Fear And Loathing In The Commercial Real Estate Industry

In most large American cities there are office buildings which sit half finished in their financial districts. There are still huge cranes next to some of them. If the construction on a site ended months ago, there is nothing left beyond the skyscraper skeleton and a security fence to keep vandals out.

As business such as law firms, investment banks, car companies and retailers cut jobs and move to less expensive offices, the commercial real estate industry is collapsing with astonishing speed. None of the unfinished buildings were erected with cash from the developers.  Banks put the money up for the physical location and structure, and perhaps even the rent from tenants, as security deposits in most cases. The land is no longer worth much. The buildings are half empty or unfinished and tenants are leaving, and, in many cases, defaulting on their leases. Lawsuits to get payment of those obligations are long and expensive. As often as not, the former tenant could not afford to pay a judgment anyway.

According to the FT, Leon Black, head of Apollo Management and a crafty investor in distressed debt told the paper that “the extra costs of cleaning up the US banking industry could total as much as $2,000bn, putting further strain on the economy. He said the woes of the commercial property had not yet been reflected fully on bank balance sheets.”

Black is reinforcing what the smart money already thinks about the big money center banks. Their CEOs are talking about profits and paying back TARP money the same way that they were calling an end to banking write-offs a year ago. Former Lehman CEO Fuld said last April that the worst of the writedowns was probably over and Morgan Stanley (MS) chief John Mack said that the financial crisis was in the “eighth inning or top of the ninth.”

It pays for bank presidents to say the most positive things that they can about their firms. They have the benefit of SEC rules that say it is OK to talk about the future as long as there are no guarantees given. In other words, CEOs are allowed to guess without getting into trouble as long as they do not turn their guesses into formal forecasts. In the world of corporate governance it is one of the great “get out of jail free” cards.

Several bank stocks have doubled or tripled since the beginning of the month and many analysts say that these stocks were “oversold.”  In reality, when buyers moved into the shares short sellers were pushed out, which gave an irregular boost to buying. But, most of those short sellers are gone now and bank share prices will have to stand on their own.

Bank stock bulls rest much of their case on the fact the write-offs at financial firms are slowing and the Fed is putting enough money into the credit system to restart the normal cycle of borrowing and lending. That may well be true. Those pushing bank stocks as a great investment would also say that, even though a stock like Citigroup (C) has had a great run, it is down 90% from its 52-week high. That makes it a bargain.

Before the subprime mess began, no one talked about the danger that mortgage derivatives posed to banks. Now, there is not much talk about what could bring the banking industry to its knees again. That talk has gone away and been replaced by a childish hopefulness that decades of overleveraging can be fixed by a few months of losses and hundreds of billions of dollars in government aid.

There is a reason that Citigroup is down 90% this year and down 95% from its all-time high. The experts who really know the banking industry believe that there are still hundreds of billions of dollars or write-offs walking around the financial system waiting for big banks to run into them.

Douglas A. McIntyre