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Seeking Normal in the Age of Credulity

November 14, 2018

Washington |  Last week in response to popular demand  we published our first Top Ten List for the largest US lenders. We noted that credit performance for the top institutions is pristine, but we also noted that spreads on loans and securities remain extremely tight, discouraging lenders in high-cost markets in such sectors as residential mortgages and even multifamily lending. 

 

This seems to be the paradox of the post 2008 markets: credit underwriting standards are better, but the profitability of originating assets is minimal and cash flow coverage is stretched, suggesting serious problems ahead that will cause loan and bond default rates to rise. The present situation in the financial markets reminds us of our favorite quotation from “A Tale of Two Cities":

 

 

This week we got to hear FDIC Chairman Jelena McWilliams talk about current market conditions at a bank conference sponsored by Kroll Bond Rating Agency.  Taking a page from “A Tale of Two Cities,” McWilliams said it is “the best of times” but noted that regulators need to work with banks to make the cost of compliance balance with the size and resources of the bank.  Chairman McWilliams then made a comment on credit conditions that could easily be applied to the equity markets as well:

 

“There has not yet been a single bank failure this year but as you all know that is not normal. We are in abnormally good times.  Usually we have three or four bank failures per year.  That happens and it is a normal part of the business cycle.  We have been in what I like to call the best of times this year.  This is the new abnormal.  At some point we will get back to normal.” 

 

What is most striking about Chairman McWilliam’s comments is that they could apply to many sectors of the debt and also equity markets.  The premium pricing seen for many assets and, as one reader put it so well, the “velocity of collateral” moving through the financial system, makes us wonder if the target for the next crisis has moved from asset quality to the operating and market stress caused by excessive competition on price.

 

The impact of an abnormal market on many normal businesses is profoundly negative.  We note from the banking channel that while there may not have been any bank failures this year, there are certainly a lot of smaller banks for sale at the present time because these businesses simply do not make money.  The rising cost of regulation and compliance has likewise raised the bar in terms of the minimum size of a bank that can be economically viable. 

 

To give you some idea of the scale of cost increases for the industry, the direct cost of servicing a performing mortgage loan in the US is about 15 basis points (bp), according to The Mortgage Bankers Association, or half of the income from the gross servicing strip.  A decade ago the cost to service a performing residential mortgage was closer to 5 bp.   With rising operating costs and horrible execution on the loan origination and secondary market sale, many banks have decided to flee residential lending.

 

Meanwhile in the market for multifamily and commercial construction and finance, there are growing signs of stress due to years of abnormal markets c/o the Federal Open Market Committee (“FOMC”).  We heard Eric Thompson, Senior Managing Director of the Real Estate group at KBRA, remark at the same conference that “interest only” mortgages are now all the rage in the market for commercial mortgage backed securities or CMBS. 

 

In the brave new world of Dodd-Frank, lower loan to value (“LTV”) ratios are supposed to protect lenders and investors from shoddy underwriting, right?  But nature finds a way.  A case in point regarding the new abnormal is New York City multifamily.  Andrew Dansker, a first vice president of finance at Marcus & Millichap, writes in The Commercial Observer about the combination of historically low capitalization or “cap” rates and low interest rates:

 

“Because of these underwriting constraints, and the low loan-to-value ratios that they imply for low capitalization rate deals, almost every acquisition made in New York City in the past five to 10 years has a loan which was underwritten to a maximum size based on the ratio of available cash flow to the cost of the debt. The low leverage points make these deals appear to be conservative, but they are actually very aggressive on current cash-flow underwriting standards.”

 

The moral of the story is that asset prices are high, abnormally so, but so is the cost of acquisition and construction.  As interest rates rise, deals that seemed “normal” three or four years ago based upon cash flow coverage of debt may no longer work at higher interest rates.  And the same logic that suggests that there is trouble brewing in the commercial real estate sector also applies to leveraged loans and collateralized loan obligations or “CLOs.”

 

One of the most interesting and frightening aspects of the great normalization is the way in which the earlier machinations of the FOMC, which were supposed to help the economy, have now become a gale force headwind in terms of both liquidity and credit.  Rising interest rates, for example, are pushing many obligors over their debt covenants with lenders.

 

Meanwhile, regulators are downgrading these cash flow stressed exposures, making lenders far less inclined to roll the credit.  And tenants are pushing back on sky high rents, further hurting the cash flow and ultimate viability of new projects.  The collective effect is a reduction in liquidity that will result in higher defaults in commercial real estate.

 

As the market for luxury multifamily properties in New York and other major metros around the US rolls over, look for sponsors to seek renegotiated terms on loans, a dangerous strategy that can get the credit flagged by auditors and regulators.  But a more likely outcome is that lenders will refuse to renew these credits, notes Dansker, “forcing the issue into the arms of borrowers.”  He concludes:

 

“Whatever course of action is chosen, it seems we are poised to see a rise in transaction volume in the coming year. Investors should be ready to transact either with banks or with owners opting to sell instead of recapitalizing their holdings.”

 

 

 

 

 

 

 

 

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