Next shoes to drop

Ed Cone has linked to an article about commercial real estate possibly being the next contributor to the ongoing financial crisis.

Two years after fissures in the residential housing market gave way to a national collapse of home prices and sales, experts warn the next shoe to drop is the commercial real-estate market, bringing more woes to the battered economy.

Thousands of commercial mortgages valued at hundreds of billions of dollars are approaching a renewal date. By some estimates, two out of every three will no longer meet the original loan conditions and won't be able to refinance. And with prices for commercial properties expected to plunge, a vicious cycle may unfold much as it has in the nation's housing market.

Commerical real estate will need to get in line behind other looming vulnerabities. For example, the New York Times gave a similar warning last week but in terms of subprime commercial debt.

So it went with the subprime mortgage crisis. And so it is now going with corporate loans and bonds. It appears that defaults on leveraged loans and corporate bonds will soon rise to levels not seen since the Great Depression.

If that does happen, a wave of corporate bankruptcies will deal another blow to the American economy, and present the Obama administration with more painful decisions about possible bailouts — bailouts that could be made directly or indirectly by persuading bailed-out banks to make loans that might not seem wise to the bankers.

The main driver of defaults in the Times story is the inability of firms with existing subprime financing to roll over that financing when it comes due.

The International Monetary Fund in its latest (April) Global Financial Stability Report has increased its estimate of bad debt originated in the U.S. by a quarter over its earlier January estimate.

Though subject to a number of assumptions, our best estimate of writedowns on U.S.-originated assets to be suffered by all holders since the outbreak of the crisis until 2010 has increased from $2.2 trillion in the January 2009 Global Financial Stability Report (GFSR) Update to $2.7 trillion, largely as a result of the worsening base-case scenario for economic growth. In this GFSR, estimates for writedowns have been extended to include other mature market-originated assets and, while the information underpinning these scenarios is more uncertain, such estimates suggest writedowns could reach a total of around $4 trillion, about two-thirds of which would be incurred by banks.

Joseph Stiglitz continues to argue that large financial institutions themselves continue to pose a huge systemic risk to the economy.

Being too big to fail creates perverse incentives for excessive risk taking. The taxpayer bears the loss, while the bondholders, shareholders, and managers get the reward. It also distorts the marketplace in another way: as we have noted, there are hidden subsidies (which have been increased in the current crisis), for instance in deposit insurance, in the government-provided explicit guarantees to newly issued bonds, and in the implicit guarantees to bondholders and shareholders associated with the bail-outs. (Even if the FDIC bears the cost, it does not stay there; ultimately, it gets borne by market participants. Unless a strict “polluter pays” principle is adopted, the costs will be shifted in part to other financial institutions, with consequent distortions to the financial sector.)

Despite some recent less negative indicators for the economy, the evidence is growing that stronger and more decisive action is going to be needed for the financial sector. Banks appear to be sitting on a mountain of bad debt. A great deal of that debt has been written down but a great deal more remains to be written down.