~CITADEL REALTY ADVISORS~ New York,NY

Ross Rant Samples

Subject: Ross Rant when will real estate lending start again

I have discussed this before but lately I have seen some uninformed internet newsletters trying to claim real estate lending may start again soon. Here are the reasons this is not going to happen.

The banks have hundreds of billions of bad loans to deal with and it will take a couple of years at best to deal with all these.
The lending departments of most lenders have been totally eliminated. They were either fired or moved over to doing workouts and servicing.
There are many flaws in the way securitization works with the tranches. This has led to tranche warfare. The whole structure is now revealed as flawed and until it is revised and fixed, volume lending will not resume.
The lending documents are now just starting to be tested in court and until there is more clarity on what works and what does not in court, there will not be new securitized lending. The standard docs need to be revised and that will take time.
There is no way to know what the right pricing of assets is yet, so lending is hard to do when there is no set value to the underlying asset.
The whole rating agency situation needs to be clarified. Who pays them for ratings. Will they be over conservative to avoid another debacle and make ratings so conservative that many securitized loans will not work.
Many of the major securitized lenders are gone- Lehman, Merrill, or are unable to return-Capmark, I Star, Citi. There are not the institutions in place to generate the volume required to just replace the outstanding loans.
Until lenders stop granting extensions and deal with the reality of greatly reduced values of the assets, then there is no way to restart lending new loans or even refinancing. Nobody is going to refi an existing loan that had high leverage of say 75% of 2007 values. There needs to be a massive reset to reality on value.
The government needs to get out of the way. There is such uncertainty about new regs and compensation rules, that there is no way to know currently what is allowed or how to compensate lending officers "to avoid risk" as Congress and the regulators demand.
The major banks and the small local banks are continuing to hide the reality of the required write-downs. This is due to the capital constraint issues. Until this is dealt with there is no way to get any material new lending going.

The bottom line on all of this is that it will take a long time to work through all of these issues and lending of any magnitude simply cannot restart until all of these issues is resolved. There will be some small amounts of banks loans at small increments, but it is a drop in the ocean. Some large loans might get made using TALF, but these are very conservative, TALF only applies to the AAA tranche, and only the best borrowers will get to play. Even with that there is still no new securitized loan in place although Citi, Deutche, JP Morgan and others are trying to figure it out.

All of the extended loans as well as hundreds of billions of new maturities will be coming over the next 2-3 years. The problem is far from getting fixed.

Subject: Ross Rant 6-19 The Fed,new proposed regs, etc

First you need to understand there are 12 Fed local districts and each has an appointed president. Except for New York, the local Fed presidents are the local link between the Fed in Washington and the local community.

Information flows back and forth, but they are mainly community outreach as well as the source for the beige book and local intelligence for the Fed analysts in DC. They have zero policy roles. Only the Fed governors in DC make policy. Only the president of the NY Fed has any real role beyond what is described here. So the whole discussion about Congress having a role in appointing local Fed presidents is all about politics and Congress wishing to insert its involvement.

The concept that Treasury has to approve emergency actions of the type we have just lived through also inserts politics into Fed emergency actions and is very dangerous. There was also a mention of Congress having a veto over these emergency acts. We saw what happens when TARP came to Congress. It was a dire emergency and they failed the initial test. That almost collapsed the entire world financial system. As we have just seen, the Fed needs to be free to act in emergencies and free form politics. Not that politics does not enter into all decisions, but in the end the Fed needs to maintain its independence or we will not be able to have interest rate and other actions taken by the experts and it will all be political. The bed rock of having the independent Fed is to be able to do politically unpalatable things when needed.

Parts of the new proposed financial regs are dead on arrival. The proposed consumer agency would be a terrible thing. That agency will be tasked to advocate for consumers. Sounds nice, but is a disaster. There is already substantial regulation of consumer loans and mortgages. The fact that the regulators did not act well, is not that there are no regulations, it is a policy issue. A consumer advocacy agency will push to make more loans like subprime, even if the regulators who are tasked to control risk say no.

Interest rates on consumer loans will be even more constrained leading to credit being limited to only those with high credit scores. Pricing of risk is already being hampered. That is exactly what helped cause the collapse.

Risk was grossly mispriced. The banks will not know who to report to.

Congress will take the side of the consumer agency because that is the better politics. We saw that when in 2002 the Bush administration wanted to rein in Fannie and Freddie and Barney Frank refused. We see the result. It is highly unlikely this consumer agency will get approved.

There is a requirement that the lenders hold 5% of the risk and not be allowed to hedge that risk. This is also a total non starter. The investment banks simply will not do this. They will just not make the loans. It is also not clear where all this capital comes from if you think about the trillions of paper out as mortgages, auto loans, credit card debt and other loans, and needing someone to hold 5% of the risk. That is why securitization was created. By moving that risk to a wide population of investors they were able to greatly expand lending. There is also a question of is this 5% vertically or horizontally over the portfolio. It matters. Is per loan or on average across the portfolio.

On the other hand, since nobody had the risk- or at least they thought they did not, we had what happened. Everyone thought it was other people's money, so they did not care about good underwriting. I know what Treasury is trying to accomplish- skin in the game, but this is not the answer that can get accepted. Just by comparison, the Europeans have proposed that lenders hold 20% of the risk.

There are many complex issues, but at the base of it all is the compensation system and what everyone believed was risk dispersion. Everyone -not just in the US, who originated loans and equity deals, was paid on volume and not results. The more loans you originated the bigger the securitized pool, the bigger your bonus. As I have pointed out before, this is nothing new. It was why we had the S&L crisis and the Texas banks crashed in 1989. Treasury and the big banks know all this and now we are seeing that bonus pools are being reset to be 3 year measurements to see what was the credit quality of the loans before you get to collect your bonus. That is exactly the right approach. Measure credit results, not volume. This will lead to far more responsible lending, although much lower lending volume. Lower volume is good. Excess lending combined with low rates, is what causes inflated values as we just saw. When Buffet took control of Solomon Bros many years ago he tried to change the egregious comp system and they ran right over him so he bailed out. Geithner is right about the problem and the need to dramatically change the ridiculous comp system that rewarded bad behavior. I just do not think is it good public policy in a capitalist system for politicians to be setting compensation rules. Then it becomes political as it now is and that leads to major distortions of another kind and very talented professionals go off to do their own thing and leave the mediocre to run the major banks.

That is already happening in a major way and it is going to cost us in the long run. The answer is responsible boards and solid management with rational long term compensation plans that pay big rewards for really good results, not instant gratification.

This results, going forward, in lower values and less money for refinancing of commercial loans coming due. The amount of commercial real estate loans coming due is far in excess of the future lending capacity that will be available to meet the need. It starts at a relatively low number in 2009 of

$33 billion or so, and rises to $459 billion by 2016, with rising numbers in the intervening years. That means that the loan extensions being granted now by all lenders is just shoving the real problem into the future and not solving the problem head on, which is what Japan did in the nineties. In the end, the system needs to be reset now, and delaying the crunch is a very bad policy.

In short, there will not be the lending capacity, nor should there be, to refinance all the bad and dumb loans that were made over the past 5-7 years.

Everyone needs to take the write downs now and deal with the problem now.

The chance this will happen is nil to none. The banks cannot take the capital hit yet, and the equity owners do not want to admit they made ridiculous investments and are now wiped out. Everyone is prying the tooth fairy will sprinkle fairy dust on them and life will return to party time.

That will not happen.

I am not clear where this all goes from here. There are huge turf wars between agencies and between congressional committees to keep what they have. The problem is being consumed by power greed in Washington. The bold leadership needed is just not there. The result I fear is a patch and fix on the margin and not the real repair that we need. Europe with its several sovereign entities is no better.

It is my view that a ton of changes are needed, but they need to be well thought out and not be the subject of the politics of the moment. Whatever they do today will affect the next 50 years. They need to look at the unintended long term consequences and then have a independent commission try to come to Congress with a set of rules and agencies that work. Doing this slowly and carefully is essential. Unfortunately that is not how this is going to happen.

Subject: Ross Rant-7-13 The CMBS market

This is rather complicated, but very instructive as to what is happening in the bond trading market for CMBS paper. When a borrower wishes to pay his loan early he has to defease it, which means he has to buy a series of Treasuries which match the annual payments on the mortgage so that the bond holder who owns the loan gets the same cash flow as if the mortgage remained outstanding. So there are now a lot of defeased mortgages in CMBS pools. The traders are now taking the defeased mortgages and packaging them into a portfolio and selling those to investors. Since they are defeased, they are essentially selling notes backed by Treasuries since the defeased paper is fully backed by the series of Treasury notes. There is no risk. The investor buys this portfolio of defeased paper for a 4%-5%, yield then uses TALF to get 85% debt from the government at 100 over, and he ends up with a 9% effective yield on Treasury backed paper. This is how TALF is being used in some cases-not what we all had thought the program was supposed to be used for. Since this is defeased Treasury backed paper that is being financed, it could get sold in any event with no TALF financing.

The other thing happening is for people -most investors- who want nothing at all to do with the government. The AAA portion of a CMBS pool is broken down in tranches of super senior, A1-2-3-4. All of these are senior to all the lower tranches of AA,A,BBB and so on, so they are safe investments. The property would have to lose at least 30% of value to have any risk at all.

In cash flow, these are stacked so the A1 gets paid first and the A4 last, but in a default they are all pari pasu since they are all AAA tranche.

Traders sell this paper for 13%-15% yields unlevered. Some I Banks are taking the A4 and splitting it up into an A and B piece and selling the B piece for 15% unlevered yields. This creates greater return for them on the A piece by lowering their cost basis. In short there are all sorts of things like this happening in the private markets to move paper, but as you see, it is the near risk free paper that is trading so the toxic junk is still left sitting on the books of the lenders and not getting dealt with.

Toxic junk today is A and BBB rated paper that used to be investment grade, but due to the dramatic decline in values, is now likely out of the money, so is toxic junk. AJ paper- the junior tranches of the AAA slice, sells for 25-30% + yields.

So now you know why nobody wants to make new loans, when you can get great yields on very low risk existing paper with proven cash flow.

Subject: Ross Rant how the capital markets exploded in volume to cause the crisis

Commercial real estate loans went form $800 billion during most of the nineties to $1 trillion in 2000. Not a problem. From 2000-2006 they doubled to two trillion. With low rates and easy access to money for any deal from Wall St, combined with huge bonuses based on volume, the race was on. Real estate developers and owners were able, through vastly increased leverage, to use low cost debt in exchange for high cost equity. The extreme example being the Macklowe deal where he only used $50 million of his own equity to acquire $7 billion of office buildings. In the old days he would have had to put in $1.75 Billion equity. This extreme leverage, which became common, meant the people buying assets were really buying an option. If things worked out that made a killing which often was within months or a year when they flipped the asset. If they lost the bet, as now, the loss was not that much relatively. These very high levels, yet very low cost, of leverage, meant prices were driven up to bubble levels. If your cost of capital provides positive arbitrage, or if you have almost nothing at risk and can flip for a profit very quickly, then price does not matter as much. As opposed to the old days where the more you borrowed the greater your risk, it became the more you borrowed the less of your capital you had at risk and risk was perceived to be low because prices were rising rapidly, so go for more leverage. As things ramped up in 05-07, risk was no longer underwritten and not priced properly. The whole thing became get money out the door faster and make a bigger bonus. There were no controls. That has ended for a very long time. That is why it will be much harder to get a loan, it will be far more conservative, and it will cost a lot more.

Had everyone had to put in real cash equity, like the old days, none of this would have happened.

The derivatives market was similar. Derivatives began to be used by commercial companies to offset currency risk in the seventies and the first interest rate swap was in 1981. They were designed so corporations could control and mitigate risk on specific transactions. Then in 2000 the hedge funds and traders go into the game and everything exploded. By 2008 derivatives amounted to -ready for this-$684 Trillion. Credit default swaps alone were started in 2003 and by 2008 they were at $60 Trillion.

Derivatives became a trading vehicle for Wall St instead of a financial instrument used by companies to hedge transaction by transaction risk. With numbers like these is it any wonder it blew up. It is unclear if anyone really knows how much risk is really out there or if the counterparties to all these trades are good for the money. Risk became forgotten and the traders just were playing with virtual money.

Now Treasury wants to and should, regulate all this. The problem is old time corporate derivatives are custom designed and not easily subject to a central exchange. The economics change badly if they are required to have a margin deposit. That is very different than the case with traders just trading securities called derivatives which do work on exchanges. This is what the industry, Treasury and Congress need to sort out and why it made everyone nuts when Pelosi stuck a derivatives amendment onto cap and trade at midnight, with no understanding of what was at stake. Now people who do understand are working on fixing this. You will be reading a lot more about all this very soon.