20th November CRE and Small Banks outlook
20th November 2009
Commercial Real Estate, Small Banks and Small Business
As we have discussed recently, commercial real estate (CRE) remains a concern for financial markets as a whole. With many large and small banks still holding CRE assets, including potentially explosive Commercial Mortgage Backed Securities (CMBS), the anaemic state of the real economy has the potential to depress economic recovery further.
Thoughts from the trading floor
After joining the risk-on trade, CMBS is starting to turn south, particularly for lower-rated tranches- a snap-shot of what occurred when the RMBS market collapsed in 2007. In 2009 so far, S&P has downgraded 3000 CMBS deals and new issuance is effectively zero. Of concern to the market is the potential sale of Lehman CMBSs held by the German Bundesbank. This would put a real value on the assets, which may be well below investment bank valuations.
CRE exposure is greatest amongst smaller banks. Exposure at large banks is around 18% of total assets, whereas for smaller banks, this is around 40%. With delinquency rates above 2 standard deviations from most predictive models, the potential for panic in the market is very high, especially as a large no. of investors at the small banks may not have the credit lines to “sit out the pain” of holding these assets. What this means for the real economy is that small banks, which lend to small business may continue to withhold credit. This could lead to further small business bankruptcies and increasing job-losses. The net effect on GDP could be at least a 0.6% subtraction. Full-scale panic could potentially lead to a new leg of the credit crunch.
Bull View
The bulls will look hope that the recession is starting to come to an end, which would help stem delinquency rates through a pickup in business activity. Business growth and a recovery in business expansion should help the market recover. This will also allow investors and banks to ride the pain of holding their CMBS positions. They will also cite that when most people become bearish of a market it is often the turning point.
Bear View
The bears will cite the collapse of the residential property market, and draw strong parallels with the commercial market. If economies suffer a prolonged period of contraction and delinquency rates continue to rise, we may see panic in the CMBS markets. This will be a disastrous event, and could lead to another bout of strong credit contraction. With interest rates already at historic lows, there remains little in the central banks’ armoury to deal with this.
Futex View
We will continue to monitor the situation closely. Hints of a prolonged economic contraction will signal danger, and a collapse of the commercial property and CMBS markets may lead us into a period of economic depression- as a worst case scenario. Commercial property recovery takes many years, maybe decades (take the Japanese example- commercial property prices are still at 45% to their early 1990s peak). In this event we are particularly bearish of Blackstone Capital, as they have major holding of CRE, especially as they went on a buying binge just prior to the Lehman Brothers collapse. We site HSBC, who exited major real estate positions just prior to the global collapse and stated their fears to the market, to be particularly savvy in CRE markets. Recently we have seen them sell their major holdings and re-iterate their fears.
