What is the Mortgage Derivatives Bond Situation telling us or is it just panic talking?

Implications: Are the derivative bond markets suggesting reality or is it just panic talking. When you look at the vast number of investment properties that were purchased in the last 2-3 years with securitized debt with unheard of lending criteria such as using pro-forma income & expense statements which forecasted totally unrealistic rent increases, low debt service coverage ratios, high LTV ratios, interest only, and cap rates in the low single digits, you have a recipe for disaster.

Analysis:

This writer has been saying for almost two years the day of reckoning will be upon the commercial real estate sector. The contagion of the subprime mess has certainly had a major negative affect on the commercial mortgage markets, but what the credit crunch has really done was expose how fragile those loans were and how so-called smart investors made such bad decisions in taking on aggressive loans on top of aggressive purchase prices.

The mentality that there are no down business cycles and it won’t happen to me is totally astounding. How the lenders could have let these purchases past muster is even more astonishing. Even if the buyer is not seeing the purchase with a clear eye, the lender should be the conscience of the deal. But what happened?

The what is that Wall St. having little to no commercial real estate experience took a relatively innovated mortgage finance approach and turned it into a greedy monster. The what is that until only a few short years ago there were only a small number of buyers for the securitized marketplace in the “B” piece market. The “B” piece bond holders actually dictated which other loans could be packaged into the SPV or the Bond. There were only a few of these buyers until the Hedge Funds arrived on the scene like a bad virus. This is when the securitized market went haywire. This is when the money began to flow and everyone jumped on the bandwagon. It was the beginning of the perfect storm.

However, the trouble was the greed of Wall St. and all those associated with the process that were making money. From the rating agencies which should have been the ultimate gatekeeper instead becoming the enabler, to everyone who had a little bit of cash and was able to get a loan were at fault. Investment buyers taking as gospel the commercial investment brokers telling them the fundamentals are so good the rents have no where to go but up. There was no consideration of looking at downside risk as any intelligent investor should do along with having an exit strategy other than it being to sell to the next investor. When asset prices are going up in some markets greater than 25% per year when traditionally if you get 5%-10% appreciation you are doing very well, that alone should have been a bell that went off in everyone’s head that things were out of control. When the Feds began to raise interest rates from their historical lows that too should have been the bellwether that low cap rates needed to go up not down. The Feds lowered rates in 2002 due to the 2001 recession which was created by the tech bubble collapse and 9/11. The fear the Feds had was actually deflation. That circumstance has come back as sale prices in one month alone for commercial properties has dropped 1.2%. Annualize that and now you see why the derivatives are signaling a major meltdown.

The fact that everyone had minimized the effect of the housing downturn was contributor for what is ahead. As this writer has pronounced on several occasions, you can not kill the housing market in the United States without creating a major economic downturn. The same way the upbeat housing market helped bring the Nation out of almost every recession or downturn the reverse can be said when the housing bubble burst. Smart investors should know that the faster asset prices go up the harder they are apt to fall. They should also know full well that nothing continues to go up in a straight line continually... that is called wishful thinking. I believe it is pure arrogance. What this has bred in the securitized mortgage bond markets is a vote of no confidence. No confidence in the banks, Wall St. Rating agencies, commercial real estate brokers and mortgage brokers or the investors who bought on such ridiculous terms and returns.

The reason the derivatives are indicating that there is a real chance for disaster in the offing is due to the fact that taking into account all the above, it won’t take much of an economic downturn to have those investment properties be “under water”. When you buy investment properties on very thin margins you do not have any wiggle room to deal with the slightest amount of vacancy. Just look at the economic headlines...Consumer confidence is at a two year low, durable good orders are down for the 3^rd consecutive month, home sales have never been this bad, commercial real estate prices have started their decent, NYC Mayor Bloomberg has ordered a total revised budget to anticipate a major economic down turn and this in the Number One Market in the United States if not the World. Lastly, there is to be an administration change in Washington, which traditionally paralyzes business decisions.

Wall St can usually figure a way out of their messes, however, this one will take a while. Don’t be fooled into thinking just because the Feds will lower interest rates that will be the cure all. Far from it, as the cost of money will not just be the interest rates but how lenders will now underwrite the loans. The interest rates will be high for commercial real estate as the risk effect is back in play. There will also be the dwindling availability of credit. Banks and lenders will say they have money to lend...go find one who really will. The risk aversion is too great so unless you are walking in with an almost no risk situation (which really don’t exist) don’t expect to get a loan. With no readily available financing the commercial market is bound to collapse. This why the derivatives are the crystal ball...its not panic it’s the new reality unfolding before our very eyes.