This week, MortgageOrb sought the perspectives of Thomas Morgan, general counsel and senior director at Tremont Realty Capital, a Boston-headquartered commercial real estate finance company. Morgan offers in-depth explanations on why federal intervention with the current market crisis may bring undesirable consequences, what should matter most during a recession, why commercial mortgage-backed securities (CMBS) instill fear right now, and more.
Q: You've argued for minimal federal involvement in asset-price regulation, even as the subprime mortgage crisis unfolds. Should the Fed adopt a similarly hands-off policy when it comes to aiding the capital markets? Was the action recently taken to rescue Bear Stearns, for example, appropriate and useful in the long run?
Morgan: The Fed's role in the Bear Stearns bailout clearly helped calm the stock market in the short term. As one of the foremost scholars of the Great Depression, Mr. Bernanke no doubt was worried about the possibility of history repeating itself. The catalyst for those devastating years was the failure of the Bank of the United States (BUS), one of the major New York commercial banks of the era. It experienced a run, and the Fed let it go.
Unfortunately, BUS had transactions with virtually every other major financial institution so its failure caused a domino effect. The 1930s hands-off policy of the Fed gave no one any confidence that there would be a backstop at any time, so investors and depositors began to all demand their money. The resulting series of bank runs created serial failures and cascaded into the death spiral we now call the Great Depression.
Perhaps Mr. Bernake felt that Bear was a bite-sized way to send a signal to the market that ‘his Fed’ would not stand by and watch the meltdown of the U.S. – and perhaps the world's – financial market.
Nonetheless, I'm concerned about the implications of substituting taxpayer dollars for equity capital in these situations. The fact that the Fed stepped in to pledge taxpayer support now gives Congress a valid claim that it therefore needs to protect taxpayer dollars with new and more aggressive regulation. To me, this heads us down a slippery slope towards greater regulation in general.
The current debate over a proposed expanded role for the Fed, an overhaul of our capital markets regulatory scheme, and new regulation designed to ‘fix’ the current capital crisis really comes down to those who believe in active governmental involvement in capital markets versus more free-market adherents.
While free-market solutions are far from perfect, I would still argue that any solution arrived at by free-market economics is going to be better than a governmental regulatory response, particularly during the current election campaign where the importance of politics over economics is more elevated than usual.
The last thing we need is a new Sarbanes-Oxley style piece of regulation that ends up costing us in the long run.
Q: A recent Fitch report found that despite concerns to the contrary, CMBS refinances were nearly universally successful since the beginning of the credit crunch. Can we expect this trend to continue? Should refinances remain a major concern?
Morgan: The results are not too surprising when you consider that all of current refinancing is on paper that was written 10 years ago under more conservative underwriting standards and when aggregate asset values were a fraction of what they are today.
But it is important to note that these refinancings are being done with life companies and other portfolio lenders, and generally not with new CMBS issues. The data we have seen show that new CMBS transactions since the credit meltdown are off 80%.
So far in 2008, there have been no successful securitizations, and our contacts on the street say CMBS is essentially closed right now. CMBS shops are laying off folks and they do not expect that market to come back for many more months, perhaps not until well into 2009. So without this major source of capital, refinancings are going to be a huge problem.
The remaining first mortgage sources: banks, savings and loans firms, and life companies cannot fill the void, and will likely only do the best credit loans. We expect new private lenders to come in at wider margins to take advantage of this opportunity.
A secondary issue is, what is going to happen to CMBS refinancing in 2016 when the 10-year paper that went out in 2006 comes due? You have underlying mortgages based on inflated values (both from an historical cap rate perspective and a lax underwriting perspective), written on an interest-only basis with no amortization, and all pushing the envelope on leverage levels.
If rates remain low during the next five years or so, you'll also have a situation where the costs of defeasance will be prohibitive.
The bottom line is that refinancing that product is going to take some creativity, and more than likely demand significant capital contributions at the mezz and equity level in order to qualify for refinance.
Q: The popular question has gone from ‘Are we going to go into a recession?’ to ‘Are we in a recession yet?’ Do you think it has happened already? What is the most reliable indicator that a recession is upon us?
Morgan: We think the most recent formal data does indeed show we are experiencing a recession. Former Fed Chairman Alan Greenspan certainly left no ambiguity in his remarks recently that he believes we are in a recession.
Having said that, we think the public's obsession with this question is misplaced. Does it really matter whether growth was slightly positive or slightly negative for the past two quarters? The fact is, relative to the past several years, we are clearly in a dramatically slower period where our economy on the whole is flat and some segments, like real estate, are really hurting.
Call it whatever you want, but our current economic situation translates to different strategies for both business and individuals. Focusing less on the word ‘recession’ and more on the key indicators is the right approach. The three indicators that we worry about are employment, inflation and currency value. Employment has been holding its own, but giving some early signs of stress.
For those of us in the capital markets, the stress is very real and very close to home. Inflation is a real concern. We don't include key cost components like energy in our consumer price index measurements, and that is resulting in an effective under-reporting of inflation numbers. If household costs continue to rise, we will see very direct impacts on the economy. Our dollar value is equally troubling. While helping exports, a weak dollar for any sustained period is not in our best interest.
We'd much prefer the Fed worry more about propping up the dollar and controlling real inflation than how to protect investors at Bear Stearns.
Q: We have heard often conflicting information lately regarding the expected future performance of the commercial real estate (CRE) market. In general, do you think property fundamentals can remain as sound as they're often claimed to be, or is fallout imminent?
Morgan: A couple of key fundamental factors that certainly favor CRE maintaining value despite a weakening greater economy are cost and competition. Due to the continued high replacement cost (primarily driven by the world demand for raw materials), we think value declines will be muted since replacement cost is a key ingredient to valuing real estate.
However, competition for tenants should remain keen because CRE was generally not drunk with overbuilding (unlike our cousins in for-sale residential). We know that a supply-driven recession takes an extraordinarily long time to overcome (remember 1988-1994), verses the demand-driven recession we seem to be in.
On the other hand, there is clear evidence that there is less first mortgage debt available to CRE. Where projects could get 80% loan-to-cost (LTC), there is now only 65%.
Similarly, mezzanine capital is less available and all debt spreads have widened, although the true impact has not been felt yet due to the current low index environment. Because most real estate is valued on a capitalization rate basis, and cap rates are simply a function of the debt-equity mix, a greater percentage of equity should drive up cap rates and lower CRE values. This academic analysis is in direct conflict with the previously discussed valuation stabilizing factors.
Our guess is that valuation changes will be mixed and driven by local circumstances. For example, in the office segment in New York City, you would expect rents and occupancy to weaken as jobs are lost. Yet landlords are not predicting a dramatic turn in occupancy numbers, despite the predicted loss of 20,000-40,000 jobs on Wall Street.
The feeling is that most of the large firms learned a lesson last time around when they reduced space dramatically only to have to get it back at much higher rates when the jobs returned a short time later. Given the dramatic growth in rents over the past couple of years, and the general feeling that the current economic downturn will not be prolonged, it seems logical that most firms will be reluctant to give up space in the short term.
Of all areas, we think retail has to have some concerns. No one is going to be surprised by a string of monthly reports showing a slowdown in consumer spending. This has got to put some pressure on the retail segment.
Q: Finally, in your opinion, have the credit markets overestimated commercial mortgage default rates (as claimed in a recent CB Richard Ellis analysis)? If so, to what degree?
Morgan: The CBRE analysis indicated that the estimate of default rates on CMBS loans might be overstated by a factor of three. But they are focusing on cumulative 10-year CMBS default rates by looking at CMBX (a set of derivatives that provides insurance against CMBS defaults).
Their issue is really whether current spreads are too wide to reflect that 10-year cumulative default rate. Clearly, CMBS has enjoyed a well-deserved reputation for extraordinarily low default rates. This reputation was won from the period 1993-2005, when solid underwriting and rating agency discipline ruled the day. That is why CBRE's analysis, over the 10-year period, is probably right.
That is a far cry from saying that the market does not have to worry about future CMBS defaults, however. This is the biggest fear of some of our Wall Street friends.
Despite a long history of solid performance, Mr. Greed showed up to the CMBS party in late 2005 and stayed until early 2007. CMBS from this vintage is, frankly, toxic. Underwriting during this period was incredibly poor with assumptions that are almost laughable.
It would not surprise us if defaults rates from this period reach as much as 10% to 20%. Losses probably will not be in that range, but defaults are easily capable of climbing there.
The only reason these default have not showed up yet is that most of these loans are still chugging along on interest reserves. Once these run out, watch out! The irony is that most issuers, in a quiet moment, will acknowledge this.
Beyond CMBS issues, there is also the dramatic increase in the use of mezzanine financing during this time. Historically, as of the summer of 2007, there had been no reported defaults on any mezz financing – ever. We were an early entrant into the mezzanine financing industry and looked on this statistic with a certain amount of pride as evidence that we know how to underwrite a deal and manage assets intelligently.
Then the mezz world fell victim to the same level of foolishness as CMBS. We saw lots of new entrants into the industry, and billions of dollars of transactions being written using mezzanine going well beyond 90% of the capital stack on assets that had little chance of ever covering to that level.
In that environment, you can imagine why more aggressive mezz providers are now scrambling as it becomes clear that the deals they did in 2006 and 2007 will never cover. We would expect defaults on this debt to increase dramatically as well.
Hopefully, the markets will recognize and price all of this in before the chaos. Otherwise, we may start getting really bad CRE default news in 2009, just as the market is recovering. That news, if not properly understood as an anomaly, has the potential to delay any recovery.
