April 25, 2021
by Steve Stofka
They’re at it again. Thirteen years ago, the financial crisis originated in RMBS, residential mortgage-backed securities. Now banks and investment companies have been packaging CMBS, mortgage-backed loans on office and retail space, not residential, properties. Most of these loans are backed by or facilitated by the Small Business Administration and other government agencies. Who will pick up the tab when some of these loans default because of the pandemic? The same people who picked up the tab for the financial crisis – taxpayers. Even if the direct cost of bailouts is repaid, the loss of economic output and incomes is a crushing blow to many Americans.
Next month, the Federal Reserve will release its semiannual Financial Stability Report a comprehensive examination of the assets and lending of America’s financial institutions. Their last report in November 2020 was based on nine months of data, six months after Covid restrictions began. Concerning the Fed were several trends that were far above their long-term averages.
High yield bonds and investment grade quality bonds were almost double long-term trend averages (Fed, 2020, p. 17). High-yield bonds are issued by companies with low credit quality. Well established companies with good credit issue bonds rated investment grade. These are attractive to pension funds and life insurance companies who need stability to meet their future obligations to policy holders. Many companies took advantage of low interest rates during the Covid crisis. 60% of bank officers reported relaxing their lending standards; that same practice preceded the financial crisis in 2008. Will we eventually learn that commercial property evaluations were overvalued, just as house prices were generously valued before the financial crisis?
Many commercial mortgages are backed by commercial real estate (CRE) and packaged into CMBS, commercial mortgage-backed securities. The Fed noted that “highly rated securities can be produced from a pool of lower-rated underlying assets” (p. 51). This was the same problem with residential mortgages. CMBS are riskier than residential mortgages and delinquencies on these loans have spiked (p. 27). The Fed devoted most of their TALF (below) program in 2020 to CMBS (p. 16).
Before the election last year, more than 70% of those surveyed by the Fed listed “political uncertainty” as their #1 concern (p. 68). 67% listed corporate defaults, particularly small to medium sized businesses. Respondents were from a wide range of America, from banking to academia. Only 18% of respondents were concerned about CMBS default. Simon Property Group (Ticker: SPG), the largest commercial real estate trust in the U.S. fell by almost 50% last spring. Although it has recovered since then, its stock price is still 20% below pre-pandemic levels.
Who thinks that the market for commercial space, retail and office, will return to pre-pandemic levels? Vacancy rates have improved, but even hot markets like Denver have a 17% direct vacancy rate (Ryan, 2021), near the 18% vacancy rate during the financial crisis, and far above the 14% during a healthy economy. 25% of space in Houston, Dallas and parts of the NY Metro area is vacant.
The stock market is convinced that the economy will come roaring back. In total, investors may be right but I think there will be some painful adjustments in the next year or two. The Covid crisis has diverted the habits of people and companies into new channels, and the market has not priced in that semi-permanent diversion. I would rather not wake up to another morning like that one in September 2008 when we learned that the global financial world was on the brink of disaster. I hope that the Fed report released in a few weeks will show a decrease in some of these troubled areas.
TALF – Term Asset Backed Securities Loan Facility
Federal Reserve System (Fed). (2020 November). Financial Stability Report. Retrieved from https://www.federalreserve.gov/publications/files/financial-stability-report-20201109.pdf. (Page numbers cited in the text are the PDF page numbering, six pages greater than the page numbers in the report).
Ryan, P. (2021, April 20). United States Office Outlook – Q1 2021, JLL Research. Retrieved April 24, 2021, from https://www.us.jll.com/en/trends-and-insights/research/office-market-statistics-trends