Retest of March lows seems unlikely
Posted
Oct 07 2009, 09:23 PM
by
Vad Yazvinski
Rating:
“Whenever you find yourself on the side of the majority, it is time to pause and reflect” -- Mark Twain
One of the main arguments "perma-bears" used in justifying why the recent stock rally is (and was) destined to fail miserably, has certainly been a widespread expectation of an upcoming collapse in the commercial real estate market.
Just yesterday the Wall Street Journal reported that "banking regulators are girding for a rerun of the housing-related losses now slamming thousands of banks that failed to set aside enough capital during the boom to cushion themselves when the bubble burst. 'Banks will be slow to recognize the severity of the loss -- just as they were in residential,' according to the Fed presentation, which was reviewed by The Wall Street Journal".
This is true. It has been clear for a while that hundreds of smaller banks heavily exposed to commercial real estate market are likely to fail or require more capital during the next 18 months or so. But isn't everyone expecting that at this point?
In my opinion, a retest of March lows would require much more than another wave of bank closures, but rather a large external credit shock to the financial system comparable to that of last year's collapse of Lehman. And at this point I just don't see where would it come from. The Fed simply won't let large banks fail, the IMF will bail Latvia/Ukraine and Co. if necessary, and the dollar "devaluation" press is working overtime on solving the balance sheet issue of emerging-market companies.
So that leaves us with commercial real estate as the last "potential cause of the collapse." However, the base misunderstanding on the comparability and potential magnitude of commercial and residential real estate crisises, in my opinion, lies in a simple but very important factor. That's cash flow and its magical ability to reduce debt over time.
Think about it this simple way. Condos and houses in Florida, California and Last Vegas at the peak of the market produced negative cash flows to their owners even with very low loan-to-value mortgages. There was and is absolutely no incentive for anyone to keep paying a mortgage knowing that their homes value would never appreciate above what they paid.
On the other hand, the vast majority of even worst -hit commercial real estate properties still generate positive net operating (pre debt) cash flows, which could be used to pay interest/reduce debt and thus very likely to eventually generate positive profit for owners.
Cash flows also make price discovery, the lack of which helped to sink the residential mortgage market, much easier. It also buys valuable time for the owners and encourages lenders to find ways to "make things work" by extending the loans and altering the payment terms -- a process we can call "extend and pretend".
And while Fed officials and many "perma bears" have been worried/warning about commercial real estate for quite a while, Wall Street has already started to solve the problem (at investors' expense and for a hefty fee as usual) by- issuing billions of dollars of freshly minted equity for pretty much all/any of the major REITS, life insurance companies and large commercial banks out there that want it.
So while it is certainly possible that many of the equity investors who are willingly absorbing all of these newly issued shares are making an expensive mistake, this massive equity fund raising effort has essentially delevered the CRE market and reduced the risk of outright collapse to virtually zero. This extra equity cushion will also help to protect the true "big boys" of the investing world, the bondholders -- i.e. insurance companies, pension funds, banks, etc.
Most individual investors out there tend to forget that the total value of the global equities (stock) market is actually several times smaller than that of the world fixed income (debt) market, and the true rulers of Wall Street are fixed-income traders, not the equity ones . (Remember, it was the fixed income market's credit-default swaps and interbank lending that brought the world to a virtual standstill last year, not the equity market.)
And the fixed income market hasn't looked as healthy as it does today in quite a while. Just look at any bond index (including the favorite "media scare"- CMBX index) and you will see that it's as if the crisis has never happened. Prices are back to sky high levels, mark-to-market losses are now magically converging to gains, and defaults on high yield bonds are now widely expected to be much lower than anyone dreamed of several months ago.
So until Fed starts raising rates, a repeat of last year's collapse seems very unlikely and may be even downright impossible. We'll see short-term corrections, sure, but not another 50% plunge.
That is why I personally have been buying debt/preferred stocks (PFF , LQD, PGF, ESD, EMD ) of many "scary" REITS, insurance companies, sovereign nations and banks since the beginning of the year, and despite the consistent media warnings of all the "upcoming major insolvencies” I still believe that fixed income is attractive even at today's prices
Vad Yazvinski, a CFA, is registered with the state of Georgia as an investment adviser representative of Jordan Capital, where he currently serves as a Chief Investment Officer. This article is his opinion only and shall not be interpreted in any way as a recommendation to sell or purchase any security. Stocks mentioned with the article are for information purposes only, and may or may not be currently holdings in his investment fund.
