Swap Spat

Two high-profile casualties of last year's market meltdown — Lehman Brothers and American International Group Inc. — are fighting over payments related to one of the instruments that caused the crisis.

Lehman, which filed for bankruptcy protection in September of last year, says AIG, which was taken over by the government around the same time, owes it about $9 million under a credit-default swap agreement.

"Somehow you always knew these two would get together," Stephen Lubben, a law professor at Seton Hall University, wrote on a blog post Tuesday.

In 2004 the parties signed a master contract, under which Lehman bought insurance from AIG and vice versa, in about 125 separate transactions, against the risk of various third parties defaulting.

Some of those "reference" credits haven't performed well. Washington Mutual Inc. filed for bankruptcy in September of last year, after regulators seized its thrift unit. Station Casinos Inc. of Las Vegas defaulted on its debt in February, the Montreal pulp and paper company Abitibi-Consolidated Inc. sought bankruptcy protection in April and General Motors Corp. did so in June.

So on July 23, Lehman sent AIG a claim for these four "credit events." The problem is that the fallen Wall Street giant had stopped paying quarterly premiums for the insurance after it filed under Chapter 11.

Lehman did subtract the $3 million of unpaid premiums from the $12 million it would have otherwise claimed. But AIG refused to pay without an assurance that Lehman would resume paying premiums until the swaps expire. (Most of them are set to do so next year or the year after.)

The insurance company's "need for adequate assurance is all the more important because [Lehman] is a liquidating debtor," lawyers for AIG argued in a filing Monday with the U.S. Bankruptcy Court for the Southern District of New York. It certainly didn't reassure AIG that after Lehman asked the court to compel payment of the claim in August, it skipped another two scheduled premium payments totaling about $715,000.

A hearing is scheduled next week.

Housing Hope

A report due out today from ClearCapital.com Inc. provides more tentative signs of improvement in the housing market.

For example, the report shows that repossessed properties made up 28.6% of homes sold from Aug. 27 to Sept. 25, down 1.5 percentage points from the previous month and 12.3 points from last winter.

However, the month-to-month pace of improvement is slowing; the repossessed property "saturation rate" had dropped 3.2 percentage points in the July 27-to-Aug. 25 period.

Moreover, "we're still far from the 10% … saturation rate seen in 2007," the Truckee, Calif., real estate research and data firm said.

The Clear Capital report also showed improvement in two hard-hit markets.

In the four months through Sept. 25, prices climbed from the previous three months in Riverside, Calif., and Orlando for the first time since mid-2006.

The CRE Shoe

While the housing market is showing signs of stabilization, commercial real estate is still on the lip of a spectacular meltdown, according to a grim overview delivered by analysts at Barclays PLC last week.

The delinquency rate among commercial mortgages backing bonds increased 32 basis points from the month prior, to 5.08% in September. And Aaron Bryson, the firm's chief commercial mortgage-backed securities strategist, said Barclays believes collateral performance "is set to weaken" at an accelerating pace, with the proportion of loans that are more than 30 days past due reaching 8% to 10% by "very early" next year.

Barclays expects payrolls to begin to expand in 2010, leading to increased demand for office space.

But spot rents — or the going rate when a lease is signed — did not rise for two to three years after office jobs began to do so following the last two downturns, Barclays found.

Moreover, it takes years for leases to turn over, which translated into a two-to-five-year gap overall between the bottom in spot rents and the bottom in income produced by properties.

Barclays projects a 17% drop in net operating income among office properties over the next five years, which it reckons could leave 37% of the sector that is now current on loans unable or barely able to cover debt payments and at high risk of default.

Bryson said it is likely that "the bulk" of borrowers with loans originated in 2005 or later "have very little to no equity left" since a Moody's Investors Service Inc. index of commercial property values has dropped back to where it was in late 2003.

Performance among mortgages on apartment buildings has weakened faster than on office properties — the largest sector — and has conventionally recovered faster also, because leases on apartments turn over more rapidly.

But Barclays believes that a recovery in commercial real estate prices will substantially lag a turnaround for single-family homes, potentially spelling trouble for places like Southern California, where multifamily delinquency rates have not reached levels hit elsewhere in the country.

(The firm predicts that single-family home prices will hit bottom early in the second quarter after sliding another 8%, for a total peak-to-trough decline of 36%.)

In another echo of the single-family sphere, so far seizures and liquidations of commercial properties backing troubled loans have been minimal, Bryson said. "At the current pace, it would take over 10 years for all these delinquent loans to work through the pipeline," he said. "So at some point these special servicers will need to start liquidating properties, but we just haven't seen it yet."

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