Where was the Big Where was the Big ““KaboomKaboom””??

Why the Distressed REO Opportunity Failed to LaunchWhy the Distressed REO Opportunity Failed to Launch

Michael WhiteMichael WhitePrincipal, Pacific Cascade GroupPrincipal, Pacific Cascade Group

June 25, 2010June 25, 2010

The Capital Markets FuseThe Capital Markets Fuse

The Capital Markets FuseThe Capital Markets FuseHeyyyy Heyyyy Abbott! WhoAbbott! Who’’s on First?s on First?

The Big Picture becomes BiggerThe Big Picture becomes Bigger

In 20 years, outstanding RE debt increased In 20 years, outstanding RE debt increased by 300%by 300%

Capital Markets FuseCapital Markets FuseThe Fingerprints of The Fingerprints of FrothFroth

Capital Markets 2007Capital Markets 2007--20082008The Amazing Met the Unexpected!The Amazing Met the Unexpected!

Total Bank Lending Y/Y % Change

-10%

-5%

0%

5%

10%

15%

20%

1995 1996 1997 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Federal Reserve, Stifel Nicolaus

10 Year CMBS Spreads to Swaps & Treasuries, 1997-2009

0

400

800

1200

1600

2000

2400

2800

3200

3600

4000

4400

4800

5200

5600

6000

6400

6800

7200

7600

1/97 7/97 1/98 7/98 1/99 7/99 1/00 7/00 1/01 7/01 1/02 7/02 1/03 7/03 1/04 7/04 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09

Bas

is P

oint

s

AAA AA A BBBSource: Bloomberg, Morgan Stanley, Stifel Research

As of 12/17/09:AAA: 487 bpsAA: 2962 bpsA: 3598 bpsBBB: 5169 bps

Credit Swaps Bank Lending Volume

Property Values

The Capital Markets FuseThe Capital Markets FuseBanks picked up CMBS biz in 2008, then they too Banks picked up CMBS biz in 2008, then they too

fell intofell into…… the Underworldthe Underworld

Vulture Culture Vulture Culture [2007[2007--2008]2008]

Vulture Culture Vulture Culture Anticipation PhaseAnticipation Phase

By 2007 distressed By 2007 distressed asset fundraising was asset fundraising was already up by 207%already up by 207%By 2009, By 2009, 35% of 35% of ALL RE fundraising ALL RE fundraising focused on distressed focused on distressed assets!assets!In 3 years, In 3 years, ““Vulture Vulture FundsFunds”” raised $75Braised $75B

Source: Prequin – Private Equity Real Estate Distressed and Debt Market Report: April 2010

Vulture CultureVulture Culture““Concentration of Risk in a Small SpaceConcentration of Risk in a Small Space””

79% of these funds 79% of these funds targeted targeted North AmericaNorth America

As of April 2010, $61B As of April 2010, $61B additional additional was still being was still being actively marketing for actively marketing for deployment in deployment in ……North North AmericaAmerica

Currently, 74% of Currently, 74% of currently marketing funds currently marketing funds target distressed target distressed investment.investment.

The Vulture perch is The Vulture perch is crowded!crowded!

Source: Prequin – Private Equity Real Estate Distressed and Debt Market Report: April 2010

Vulture CultureVulture Culture““Inexperience compelled by FeesInexperience compelled by Fees””

70% of Vulture Fund sponsors were 70% of Vulture Fund sponsors were First-Time Managers of of distressed and debt vehicles.distressed and debt vehicles.Hedge fund fees in distressed sector among highest in the Hedge fund fees in distressed sector among highest in the industry!industry!

Source: Prequin 4/2010 Distressed RE Report

Source: Prequin – Private Equity Real Estate Distressed and Debt Market Report: April 2010

Vulture CultureVulture CultureWhy DidnWhy Didn’’t the REITS get Hit?t the REITS get Hit?

$0

$5

$10

$15

$20

$25

2004 2005 2006 2007 2008 2009

Proc

eeds

(in

billi

ons)

200

400

600

800

1,000

1,200

1,400

1,600

1,800

Shares (in millions)

Proceeds Shares IssuedEquity REITs only. Consists of follow -on offerings and private placements only.Sources: NAREIT, SNL Financial, Stifel Nicolaus

Reason #1Reason #1

Wall StreetWall Street’’s 2009 s 2009 ““Recapitalization Rally!Recapitalization Rally!””REITsREITs issued over 1.5B shares issued over 1.5B shares [worth $18.7B] of new stock [worth $18.7B] of new stock equity in 2009!equity in 2009!REIT issued more shares in REIT issued more shares in 2009 than in 2009 than in anyany of the of the previous 10 years!previous 10 years!What did What did REITsREITs want to buy want to buy with all this money? with all this money?

DISTRESSED ASSETS!DISTRESSED ASSETS!

Vulture CultureVulture CultureWhy didnWhy didn’’t the t the REITsREITs get hit?get hit?

Reason #2Reason #2REITS were NET SELLERS into the Valuation Peak! REITS were NET SELLERS into the Valuation Peak! Effectively, they were Effectively, they were ““rere--calibratingcalibrating”” their balance sheets.their balance sheets.

The Government BootstrapThe Government Bootstrap

The Government The Government BoostrapBoostrapWhy isnWhy isn’’t this woman smiling?t this woman smiling?

Possible Answers:Possible Answers:

–– ““SheilaSheila’’s on Firsts on First””

–– She is looking at the She is looking at the next chartsnext charts

–– Her Boss puts her on Her Boss puts her on ““holdhold”” every time she every time she callscalls

Sheila Bair: Head of the FDIC

The Government BootstrapThe Government Bootstrap““Exactly where does it hurt, Sheila?Exactly where does it hurt, Sheila?””

87% of CRE risk is 87% of CRE risk is concentrated in concentrated in local and local and regional banksregional banks with <$1B with <$1B in assets.in assets.

Average commercial loan Average commercial loan held by those banks is only held by those banks is only $8M*$8M*

US MoneyUS Money--Money Center Money Center banks are banks are NOTNOT at Tierat Tier--1 risk 1 risk (thanks to TARP)!(thanks to TARP)!

What size deals are Vulture What size deals are Vulture Funds targeting with $120B?Funds targeting with $120B?

*Mortgage Bankers Association, Press Release 2/5/2010*Mortgage Bankers Association, Press Release 2/5/2010

The The GovtGovt BootstrapBootstrapThe The ““4 Horsemen4 Horsemen”” ChartsCharts

The Government BootstrapThe Government BootstrapDisturbing FactsDisturbing Facts vs. vs. Disturbing RealitiesDisturbing RealitiesAs of May 2010, the Deposit As of May 2010, the Deposit Insurance Fund, or DIF, had Insurance Fund, or DIF, had a a negative balancenegative balance of of $20.7 billion.$20.7 billion.

The FDIC has $46 billion in The FDIC has $46 billion in three years of three years of prepaidprepaiddeposit insurance deposit insurance premiumspremiums and $17 billion in and $17 billion in cash for a grand total of $63 cash for a grand total of $63 billion in billion in ““liquid resourcesliquid resources””to close insolvent banks. to close insolvent banks.

Deducting the $20B DIF Deducting the $20B DIF deficit, theredeficit, there’’s s $43B in $43B in ““netnet”” liquid assets.liquid assets.

In the next 12 months, the FDIC In the next 12 months, the FDIC is expecting to spend is expecting to spend ““$40 $40 billionbillion”” closing troubled banks.closing troubled banks.

Commercial banks hold $1.5T of Commercial banks hold $1.5T of CRE mortgage debt outstandingCRE mortgage debt outstanding

CRE Loan Losses CRE Loan Losses at banks aloneat banks alonecould be could be $200$200--$300B*$300B*

Potential CRE bank loss exposure Potential CRE bank loss exposure is is 697%697% of current of current ““netnet”” FDIC FDIC resources available today.resources available today.

* Source: Congressional Oversight Panel, February Oversight Report: “Commercial Real Estate Losses and the Risk to Financial Stability” Feb 10, 2010

Government BootstrapGovernment BootstrapThe Trend is The Trend is NOTNOT the FDICthe FDIC’’s Friends Friend

2008:2008:–– $14.9B $14.9B –– 25 banks25 banks–– $596M/bank$596M/bank

2009:2009:–– $36.4B loss $36.4B loss –– 140 banks 140 banks –– $260M/bank$260M/bank

June 2010June 2010: : –– $17B loss (first 6 months!)$17B loss (first 6 months!)–– 81 banks 81 banks –– $321M/bank$321M/bank

Annualized 2010Annualized 2010 ProjectionProjection–– 162 failures 162 failures –– $277M/bank ($277M/bank (avgavg))–– $45B estimate total liability for 2010$45B estimate total liability for 2010

Current Trend: Chart on the lower Current Trend: Chart on the lower left left –– the the ORANGEORANGE lineline

The Government BootstrapThe Government Bootstrap

The Government BootstrapThe Government BootstrapPolitics trumps EconomicsPolitics trumps Economics

WhatWhat’’s Washingtons Washington’’s political motivation to s political motivation to accelerate Tieraccelerate Tier--1 loss defaults into bank 1 loss defaults into bank

failures failures prior to Novemberprior to November? ?

ZERO!ZERO!

The Government BootstrapThe Government BootstrapSticky issue: Sticky issue: FDIC Funding in 2011??FDIC Funding in 2011??

November ElectionsNovember Elections““BailBail--OutOut”” Political BacklashPolitical BacklashState Budget Meltdowns (CA)State Budget Meltdowns (CA)RecordRecord--setting Federal deficitssetting Federal deficits

““Hello Sheila? NoHello Sheila? No…… itit’’s s notnot a a good time to talk about thisgood time to talk about this……can I put you on hold?can I put you on hold?””

Government BootstrapGovernment BootstrapWhat What ““HOLDHOLD”” looks like to the FDIClooks like to the FDIC

Government BootstrapGovernment BootstrapWhy Why ““HoldHold”” is better than is better than ““FoldFold”” for for

FDICFDIC

The Government BootstrapThe Government Bootstrap““If you only remember one thingIf you only remember one thing…”…”

The US The US Government Government controls the controls the distressed distressed

asset market asset market because they because they regulate the regulate the keykey player: player: the banksthe banks..

Atlas Shrugged [2010]Atlas Shrugged [2010]

Distressed Asset Distressed Asset Investors: Investors:

All dressed up with All dressed up with nowhere to gonowhere to go……

Disappointment in Disappointment in 20102010

““Today IToday I’’m sitting with $125M in cash that I canm sitting with $125M in cash that I can’’t find investment t find investment forfor””

Stephen Richter, CFO – Weingarten Realty Investors

““The volume of properties that are truly distressed and will be sThe volume of properties that are truly distressed and will be sold in old in a distressed fashion will be significantly less than had initiala distressed fashion will be significantly less than had initially ly been thoughtbeen thought””

Bob Steers, Co-Chief Executive Cohen & Steers, Inc.

““Funds are fighting over a slim group of available dealsFunds are fighting over a slim group of available deals””Mark Edelstein, Real Estate Group Head, Morrison & Foerster, LLP

What Happened and What Happened and WhyWhy

Only 17.5% actually transactedOnly 17.5% actually transacted59% of investors targeted un59% of investors targeted un--levered levered IRRsIRRs north of 16%north of 16%49% sought leverage of 50% or 49% sought leverage of 50% or greater. (greater. (ieie, levered , levered IRRsIRRs >30%)>30%)Resulting BidResulting Bid--Ask spreads too wide for Ask spreads too wide for sellers (banks)sellers (banks)FDIC handed the banks an option: FDIC handed the banks an option: refusal of lowrefusal of low--ball offers.ball offers.

Charts: Ernst & Young, US Distressed Real Estate Loans Invstor Survey, April 2010

Throwing in the Towel?Throwing in the Towel?

A total of 19 privateA total of 19 private--equity realequity real--estate estate funds have either funds have either returned or plan to returned or plan to return more than $6 return more than $6 billion of capital to billion of capital to investors. investors. WSJ, “Dearth of Properties Spurs Fund Givebacks” May 26th, 2010

Where Are We, Watson? Where Are We, Watson? [2011[2011--2017]2017]

Sleuthing for Clues At the Scene of the Crime

Mysterious Footprints Mysterious Footprints

Bank Maturities Bank Maturities peak in 2010peak in 2010--2013?2013?Not quite Not quite -- 3 3 year workouts year workouts suggest our suggest our villain will return villain will return in 2013in 2013--2016.2016.But Holmes But Holmes ––look at look at CMBS!!CMBS!!

Another set of Footprints Another set of Footprints leading toleading to……..

Right you are, Watson!Right you are, Watson!A A secondsecond set of footprints set of footprints –– CMBS CMBS –– leads to leads to the same exact destination: the same exact destination: 20142014--2017!2017!But thatBut that’’s preposterous, Holmes! What thens preposterous, Holmes! What then……??

Source: Goldman Sachs and Trepp

Death by Blunt InstrumentDeath by Blunt Instrument[the Re[the Re--fifi Gap!]Gap!]

Difference between debt outstanding upon maturity and debt that Difference between debt outstanding upon maturity and debt that is is sustainable today based on normalized sustainable today based on normalized LTVsLTVs (~65%)(~65%)Bank extensions are shifting these maturities three years forwarBank extensions are shifting these maturities three years forward! d! 2010 shifts to 2013 ! CMBS maturities peak in 20152010 shifts to 2013 ! CMBS maturities peak in 2015--20172017

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10

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2010 2011 2012 2013 2014

($ B

illio

ns) Others lenders

Banks (Construction Loans)Banks (Income producing CRE)CMBS

Source: Morgan Stanley, MBA, FDIC, FFIEC, Intex, PPR, and Jones Lang LaSalle

Critical Impact: Critical Impact: ReRe--fifi Rates in 2013?Rates in 2013?

A 3.3% 10A 3.3% 10--year treasury rate is way below year treasury rate is way below our 30 year average! (why?)our 30 year average! (why?)

An Extraordinary Puzzle!An Extraordinary Puzzle!

INVERSEINVERSE correlation correlation between debt and between debt and interest rates. More interest rates. More debt = lower rates!debt = lower rates!CounterCounter--intuitive? intuitive? Convenient? Convenient? Conspiracy?Conspiracy?We borrow more We borrow more when rates are low, when rates are low, why shouldnwhy shouldn’’t Uncle t Uncle Sam?Sam?Excludes Public debt Excludes Public debt (Soc Security, et. al.)(Soc Security, et. al.)

But But ……what about Public what about Public debt?debt?

Public debt is Public debt is offoff--balance sheetbalance sheet liability.liability.Guarantied (but not Guarantied (but not serviced) by US Govt.serviced) by US Govt.Bad trend in net Bad trend in net foreign purchases of foreign purchases of US Treasuries!US Treasuries!

Foreign Buyers frame Foreign Buyers frame dynamic float for US debtdynamic float for US debt

But EVENTS (not rates) are But EVENTS (not rates) are defining demanddefining demand

[The most interesting chart of the morning![The most interesting chart of the morning!

Clues to watch in the next Clues to watch in the next 12 months!12 months!

Higher rate indicatorsHigher rate indicators–– Net drop in Treasury purchases by central banksNet drop in Treasury purchases by central banks–– More bailMore bail--outs/guarantees by US Governmentouts/guarantees by US Government–– Stock market drop below 9600 on DOW (Stock market drop below 9600 on DOW (FibonnaciFibonnaci 38.2% 38.2% retracementretracement

support.support.–– Increase in residential foreclosures after November (perceived lIncrease in residential foreclosures after November (perceived loss of oss of

economic virility devalues fiateconomic virility devalues fiat--based $ resulting in increasing interest based $ resulting in increasing interest rates to lure investment back into Trates to lure investment back into T--bills.bills.

Lower rate indicatorsLower rate indicators–– Environment of political or economic crisis (Euro PIIGS, Iran, NEnvironment of political or economic crisis (Euro PIIGS, Iran, N. Korea, . Korea,

Mexico)Mexico)–– Dow regains 11,136 (unlikely Dow regains 11,136 (unlikely –– 61.8% 61.8% FibonnaciFibonnaci))

THANK YOU!

Source: Morgan Stanley, MBA, FDIC, FFIEC, Intex, PPR, and Jones Lang LaSalle