At Lani Warren Properties we have been somewhat surprised by the relative lack of distressed assets in the marketplace thus far in this cycle. Investment firms are eager to buy distressed assets and institutions are seemingly holding on to them for dear life.

Over the past few years we have been anticipating a significant amount of distressed assets coming to market. After all, there are over 3.5 trillion dollars worth of Commercial loans currently outstanding in the US and over a trillion dollars worth of these loans will be ballooning between 2010 and 2012. Only half of these commercial mortgages will be able to qualify for a refinance and at the same time there are hundreds of millions of dollars worth of Pay Option Arms and other types of non-conventional loans due to reset.

So, why aren’t all these distressed assets on the market? There are two primary reasons for this. First of all, everything the government has done from a regulatory standpoint is allowing lenders and special servicers to avoid dealing with their problem assets. Regulators have essentially said to banks that if they have bad loans on their books at par and they know the collateral is only worth 60 percent of par, they can leave asset values as they are without incurring any write-downs.

The second reason banks are not selling is that the Federal Reserve’s monetary policy is allowing banks to borrow at close to zero and, if they are lending, they are making huge spreads of 500 to 700 basis points depending upon the loan type. Even if they don’t lend at all, they can simply buy Treasuries and make nearly 400 basis points.

Just a couple of years ago, spreads were as narrow as 30 or 40 basis points on some loans because there was intense competition to put debt on the street. Today’s massive spreads are allowing the banking industry to recapitalize itself, which was, of course, the reason for the Fed’s intervention in the first place. Tremendous profits are being generated which can be used to gradually write down all those bad loans.

The banks are able to make huge quarterly profits, write-down bad loans and wait until the write-downs reduce book value to market value. Once this is accomplished, distressed assets can be disposed of without incurring losses. This is why the banks have been holding on to assets that they would ordinarily write off and dump on the market.

In spite of all this, we have seen a significant increase in the amount of distressed assets coming to market recently. Although the flow has increased, it remains a drop in the bucket compared to what actually exists in the market.

As interest rates start to rise it will put additional stress on under water loans and could motivate sellers to act quickly as they realize that holding on to distressed assets is causing them to miss other opportunities.
Adding to the increased flow of distressed assets is the fact that advantageous mortgage terms are beginning to expire. We have seen interest-only periods provided on loans originated in 2006 and 2007 beginning to evaporate.

Floating rate loans originated in 2005 and 2006 are either at or nearing maturity. If these loans were floating over LIBOR, debt service rates may only be 2 or 3 percent today and no lenders are willing to renew or extend a loan at those extremely low interest rates. We, therefore, expect the flow of distressed assets to continue to increase as we move farther into 2010 and 2011.