SERIOUS MONEY:ALBERT EINSTEIN published the general theory of relativity in 1915. His geometric theory of gravitation points towards the existence of black holes – regions of space in which space and time are distorted in such a way that nothing, not even light, can escape – as an end-state for massive stars.
In the world of finance, banks have proved particularly adept at locating black holes in which to sink shareholders’ funds, and “bricks and mortar” has emerged through the centuries as a favourite end-state in which investor wealth has disappeared.
The recent boom and bust in real estate worldwide has proved not to be an historical anomaly in terms of the wealth destroyed by bankers. But the growth of structured finance enabled naive banks to erase their capital in new ways.
The traditional banking community sold their less-than-stellar mortgages to investment banks, and repurchased the repackaged loans via highly rated securities that were subject to lower capital requirements. The game continued apace as property prices moved higher but, once the capital gains stalled and losses mounted, it became clear the financial alchemy was a mirage – it seems a silk purse cannot be made out of a sow’s ear. Exposure to subprime mortgages proved to be the weakest link in the world of structured finance, but it would be foolish to think that the excesses created by the combination of easy money and investors’ hunt for yield were confined to residential property. Indeed, the chronology of developments in residential property during the asset-price bubble was paralleled in commercial real estate, albeit with a lag.
Cheap money increased borrowers’ capacity to service debt, while investors’ thirst for yield increased the demand for evermore esoteric products. Lenders were happy to oblige to boost income in the face of a flat yield curve or a negligible spread between short- and long-term interest rates that placed significant pressure on net interest margins.
Not surprisingly, new issuance of commercial mortgage-backed securities (CMBS) soared and reached $240 billion (€178 billion) in 2006, a greater than fourfold increase in just five years.
Meanwhile, larger institutions and less-regulated participants came to dominate the market for home mortgages during the boom in residential real estate, which served to increase the willingness of small-to-mid-sized banks to authorise commercial property loans. Predictably, the banking sector’s outstanding commercial property loan book exhibited rapid growth, increasing almost 60 per cent in the four years to end-2008.
Disturbingly, mid-sized banks’ exposure to commercial real estate reached dangerous levels and, at almost one-third of total assets and 4.5 times Tier 1 capital, the loan concentration is now more than double the levels of large-sized institutions.
Increased exposure to commercial real estate was accompanied by a decline in asset quality. Loans to the highest-quality borrowers were increasingly originated by the larger banks for subsequent distribution to the CMBS market. The relatively smaller mid-sized banks lacked the resources to satisfy the needs of these customers and were thus unable to capture the most secure commercial real estate investments. This trend, combined with rapid growth in their commercial property loan books, meant mid-sized banks became increasingly exposed to a riskier set of commercial real estate loans.
Asset quality suffered as investors’ insatiable appetite for high-yielding CMBS products permitted the aggressive use of leverage, and pushed collateral values to fanciful levels. Loan-to-value ratios climbed higher and surpassed 100 per cent in early-2008, debt to net cash flow soared to almost 13 times – a 60 per cent increase on the previous peak in the late-1990s, and interest coverage dropped below 1.3 times.
The aggressive use of leverage also became apparent in the CMBS space. The share of loans with full or partial interest-only loan terms jumped from below 10 per cent in the late-1990s to more than 85 per cent of the loans consummated during 2007, and the percentage of deals with subordinate debt in place at origination or with the ability to add debt over time also reached record levels.
The overbought and overleveraged commercial real estate market was ripe for a fall and duly obliged as the economy transitioned from slowdown to deep recession. Values have dropped more than 40 per cent from their peak and remain under pressure. The increased vacancy rates and the resulting downward influence on rents, which have dropped 40 per cent for office space and 33 per cent for retail space, means prices are unlikely to turn higher anytime soon.
The commercial real estate “black hole” is of grave concern to America’s mid-sized banks, which managed to sidestep the worst of the fall-out in residential mortgages. Roughly $650 billion in commercial property bank loans and some $400 billion in the CMBS space will mature in the next four years; refinancing will be difficult. Troubles in the banking sector are far from over.
