s week, MortgageOrb spoke with Christopher Grey, managing partner and co-founder of Third Wave Partners. [/b]The El Segundo, Calif.-based firm focuses on distressed real estate opportunities, joint ventures with distressed borrowers and owners, and loan workout advisory services. Grey offers his thoughts on commercial mortgage workouts, distress forecasts and why he believes keeping struggling banks alive will only prolong our crisis. [b]Q:[/b] Within your commercial mortgage workout and restructuring business, what specific features have been most common in these loan restructurings (e.g., principal write-down, interest-rate reduction, other modifications?). How do you overcome resistance from lenders or other involved parties that would be required to take a loss? [b]Christopher Grey: [/b]The most common features are interest-rate reductions or deferrals, as well as deferred fees. Also, lenders are often willing to extend the maturity of loans to delay having to enforce remedies and foreclose. In general, lenders are reluctant to take significant principal writedowns or sell at significant discounts because they don't want to recognize large losses in their portfolio. Most lenders are either in denial about the magnitude of their losses or don't really understand the market value of their assets. [b]Q:[/b] In your view, how severe has the commercial real estate crash been so far, both within your region and nationally? [b]Grey: [/b]So far, we have no idea about the severity of the downturn in commercial real estate, because there has been hardly any transaction activity for almost 18 months. What little activity we have seen during that time shows that market values have been declining and continue to decline. Privately, brokers and other market players believe that if we want to see significant transaction activity, commercial real estate values would need to fall by an average of 40% to 60% just from the rise in cap rates that buyers are willing to pay. If incomes are also declining, as they are in many properties, the declines in market values will be a lot more severe. We haven't seen many transactions reflecting those declines yet, but there have been a few. If we're going to have more transactions, we need much lower prices to pull real buyers into the market. Without much lower prices, or free money from the government, the market will remain mostly frozen, as it has been for a long time now. [b]Q: [/b]Overall, how many problem loans are experiencing issues due to low cashflow or other property-level struggles? On the other hand, what portion are performing mortgages that have simply fallen victim to the refi crisis and lack of available credit? [b]Grey:[/b] Most loans today are in trouble because of problems at the asset level, such as leasing issues or completion problems with construction loans. Then you have loans on properties that are doing well, but the borrower cannot refinance because of the freeze in the capital markets. These borrowers aren't finding themselves in that much trouble because the lenders on those performing properties are generally willing to forbear and even extend those loans. Lenders don't want to foreclose on properties that are doing well. They usually don't even want to foreclose on properties that are not doing well because lenders don't want real estate owned property on their books. I expect that if the government keeps allowing lenders to avoid recognizing losses and encourages lenders to keep making credit available regardless of the fundamentals, there will be more forbearance and extension of loans in the future, rather than foreclosures and liquidations. The direction right now from the government seems to be that if we ignore the problems and flood the system with liquidity, the problems will magically disappear. I don't agree with that approach because I don't think it will work, but the government and the banks can keep it going for a while before it falls apart. We are headed down the road Japan took in the 1990s. It will end badly, but it takes a while to get there. [b]Q: [/b]Third Wave's Web site indicates that equity investment activity in distressed opportunities will be dictated by the market. How have conditions been so far, and how active have you been in this space? [b]Grey: [/b]So far, conditions for investing in distressed properties have been terrible – for the reasons stated above. The government and lenders are cooperating to prevent the market from correcting itself. Holders of distressed assets, most of whom are lenders, are generally not willing to sell those assets at market values. Now, with the change in accounting standards by the Financial Accounting Standards Board, regulatory forbearance and the government bailout liquidity programs, there is no longer any incentive to sell distressed assets at market value. It makes a lot more sense to avoid recognizing the losses, take the free money from the government, and just hope that the value of the distressed assets goes up in the future. Our investment activity has been very limited so far because of these factors. Eventually, this system of denial will break down as it started to do in Japan, but it could take many years for that to happen. For now, we're focusing on buying from real sellers instead of lenders who are getting support from the government. Private owners of assets who need to sell in this buyer's market are a better source of deals than lenders who don't have to sell because they are getting free money and fantasy accounting standards from the government. [b]Q: [/b]Finally, you recently published an article criticizing recent initiatives from the Treasury and Federal Reserve that were intended to help boost banks and jump-start the economy. In your opinion, what specific actions should the federal government be taking instead to aid in recovery? [b]Grey: [/b]The right way to handle this problem is very simple, and it is basically what we did in the savings and loan crisis in the late 1980s and early 1990s. You nationalize and liquidate failed and insolvent institutions and sell their assets at market prices to real private buyers. This is not rocket science. The reason we are not doing that is that our system has been hijacked by powerful interest groups backed by the money center banks and Wall Street, who would be big losers if this sensible and historically successful approach were implemented. Their equity and their bondholders would be wiped out in this scenario – just like in the situations with Lehman and Washington Mutual. Taxpayers are being robbed of trillions of dollars to bail out a few big banks and Wall Street firms. This money should be spent to stimulate the economy, but instead, it is being spent to bail out financial institutions, with the excuse that it is necessary to avoid a meltdown in the economy. In reality, these bailouts of zombie banks are a drag on the economy. They are not helping economic growth at all, in the same way that the bailouts of the Japanese banks in the 1990s did not help the Japanese economy. Every legitimate economist on both sides of the political spectrum opposes these bailouts. George Soros, who was one of Obama's biggest supporters, also opposes these bailouts. The only people supporting the bailouts are at the big banks, Wall Street and the bureaucrats at Treasury and the F
