Time Still Necessary to Heal Financial Wounds

MBA (6/24/2008 ) Murray, Michael
While some industry analysts view the second half of this year as time to heal commercial mortgage backed securities and capital markets, others believe financial wounds left from large investment banks will cut deeper into commercial real estate finance and regional banks.

“Because we’re not all the way out of this financial crisis, it really leaves us to believe that the Fed is going to focus on the financial system more than inflation for nearly the remainder of the year in that now is not the time to risk raising rates and reigniting this possible financial crisis,” said Jon Southard, principal and director of forecasting at CBRE/Torto Wheaton Research, Boston. “The first quarter this year was very dangerous territory for the economy. It is our belief that had chaos ensued in the financial markets, you really would have seen a deep recession.”

The J.P. Morgan Chase buyout of Bear, Stearns marked the peak widening of spreads by synthetic CMBS derivatives—CMBX indices—that acted as a form of insurance or leverage against CMBS pricing. Spreads widened more than 200 basis points at their peak—just prior to the Bear, Stearns purchase—before narrowing to their current level of nearly 50 basis points.

“We can now look back, in retrospect, and see not a measure of how bad commercial real estate was going to get but really that the CMBS paper was about to be dumped on the market because there was such concern that Bear, Stearns or another investment bank—if they go under and their assets spill out onto the market—that those paper assets would not have been able to be bought up quickly enough, and [there] very well could [have been] this breakdown in the financial system—such that it would be necessary to charge outrageous rates for paper,” Southard said.

“I think we are going to look back and see that the Fed really was successful in stemming what could have been a real financial crisis," Southard added. "While we are not all the way back, we are certainly well into the healing process from this credit crisis and that has a lot to do with the Fed actions, not just in Bear, Stearns but, obviously, all these securities auctions that they have placed themselves—the line of credit they have given to the banks and to the investment banks.”

Southard said the CMBS bonds that experienced wider spreads from the CMBX indices were bonds with a “fairly stable default probability.”

“You would really have to have an awful recession to see them not pay off,” Southard said.

However, Michael Shedlock, investment advisor at Sitka Pacific Capital Management, Edmonds, Wash., and author of Mish's Global Economic Trend Analysis, said supply continues to increase in commercial real estate as demand for office and retail decline.

“The environment for commercial real estate couldn’t possibly be worse,” Shedlock said.

He said that retail supply—including more strip malls coming online—continues to increase while consumers become “tapped out” and start to cut back on expenses.

“Vacancies are rising—although from a low level—and office rents are declining,” Shedlock said. “None of that was factored into the last big wave of commercial real estate deals that were done, none of it was factored into all of the building that is going on now where regional banks provided loans on the basis of cap rates that are not going to be there. The vacancies are not going to be as low as was factored in, and the lease rates are not going to be as high as what was factored in. And all of that is just going to further pressure regional banks that are most ad hoc here to the commercial real estate market.”

Rather than collateral concerns, Southard said the main concern is a typical recession—slowdown in output and employment—and its effects on consumer credit and regional bank loans.

“If we do continue to have this mild recession, then we certainly will not see spikes in these types of measures to the degree we saw before,” Southard said. “We will be dealing with much more normal—for a recession type—expansion of spreads.”

Shedlock referred to Macklowe Properties and its default of the GM Building in New York City as one of many problems in commercial real estate, despite strong fundamentals in some geographic regions.

“Huge mistakes were made, and I don’t know how anyone can honestly look at this situation and say that commercial real estate is some sort of 'buy' here. This might be the last chance to get out,” Shedlock said.

Southard said “so far, regional banks have been relatively unscathed,” and although he expects some job losses to still occur in Manhattan based on financial market weaknesses, the potential for a “slow bleed” in job losses translates into flat-to-modest average rent declines rather than a situation comparable to the 1991 recession.

“Again, not good news but—given what we would have said in December with all the problems—it has been surprisingly resilient,” Southard said.