by Kyle Johnson

 

Liar loans aren’t back. They never left.

You probably remember the so-called liar loans (or NINJA loans, for “no income, no job, no asset verification”) that contributed to the housing bubble and subsequent Great Financial Crisis (GFC) of 2008. Millions secured mortgages without proving their income, employment status, or assets. Unsurprisingly, many applicants were less than forthright about their finances.

Not even the near-collapse of the banking system purged such behavior from finance. Due diligence isn’t how Wall Street earns its keep. The biggest and most prestigious firms earn fortunes by purchasing assets, restructuring them, and flipping them at a profit. Granted, the transactions involve staggering sums—but Wall Street often behaves like pawn-shop scavengers.

Proper due diligence is time-consuming. Reducing the number of transactions would reduce profits, an unforgivable sin on Wall Street. The game is to purchase and flip assets of dubious provenance before their true values are discovered. It’s a problem for the purchaser, not the seller.

Think of it as a high-stakes game of hot potato.

To my mind, this explains why liar loans remained in use for commercial real estate (CRE) loan applications even after the GFC. For some time, it’s been standard procedure for borrowers to submit a financial statement (T12) listing a property’s income and expenses for the previous year. Despite using them to make decisions about loans, the Wall Street Journal reports that lenders rarely audit the claims made.

I’m sure you don’t need me to explain the economic incentives here. But it’s important to examine the scale of the problem.

 

Fannie, Freddie, and Big Financial Institutions

Fannie Mae is reportedly scrambling to hunt down fraud in already approved loans.

Earlier this year, Freddie Mac began requiring borrowers to submit rental receipts with their loan application. Of course, a teenager with an iPad and Photoshop can make a convincing forgery. But it’s staggering that such a minimum level of due diligence wasn’t implemented until 2024.

Recently, a Michigan-based landlord pled guilty to falsifying financial statements stating that a property earned $644,000 in profit one year, when the true figure was $296,000. This might not seem like such a big deal. But this property was part of a portfolio purchased by a New York firm that received a $481 million loan from JPMorgan Chase.

I don’t want to get political—that’s not my point today—but I can’t fail to mention the highest-profile liar-loan case in decades: Donald Trump’s conviction. Leaving aside the matter of politically motivated prosecution, the crux of the matter was exaggerated property values. Whether or not Trump exaggerated in this case, the incident shows just how common the practice is.

How common? I don’t know. But a prudent investor would operate under the assumption that 100% honest loan applications are the exception, not the rule.

Enhanced standards will improve the quality of borrowers. Firms might be able to sniff out loans obtained by fraudulent means. But there is no way to isolate the price of a specific property from the rest of the CRE market. Fraud taints the entire market. Similar to the housing bubble, the extent of fraud in CRE probably won’t be discovered until there’s a crash.

In case you haven’t noticed, the CRE market is in turmoil.

 

Collapsing CRE Prices

Big cities that people fled during the COVID-19 pandemic aren’t the only places seeing CRE values tanking. Here’s a tiny fraction of shocking CRE transactions and valuations I found from just the last year.

Los Angeles: The Gas Company Tower (555 West 5th Street) was appraised at $632 million in 2021. It’s now worth an estimated $200 million.

San Francisco: Union Square and Parc 55 were valued at $1.56 billion in 2016. The Kroll Bond Rating Agency now puts them at $554 million. 995 Market St. sold for $62 million in 2018. It just sold for $6.5 million. The owner of Parkmerced (the largest apartment community in the area) recently defaulted on a $1.8 billion loan. The complex was appraised at $2.1 billion in 2019 and is now worth just $1.4 billion.

Silicon Valley: Oakmead West sold for $188 million in 2019. It recently sold for $100 million.

Hollywood: The Ovation Hollywood property was purchased for $320 million in 2019. It’s now facing foreclosure.

New York City: 1407 Broadway was appraised for $510 million in 2019. That same year, Barclays made a $350 million loan on the property. It’s now appraised at $136 million. 222 Broadway sold for $500 million in 2014, and just sold for $150 million. 321 W 44th St. sold for $153 million in 2018. It recently sold for under $50 million.

Chicago: The Jewelers Building recently sold for $39 million after the seller spent over $118 million on upgrades. JPMorgan purchased a condominium building at 850 N. Lake Shore Drive for $140 million in 2016. The bank just sold it for $80 million.

Seattle: The Dexter Horton Building sold for $151 million in 2019. It recently sold for $36 million. Pacific Place Mall was purchased for $358 million in 2014 and just sold for $88 million.

Washington DC: 1776 Massachusetts Ave. NW sold for $45 million in 2012. It recently sold at auction for $10 million. Gallery Place was acquired for $336 million in 2015. It just sold for $39 million.

Houston: 19219 Katy Freeway sold for $47 million in 2016. It recently sold for $17.6 million.

Birmingham, Alabama: The Shipt Tower was purchased for $76 million in 2015 and was recently placed in receivership.

Denver: An office building which sold for $17.3 million in 2014 was recently purchased for just $2.3 million.

Indianapolis: 360 Market Square, a downtown complex with 292 luxury apartments and retail with highly desirable tenants like Whole Foods, is the center of a $101 million foreclosure lawsuit.

 

More Bad News

According to Reis Inc., the office vacancy rate is at an all-time high. And there’s reason to believe it will rise. It’s estimated that over 217 million square feet of office space has leases ending in 2024 or 2025.

But there’s another factor at play. Corporate executives are often held personally liable for CRE rental agreements. Industry insiders warn of shadow inventory in CRE. Many businesses have downsized or gone bankrupt since leases were signed. Some executives are reported to be making rental payments to meet legal obligations, but have no practical use for the office space. Thus, offices sit empty even though they show up as occupied on the books.

Obviously, there’s no need for such agreements to be renewed. These tenants do not genuinely enhance a property’s long-term value, but they superficially boost many CRE stats. There will be downward pressure on prices as the shadow inventory comes online.

 

Fake Job Stats Can’t Hide This

Making matters worse, we’re unlikely to get a sudden boost in demand for office space. Government economists and pundits can fiddle with the unemployment and jobs statistics all they want, but none argue that the new jobs will create significant bump in demand for premium office space in America’s biggest cities. The jobs you read about in the headlines are almost entirely part time and low paying (often in the service sector)—not the kind that fill skyscrapers.

Now consider the work-from-home trend. Prior to 2020, under 10% of employees worked from home. That number reached 60% during the pandemic and has since settled around 25%.

Some companies are trying to require onsite work. But many workers will sacrifice pay for the ease and convenience of working from home. Also, younger generations are willing to change employers at the drop of a hat. One study found that millennials stay with an employer for just 2.8 years on average, whereas workers between 55 and 64 averaged 9.9 years with their employer.

The world is becoming better connected. Starlink can bring fast internet to an off-grid cabin.

There will always be companies that need office workers. But barring a historic economic boom, it’s reasonable to expect a significant and long-term excess supply of office space.

 

Bank Failures Are Expected

Most CRE deals are financed through debt and equity. Crashing prices have put many developers and their banks in financial jeopardy. Eight, nine, and ten-figure losses garner the most attention, but for every high-profile fire sale, there are likely several involving less glamorous and less expensive properties. It’d be a mistake to assume their smaller scale makes them unimportant.

Regional and community banks hold 31.5% of all CRE mortgages (representing 20% of their total assets).

CRE is a known threat to the banking system. CRE billionaire Barry Sternlicht expects we’ll eventually see one or two bank failures per week. This March, Jerome Powell stated:

“We have identified the banks that have high commercial real estate concentrations, particularly office and retail and other ones that have been affected a lot. This is a problem that we’ll be working on for years more, I’m sure. There will be bank failures, but not the big banks.”

However, the US Office of the Comptroller of the Currency recently found that half of large US banks are failing on operational risk. The $481 million JPMorgan loan discussed above proves fraud has infected transactions involving mega banks.

Big banks hold 14% of all CRE mortgages, representing “only” 4% of total assets. That might not sound like much, but illiquidity can turn small losses into big ones in a hurry.

 

Picking Favorites

It’s quite clear to me that regulators and banks are in cahoots. But it would be a mistake to view the power structure as monolithic. There’s a reason Lehman Brothers failed in 2008 while other banks were bailed out. And it wasn’t strictly the numbers.

Insiders play favorites and don’t even deny it. In the aftermath of the Silicon Valley Bank collapse, Janet Yellen told senators that refunds of uninsured deposits will not be extended to every bank failure. Quite literally, she advocates for special treatment. It’s only reasonable to assume her next determination will depend on the specific parties involved, in addition to more objective criteria.

 

Caution

I want to be extremely clear: I’m not predicting a catastrophic banking collapse—but we could wake up one morning to news of bank failures. And by lunch, Powell and Yellen could be taking emergency measures.

Giving credit where due, they handled the collapses of Silicon Valley Bank et al. pretty well. But I suspect the national CRE problem poses a much bigger threat to the banking system compared to the three regional bank failures of 2023.

It’s not humanly possible to keep track of all the variables in play (valuations, sales, foreclosures, counterparty risks, etc.) in real time. The extent of fraud is unknown, making it difficult—if not impossible—to properly model.

“How could anyone let this happen” was a typical response to the GFC. Conditions are ripe for that question to become popular once more.

A CRE-driven banking panic would likely force capitulation from Team No Landing. This would leave the Soft Landing as the remaining best-case scenario, which is still a recession. Of course, a hard landing would still be on the table.

Regardless, we don’t want to be formulating plans when the banking system is front-page news. We can finger-wag about Wall Street’s lack of due diligence, but it’s hypocritical not to do our own. There’s no downside to being prepared for bank failures and a potential market crash, even if they never come. Of course, we’re happy to help.

KJ

 

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