September 29, 2008

California's Diverse Economy Well Positioned For Recovery

These are the times that try our souls and test our resolve. However, given that we have already endured the initial shock of the Countrywide and IndyMac Bank debacles, the diverse Los Angeles economy is now well positioned to emerge from the current challenges stronger than ever. More about that later, but first let's examine how we got here.

For the real estate industry, these are unprecedented times.

Institutional real estate transaction volume is estimated to be down more than 70 percent from last year's average, and huge discrepancies between the bid and asking price of assets--combined with a lack of purchase or sale velocity--make it nearly impossible to establish "fair market" values.

As a result, a seller in the market is generally motivated by distressed circumstances or some otherwise adverse condition such as the breach of financial covenants or the maturity of short-term bridge financing. Knowing this, savvy purchasers have decided to bide their time with the expectation that their best deal will likely be made after the underlying lien holder exercises its rights in default- e.g., foreclosure.

Alternatively--on the rare occasion when there is a meeting of the minds with regard to value--there is little or no available debt financing. The overwhelming majority of permanent loans have been funded recently by conduit lenders. In order to maximize loan proceeds at attractive interest rates, however, conduit lenders must rely upon the clearing mechanism offered by commercial mortgage-backed securities, or CMBS.

In short, CMBS underwriters issue bonds that are collateralized by the cash flow resulting from the underlying pool of associated commercial mortgages. Given concerns about mortgage underwriting guidelines and anticipated rates of default, investors no longer believe that CMBS bonds offer an attractive risk-adjusted return, and underwriters have been forced to carry the bonds on their balance sheets and to hold them in portfolio. Consequently, a majority of transactions that are successfully executed in the current environment are now modest in size and financed by either the seller or regional commercial banks.

Moreover, abundant inventories of supply, rising labor and construction costs, near-record unemployment and a further weakening global economy indicate that any new development will be out of favor for the foreseeable future.

During this extended period of uncertainty, real estate industry participants struggle to protect the value of their assets and to reconstitute themselves for a brighter future ahead.

Better days?

Not to fear, the cavalry is on the way.

By assessing economic indicators on a historical basis, the Federal Reserve is essentially driving while looking in the rear-view mirror. Financial markets, on the other hand, are much more efficient and anticipatory. For example, homebuilder share prices began to decline long before residential construction starts or housing prices fell.

Recent turmoil in our country's financial markets foreshadows current or impending recession. Our government's quick action to bail out Fannie Mac, Freddie Mac and AIG sought to mitigate collateral damage and to ensure that this recession will be short-lived. Similarly, resurrecting the Resolution Trust Corp. would bolster confidence and provide a clearinghouse mechanism to resolve the underlying liquidity crisis. By providing a secondary market for these assets, new life will be breathed into an otherwise stagnant economy, and significant capital may be redeployed for more productive purposes.

John Carrick, Studley, Los Angeles Business Journal, 9/08

Ultimately, the practical effect of these actions will likely be an environment of:

* Increased regulation, oversight and transparency

* Dramatically less leverage

* Decreased structural complexity

* More appropriate alignment of interests and sharing of risk

* Restoration of available capital and credit

In many ways, Los Angeles is now much better suited to weather this storm than it was during the recession of the early 1990s. At that time, dependence upon the defense and aerospace industries made the local economy exceptionally vulnerable and magnified any recessionary effects.

Today, in contrast, the robust diversification and vibrant resilience of the Los Angeles business community should allow us to recover more quickly and with fewer scars. I am not suggesting that the solution will be quick or painless. I

do believe, however, that the interim growth of the entertainment business, legal and professional services, and health care and technology industries--combined with the busiest port in America- should afford Los Angeles the pole position in our nation's race to recovery.

Markets hate uncertainty regarding economics and politics more than anything.., given the foregoing, and the November presidential election, we will soon have greater clarity in both respects.

John Carrick is managing director of the Structured Finance Group at the Los Angeles office of Studley, an international real estate advisory firm. He served as senior attorney for the Resolution Trust Corp., vice president at Nomura Asset Capital and senior vice president of Countrywide's Mortgage-Backed Securities practice.