This post first appeared in the November edition of Cirios Trends: Getting to the Bottom of the Housing Market

This piece first appeared on Minyanville.

By Andrew Jeffery

Reality, it appears, is a dish Washington believes is best served, never.

Late Friday evening on October 30th, long after most Americans had shut off their computer screens and turned their attention to more important things — namely, Halloween — banking regulators dropped a silent, rotten egg onto the financial system.

Despite an alarming increase in the number of troubled commercial real estate loans gumming up bank balance sheets, the Federal Reserve, FDIC, and Office of the Comptroller of the Currency issued new guidelines Friday easing the burden this souring debt will have on lenders. Regulators are encouraging banks to modify loans, rather than foreclose and repossess property, even if the value of the building has fallen below the amount of the loan.

Loan workouts, regulators argue, can be beneficial to both lender and borrower, and are preferred to foreclosures, which drag down prices. But one look at the earlier-to-crash residential real estate market quickly proves this notion as a fallacy.

In many of the hardest hit real estate markets, ones which imploded well before ill-fated mortgage modification attempts were launched, true price discovery was given a slim opening to take hold. Now, as prices have fallen back to more affordable levels, traditional homebuyers and real estate investors have stepped back into the market, helping to stabilize prices.

Sure, there’s still a healthy dose of government intervention propping up the housing market as a whole, but only through these fresh starts can markets begin a genuine healing process.

Well-to-do markets, on the other hand, have not yet had their requisite dose of price discovery, as corrective market mechanisms are being prevented from functioning. Foreclosure moratoria (ongoing) and modification efforts (floundering) are simply kicking the proverbial can down a long proverbial road.

So too in commercial real estate, as landlords face increasing vacancies, falling rents, and, according to the Wall Street Journal, $1.4 trillion in maturing loans over the next five years. Around half of these are said to be underwater, and thus cannot be refinanced at current price levels.

Regulators’ answer, not unlike the failed mortgage modification programs introduced by the Bush and continued by the Obama Administration, is to allow big banks like Citigroup, JPMorgan, and Bank of America to forestall the recognition of losses, trying to delay the inevitable bursting of the commercial real estate bubble.

With Wall Street’s collective eyes focused on Monday’s headlines — CIT’s bankruptcy, Goldman Sachs picking up tax credits from Fannie Mae and Freddie Mac, and of course the Yankees a single win away from their twenty-seventh World Series title — regulators are hoping investors will ignore the stench of this well-timed announcement as just another holdover from Halloween revelry gone awry.

And while the new guidelines may bolster efforts to make the banking system look healthier than it actually is, it’s further proof that rumors of a legitimate economic recovery are, in fact, greatly overestimated.

This post first appeared on Minyanville.

We have truly become a bailout nation.

As regulators mull over the possibility of rescuing CIT Group (CIT) — a small-business lender that counts over 1 million US firms as customers — analysts debate whether the relatively small firm is deserving of a taxpayer-funded bailout. Or for that matter, a bailout at all.

After converting to a bank holding company last year, CIT received $2.3 billion in TARP money to help solidify its financial footing. Yet even this injection of taxpayer capital couldn’t prevent its financial position from deteriorating further, and the company now faces the maturity of over $1 billion in bonds next month. Without government support, CIT doesn’t believe it will survive the summer.

The specter for a CIT bailout is a tricky political issue: It pits those that argue Washington must step in wherever necessary to support the reeling US economy, against those who are starting to wonder when the bailouts will stop and when bureaucrats will step back and allow the free market to determine who survives.

Few would argue that CIT presents a systemic risk to the US financial system; with a balance sheet of around $75 billion, the company is one-eighth the size of Lehman Brothers, according to research firm BTIG.

CIT is, however, a key lender to small businesses around the country. This means its failure could threaten salary payments for millions of American workers if the company’s customers are unable to get lines of credit with other financial institutions. Under different circumstances, banks like Wells Fargo (WFC), Citigroup (C), and Bank of America (BAC) would be eagerly serving CIT’s clients. Instead, they’re focused on reining in lending of their own.

If CIT were to fail, it would mark the biggest bank failure since Washington Mutual — now part of JPMorgan Chase (JPM) — collapsed last September.

By letting CIT fail and coordinating an orderly shuttering of its operations, the Obama administration has the opportunity to re-establish an old precedent long since forgotten in these turbulent economic times: Firms that should fail actually fail.

If, instead, the government rescues CIT, the yardstick by which we measure “Too Big to Fail” will be severely shortened. This wouldn’t be a welcome development.

For the past year, government power brokers — rather than market forces — have picked the winners and losers as financial firms have been besieged by a massive deflationary debt unwind. Further, as Washington wades deeper and deeper into the day-to-day operations of American business, companies are starting to compete for government cash, not customers.

Moral hazard is a concept quickly brushed to the side during times of crisis, but it’s precisely during these trying times that market principles should be the most firmly upheld. Sadly, over the past 24 months, the opposite has held true.