Free Falling

Ok, I admit that was weak. But in this market one has to look for humor wherever one can find it. I spent two of the past four weeks in Manhattan talking to a variety of capital providers. Needless to say, the mood on Wall Street is gloomy at best.

The new year began with a certain cautious optimism. Many market players including myself had hoped that as the supply of new CMBS issuance dwindled, the supply/demand dynamic would reverse. During late 2007, there were more bonds for sale than buyers. Given the fall off in CMBS production, we had hoped that at some point during early 2008, there would be more buyers than bonds.

Unfortunately, this scenario has not played out. No new CMBS pools went to market during January, making it the first month in 18 years without new issuance. In the absence of new securities, trades in the secondary market constitute the only actual transactional volume.

Senior AAA spreads began the year at Swaps + 88 bps. By early February, spreads had reached the breathtaking range of 225 bps over Swaps, well in excess of the all time high.

Into this mess, Morgan Stanley and Bear Stearns stepped up and priced a $1.2-billion TOP pool. But it did not help that Wells Fargo pulled out of this TOP securitization citing unrealistic spreads in the market. Some had hoped that the TOP pool of new mortgages underwritten to more conservative standards would fair better than bonds trading in the secondary market. But insiders have told me that the quality of the mortgages fell somewhere in between the old and new underwriting standards.

The market rallied briefly the week of Feb. 18 with Senior AAA spreads coming in about 25 bps. But that proved a false rally as spreads blew out again in late February and early March. It appears that some investors and issuers sold bonds to raise capital and dress their balance sheets for the end of the quarter.

Spreads rallied somewhat later in the week when the Fed announced that it would pump more liquidity into the market. But the Fed's actions, while welcome, did not address the core of the liquidity crisis. The rest of the week saw a cascade of bad news starting with a Carlyle Group bond fund defaulting on its credit lines and ending with the spectacular collapse of Bear Sterns over the weekend of March 15.

Misery loves company and CMBS is not alone as the rest of the capital markets are in disarray. Spreads have widened across the capital markets including asset-backed securities, corporate bonds and residential mortgages. Concern over the health of bond insurers has whipsawed the stock market while the muni fund market has melted down.

All of this indicates that bond buyers remain on the sidelines. One investment banker told me that real estate in particular is now a dirty word because of expectations that commercial real estate will go the way of residential. Various analysts have estimated that commercial real estate values will drop 20% over the near future. And indeed, cap rates have risen 50 bps on average since the meltdown began. At the same time transaction volume is off 69% from April of last year.

Nevertheless, the current capital markets crisis began at a time when commercial real estate fundamentals were strong. The current .38% default rate for CMBS remains near an all-time low. Market pundits expect CMBS defaults to rise over the near term as a weaker economy hurts commercial fundamentals. The most pessimistic forecasts predict defaults will rise to between 1% to 2% over the next year, in line with other historical down cycles. But the current spreads for CMBS make sense only if default rates rise closer to 8%.

It is hard for me to conceive of a scenario where defaults would reach a level four times the default rate of the early 1990s notwithstanding rising cap rates. The 1990s recession began with significant vacancy in virtually all product types throughout the major US markets. During the go-go days of the 1980s, the market was awash in capital. Banks and equity sources continued to lend money for new construction in the face of double-digit vacancy rates. Once the downturn hit, lenders began experiencing losses as vacancy and default rates rose. Government regulators hit the panic button and made it difficult if not impossible for banks and S&Ls to lend.

Today's situation feels very different. Commercial real estate fundamentals remain strong. Although expected to weaken with the economy, commercial real estate defaults should rise only moderately. Some remain concerned about the ability of property owners to refinance pending debt maturities. Indeed, properties purchased with high leverage over the past two years will suffer. But most fixed-rate CMBS loans originated over the past five to 10 years have experienced both amortization and rising rents. As a consequence, these properties are not overly leveraged and should qualify under today's more stringent underwriting. Furthermore, Libor has dropped from 5.7% to 3.1% over the past six months which will ease the pain for many floating rate borrowers.

Ironically, the savior of today's capital market debacle is likely to be the capital markets themselves. The market has always operated on the basis of fear and greed. Wall Street traders tell me that investors agree that bonds look attractive today but that no one wants to be the first one to jump into the market.

Nevertheless, capital seeks a vacuum. Life companies and banks do not have the balance sheets or appetite to fill the hole left by the shutdown of the CMBS market. Yet there are signs that significant liquidity is sitting on the sidelines waiting to take advantage of the ridiculously wide spreads. Rumor has it that opportunity funds have raised upwards of $30 billion to purchase debt securities while fixed-income shops such as PIMCO and TCW have started eying CMBS opportunities.

I would guess that a few things have to happen before the market rebounds. First, banks need to take further write downs to cleanse their books. Second, we need a couple of quarters of continued performance to show the market that commercial real estate has not fallen off a cliff.

The Fed's actions over the past few weeks provide a glimpse of hope. The market had turned against Bear Sterns as customers withdrew cash and fellow banks stopped lending to the company. The Fed arranged an emergency loan to the company through JP Morgan. By Sunday, Bear was effectively bankrupt as evidenced by its agreement to sell itself to Morgan for the bargain price of $2 per share. Even then, JP Morgan only agreed to the purchase because of the Fed's guaranties of certain Bear liabilities. Even more important, the Fed took the unprecedented action of providing liquidity to primary dealers (consisting mostly of investment banks) by accepting a wide range of mortgage collateral in exchange for treasuries. The Fed has pledged $200 billion to this Term Securities Lending Facility.

The Monday following the Bear Sterns collapse was volatile, to say the least. The Dow Jones Industrial Average sold off before recovering later in the day. But much of the recovery was attributed to a rise in JP Morgan's stock price as the street felt that the bank had bought Bear at a bargain price. But the wider market, and financial stocks in particular, sold off. More troubling, rumors circulated that Lehman Brothers might fail. At one point during the day, Lehman's stock had fallen 48%.

On March 18, Lehman announced that it had earned 81 cents per share for the first quarter versus analyst estimates of 72 cents. Goldman Sachs also reported better than estimated earnings shortly before the Fed cut the discount rate by another ¾%. The Dow Jones soared by 420 points as it became clear that Lehman would not collapse. Financial stocks in general rose 8% while Lehman rose 46%.

The Fed's actions indicate that it is willing to pull out the stops to address the current liquidity crisis. Lehman's and Goldman's earnings indicate that the large financial services companies are unlikely to fail. Furthermore, Morgan Stanley and Citigroup have separately issued reports stating that fixed income looks cheap. Neither report was bullish, but the tone indicates that they are less bearish. It is too early to call a bottom but this is the first indication of a possible change in attitude.

In the meantime, deals are still getting done. CMBS may be moribund for the moment, but life companies, commercial banks and credit companies continue to close loans onto their balance sheets. Portfolio lenders have become more conservative in their underwriting standards but actively seek to put out debt. Having said this, lenders have become selective.

Finally, a few brave institutions have stepped up to buy whatever bonds come to market. I spoke to one experienced real estate lender that has been actively buying CMBS paper over the past few months. He sees the current prices of bonds as a once in a lifetime opportunity. He will happily hold the bonds in inventory and suffer the mark to market because he knows that long term, spreads will tighten and the value of the bonds will rise. His biggest fear is that the market will stabilize before he has used up his liquidity. So who is right, the short sellers that know nothing about real estate or the long-time real estate lender that has seen several cycles? I know whom I am betting on. Scott Bottles is principal at George Smith Partners. The views expressed in this article are the author's own.