Credit Crisis Plus Recession, and the Effect
on US Real Estate

At the beginning of 2008, the extent of the sub-prime credit crisis and the seriousness of the slowdown in the U.S. economy were both issues that were still open to question. The events of the first quarter of the year, however, have made it abundantly clear that the credit crisis is extraordinarily serious and that the U.S. economy has almost certainly fallen into recession.

It cannot be emphasized too often that the sub-prime credit crisis arose solely out of the lack of lending standards in the U.S. residential market. Home loans were made to people with no credit standing of any kind on the theory that only a small percentage of such homebuyers would default. These loans were then packaged, given investment-grade ratings by the rating agencies and sold to banks, hedge funds and others not only in the United States, but also around the world. In hindsight it is hard to believe the amount of leverage that was placed on many of these purchases so that when a slight downturn occurred in the market, the equity in many of these funds was immediately wiped out. The widespread losses that are occurring throughout the financial system have had a serious effect on the mortgage markets for commercial real estate, as banks and investment houses are still trying to determine the extent of the losses that they might face and are therefore reluctant to make new loans.

The paralysis in the credit markets has had a dampening effect on the entire economy and has added to recessionary pressures. Another important recessionary factor has been the sharp decline in consumer spending and consumer confidence. The consumer has, of course, been badly hurt by the implosion in the housing market, but the consumer is also suffering from sharp increases in the cost of gasoline and food, both of which have reached record high prices recently. In addition, there has been a clear weakening in the employment market.

At this point it is difficult to predict just how long the credit crisis and the recession will last. Before the credit markets can begin operating normally again, lenders will have to believe that they have written off or disposed of all of their questionable assets. In our opinion, this may take at least six to nine months. And it will be hard for the economy to recover until the credit markets have opened up again.

So although the U.S. commercial real estate market itself remains in relatively good shape, transactions in that market will be restricted by the lack of adequate credit. In Falcon Real Estate’s opinion, all-cash investors, or those with established credit relationships, will be in a strong competitive position during the balance of 2008.

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The Credit Markets

Until very recently, few people had understood the extent to which the entire banking and financial system of the United States and many Western European countries had been infected by assets of one kind or another that were tied to U.S. residential sub-prime mortgages. As the default rate on such mortgages rose, it became impossible to value these assets and investment banks, such as Bear Stearns, and hedge funds, such as one run by the Carlyle Group, began to collapse. The entire credit market in the United States almost ground to a halt as the conduit market disappeared and those purchasing for their own account preferred to buy loans at a discount from troubled institutions rather than to make new loans. The Federal Reserve Board had at first responded by cutting interest rates repeatedly, but these cuts did little to restore confidence in the credit markets. Until a way could be found to value the various funds that had been created to hold sub-prime mortgages – or to value the mortgages themselves – it was impossible to try to determine the extent of additional losses that the financial system might face.

However, with the Bear Stearns collapse and its purchase by JP Morgan Chase, the Fed not only loaned JP Morgan $30 billion to acquire Bear Stearns but it guaranteed that if the assets acquired by JP Morgan declined in value, the Fed would cover that cost. As happened after the Savings and Loan debacle in the 1980’s, when the U.S. Government stepped in with the Resolution Trust Corporation, the Fed’s action signaled that the Federal Government would again step in to save the financial system from the effects of imprudent real estate lending. This is probably the first step in the re-establishment of trust in the credit markets and we believe that those markets will eventually begin operating normally again. But it is going to take quite a long time before that can happen.

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