Economic Update — Did Commercial Real Estate Dodge the Derivatives Bullet?

Warren Buffet’s annual letter to Berkshire Hathaway, published over the weekend, contains a number of interesting statements besides his opinion that the economy is in “shambles” and the hard numbers that show 2008 to have been the worst ever for his company. The letter will likely be long remembered for characterizing the systemic failure among large financial institutions like this: “Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required.” Or, to put it another way, if you’re going to fail, fail big, otherwise the government isn’t going to bail you out. Another pithy observation from the Oracle of Omaha in the letter was this: “Derivatives are dangerous.” Why? “They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.” This could easily become the conventional wisdom about derivatives, considering everything that’s happened since the fall of 2008. But it was not always thus. In the Summer 2004 issue of the Journal of Economic Perspectives, René M. Stulz, a professor of finance at Ohio State, wrote, “Derivatives make markets more complete–that is, they make it possible to hedge risks that otherwise would be unhedgeable. … [R]isks are born by those who are in the best position to bear them and firms and individuals can take on riskier but more profitable projects by hedging those risks that can be hedged. As a result, the economy is more productive and welfare is higher.” Theoretically, that might be the case. In practice, maybe not. In any case, for some time now the financial industry has drunk the derivatives Kool-Aid, but commercial real estate never quite got around to it in a big way. Had the bubble gone on longer, though, it might have happened. For instance, by mid-2007 the National Council of Real Estate Investment Fiduciaries (NCREIF) had inked deals with seven investment banks to begin offering derivative contracts based on NCREIF property return indices. Also, the GFI Group Inc., a London-based specialist in derivatives, formed a joint venture with CBRE-Melody in late 2006 to broker real estate derivatives in the United States. The market was budding, but the credit freeze and recession have nipped that bud. On Friday the major equity indices looked like lines on a seismograph during an earthquake, with averages bobbing up and down all day. Eventually the averages settled somewhat lower, with the Dow Jones Industrial Average down 119.15 points, or 1.66 percent. The S&P 500 was down 2.36 percent (to its lowest level since 1996), but the Nasdaq lost only 0.9 percent. As the federal government edged ever closer to an unspoken nationalization of the behemoth Citigroup Inc., the company’s stock took its familiar place on the roster of big losers for the day, down over 40 percent to $1.50 a share, which is not only dangerously close to penny-stock status, but also well below an average ATM fee these days.