Many, too many, have stood where I stand. Many more will stand here too.
The markets have been casting a wary eye on rising CRE losses – figuring these may trigger a renewed bout of banking weakness, but the reality is the market has to cope with normalised interest rates and changed demand patterns. Its pain but also opportunity.
It’s Deja-Vu all-over again in Blain Towers this morning.
Many times I have written about the Global Financial Crisis of 2007-2035. It all began with a few shuttered CLO funds, shocked us with the run on Northern Rock, but most folk assume it ended with the collapse of Lehman on the 15th September 2008 and the subsequent bank bail-outs. Not so – the consequences and distortions that followed in terms of QE, ultra-low interest rates and regulation will continue to haunt markets for decades…
PIMCO were on the wires y’day warning of significant higher US regional bank risks as a result of “very high” concentrations of troubled commercial real estate (“CRE”) loans. Does that mean there is another global banking crash waiting in the wings as the $4.3 trillion CRE market spirals into disaster, triggering a liquidity maelstrom as the tsunami of bad CRE lending overwhelms bank capital reserves? (Oh, I do love a cataclysm of mixed metaphors before breakfast…)
One of my coveted “No Sh*t Sherlock” awards is winging its way to PIMCO’s head office for their startling spot of the downright bleeding obvious of the CRE crisis. I started warning of a likely CRE shock about 6 years ago (pre-pandemic) when the usual German bank suspects (Deutsche Pfandbriefe, Aareal, and LBBW) went all-in on the US CRE market. Where German bankers lead, mayhem is duty-bound to follow.
Earlier this year S&P downgraded a raft of US banks due to CRE concerns, and a mini-crisis erupted around an $800mm CRE loss provision hit at New York Community Bankcorp in Feb. Suddenly banks around the globe found themselves asked difficult questions on CRE provisions and security.
The question is why have PIMCO suddenly woken up to the looming CRE crisis now? Probably because it’s becoming increasingly obvious the CRE problem is just one part of a much larger crisis delayed. The issue is leverage – the degree to which it is slowly becoming apparent just how exposed global capital markets are to higher interest rates. All the financial sectors that expanded in the era of cheap money – including Private Equity and Private Credit – are now finding the going tough, constrained by much higher financing costs of their debt.
The pain of higher rates has been significant, but funds had been willing to bear it, safe and secure in the knowledge the Fed and other central banks would rapidly act to cut interest rates back down, close to zero, after the inflation spike…. Er no. Didn’t and isn’t going to happen.
Increasingly the shocked realisation that interest rates are unlikely to ever fall back to 2%, and will remain normalised around current 4-6% levels is shaking the confidence of markets. The model underlying private equity leverage plays will struggle. Stock markets will have to reprice to the normalised cost of money. Even though higher rates are likely to turn a soft US recessionary landing into something harder and more painful, even stock gurus now accept that easing rates back to QE or Pandemic levels would be nothing but an inflationary sugar-rush.
Get used to it folks. Higher rates for longer. That’s the bad news. The good news is a market crisis is a great time to snap up opportunities – and I reckon CRE will be one of the most attractive games in the town – spotting the right plays.
Let me paint a picture and tell a story…
If the London underground should ever take you to the now-dowdy pretender to London’s financial crown, Canary Wharf, gaze upon the tumble-weed blowing down the streets, rolling past the empty buildings, and form a sense of where the CRE market is likely going. Even HSBC’s monolithic Temple of Gloom will soon be empty. You might even think the rapid decline of the Wharf is a metaphor for the decline and fall of the UK’s mercantile and market might… (Think of the final scene in The Long Good Friday, as the realisation dawns on Bob Hoskins in the 1979 UK gangster film that correctly predicted the rise of London’s Docklands.)
Oh, how different it was just a couple of decades ago when we thought it would last forever. Look upon my works ye mighty and despair. One of Blain’s Market Mantras I should invoke more often is: “when a financial institution builds a prestige new office block – short the stock.”
The best firm I ever worked for was Bear Stearns. I spent 10 years in that Tower in Canary Wharf. We were hungry and aggressive. We understood Bear was the underdog in financial markets – no corporate treasurer ever lost their job giving a mandate to Goldman Sachs. While Morgan Stanley was “white shoe” we were blue collar. The internal culture was “aggressive”, but we understood the truism: “information is only valuable if you can withhold it.” Curiously, it made us work better together. Our Chairman, Ace Greenberg fostered a unique culture of cost control and praise for a job well done. We strived harder, gave it 120% every day, and the business started coming in.
But then the culture of the firm began to change. Hubris. Greenberg retired. His successor was a jerk. The firm built a grandiose HQ in NY. Suddenly my new boss was a second rate ex-Goldman guy. I saw the writing on the wall and an accepted an offer to go head up FIG elsewhere. A few years later, Bear was one of the first up against the wall as the dominoes of the Global Financial Crisis started to tumble in 2007 – bought in extremis by JP Morgan in 2008.
Bear were about to move into a new European HQ building on Canary Wharf. The Logo was up on the building – but was swiftly removed. Years later you can still make out the shadow the studs that held the Bear Stearns name cast on the fake marble cladding.
Back in January that Bear Stearns building, 5 Churchill Place, was bought of bankruptcy for £110mm. It had been bought by a Chinese firm for £300mm in 2017. It pretty much sums up the crisis in CRE: no-one wants old offices. The whole of Canary Wharf, conceived in the Thatcher years with an architectural pallet taken from a child’s box of wooden bricks, looks jaded, tired and dull.
But here is the thing – I bet someone makes an absolute fortune on Canary Wharf in the coming decade. Any smart developer knows what is old can be new…
There is a crisis point in CRE coming. Following the pandemic, and then the spike in interest rates following Russia’s invasion of Ukraine, CRE bankers have been playing a waiting game: for office workers to return to offices and for interest rates to fall. Pretend and extend only works so long. Yet, the problem is not a surfeit of office spaces to sell – in fact, there is crying demand for high-quality, prestige offices that meet the latest environmental and sustainable criteria for the most credit-strong clients.
The lesson from the 2008 crisis was most CLOs, RMBS and Banks collapsed in price, but most paid back at 100%. Although equity holders were hosed, bank debt proved money good… The same may yet prove true with much of the distressed CRE stock. But to get there, there will be pain.
PIMCO are hardly unique in spotting the coming storm across the real estate markets. For banks it will lead many into a liquidity crisis. When banks die, they die quick – losses ripping through their capital stack as immediate crisis leaves them unable to fund. Across Europe the ECB is trying to shore up the weaker bank CRE participants by insisting they increase capital reserves, but as another of Blain’s Mantras states: “The time to raise new capital is before you even think about it.”
Keep a weather eye on banks and property…
This article was originally published in Bill Blain’s Morning Porridge and is republished here with permission.
