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Last month I asked when it would be safe to go back in the water. The capital markets had shut down during July and August as bond investors went on strike after the subprime meltdown. Market watchers, including myself, had expected that September’s extensive pipeline of CMBS issuances would provide us some sense of how long the credit crisis would last.September has come and gone but the crisis has not disappeared. Recent trends, however, indicate that the market has begun to settle down. The Fed helped by lowering the Fed Funds rate by 50 basis points to 4.75%. Minutes from the Fed meeting indicate that the Board of Governors has shifted its focus from keeping inflation in check to avoiding a capital markets collapse. The stock market rallied on news of the rate cut and continued to climb as various financial services companies announced their third-quarter earnings. The earnings reports disclosed significant write downs, which investors chose to interpret in the best possible light. Citigroup, for instance, reported $5.9 billion in credit and trading losses, causing its third-quarter profit to plunge 60%. As more financial services firms disclosed the fall out of the credit crunch, investors declared that the worst must be over and that earnings would recover in the fourth quarter. The Dow Jones Industrial Average and S&P 500 Index soared to record territory by the beginning of October.The stock market gains left many of us in the trenches scratching our heads. It sure doesn’t feel as if the crisis is over. Uncertainty continues to characterize the CMBS market, while the CDO market remains shut down. Many commercial real estate transactions have fallen out of bed and transaction volume has slowed.Despite the recent run up, the stock market remains fragile. Wells Fargo, one of the most disciplined financial services companies in the country, reported record earnings for the third quarter. However, its rate of earnings growth was the lowest in several quarters, it showed increased losses in its residential mortgage portfolio and it missed the Street’s earnings estimates by $.01 per share. Wells Fargo’s stock immediately sold off by 4% and sent the Dow Jones temporarily plunging by more than 200 points before recovering somewhat by the end of the day. Two weeks earlier Citigroup’s third-quarter profit declined by 60% but its stock rose 3%. Go figure.The stock market’s volatility indicates how much uncertainty remains in the market. The Los Angeles Times reported this week that home sales in Southern California dropped by nearly 50% during September as compared with the same month last year. Southern California’s median house price remains significantly higher than Fannie Mae and Freddie Mac’s investment thresholds. Most home loans in the Los Angeles area therefore fall into the jumbo loan category. The credit crunch disrupted the jumbo loan market during the summer. Consequently, the huge decline in sales may reflect a temporary problem. Nevertheless, the nation has clearly fallen into a housing slump. Nationwide housing starts declined by more than 10% last month. The deepening residential slump threatens the economy by increasing the possibility of a near-term recession. A nationwide recession would deepen the problems in the capital markets.Despite the fragility of the economy and stock market, we have recently seen signs that the capital markets may have begun to stabilize. As expected, several CMBS pools went to market in September. The benchmark senior triple-A bonds settled into the swaps plus 55 to 58 basis point range after having hit a high of 76 basis points in August. Even more encouraging, a $1.8-billion “Top” branded pool that priced two weeks ago saw its senior triple-A spreads tighten even further to 44 basis points. TOP enjoys a reputation for high quality issuances and this particular pool included recently closed loans underwritten to more conservative standards. Nevertheless, the tightening of spreads across nearly all of its bond classes bodes well for the future stability of the market.September provided other inklings of stability. Most CMBS issuers had failed to sell the intermediate bonds in their pools during the summer. Issuers would sell the triple-A bonds and the B pieces (that is, the safest and riskiest bonds) but could not clear the bonds in between. This forced investment banks to hold these intermediate bonds on their balance sheets in the hope that they could find buyers when the market improved. During September, a few investment banks began selling their inventory of intermediate bonds while new issuances sold through most of their classes. For instance, the TOP pool referenced above was oversubscribed for all of its single-A- bonds and above.More recently, the Treasury Department convened a meeting of the largest banks in the country to set up a $100-billion fund to purchase asset backed commercial paper. Bond investors have shied away from the commercial paper market because of concerns over the quality of the collateral. The new investment fund will buy commercial paper at market rates in an attempt to get this market functioning again.But not all the news is good. Many investors interpreted the Treasury Department’s actions as an admission that the markets are in worse shape than people had realized and that stabilization is further off than previously anticipated. Meanwhile, the success of the TOP pool, along with the earlier sale of bonds held in inventory, lifted the secondary CMBS bond market. Lenders subsequently flooded the market with unsold bonds. Nor did it help that Bank of America reported significant trading losses and a 32% drop in its third quarter earnings last week. At the same time, the rating agencies accelerated the downgrading of bonds backed by subprime and Alt-A residential loans.All of these events caused the CMBS market to back up late last week. A $2.7-billion CMBS pool saw its senior triple-A bonds widen to swaps plus 58 basis points. So it is one step forward and one step back.Nevertheless, the improvement in the capital markets has encouraged a few CMBS lenders to creep back into the market. CMBS spreads had topped Treasuries plus 200 basis points with little certainty of execution. Several lenders in the last couple of weeks have announced that they are back in business by issuing firm quotes with spreads in the Treasuries plus 165 to 180 range.So what does this nascent stability mean for the commercial real estate market? The answer depends partially on how the general economy holds up over the next couple of quarters. The deepening residential market slump is clearly a concern. Consumer spending drives the US economy. If consumers cut back purchases because of the housing crisis, the economy could tip into a recession. The fourth quarter retail sales should give us a strong indication of how the economy will perform in 2008. In addition, the economy remains subject to other risks. For instance, oil traded above $90 a barrel late last week because of a weakening dollar and concerns over Turkey’s threat to attack Kurds in northern Iraq. Nor has the threat of a terrorist attack on American soil disappeared. Any of these negative events could send the economy into a recession, which would delay a recovery in the capital markets.Fortunately, commercial real estate fundamentals remain strong. Vacancies and loan defaults across most product types remain low, although the residential builders are suffering. The current strength of the commercial real estate market should partially mitigate the pain if the general economy does indeed head into a recession. Furthermore, there is a lot of money sitting on the sidelines today. Some investors and lenders have decided to sit this one out, waiting for opportunities to arise or for the market to stabilize. In past recessions, such as the early 1990s, capital for real estate was in short supply. That is not the case today. Legendary real estate investor Sam Zell said the other day that we are currently experiencing a “confidence crunch” more than a credit crunch.Most observers agree that the commercial real estate markets will not completely stabilize until sometime in 2008. The markets remain fragile and transaction volume has dramatically declined. Buyers and sellers cannot seem to agree on selling prices for commercial buildings. Cheap, high leverage debt that had led to an unprecedented cap rate compression over the past five years has disappeared from the marketplace. CMBS volume, for instance, has declined by as much as 85% over the past few months. Floating rate bridge lenders have plenty of money to lend but at significantly higher spreads and on more conservative terms. As a consequence, savvy investors expect cap rates to rise by as much as 50 to 125 basis points depending upon product type and asset quality. Many sellers, on the other hand, are holding out for pre-credit crunch prices. Until sellers realize that real estate values have declined, transaction volume will remain low.So expect the market to stabilize sometime in 2008. The most pessimistic players say the market should get back to normal by Christmas; they just don’t know which year. But having gone through the early 1990s when there was little to no capital available for commercial real estate, I cannot imagine the credit slump lasting beyond late 2008, barring a severe recession. There is too much capital sitting on the sidelines waiting to jump back into real estate. The exceptions, of course, are tract housing, condos and residential land. New home sales are off significantly with some markets experiencing a serious oversupply of both condos and single-family residences. Most players believe the residential slump will last into 2009.So is it safe to go back in the water? It is still early and the recent market improvements remain fragile. Commercial real estate players and bond investors are not exactly plunging head first into the water, but at least they seem to be wading out into the surf. Scott Bottles is principal at George Smith Partners. The views expressed in this article are the author’s own.

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