Debtor's Prison

Greetings fellow inmates:

Since the launch of this blog, we have repeatedly talked about the worsening and impending problems in the commercial real estate (CRE) market. Surely enough, the deterioration of this troublesome market has been gaining more notoriety in the mainstream media as it becomes more and more difficult to ignore. Even The Economist, a green-shoots cheerleader, has recently published a couple of articles about the subject. The first one starts off by noting that concerns are switching from the residential to commercial markets. No kidding. We’ve been saying this for several months now, and as usual, the media is a little late in realizing glaringly obvious problems. They note that according to Moody’s, American commercial-property prices dropped by 7.6% in May alone, leaving them 35% below their October 2007 peak. The article also dilucidates how the rest of the world is doing just as badly, for pretty much the same reasons as in the US. The second article is a more succinct exposition of the problem. Again, they mention how attention is only now turning to the commercial sector. Excuse us dear sir, but many of us out there have honed in on this problem for several months, if not years.  One particular statement in the article befuddles us, “all the bad news may not yet be reflected on their [banks’] balance sheets”. They clearly and unambiguously have not. But, we leave you to read the articles yourself dear readers. Our purpose in this post is to revisit some of the data and Numbers. As you know, we are extremely interested in this market because it will cause reverberations throughout the entire credit spectrum, bring down a slew of banks and prolong/deepen the recession.

It is important to remember some basics about the commercial property debt markets. In general, CRE loans suffered from the same loose underwriting that crippled residential markets. A big proportion of CRE loans are also interest-only, with the principal being paid at maturity. This difference weighs heavily on the default profile and the susceptibility to refinance capacity of these loans. As we all know, CRE operators require cash-flow from rents in order to meet debt payments.  Rising vacancy rates and falling property prices are at the epicentre of this downturn.  An important and oft-overlooked fact is that the borrower typically puts a large percentage, if not all, of the interest up front. This cushion naturally leads to an underestimation of delinquency rates which, though very high already, will climb much higher when these reserves dry up. Keep these basic facts in mind as you comb through the following data.

Property prices have fallen dramatically already, though there is much left to go. Prices are perhaps even more important than for residential property since they not only depress sales but severely impair the ability of debtors to refinance their IO loans, which must be rolled over to prevent an avalanche of defaults. Keep in mind, that there is a significant lag between falling prices and realized losses, again, even moreso than in residential. Below is a chart of the MIT Moodys/REAL Commercial Property Price Index. The index is normalized to 1.00 at the beginning of 2001, arguably around the beginning of the current bubble. There is still another 25% or so to go before we even reach those levels. The gargantuan nature of this downturn and the preceding bubble pretty much guarantee that we will break those 2001 levels to the downside.

The following is a chart of the MIT transaction based index. Notice the bottom fell out of the price and demand index in Q2 09, even from the low base of the previous quarters. For now, all we can say is demand is shrinking at an accelerating rate, and there is no end in sight.

At this point, we’d like to remind you of the difference between CMBS and CRE whole loans. CMBS, like RMBS, are structured securities that reference an underlying pool of CRE loans. These are traded like securities by investors across the world. Whole loans on the other hand (more on this below) typically stay on banks’ balance sheets. As the story goes, the enormous growth of the CMBS market up until 2007 snatched up a large proportion of the higher-quality loans, leaving banks with more of the riskier debt on their books. This will be another point to keep in mind. Below is chart of the Markit CMBX indices for AAA, A, BBB and BB tranches of these securities. These indices track 25 (each) securities that are meant to be representative of the broader market.

The AAA-rated index has recently reached new highs, trading close to 80. Rather than being indicative of improved fundamentals, this is mostly due to the artificial bid created by Uncle Benny agreeing to purchase CMBS for his FedBS. The same can be seen in the A and BBB portions, though to a lesser degree. Though these are not thus far slated to be purchased under TALF, the announcement that AAA CMBS would be included certainly led to that late April spike in both. Nevertheless, the A and BBB securities remain 20% and 28% off their January levels, respectively. The BBB are still trading at 16 cents on the dollar; remember these were investment-grade securities, or at least were sold as such. The BBs are truly paltry, trading at 6 cents on the dollar.

Now, let’s examine the CRE loans that remain on bank balance sheets. Up until July 30^th, banks had an aggregate $1.7tr of these assets on their books. This has not changed in the past year, which leads us to one of two possible conclusions. Either they have not written down the values of these loans or they have written new debt as some of the existing one goes down in value.  Given that the CMBS market shut down entirely in the middle of last year, the tough credit conditions that have prevailed since then and the accounting rules in place, it is overwhelmingly likely that the first case is what is actually happening. What this means is that there is an enormous amount of losses yet to be reported.  The banks are simply stalling for time. Ultimately however, because CRE loans are so dependent on refinance at maturity, the fact that prices will not recover to the lofty highs they were at when the debt was issued will lead to an onslaught of losses.

Since there is no real or verifiable price mechanism for this $1.7tr of assets, we are limited to examining their performance. Below is a chart of delinquencies on CRE loans up until Q1, as reported by Uncle Benny. We have now had 11 straight quarters of rising delinquencies from their low of 0.99% in Q2 2006. We are now at 6.94%, an enormous rise. In spite of this, we are still well below the highs reached during the early 1990s when delinquency rates reached 12.6%. Given the nature of this recession, we have every reason to believe that it will be at least as bad as it was in the 1990s. Back then, much as it will happen now, many banks were brought down by their heavy exposure to this sector.

Since the data from Uncle Benny only goes to Q1, we’ve included here some charts recently put out by Deutsche Bank on the deterioration of defaults from Q1 to Q2. The numbers are different than Uncle Benny’s, but this is due to sampling.

Ultimately, the crux of the issue is that there is an enormous amount of bad commercial property debt still on banks’ balance sheets. This will have heavy repercussions not just on the credit markets, but on the economy at large. A massive number of banks will go under, putting the FDIC’s already-thinning funds under severe strain. Access to credit will be further restricted, hampering the ability of businesses right around the time when we were supposed to be coming out of the recession. There is also the likelihood that more bailout packages will be instituted, leading to a further ballooning of the federal debt. As you know, we believe this is the principal risk to the world financial system in the next few years. Absent an alternative method, comparing the value of these loans to the prices of CMBS indices can shed some light on what they are actually worth. Honestly reporting these now, would lead to a lot of short-term pain, sure. But this pain will come anyway, it is always best to get it over with as soon as possible. Especially when it comes to debt.

May your capital be safe and your investments prosperous,

MAAA