If that title doesn’t scare you then you might need to check your pulse…  Reuters ran an article this morning talking about how the US Federal Reserve couldn’t understand why the yield curve reached its steepest level in history last week.  Some of the theories it puts forth include, “the economy is recovering so well so there is less need for secure government backed investments”, “China may be repositioning its portfolio of treasuries”, and “the US economy is worsening and there might be a collapse of the US dollar”.  Some of these theories are in diametric opposition to each other, providing further indication that the Federal Reserve really isn’t sure of much.

I know I only have a college degree in economics, but let me give this a try…  We know the US Government is going to have to issue roughly $2 trillion of Treasuries to fund next year’s deficit.  That will push the Supply curve for treasuries out to the right.  We also know that the US economy continues to struggle, signs of improvement are few and far between and there is a very real prospect of inflation on the horizon.  That will shift the Demand curve in to the left.  What you are left with is reduced quantity demanded for Treasuries and a reduced price for Treasuries.  A general believe that this economic condition won’t last forever, and some change will be coming amplifies the effect the further out the yield curve you go.  A lower price means a higher yield and, voila, your yield curve is steepening.  I know this is a gross oversimplification of the Treasury market, but it at least gets you heading in the right direction.

The US Government’s Legacy Loans Program may soon be put on hold.  The program that is part of the $1 Trillion Public-Private Investment Program was designed to encourage banks to sell off loans and securities that were caustic to their balance sheets.  However, there has been both a lack of demand and supply in the marketplace.  Willing investors have turned un-willing over concerns that the government will later decide to change the terms of the agreement and impose salary caps or other onerous provisions.  On the supply side, many of the banks have already written down the assets and believe they can weather the economic storm without the program.  All talk, no action seems to be a recurring theme in the Geithner era.

The Wall Street Journal is reporting that a consortium of 20+ real estate trade associations is petitioning Congress, the FED, and the Treasury for a piece of the $200 billion lending facility established for consumer debt (credit cards, auto loans, etc.).  Their argument is that with over $530 billion of loans coming due in the next three years, they will need significant aid in refinancing.  Their argument continues that if the capital markets are not liquid enough to refinance, they will have to default.  Consequently, the banking system will have to process these assets, something they are not set up to do on this scale.  The encouraging part is that they aren’t asking for a freebie.  Instead, they are asking for the government to play bank and provide low cost loans to the developers needing to refinance.  That sounds admirable, but there is potentially a hidden cost (and handout) in there.

Let’s work through the math here.  The $530 billion of loans coming due were most likely underwritten at a loan-to-value of between 70% and 75%.  So, the presumption is that at the time of lending, the loans were secured by approximately $731 billion of assets.  In the next three years, when those loans come due, the owners will need to refinance and the deals will need to be re-underwritten.  As we are all aware, asset values have already fallen significantly and underwriting standards have tightened.  For this analysis, let’s assume that the values have fallen 20% and that 60% LTV is now common.

So, when it comes time to refinance, traditional lenders will be willing to loan only $350 billion to pay off the $530 billion in loans.  Who is going to come up with the $180 billion difference?  That would be cold hard cash that the building owners have to come up with – even if the government is the lender.  Now my assumption is that, under a bailout deal, the trade organizations would ask that the government issue new loans at the previous principal amount – a one for one issuance with no regard to current market value.  That would put the government making 90% LTV loans, assuming asset values don’t decline further.  Also keep in mind that this assumes all other things being equal.  We haven’t addressed a decline in occupancy, rental rates, absorption etc.  The 20% decline has been mostly in an increase in cap rates.

I don’t know about you, but that’s not how I want my tax dollars being used.  You?

(In the interest of full disclosure I should point out that I am a member of a number of the trade associations that have made this request.)