More Pennies Dropping/Fichas Caindo

As I've been predicting in lectures and classes, shopping malls in the US are the next problem area for the financial system there. Today, GGP filed for Chapter 11 bankruptcy protection because it has not been able to restructure all the debt it took on during the housing boom of 2002 - 2006. GGP has 200 malls throughout the US of which 158 also filed today.

There are two basic reasons why shopping malls, particularly those owned by REITs and other public companies, are vulnerable to this recession. In general, they took on absurd amounts of debt during the boom, normally exceeding the standard 80% that banks and other lenders have allowed in the past. As I just explained Tuesday night to my entrepreneurship class, the risk with debt is that you have to make the payments whether you have sufficient income to support the payment or not. In a boom environment, that is generally not a problem. Rental income rises as consumer demand for goods in the stores increases. However, when there is a precipitous drop in consumer demand, rental income shrinks, frequently leaving the mall operators with an income insufficient to pay both expenses and debt.

Why rental income shrinks in a recession is the second reason why malls are vulnerable. Unlike apartments, rental contracts in shopping malls have two income components. The first is a fixed rent charge (like apartments). The second is a variable component based on the store's sales figures (generally 7% of sales). If sales go down, two things happen. First, the store owners are themselves squeezed. Although their variable rent will decrease, their sales may be insufficient even to pay their full fixed rent after they pay for their merchandise and administrative expenses. And, as I just said, variable rents go down with the decline in sales.

As a result, the mall operator faces two risks. First, a declining variable income, which he or she may rely on to pay the mortgage payment (although a bank, insurance company or fund should only have counted a small portion of this in assessing the creditworthiness of the mall property). Second, an increase in the stores in the mall that are in default on their rental payments because of their loss of income.

The mall operators have tough decisions to make. Should they keep on the stores even if they are in default in the hope that the default will be brief and that a workout can be structured for them? How should the mall "de-leverage", the artless term used by GGP on their web site, that is, to reduce their debt load to bring their level of debt back into balance with their properties' ability to pay? The situation is not a pretty one right now. Other large mall operators are likely to file for Chapter 11 reorganization in the wake of GGP's filing. This could be the next major bubble to break as the loan holders, the creditors, themselves are being pressured to restructure their debt portfolios, get out of the boom mentality and return their businesses to a more conservative debt posture.

If consumer demand is falling, then consumers are staying at home with their credit cards in their wallets. One reason for this is they themselves are falling to default on their credit cards. This could be the next major area of impact that will keep the United States in a recession through 2009 and keep the credit markets closed.