Bernanke’s Eye on Real Estate

Does Ben Bernanke care about the stock market or inflation? Yes, he wants both higher. In fact, he’ll take any increase in any asset prices because the real problems with this economy are much scarier than stock bubbles, $3.00 gasoline, or a falling dollar.

The real problems are the systemic banking crisis and its ties to real estate, both residential housing and commercial property. Bernanke and Hank Paulson staved off a banking—and therefore, an economic—collapse last year with swift action. But that was only the beginning.

And quickly going from credit bubble to credit freeze in 2008 only intensified the problems that had been brewing for years. This made the next tasks of Fed and Treasury, after halting Depression 2.0, even harder: (1) help banks stabilize their junk-filled balance sheets so they can survive, pay their debts, and lend to businesses and conumers, and (2) help homeowners keep from drowning in their underwater homes, which obviously has spillover effects for banks and the economy at large.

So, where are we now in that healing process? Bottom of the third inning is my guess. But my analysis or opinions aren’t the ones that count. If Ben thinks we’re still in the second inning, we may not see a rise in the Fed funds rate until the fourth quarter.

And keep in mind that the Fed funds rate is not the key benchmark here that he’s worried about. It’s just a symbol of his campaign. The real goal is keeping mortgage rates down, and he has and will continue to use all available tools. Quantitative easing (QE) is all about throwing liquidity at the problem, whether it’s TARP, Treasury and MBS purchases, or other creative credit facilities.

The Fed vs. the Bond Vigilantes

Lots of non-experts (myself included) go on TV and talk about how the bond market “vigilantes” will drive interest rates higher before the Fed thinks it necessary to “take away the punch bowl.” This is barely noticeable now, with 10-year Treasury yields crawling up toward 4% in the past month.

It doesn’t seem like this pace will quicken much, as I’ve talked here repeatedly about the Treasury curve finding it harder to get much steeper. Not an economist or financial analyst, I don’t try to figure out where things should be. As a trader and market analyst, I simply watch what big-money investors are doing and then follow where things are going, and at what pace.

These three articles from the third quarter of 2009 may still be relevant into that of 2010:

September 9:  Don’t Fight Inflation – Buy it! : Asset re-flation has been in full force since early this year, and it’s not over yet.

September 24:  Bernanke’s Bet, Bernanke’s Trim Tab: Fed Chairman stays the course, adjusts gradually.

September 30:  Inflation and Higher Interest Rates Coming? Still Not Yet: The yield curve sees inside the Fed’s mind.

The question becomes, “When does Bernanke think we’ll be out of the real estate-haunted woods?” I am keeping my bets on late this year, more likely Q4 than Q2. Craig Torres’ Bloomberg story this morning, “Commercial Property Is Biggest Risk, U.S. Bank Examiners Find,” has a lot of good quotes and data points that we can assume are front and center on the Fed radar. Here are some bullets I threw together from that piece:

• Loan losses will continue to be historically high and hundreds of banks will fail (this is consistent with the prediction I highlighted in 2Q 2009 from Wilbur Ross that “thousands” of banks would need to fail before this crisis was over).

• Fed Governor Elizabeth Duke said Monday that credit conditions in commercial real estate “are particularly strained.”

• Loan failures in commercial properties like malls, hotels, and apartments hit the economy in a vicious cycle as banks “reduce lending and conserve capital to absorb losses,” thereby impacting investment and job growth.

• Default rate on commercial mortgages doubled to 3.4% in 3Q09, highest since 1993.

• $3.5 trillion in commercial property debt in existence as of June 2009. Over $1.5 trillion in loans will mature over the next three years. As I said in the middle of last year in several media appearances when I first heard these figures, the simple math in Bernanke’s mind is that a big chunk of these loans will struggle to get refinanced, so he’d better keep rates down for as long as possible to keep the bloodbath manageable.

• “Regional banks are almost four times more concentrated in commercial property loans” than the big banks, Torres reports. This is what I talked about in November after meeting a board member of the Chicago Fed who explained to me how small-to-medium sized banks got forced into the risky lending market for strip malls and motels in the middle of the last decade after mortgage monsters like Countrywide squeezed them out of the residential housing market.

• Case and Shiller pessimistic on prime mortgage defaults. I wrote about this trend based on another Bloomberg story on Monday in “How Long the Last Decade’s Housing Hangover?”

• Finally is the question of whether the Fed flinches at the end of March and extends its MBS purchases instead of ending them as announced. Mortgage rates have held close to their record low of 4.71%, ending 2009 at 5.14%. But any quick ascent this year could make Fed officials re-enter that market.

Transparency is King

Some of the best and brightest yield curve minds in the nation are starting to turn up the rhetoric against Bernanke’s methods. Exhibit A is PIMCO’s Bill Gross referring this week in his commentary to the “sugar daddy” that is current Fed policy.

That kind of talk could get tougher. It’s one thing when your average market analyst (think me) says so. But when the steady-hand manager of the biggest institutional bond money in the world says so, it’s a good idea to pay attention and figure out what he sees and thinks. If Gross believes that low interest rates hurt more than help, that makes me think the crisis has many years to go before it’s worked out.

The only thing you can count on now is the Fed continuing to monitor all aspects of the banking and real estate recovery. They will report often on the health of and risks to the patient here because it’s the number one area they are watching. Unemployment, consumer confidence, and inflation numbers are mere symptoms of the disease underneath it all.

Counting on the Fed is not a bad trade either. I think we’re in good hands with Bernanke because he will use the data to direct his policy decisions, and change course accordingly. It’s not all in his hands either—there’s a lot of bright minds and a deep information network fueling Fed policy.

The biggest market participants seem to have their confidence in the same place. How do I know? Well, I don’t know for certain. Again, I just watch what the big and smart money is doing. Now they are voting with their investment dollars that the economy is on the right track and in good hands.

And they trust that we will get plenty of notice if and when conditions are set to change. That’s why I called Chairman Bernanke the Maestro of Transparency weeks before Time magazine made him 2009’s Person of the Year.