Surprise! Commercial Real Estate Woes Will Hit Wall Street

Why does the media treat entirely predictable events as news?

Fitch has been saying since last April that commercial real estate was exhibiting the same sort of frothiness as subprime. CMBS spreads started widening sharply last August. Investors started pulling back from purchases in September, expecting prices to fall considerably. In November, Nouriel Roubini added commercial real estate to his list of impending financial train wrecks, estimating the damage at $100 to $150 billion.

It’s a no-brainer that financial firms would be hit by the commercial real estate downturn. So the only newsworthy item is the timing and magnitude of possible losses. But the Wall Street Journal acts as if the concept that investment banks will be damaged by deteriorating commercial real estate credit is novel.

Despite the disingenuous framing, the Journal story, “Wall Street Gears for Its New Pain,” does have some useful data. Bottom line: it cites estimates first quarter commercial real estate writedowns across the Street at $7.2 billion. That may not sound terrible, but with investment banks having taken so many losses so far, each incremental hit is increasingly painful.

From the Wall Street Journal:

….commercial-real-estate values are starting to slide, with analysts at Goldman Sachs Group Inc. projecting a decline of 21% to 26% in the next two years…

William Tanona, a Goldman analyst, expects total write-downs of $7.2 billion by Bear Stearns Cos., Citigroup Inc., J.P. Morgan Chase & Co., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Morgan Stanley in the first quarter. Those firms had combined commercial-real-estate exposure of $141 billion at the end of the fourth quarter.

A team of Goldman analysts predicts the financial damage from commercial real estate could last as long as two years, which would mean “a significantly longer tail than subprime.” That is because only 28% of commercial-real-estate loans have been packaged into securities since 1995, while about 80% of subprime loans have been securitized; the higher level of securitization subjects the subprime assets to more-immediate mark-to-market accounting, which is playing out in the form of the write-downs that are dominating headlines….

Aside: that sounds like a backhanded admission that firms have latitude to fudge the accounting.

If there is a silver lining, it is that the excesses that overtook the U.S. housing market aren’t as prevalent in commercial real estate….

Market values of commercial-mortgage-backed securities, which are pools of mortgages that are sliced up and sold to investors as bonds, are down about 5% since late last year, compared with declines of roughly 50% or more last year for some collateralized debt obligations….

Overall, commercial-real-estate write-downs in the first quarter are expected to rival those for CDOs and leveraged loans. Mr. Tanona predicted write-downs of commercial-mortgage-backed securities should “intensify” in the first quarter to $7.2 billion from $1.8 billion in the fourth quarter. By comparison, he foresees first-quarter write-downs of $10 billion in CDOs and $5.8 billion in leveraged-loan commitments.

So far, default rates on commercial-mortgage-backed securities are a slim 0.4%. But that is likely to rise as loose lending standards on some commercial-real-estate loans come back to haunt lenders and investors. More than $50 billion of five-year, full-term interest-only loans written at aggressive loan-to-value ratios could turn into defaults “at a significant level” if the loans can’t be refinanced this year, according to Jones Lang LaSalle, a real-estate brokerage and money-management firm in Chicago.

The sluggish economy will add more stress….

It isn’t easy to size up the potential damage. Financial firms’ public reports “don’t paint a full picture,” says Peter Nerby, a credit analyst at Moody’s Investors Service. For example, Morgan Stanley reports commercial-mortgage exposure before and after the effect of offsetting transactions, or hedges, while Bear, Goldman and Lehman don’t….

An even bigger problem is the firms’ own holdings of leftover, unsold commercial-mortgage-backed securities. Because the market for these bonds has virtually shut down and made it hard to determine what they are worth, Wall Street firms are being forced to rely on the CMBX index, which tracks the performance of commercial-real-estate bonds with different credit ratings.

Portions of the index have more than tripled this year, indicating soaring perceptions of risk. The index’s movement implies a 5% loss rate, pressuring banks to mark down the value of their bonds even though the underlying properties are still generating cash.

Morgan Stanley, last year’s No. 1 underwriter of commercial-mortgage-backed securities, cut its exposure to such mortgages by 52% to $17.5 billion after hedges in the fourth quarter, compared with three months earlier. That might have pointed investors to the spot where Morgan Stanley expects the “next shoe will drop,” Guy Moszkowski, an analyst at Merrill Lynch, said in a report.

Another trouble spot is the debt financing provided last year to facilitate leveraged buyouts of real-estate concerns. One of the biggest examples: A group led by Bear still is trying to sell the debt offered to Blackstone Group LP for its $20 billion takeover of Hilton Hotels Corp. In December, Moody’s cut its ratings on Bear, partly blaming the firm’s “concentrated risk” from the Hilton deal.

Another noteworthy story today: the Journal reports on Countrywide’s deteriorating loan book. Its option ARM portfolio is showing defaults of 5.4% (remember, the increase in required payments on them doesn’t rise in many cases till 2009-2011) and it took a $704 million loss on home equity lines of credit.

Couldn’t happen to a nicer bunch…