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WHEN DEBT FREEZES OVERPeter Slatin
08 02 07
SourceLed by seismic subprime holdings, the roiling debt markets are casting a pall over the entire real estate sector. And so they should: published reports put the total number of unsold loans sitting in financial institutions' warehouses waiting to be resold at around $260 billion in the US and another $200 billion in Europe. And with investment spigots turning off across the US, that money is going to sit for a while.
In a July 30 conference call with investors, a team of Wachovia Securities research analysts in credit markets and real estate addressed the rapidly changing nature of trading in debt and property.
Yes, it's quiet out there. Too quiet.
Dan Sullivan, a Wachovia managing director who tracks fixed income securities for REITs, called the current situation "a buyers' strike. There is a complete malaise on corporate credit."
Fixed-income market strategist Richard Gordon noted that what was more surprising than the subprime meltdown itself was "how many [lenders] refused to alter their positions despite a sure bet of an increased default rate on subprime and collateral mortgages originated in 2006." Last year, noted Gordon and others on the call, saw a significant deterioration in underwriting standards. Some loans, Gordon went so far as to say, were even "fraudulently securitized and sold up into the secondary markets through CDOs." The ensuing blowback from all of this, said Gordon, "has morphed into a bigger problem in corporate credit" in general.
Today, two critical questions remain unanswered: First, how deep is the subprime problem, and how deeply will it affect the entire economy or create other credit problems? One estimate is that at least half of the risky subprime deals have yet to surface, indicating much more bad news on the way. But the second issue is of perhaps even greater concern: what are the long-term problems that could be created by the unwinding of a "massive pipeline" of existing leveraged buyout and other restructuring deals written in the last few months and predicated on pricing assumptions that no longer hold true? Many of these corporate deals were "priced aggressively or with risky structures, and it is Impossible to get these deals done now. There is no acceptance for that type of risk," Gordon declared. "The markets have shut down" as investors wait for risk to be repriced. The overhang, he said, is "billions of dollars in bridge loans" that have not yet been funded.
The result? "We have seen this drag down markets that are fundamentally very sound, especially commercial real estate and the financial sector."
Some serious risk factors have taken on elevated profiles in recent weeks, noted Wachovia's Tony Butler, a director specializing in CDO and CMBS research. From "systemic risk" – the risk that a larger percentage of assets in a given debt pool will default – to the "growing risk of implied correlation," or the spreading of risk across asset classes. Indeed, said Butler, "almost all assets are mispriced to some degree."
As a result, the credit markets are heading into what may be a sustained repricing period. The simple fact of the slow late-summer trading season, with many traders on vacation, could actually delay the kind of activity needed to eventually create a "more permanent repricing to risk that was mispriced." Indeed, said Butler, at present there is almost no lending activity – which has more to do with concern in the market that carousing at the beach. The market is "extremely illiquid, and there can be no pricing without a trade," noted Butler. "The clear message is that investors simply will not tolerate the lending standards of 2006."
One very near-term concern: the monthly marking to market by hedge fund managers of their investments. This updating of benchmarks could reveal damage in the debt markets akin to revelations in the stock market by companies such as American Home Mortgage Corp., and thus set off further panic.
Panic to some, though, is mother's milk to others. "There are real money accounts interested in buying good collateral at cheap prices," said Butler. "When those accounts start to apply capital, we will see liquidity return." Much of that money is believed to be overseas capital sitting on the sidelines waiting for the appropriate moment to jump in; clearly, that moment and the bottom it signals have not arrived. For that to happen, though, says Butler, the "forward pipeline will need to clear the market and get priced." And still, he adds, "the downturn in the credit cycle will take some years to play out."
The negative sentiment has already led to some pullback in CMBS issuance, said Butler. Already headed for a 50% slower pace than last year, he said that recent market conditions indicate issuance will slow even further. "It's difficult to make loans when you don't know where you can sell the liabilities."
Butler also pointed to increased concern on extension risk – basically, the challenges of refinancing a loan five years out if interest rates and cap rates have both changed dramatically along with real estate values. "Somebody will have to take a hit" in that scenario, Butler noted. But, he added pointedly, "I don't think it's at a crisis level."
Still, the silence is contagious as investors, traders and lenders watch to see where the next shoe will drop – or who will have the nerve to call a bottom and dive in and start harvesting. Or who will simply decide it's time to start counting and cutting losses. "No one likes volatility," says Dan Fasulo, director of market research at Real Capital Analytics. "Even if debt gets repriced higher, that's fine, as long as buyers know what their price is."