January 9, 2009 Volume 10, Number 1
by Jon Southard, Principal, Director of Forecasting
CBRE Torto Wheaton
The Treasury and Federal Reserve have taken some heat recently for inconsistency in their attacks on the financial crisis. In particular, critics argue that differing policy actions taken in response to various cases of companies in severe distress, along with the dramatic change in approach toward implementation of the TARP legislation, have made the crisis worse. While we are not, from our perch of examining commercial real estate, in a position to evaluate the impact of actions to-date on the overall economy, we can say that most actions seem more inconsistent than they really are, because our financial markets are involved in a downward spiral that needs to be broken, and the actions may take place in different parts of the spiral.
To explain, we can look to commercial real estate as an example that we know well. Here, as in the broader economy, trouble began in the debt markets. As leveraged financial companies started to pose a risk of bankruptcy, fear struck these markets. Largely, this fear was that the bankruptcy of one of these large financial players might result in a fire sale of assets, particularly Commercial Mortgage Backed Securities. This fear was also taken advantage of by hedge funds, which are concerned only with how the movement of assets can be correlated and not with any fundamental meaning behind those movements. When it was found that CMBS spreads tended to move in the opposite direction of the stock market because of fear of a fire sale, prices started to diverge greatly from their discounted streams of income provided by interest returns, coming instead to relate only to stock market changes.
The result of these divergences was an inverse bubble in some securities—just as large as the housing bubble, whose pop drove up the risk of large financial institutions in the first place—only with prices too low, rather than too high. This inverse bubble of high commercial mortgage spreads began in the public markets and still exists today. As high spreads over Treasurys moved from the CMBX derivative market to CMBS spreads to the private mortgage market, a derivative instrument that was supposed to be reflecting the market instead created an alternative for higher returns on the same assets, driving the collateral it was supposed to be reflecting.
Commercial Real Estate's Adverse Feedback Spiral
This pricing has now persisted for so long that the fear itself is having its own effects, which are actualizing an adverse feedback loop, making what was once just a fear all too real. This is occurring as the high spreads on mortgages are resulting in higher capital costs for owners of real estate and therefore reducing values. This value reduction, combined with a dearth of capital willing to take on even moderately risky investments, has put the commercial real estate market in a situation where even low-risk assets face refinancing difficulties. Though there are several intermediate steps, the short version of what is commercial real estate's biggest problem today is that the fear of defaults has begun to cause defaults, as equity players cannot replace such significant loans with equity and face default as their loans refinance. What caused the credit crisis? Fear of defaults. What is causing defaults? The credit crisis.
So 2009 will see more loans default that would not have in the absence of this credit crisis, even considering the severe economic downturn we are facing. This also puts additional stress on the financial institutions that own the mortgages, the mortgage securities, or the real estate equity. As all these assets succumb to what is now panic, the firms that own them are placed closer to bankruptcy, thus completing the circle where the initial fear began—with the possibility of a bankruptcy leading to a fire sale of assets. Only now this fear is actualized by bankruptcies such as AIG and Lehman Brothers, so the circle is not merely a loop but a process that spirals outward.
Points For Government Intervention To Break Spiral
This spiral can only end in one of two ways: either when the process burns out when there are no firms left to damage, or when the government intervenes to break the spiral at one of its steps. Note that this is a different reason for intervention than the fact that an industry needs help. The reason is that the situation is being governed by a process other than long-term fair valuation of companies. Put another way, this spiral long preceded the severe economic downturn, and would have occurred even had we not entered a recession. That the recession is driving additional defaults is a separate, very real concern that should not be addressed with the same government programs as the restoration of a properly functioning financial market. That is why we are considering both a stimulus package and how best to use the second half of the TARP funds.
To return to the initial criticism—that of inconsistency—the multitude of proposals and Treasury and Federal Reserve actions makes more sense when the problem is diagnosed as a spiral, with the government trying at different points in the cycle to take steps that might break the pattern. This crisis being so unique, it should not be surprising that the intervention that will work best is not known in advance. What has been surprising is the certainty with which various economists, commentators, and actors in the process have insisted that some interventions should work better than others. Unfortunately, what works is only becoming clear through experimentation.
What has not worked is allowing the process to play out, as was tried in the case of Lehman Brothers. After that, the government focus was planned to be on the problem itself—the high spreads on commercial loans. In theory, the Troubled Asset Auction Program that was the original TARP proposal was focused on separating the portion of spreads that was driven by fear from the adjustment necessary given the under-appreciation of risk and the now-apparent recession. Alternatively, a program could focus on assets by having the government insure a portion of the assets that is greatly unlikely to face losses, thus reducing the exposure of the at-risk institution. This path was chosen for a portion of the rescue of Citigroup but, in what is the most direct way to address the problem, could be greatly expanded.
Instead of directly approaching spreads of the troubled assets, the choice was made to address the institutions that held the assets. The Capital Purchase Program aimed to re-capitalize the banks themselves, particularly ones deemed too big to fail. In theory, this could also solve the problem of mortgage spreads by reducing fear of fire sales. In practice, however, this fear has been extremely slow to recede. Perhaps here, the Treasury and Federal Reserve can be criticized for not effectively communicating their approach, allowing portrayals of the money spent as a giveaway, not placing the program within a broader plan and not providing a more transparent summary of their view of the problem, even if that view was unlikely to gain universal acceptance. In concert with reducing this fear, the regulation of the shadow banking system (about which there is bipartisan agreement that more must be done) could conceivably include measures to insure that the short side of the financial trading universe be focused only on value derived from the estimation of prospective income over a longer period. A long-term focus could be promoted either by regulation or, more efficiently, a "Tobin tax" that discourages short-term trading—much as many mutual funds discourage day-trading through fees.
With half of the funds slated for the TARP spent to modest effect, the proposals are becoming more modest as well. What the press has labeled a bailout for developers is really a proposal to use the smallest proportion of TARP funds possible to create liquidity only for the small percentage of loans facing re-financing—which, in the process, would spare many pension funds (often with heavy CRE concentrations) from being unnecessarily caught up in this vortex. This is being considered as part of the extension of the liquidity facility now being set up for consumer loans. One way of implementing this would be to outsource the lending to market players, but have the government insure the safest portion of new loans—for example, an amount that would not be lost even if values were to decline by record amounts. Even this portion would have an insurance premium on it so that taxpayer risk would be truly minimal. That the government is considering some way to break the commercial real estate spiral provides hope; the real concern is that in waiting for the consumer liquidity facility to get running, help might come too late to bring the spiral particular to commercial real estate under control. Also modest in scope would be to insure that tax policy does not discourage foreign investment in commercial real estate, as liquidity is still more likely to come from overseas in this environment.
Separately, a final step that has been discussed—with more controversy—would be to address the way that these spreads have filtered into companies' balance sheets through the mark-to-market accounting rules adopted over the past five years. While the rules have resulted in a lot of unnecessary damage to the economy, the difficulty is in fixing them so that short-term price fluctuations do not lead to the irreversible default of a company (particularly if the short-term fluctuation represents valuations straying from any acceptable long-term-based analysis), while at the same time not loosening the rules so much that Enron-style accounting again becomes possible. There has been little progress in breaking the cycle at this pressure point.
Rather that getting caught in partisan bickering over whether the problem is the banks or the assets, the accounting or the liquidity, we all need to recognize that a spiral means that the problem is all of these things. In changing emphasis once again, the Obama administration seems to be returning to an old approach: focus on the housing problem that has shaken the confidence in the financial institutions. This is being done through the government purchase of residential mortgage assets and a renewed focus on loan modifications. The parallel to previous programs' effect on commercial real estate is to the CPP: it may eventually help the overall financial crisis and therefore reduce the fear driving commercial mortgage spreads wider; given the relative difficulty of solving the larger overhang in the residential sector, however, the question is whether this solution will take too long when there is an opportunity to minimize the spiral in commercial real estate at a much earlier stage, saving taxpayers a greater amount of money—money that we might later need to spend, when the commercial real estate spiral has reached a more advanced stage.
Copyright CBRE Torto Wheaton 2009. Used with permission.