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Monday, March 16, 2009

Do Charge-off Rates impact the UltraShort Real Estate ETF?

You may have noticed today that the ProShares UltraShort Real Estate ETF (SRS) was up strongly Monday (3/16/09), tacking on almost 16%. This is far in excess of the 4% that the UltraShort Financial ETF (SKF) rose.

What gives?

It could be that investors are beginning to realize that the situation in commercial real estate is becoming worse than what we have seen in residential real estate. The Fed provides the data from which we constructed the following chart. It contrasts the charge-off rates for residential real estate loans and commercial real estate loans.

Real Estate Charge-off Rates
Whereas it looks like charge-offs in the residential sector are beginning to moderate, it appears that charge-offs in the commercial sector are really taking off, increasing rapidly and surpassing the rate for residential loans. As of the end of the 2008-Q4 there was no moderation at all in the slope of commercial loan charge-offs.

Many financial institutions have seen their stock prices decimated when mortgage-backed securities (MBS) imploded, typically due to the underlying residential mortgages going through delinquency, foreclosure and the charge-off process. It stands to reason that banks facing these levels of charge-offs for commercial real estate will be under further pressure. Banks will be running into problems not only with the actual loans but also due to the decline in value of commercial mortgage-backed securities (CMBS).

With all this turmoil in the commercial real estate sector, it is quite reasonable to assume that real estate investment trusts (REITs), which almost universally are concentrated in commercial real estate, not residential, are feeling the impact in a big way. Projects are left incomplete, properties go into receivership, write-downs occur, etc. This is bad for investors in REITs but good for anyone who owns an inverse real estate ETF like SRS.

Chart of SRS, 03-16-2009
This rally we have seen over the past week drove SRS down from over $100 to almost $60. This may turn out to be a pretty good buying opportunity for SRS. It appears the bear has further to run in the commercial real estate sector.

Disclosure: small position in SRS

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