Commercial Loans: The Next Potential Bailout?

Good Evening Folks!

Well, a lot of news hit the wires today in the commercial area. Since we like discussing SRS, I thought I would focus on the commercial area today. It looks like a commercial bailout is on the way folks. I don't think the banks can afford a huge commercial hit right now, and it will be interesting to see how Wall St trades commercial in the oncoming weeks.

Many bond traders have been saying for weeks that the best trading strategy is to attempt and front run the Fed before they arrive with their deep pockets. This is why you saw a buying binge of MBS's by Pimco and others in the last month when the Fed hinted they may be a buyer of these assets.

A similiar game is played by traders in the equity markets with the bailouts. Once one bailout gets done, the first question traders then ask themselves is whose next? Now that the automotive deal is done, commercial is the next area to focus on in my opinion. Things are a disaster in the commercial lending area. Take a look at this graph I picked up today on commercial lending:

Here is some more commoercial research from Deutsche Bank. I want to thank John for sharing this in the comments section. This is an excellent research report by Deutsche.

I advise everyone to read this. It is extensive and very informative. As you can see by the graph above, lenders are literally running away from commercial refi's this year. If you were a bank why wouldn't you? Commercial rents will be dropping like a rock as the consumer dies.

I want to repeat the details of a conversation I had with a friend who was involved in securitizing commercial CDO's before the market blew up in '06.

He told me the lending standards used on commercial loans were terrible. He should know because he was the guy that was involved in pooling the loans together to form the commercial securitizations!

I asked him: "what was wrong with the lending?"

He explained to me that the REITS were allowed to lend money on the basis that rents would rise 5% a year. This allowed them to borrow much larger sums of money. He told me this was a recipe for disaster. He also explained that banks are usually very tough when it comes lending to the commercial side. Commercial lending is usually extremely conservative, and usually involves down payments of 30%. I guess the banks decided to look the other way this time as they dropped money out of helicopters.

These REIT's are now screwed because rents have stopped rising. In fact, they are actually falling as the consumer continues to pull back on dining out and shopping. On top of that, vacancies are about to soar due to BK's following the Christmas season as the recession deepens. This is a nightmare combo folks! Its obvious that many of the commercial REITS are no longer generating enough revenue to pay back the loans that were done based on lending standards that assumed the glory days would rock on and rents would continue to rise. Leverage strikes again! Its great on the way up but it sure sucks on the way down!

Bloomberg had an interesting article today on commercial:

Bloomberg reported that commercial drfaults could triple if rents drop 5%:

"Dec. 22 (Bloomberg) -- U.S. commercial properties at risk of default could triple if rental income from office, retail and apartment buildings drops by even 5 percent, a likely possibility given the recession, according to research by New York-based real estate analysts at Reis Inc.

Lenders that used optimistic rent estimates to grant mortgages beginning in 2005 stand to lose as much as $23.1 billion, or 7.02 percent, of total unpaid balances if landlords lose 5 percent of net operating income, according to Reis. Analysts examined data on 22,890 properties that together may account for unpaid loans of about $329 billion in 2009, said Victor Calanog, director of research.

Banks are at risk as office vacancies are forecast to rise to 15.6 percent next year from an estimated 14.6 percent at the end of 2008. Lenders who sold commercial mortgage-backed securities to pension funds, investment banks and foreign governments have been hit by more than $1 trillion in losses and asset writedowns connected to bad residential loans. "

Quick Take:

Ha! They will be lucky if rents only drop 5%. I also think the vacancy expectations in this article are a pipedream.

Bottom Line:

So the question becomes how do you trade commercial if a bailout looks likely? The Fed has already hinted that they may throw a lifeline to the commercial area. The banks want nothing to do with commercial, and companies like GGP are about to go under. Something needs to be done or commercial is going to blow up! This could be a potential death blow to the banks, and it would force the Treasury to cough up more money from the TARP in the form of capital injections to the banks in order to keep them solvent.

My guess is many of these REITS are about to explode. I don't think the Fed has no desire to see hundreds of malls get liquidated when no one wants to buy these bloated assets unless they are priced at pennies on the dollar. Circuit City is a prime example. They put together an auction in order to selloff the 150 stores that they are closing down as they reorganize. CC ended up cancelling the auction due to a lack of bidders. Can you imagine how tall the weeds are in those parking lots by now?

The banks will take massive losses if they are forced to sell such large assets in this economy.

Add all of this up and it spells TARP BAILOUT if you ask me folks. We all know the Fed doesn't know how to say no!

IMO you can trade this two ways. If you have a brass set of balls, you can jump in and by a couple of beaten down REITS and bet on the Fed coming to the rescue. These could be 3 baggers if the bailout arrives. Obviously you play small when you place a trade like this and you sell on the news. This is highly speculative. Consider this to be a bit of a lotto ticket.

The other way to play it is to wait for news of a bailout and buy SRS on the dip after the announcement.

As for myself, I plan to buy SRS on the dip if we get a Fed bailout. I already have some at 85 so I am in no rush to buy more if I think the Fed is on its way.

My REIT lotto long bailout bet will be on GGP. Its down 22% on the negative commercial news today to around $1.40. I know they look dead, but if the Fed comes through with the bailout, this thing could easily be a double or more. This could also be a zero folks so make this trade knowing that you could lose all of it, and make it small if you pull the trigger.

I thought this was crazy at first until I asked myself this question: Why was SRS up only $2 on a day where we learned that commercial is on the brink of a meltdown? The WSJ, Bloomberg, and Deutsche Bank news should have pushed SRS up $20 today. That fact that it didn't budge tells me somethings coming. Just a hunch.

Another trade I am going to make this week is on (CHK). Its getting chilly out there folks and natural gas is down to $5 bucks. The call option here were extremely high today. The stock has pulled back to $15 from $20 recently and I like the play. I will look for some Feb. $18 calls tomorrow. I didn't get home in time to put this in.

That's it for today folks. I like to pass on my trades to you. By no means am I recommending that you should play them.