads on money they lend are widening deeply.

Another factor that is contributing to the malaise in the transaction volume is the lack of lending on the part of banks. The majority of current financings are in fact the funding of prior commitments by banks, the restructuring of deals gone badly, or the refinancing of maturing debt - since the borrower has nowhere new to place this debt. Right now the banking system has $1 trillion of reserves in excess of the US Federal Reserve's regulatory floor. Back in September 2008 when the credit crisis was intensifying this excess was only $2 billion. These reserves have steadily built up over the past year due to the Fed printing more money. This money has in turn been used by the Fed to lend to banks, buy mortgage backed securities from banks, or for TARP funding.

This extraordinary buildup of cash reserves by banks is possibly for the inevitable commercial real estate write downs or the banks' own looming debt maturities in the form of bonds. This is discussed further below. If such large cash reserves are being kept to shore up anticipated loan losses, it is ironic that this act of not lending to conserve cash could ultimately bring about these feared loan losses. A stagnant credit market reduces the volume of real estate transactions in the market.

Fortunately for clients of Mulcahy Capital, with our extensive lender network we have continued to successfully close on debt financing throughout the current crisis!

Banks' Debt Mountain

While grappling with pending debt maturities corporations are not alone in struggling to figure out where to refinance these debts. Would you believe that the banks, which most corporations are struggling to repay, have their own pending debt maturities to deal with?

Not only are banks dealing with massive loan write downs and write offs, they have a huge mountain of debt obligations coming to maturity. Over the past decade banks were able to sell debt in the form of bonds at very low coupon rates. As this debt now matures, the same low cost of funds is not available, and refinancing the debt will be at much higher coupon rates.

Banks with extensive branch networks and large deposit bases will start having a clear advantage over banks that once heavily relied on cheaper capital markets. Banks that sourced their funding from deposit holders were once at a disadvantage due to the cost of maintaining a branch network, however the tide has now turned in their favor.

According to Moody's Investor Service, up to $10 trillion of debt will be maturing by the end of 2015, and $7 trillion of this will be maturing by the end of 2012. Bank of America has $55.4 billion due in 2010, $35.3 billion due in 2011, and $58.4 billion due in 2012, while J.P. Morgan Chase has $130 billion maturing through to 2012.

This could be another reason why banks are hording cash and cutting off any new lending. They are beefing up their reserves to handle these looming maturities.

Massachusetts Home Sales on the Rise

October marked the fourth consecutive month for a rise in the volume of single family home sales in Massachusetts, which showed a 17.2% increase compared to October 2008. The median sales price for single family homes fell by 2.8% to $277,000, and for condominiums the median sales price fell by 8.1% to $240,000, compared to October 2008.

This sustained increased volume of sales is a good sign that the residential market here is bottoming out. No doubt the $8,000 federal tax credit to first time buyers is helping this trend. However inventory of unsold units is also dropping which is another good sign of an improving market.

In October inventory has fallen for the 19th month in a row. It is 15% lower compared to the same month last year. There is now a 7.1 month supply of single family home inventory on the market, and the Massachusetts Association of Realtors considers a 7.5 to 8.5 months supply to be a balanced market.

A contributing factor to the lower inventory can be attributed to sellers taking their homes off the market as they have witnessed prices decline. Once prices have stabilized and begin rising these sellers are likely to return to the market.

An interesting breakdown of the statistics of increased sales volume reveals that the majority of the increased sales were for the lower end of the market. Units priced up to $300,000 showed increased sales of 13.8%. Units priced $300,001 - $600,000 were up 3.1%. However units priced $600,001 - $1 million declined 0.33%.

Overall these are encouraging signs of a bottoming out of this current cycle which should see Massachusetts lead the rest of the country out!

Stagnant Foreign Investment in US RE

2009 will be one of the leanest years for foreign investment in US real estate. It is estimated that it will close out the year with $5 billion invested. This is a long way off its peak of $33.4 billion invested in 2007. In 2008 $12.4 billion of investment was made.

The massive drop in volume of foreign investment is not surprising considering the lack of transaction volume in general. However, what few transactions there have been has seen a lot of foreign interest. If the dollar remains weak we should see increased foreign activity into next year, dependent of course on the investor's long term view of the greenback.