The Agony Out There

During the televised Berkshire Hathaway annual meeting five-hour Q & A, Warren Buffett, responding to a question about real estate, made the point that often the price of a building is derived by how much a buyer can borrow to buy it. Knowing real estate developers the way I do, that is certainly true. 

At the same time, Wolf Richter wonders if maybe, just maybe we will find out over the next few years that the chase for yield during the zero interest rate era created such a feeding frenzy among investors/lenders who “eagerly originated floating-rate mortgages on overvalued buildings because they figured that the Fed would hike rates soon, and that they would benefit from those rising short-term rates which would push up the floating rates and thereby push up the yield and income from the loan, and therefore protect the value of the loan.”

Of course these financial wise guys figured the Fed to hike rates 200 basis points and all would be well and good, with borrowers able to withstand such a rate increase, and they would have a big, fat earning asset after the no interest era was passed. But, J. Powell’s Fed has gone from zero to 500 basis points and borrowers are handing over the keys, with monthly payments tripling, tenants leaving employees at home and building values plunging. 

Given all that, Richter wonders, “And maybe banks were onto it, and instead of hanging on to those riskiest loans, they securitized them and sold the CMBS to investors? That would be a hoot to find out.”

Hoot or no, Eurodollar.university’s Jeffrey Snider wondered aloud about the same thing with Real Vision’s Maggie Lake. Snider  speculates that some of this variable rate office-secured debt has been securitized into CLOs (collateralized loan obligation) and may have entered what he calls “the collateral stream.” 

Individual loans, by themselves, are illiquid. But, when packaged with other loans securitizing a CLO, that CLO is considered liquid and is used as collateral for Repo (Repurchase agreement) and derivative transactions.  Unfortunately, under stress, these loans, the inner workings of CLOs, don’t perform as modeled by the ex-physics majors who put them together.  

Snider’s guess is that these CLOs have been used as collateral just as treasury bills or agency bonds (collateral streams) and have degraded the monetary system similar to how collateralized mortgages did leading up to the Great Financial Crash.  As these CLOs have come under price pressure due to defaults of the underlying mortgages, the CLOs are rejected as overnight collateral, and thus there is, as Snider says, a shortage of collateral in the system. Thus, the wild swings in the usually staid Treasury Bill market. 

As Snider points out, “There is so much hubris attached to [CLOs] because they are basically made to be quantified by mathematical models.”  So, the Fed can lower rates but that won’t save real estate. Real estate will continue to crash and THAT will bring down rates. 

“In the beginning of any downturn, the first things that come to light are the worst problems,” Josh Friedman, the co-founder and co-CEO of alternative-asset manager Canyon Partners said on the sidelines of the Milken Institute Global Conference in Beverly Hills. “There’s going to be carnage in some parts of the commercial real estate business.”

“Berkshire has made some bank investments that worked out very well for us,” Charlie Munger told The Financial Times. “We’ve had some disappointment in banks, too. It’s not that damned easy to run a bank intelligently, there are a lot of temptations to do the wrong thing.” 

Berkshire Hathaway’s reticence stems in part from lurking risks in banks’ vast portfolios of commercial property loans. “A lot of real estate isn’t so good any more,” the 99-year old Munger said. “We have a lot of troubled office buildings, a lot of troubled shopping centers, a lot of troubled other properties. There’s a lot of agony out there.” 

He noted that banks were already pulling back from lending to commercial developers. “Every bank in the country is way tighter on real estate loans today than they were six months ago,” he said. “They all seem [to be] too much trouble.”

Yes Charlie, there is lots of agony out there, just some people don’t know it.