New York | This week The Institutional Risk analyst released our latest credit profile on the housing GSEs, Fannie Mae and Freddie Mac, which is now available in our online store. Registered readers received a special coupon code to save 50% through COB this Friday. (Hint: "Calabria")
Suffice to say that our outlook on the credit profiles of the GSEs is negative. The posture of the world class regulator, the Federal Housing Finance Agency, is confusing to both lenders and investors in conventional mortgage backed securities. The lack of support shown to conventional lenders is particularly of concern since it undermines the value of the entire asset class.
On the one hand, the FHFA is reducing the footprint of the GSEs and ignoring the liquidity needs of the conventional market. On the other hand, the two GSEs are preparing to raise money from investors, this despite the lack of clarity on the future business model. Can you do both? No.
But wait, if all this were not enough, FHFA is also imposing impossible and really silly Basle III style bank capital requirements on the GSEs. We write:
“The FHFA capital proposal attempts to benchmark the capital of the GSEs with that of the largest bank SIFIs. In the narrative to the rule, the FHFA makes clear that they seek to not only ensure sufficient capital to remediate losses on insured loans, but to also provide sufficient mass financially to keep the enterprises liquid in a stressed economic scenario. Ensuring 100% safety against credit loss and market stress is not possible in an economic sense, raising basic questions about the FHFA capital framework.”
And in the back of the minds of lenders, there is worry that the GSEs will seek to reject conventional loans that fall into default once the borrowers exit the CARES Act forbearance. It has happened before, after all. Indeed, senior officials at FHFA have made clear that any perceived defect in credit underwriting after March will result in the GSEs cranking up the good old loan repurchase engine as in the 2009-2015 period.
But truth to tell, while we remain concerned about the lack of clarity coming from the FHFA on COVID19 forbearance and conventional loans, we are far more concerned about the state of commercial real estate and how this catastrophe will impact state and local finances.
How things change and so quickly. A year ago, equity REITs that owned prime commercial real estate in New York and other major metros were the top of the heap in the world of real estate investing. Today these same investors face the prospect of foreclosures and protracted litigation over busted commercial properties. And the impact of this economic collapse on the revenues of major cities is enormous.
Matthew Haag writing in The New York Times describes how the decline in rent payments to landlords means an inevitable drop in tax payments to New York City. “The drop in commercial rent payments could imperil property tax collections that pay for city services,” notes Haag concisely in what may be the most important article published by the Times this year. He illustrates the disaster:
“The cascading impact of the coronavirus pandemic and stay-at-home orders on New York City have reached a breaking point, property owners and developers say. Two months into the crisis, the steep drop in rental income now threatens their ability to pay bills, taxes and vendors — a looming catastrophe for the city, they warn.”
The impact of the disruption in commercial real estate will be felt by REITs, banks and bond investors widely. We hear tell that a favorite trade chosen by some managers was to pair commercial mortgage backed securities (CMBS) with credit risk transfer (CRT) bonds issued by the GSEs, both leveraged of course. Both exposures went sideways at the same time! Wonderful.
But now the CMBS paper and the derivative indices that some managers found so fascinating have both crapped out, leaving investors with another example of the fickle nature of markets. Where is Joanie McCullough when we need her? Indeed, there are distressed investors already buying up CRT paper at triple digit spreads, a testament to the ability of the speculative classes to become comfortable after any market event.
The CMBS delinquency rate, which measures payments that are late for more than 30 days, climbed 22 basis points to 2.29% in April, the biggest jump since June 2017, according to Trepp. No surprisingly, lodging and retail loans were among the hardest hit. May data should show CMBS delinquency well into double digits. JPMorgan (NYSE:JPM) estimates that new issue CMBS volumes will be cut in half this year as retail and hotel deals were sidelined.
The spreading disruption in CMBS is already forcing investors to take a “different” approach to loan delinquency for loans in a given deal, namely ignore it. Extend and pretend as we say in the world of risk. Kroll Bond Ratings wrote in a surveillance report on COVID19 at the end of April:
“[M]any deal participants are considering whether it may be in the best interest of the trust to allow certain relief requests, including temporary debt service forbearance, to be accomplished without a transfer to special servicer. Given the immediacy and severity of the cash flow disruptions to many properties (in particular, lodging and retail) and great uncertainty as to how long the economic disruption will last, some believe that short-term relief may be warranted, particularly for properties that were performing well prior to the pandemic.”
It is important to state that there are deals getting done in the world of CMBS. Blackstone Group (NYSE:BX) just brought a $608 million deal for its REIT comprised of loan participations on commercial properties, including a portfolio of 68 warehouse and logistics facilities, but no hotels or retail properties please. There is a great separation underway between viable CRE assets and commercial properties with retail and office tenants.
While stocks have rallied in recent weeks on the elation arising from the economic opening after 90 days of lockdown, the joy is not being felt by many subsectors of the financial ghetto. Bank for example have rallied double digits in the past 30 days, but are still well off the highs of 2019. Names such as JPM are currently trading near 1.3x book, but are still down for the past 52 weeks. And Q2 2020 earnings loom ahead in just six weeks. Banks, lest we forget, have lots of exposure to commercial real estate.
Meanwhile, equity REITs such as Equity Residential (NYSE:EQR) and Starwood Properties (NYSE”STWD) are deeply depressed, reflecting the negative expectations for the group as a whole. Meanwhile in the world of CMBS, the “AAA” CMBX index still trades well off the highs of the past year, reflecting the fact that some investors still don’t quite know how bad the crash will be in commercial real estate.
We certainly do know that the world of commercial real estate will be really, really dreadful in the next several years. Default rates could exceed peak losses of the 1990s by a wide margin. Act accordingly. And as you read about the trials and tribulations affecting the commercial real estate sector, remember that the big northern cities like New York and Chicago are right behind the busted property deals. Social distancing means financial Armageddon for commercial real estate and municipalities in coming months. Get used to it.