Serious Money:The panic that gripped financial markets during the summer has returned with a vengeance and the positive sentiment that surfaced following the Federal Reserve's first reduction in official interest rates just weeks ago has disappeared as the magnitude of losses arising from the subprime meltdown continue to be revised upwards, writes Charlie Fell.
Exposure to subprime mortgages has proved to be the weakest link in the world of structured finance, but it would be naive to think that the excesses created by the combination of easy money and investors' hunt for yield have been confined to residential property.
Investors should cast a glance towards commercial real estate, where a subprime sequel could well arise in 2008.
The chronology of developments in residential property in recent years has been paralleled in commercial real estate, albeit with a time 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) exceeded $200 billion (€136 billion) in 2006, a fourfold increase since 2001.
The surge in new supply was accompanied by a disturbing deterioration in transaction quality. The unprecedented demand for higher-yielding products saw capitalisation rates decline by roughly three percentage points to their low earlier this year versus 2001. As the bull market progressed, the inflation of asset prices became increasingly artificial.
Meanwhile, deal leverage rose to unprecedented levels. Loan-to-value ratios surpassed 100 per cent earlier this year, while debt to net cash flow soared to almost 13 times, a 60 per cent increase on the previous market peak in the late 1990s. Consequently, interest coverage dropped to below 1.3 times as euphoria reached fever pitch earlier this year.
The statistics provided so far are significant cause for concern but, unfortunately, it gets worse. The share of loans with full or partial interest-only terms doubled over the past three years to more than 80 per cent on transactions consummated during the first half of the year. 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 excessive leverage is disturbing.
The perennial optimists point to the fact that the underlying fundamentals of present and prospective property lessees remain strong, but more astute analysts will be aware that subprime problems surfaced as the unemployment rate hovered close to cyclical lows while consumer confidence was high.
Furthermore, the capital appreciation of commercial property prices is slowing as is the increase in rents, while corporate profits appear on the verge of a downturn.
Deterioration in corporate fundamentals combined with inflated asset prices and high leverage mean it would not take a significant increase in delinquencies to wipe out the lower tranches in recent CMBS transactions.
The capital markets no longer believe the opinions emanating from the blue-sky optimists. The spreads on BBB-rated tranches have jumped by 500 basis points since the credit crisis began, with a two percentage point increase in October alone and are rapidly approaching 7 per cent.
The optimists like to draw comparisons with the sharp but short crisis of 1998 following the Russian debt default and subsequent collapse of Long Term Capital Management. Such comparisons look null and void as the current turmoil has proved more extended and the surge in CMBS spreads is roughly double that of the previous episode.
The credit crisis rolls on and commercial real estate could soon emerge as the subprime sequel. A recession seems inevitable, despite the best efforts of the Fed.
Indeed, the losses arising from the residential mortgage mess already announced will restrict the lending capacity of America's major financial sector, which will lessen even more as the cumulative damage of Greenspan's easy money policies becomes apparent.
The highly-paid experts will soon declare that they told you so - they didn't and shouldn't be let off the hook. The US economy is headed for a downturn and interest rates will go far lower than most so-called experts currently believe.
