I’ve been offline for a bit. An amalgam of writer’s block caused by the enormity of the Coronavirus mess – what can be said that’s useful – and the consequence of being wildly busy as everyone across financial markets tries to pivot to the new reality. Unburdened by any knowledge of science, medicine or epidemiology, I have been marinating in the output of such intellectually distinguished journals as The Sun, The Daily Beast, The Onion, The Mirror, The New York Post and Drudge on the daily ups and downs of our plague, its cost in blood and treasure and the disruption it has caused across all aspects of our life. Consequently, I have opinions but I’ve concluded they’re pretty damn worthless. We’re in uncharted waters, akin to those bits on a medieval map where the cartographers had no clue and wrote: “Here be Dragons.”
How fast has our world changed? Go back and read my January 2020 Outlook to enjoy a little schadenfreude; dear God, do I look dumb in hindsight. (Although I did mutter something about it all being subject to black swans … which, of course, I didn’t think would happen. Ha!)
So I won’t bloviate about how all this plays out and instead will offer a report from the trenches (or tranches). But, because I can’t help myself – two observations: The economy is going to take a long time to recover. The first month after the “all safe” is sounded won’t look like the last month before the Chinese said “Pardon folks, we might have a small problem here.” It will be a long time before we see another month like January 2020.
Second, we may finally see the inflation whose absence has caused a considerable amount of head scratching among the great and good this past decade. The Great Recession ballooned the Fed’s balance sheet to more than $4 trillion. Inflation moved up nary a tick. Well, so if that didn’t do it, maybe a $10 trillion balance sheet will. Will you give me $12 trillion? It’s hard to see how all that debt that exists now and is about to be added, to both public and private balance sheets, can be dealt with through taxation (of the top 1% only, of course), savings, profitability and renewed growth. So real, meaningful inflation will slouch back into Bethlehem, because it has to. Through a combination of the sort of inadvertence that got Britain its empire and intentional policy prescriptions, both overt and covert, we’re going to inflate our way out of this mess. Good to hold assets, bad to hold a job or be a saver.
When these observations become realized wisdom, they will inform the path of how our markets adjust and what the CRE finance marketplace will look like for probably 18 months or more. More on that later.
Most borrowers made the scheduled monthly April payment. Word from both the multifamily space and the SFR space is that most folks paid rent for March. Consensus is that ends in May and that rent, both personal and commercial, and consequently debt service, will be deeply impaired starting with the payment due during the first two weeks of May. And that’s going to go on for a while.
How’s the industry responding? The commercial multifamily debt markets are getting ready to embrace forbearance, at least for a relatively short period of time. With the GSEs having already put a stake in the ground around 180-day forbearance (with a right to request another 180 days under the CARES Act) it’s hard to think about almost anything else to do. So grudgingly or enthusiastically, CRE capital market participants, banks, life companies and other lenders will generally reach agreements with their borrower for forbearance in the short term. We’ve already seen hundreds and hundreds of pre-negotiation agreements to set the stage for conversations between lenders and borrowers and that will become one of the most popular and common legal documents in America over the next month or two. (Practice point: if you are a lender and you don’t have one ….get one).
Forbearance makes a lot of sense right now for a bunch of reasons, but has one horrible, glaring weakness. First, the case for doing so. It’s sort of in the national interest isn’t it? Is this really a time to get punctilious about contractual language and begin the aggressive enforcement of loan documents? I don’t think so. First, if you’re a lender do you think you’re going to succeed? Courts are closed and God knows when they will reopen. The public narrative is that “We’re all in this together” and you’ll be about as popular as a dry cough in a crowded room if you are perceived as taking advantage of a crisis by aggressively enforcing loan documents. Courts will not be sympathetic, and we know what happens when the courts are emotionally inclined to be in the borrower’s corner. If you want to see bad law created by bad facts, have at it, because that’s what’s going to happen here.
Bad facts will be temporary, bad law will be with us forever.
Second there’s not really a need to hurry, is there? In a typical downturn, assets continue to fall in value as a contacting economy drives values down. Here the damage was largely done on day one. Closed is closed. There’s just not much upside in acting quickly.
Third, defaulting borrowers will just accelerate the vicious cycle of fire sales leading to fire sales, leading to lower asset values. Under GAAP, the balance sheets of lenders and investors will be savaged by these marks, and internal marks on the loan book will infect all other asset classes leading to a cycle of deflation in the value of all assets and the need to further dispose assets at fire sale prices. Round and round we go. That’s a self-inflicted wound. A circular firing squad. We’ve done it before. It was fun then, right? Ready for more fun now?
One can take the position now that forbearance is not a troubled debt restructuring and it’s not. Recently, Federal Regulators, the Financial Account Standard Board and even Congress gave lenders a chance to avoid triggering a troubled debt restructuring designation, and all that entails, in light of the current crisis. Under Section 4013 of the CARES Act, Congress provided that any modification of a loan related to COVID-19 between March 1, 2020 and the earlier of either December 31, 2020 or the 60th day after the end of the National Emergency, would not be seen as troubled debt restructuring. Following suit, the Comptroller of the Currency, the Federal Reserve, the Consumer Financial Protection Bureau, the Federal Deposit Insurance Corporation and the National Credit Union Administration banded together to grant relief to short term modifications related to COVID-19 not covered by the CARES Act.
That’s incredibly good as it will cushion the impact of addressing the virus’ impact on the loan book and maybe it’s one of the more consequential things the government has done recently.
We’re also of the view that a properly structured forbearance does not constitute a “modification.” An asset becoming a modified asset often has significant negative knock-on effects triggering appraisals, appraisal reductions, termination of advancing, change of control and a number of other chaotic changes to the pattern of contractual relationships in CMBS and the CRE CLO space writ large. A shambolic reconfiguration of contractual rights in order to do something that’s fundamentally a bad idea is, in fact, a working definition of insanity.
TALF is going to be helpful. It’s not as good looking as it thinks it is and it’s flawed in comparison to the 2008 version. For CRE, only legacy conduit securitizations count as SASB, CRE CLO and new issue conduit were scoped out. The jury is out as to whether SFR counts or not, but it’s a reasonable ask and hopefully the powers that be will allow SFR assets to be included.
As I said, it’s flawed. It is a one shot deal by the way, with the TALF lending program expiring at the end of September 2020. That does not leave us a lot of time since billions of dollars of money to invest in a new strategy won’t get assembled overnight. Moreover, if they would only allow SASB into the sheltering arms of TALF, we could actually get things done and get many deals teed up before September 2020. Even if they repent their irrational hostility to CRE securitization and decide to let newly issued conduit in, we won’t see much, as the traditional conduit lenders empty out the cupboard of paper originated before this began, and that will be a good chance lost. Note for those who really embrace anxiety and have nothing better to do at 3 a.m., the eligible borrower definition in the new TALF term sheet is broken as it appears to scope out all fund vehicles. We think that’s a drafting error and our trade organizations are right now pressing for clarity, and we expect to get it, but a relief program which is designed to be unavailable to the only investable dollars is, like Catch 22 when you could only see Major Major when he wasn’t in. It doesn’t need to just get fixed, it needs to get fixed soonest.
But we expect the eligible borrower thing to get fixed and then the program will help, it should do what its intended to do, which is bring in pricing, first in the legacy market and then in a positive knock-on effect to the new issue market. The way I think of it is, if $10 billion is raised to buy legacy CMBS, AAAs with a 15% haircut, that’s effectively the same thing as $80 billion of new buying capacity. As a thought exercise, just imagine if the Chinese (bearing dollars again) came back and said they wanted to buy $80 billion of CMBS. Positive impact on pricing? Sure enough. It might actually be enough to reopen the capital markets for some type of transactional activity in the near term.
The other program worth mentioning is the new Paycheck Protection Program (PPP) from the U.S. Small Business Administration – a program so popular, it seems to have already run out of funding. However, when it returns (for it does seem a question of when and not if), for those who qualify, this is virtually free money. Interest rates are low, fees are low, documentation to get into the program is low, and funds used for qualified expenditures don’t have to be paid back. It’s non-recourse and unsecured. It just doesn’t get better than that.
It’s been said that PPP documentation and obligations might violate certain foundational principles of structured finance. But really, free money? Let’s find a way to facilitate the borrowers’ access to the program. It’s going to be helpful for all borrowers but super helpful for the hospitality industry where it’s already been interpreted to allow hotel operators to draw funds even when employees are technically employed by the related management company.
Can I say it again? Free money (except for all us taxpayers who will ultimately have to pay it back, but we’ll deal with that later, see my comment about inflation above).
I’m also watching the rating agencies. What are they going to do? May they take the position, which I’m beginning to hear the appraisal industry is taking, that the proper way to look at the commercial real estate assets is on a stabilized basis with a haircut for short term interruption? Recently, KBRA fired a warning shot over the CRE CLO’s bow regarding the impact of the downturn on future funding. Is this a harbinger of things to come? Do we really need a round of aggressive downgrades? They are hardly necessary to alert investors that there’s a virus out there and bad stuff has happened. Obviously downgrades are not good for investors or the market place, but they’re particularly not good to the extent that bonds drop out of the top two highest rating classes, or if bonds cross the investment grade meniscus, both of which have significant implications for the ability of certain investors to hold bonds and could result in bond dumping in the market place. That by itself could offset all the positive benefits of TALF, PPP and the other fiscal goodies and keep markets closed longer.
Remember that my take on this is that forbearance is largely good but has one deep and troublesome flaw. Forbearance will only last for the short term and the problem will not be short term. One of the lessons from the Great Recession is that extend and pretend, actually sort of worked. But it requires deep pockets. If you managed to hold on to assets through the trough and enjoy the upside of the other end of our now increasingly bathtub looking recession and didn’t have to monetize your losses, then things look pretty good. But that strategy will not be universally available. When failure to pay continues and economic conditions do not right themselves rapidly, there will be enormous pressure to exercise remedies. That’s what the contracts the servicers, lenders and investors signed said should be done. In some cases, enforcement will begin even though the business folks know in their heart of hearts that it won’t lead to a good outcome. You can get fired for bad process.
So, forbearance as a strategy will begin to wobble and ultimately fail sometime in the days beyond the 90th day that’s the currently fashionable forbearance period. The market will simply have to deal with it. The political cost, writ large of actually enforcing remedies will diminish and it will be increasingly clear that this is a relatively long trudge back to January 2020. So for those special servicers who are a tad pouty that they may not get resolution fees out of the forbearance process, don’t worry at all. Regrettably, you’ll get a second bite of that apple.
But don’t worry, inflation is on the way and inflation will do what it does best and make repaying debt easier. As the market grows accustomed to the dual realities of the duration of this downturn and the recognition that inflation is finally arriving, it will change behavior on both the buy and the sell side. Grab a low fixed rate loan and wait for the tsunami? Give a fixed rate loan and worry about the deterioration of the value of the asset because of inflation? Hang on and pay with cheaper dollars?
These are thoughts that we haven’t thought for as much as a decade and we’ll have to get used to thinking again.
We are so blessed to have this much fun, right?