Markets Confounded by Ambiguity
Markets are complex things. Chief among their virtues is that they take a world with a vast number of possible futures, and several views on the implications of those probable futures, held by market participants, and distill them into a single price. The price system in turn enables individuals, occupiers, investors, and lenders to make decisions. Markets are always dealing with uncertainty. Today, however, we see that many markets have all but ceased to function: equity market volatility is at some of the highest levels on record, high yield bond markets issuance has all but dried up in the U.S. and European markets, and private CMBS issuance has ground to a halt leaving banks with an inventory of mortgages stuck in the securitization pipeline. The situation is only marginally better in the origination markets for bank, life company, and debt fund CRE loans. This has happened not because the current crisis presents markets, and capital market participants with uncertainty – though there is much of that, too – but because the crisis is deeply ambiguous.
An uncertain situation is when the possible outcomes and the probabilities of those outcomes are known to some level of confidence. An ambiguous situation is when neither the possible outcomes nor the probability of those outcomes is known with a degree of confidence. The world is always somewhere in between these two paradigms, but it seems clear – if anything is clear today – that we are much closer to the second world than the first, and it is terribly difficult, if not impossible, to develop conviction on pricing risk in the ambiguous world. Therefore, markets are either closed to new issuance, have had massive increases in risk premia, reduced liquidity and/or exhibited exaggerated volatility in recent weeks.
Fortunately, the situation is temporary. Events will unfold, and in so doing, they will cut down on the range of possible futures and provide data that will help us assign likelihoods; we escape from ambiguity back into uncertainty. Markets can resume function even if the outlook were to become confirmedly bleak.
In the meantime, what follows, are several indicators that we should be tracking to assess the re-opening of the CRE debt markets.
Three Indicators to Watch for Inflection in CRE Debt Markets
LIBOR-Federal Funds Rate spread. In a normally operating market, the spread between LIBOR and the federal funds rate is small, perhaps 10 basis points (bps). The difference between the two reflects liquidity conditions in the interbank lending market as well as counterparty credit risk (i.e. the credit risk in the banking system). 3-month Libor is now ~1.4% while Fed funds has been set within a band 0 to 0.25%. This reflects a combination of low liquidity in the interbank market, owing to the massive race to cash from all sectors of the economy and increased risk to bank’s capital positions from the incipient recession. Bottom line: while this spread is elevated, it is unlikely that banks will be issuing new loans to any significant extent, including to commercial real estate. Similarly, many debt funds rely on bank warehouse lines to support their lending, as this measure normalizes, we would expect to see these debt funds become more active as well on the margin.
Corporate Bond Spreads and Issuance. Spreads on corporate investment grade, and to an even greater extent high yield debt, have widened dramatically. Until last week, investment grade bond issuance was anemic, but with the announcement of the stimulus and Fed Reserve facilities that will directly purchase new and existing corporate debt, potentially in the trillions of dollars, issuers returned to market in the U.S. and spreads have begun to come in, though they remain several hundred basis points wide of pre-crisis levels. In Europe, the investment grade market has been less impacted, perhaps because the ECB had existing mandates to purchase highly rated corporate bonds through its QE programs. High yield debt markets remain under considerable stress with sky high spreads and next to zero issuance. High yield funds have received inflows in recent days, but it is too early to call an inflection point. Further normalization of the investment grade market, even if it is largely due to central banks playing the role of market maker (overriding the problem of ambiguity), should positively impact CRE debt markets in several ways. For one, it improves the likelihood that tenants will be able to limit layoffs and fulfill their contractual obligations, notably rents. Additionally, as corporate bond yields decline, CRE debt will become more attractive on a risk-adjusted basis to a range of capital providers, including banks and life insurance companies. We would also expect secondary market trading and pricing in CMBS and CLO markets to improve for higher-rated tranches. However, should high yield corporate bond markets continue to trade at distressed pricing, this would augur poorly for higher risk segments with CRE debt markets, particularly private label CMBS.
CMBS Secondary Market Spreads and Delinquencies. Similar to the corporate debt markets, private label CMBS spreads have widened sharply across risk tranches compared to pre-crisis. The stimulus package seems to have caused spreads to tighten modestly, though like corporate debt, they remain elevated, particularly for lower rated tranches. Meanwhile, the market has been closed to issuance since early March in the U.S., and any significant improvements in secondary market trading, especially combined with a successful issue, would be a reopening of the debt markets and would also predict well for revitalization of other lender capital groups. Delinquencies are near-historical lows presently, but this could change rapidly as rent payments become due. If the rise in delinquencies is limited, particularly if this lasts through May, then it would be a positive indicator that a) many tenants remain able and willing to pay their rents and/or b) fiscal and monetary stimulus measures are having their intended effects and filtering up through the capital chain to borrowers.
There are many more indicators that investors and lenders should be watching. We will continue to explore these factors and provide real-time commentary on the various lender segments.