We at Crunched Credit have taken a bit of a pause of late.  It is, of course, the dog days of summer.  But it’s time to get back into the fray.  Let’s start by noting the doldrums seem to have taken a pass.  From where we sit, the markets seem to be in robust health.  As we look over this complex web of transactions, deal structures, innovations, capital flows, business plans, business goals, failures and successes that is our market, things look pretty damn good.

Okay, all perspective is positional, and maybe there is something horrible out there that’s about to ruin my happy place.  Frankly, if you look back over the past several years, we’ve had a long list of nasty summer surprises.

And there are plenty of storm clouds for the glass half empty set.  We all still have, for the moment, a deep and visceral appreciation of the reality of black swans and fat tales.  Putting to the side geopolitical events entirely, there is plenty of range for more pain by self-inflicted wound.  We all watch with some level of trepidation, and, perhaps, fatalism our elected representatives and our regulators do things that just don’t make much sense.  Our Olympian governing class seems bound together, regardless of party politics or position, by an unshakable conviction that markets are a great Newtonian machine amiable to the pulling of levers and the adjusting of dials.  A Steampunk view of economic policy.  Moreover, and to make matters worse, we have poked our monetary nose outside the tent flaps of the known financial universe and neither bankers, traders, or the intellectually glitterati of the economic profession can tell us with much certainty how markets perform following momentous central bank intervention, zero bound interest rates, and highly activist central bankers who continue to embrace monetary policy as a woefully inadequate palliative for fiscal inactions.  What’s that all amount to?  A ship captained by a person regularly wrong but rarely in doubt, firmly gripping a tiller which may or may not actually affect the direction of the ship in unchartered waters.  How comforting.

One of the highlight of this year’s CREFC meeting (generally a pretty cheerful affair) was Kevin Worsh’s comments at Tuesday’s lunch.  Mr. Worsh, a former member of the board of governors of the Federal Reserve during its most trying times had much to say that seemed wise (I freely admit my conformation bias).  He worries about the disconnect between the bad news on the front page of the paper and the happy talk in the business section.  He worries that one of those versions of reality is right and one is wrong and that discontinuities of this type can collapse rapidly – and usually, painfully.  He worries that our economy is underperforming because of a variety of ill-advised fiscal policies including the continued unsettled regulatory environment.  He notes that the tsunami of liquidity provided through monetary policy has essentially created a disequilibrium evidenced by a bullish stock market and insipid GDP growth.  He notes that while central bankers have the tools to intervene in a true credit crisis, they do not have any tools to increase GDP growth from our current anemic 2% to the 3+% required for this economy really to succeed.

But we continue to rock and roll.  So, we ok?

Some observations from where we sit now:

  • Structural complexity is returning to the marketplace in the search for yield.  Many will say that’s bad.  I think that’s Luddite thinking.
  • There continues an almost comical hand-wringing about loss of underwriting discipline as the cycle grinds along.   As Captain Renault said in Casablanca, “I am shocked, shocked!” Isn’t worry about the cycling about as dramatic (and productive) as worrying that winter is coming?  Have we lost our collective minds and thrown caution to the winds? No, at least not yet.  Has the market achieved an epiphany where, confounding the Problem of the Commons, individual behavior is mediated for the common good?  Hardly.  Let’s face it, folks.  We are in the middle of a regular cycle with a fair amount of headroom.  Some appreciation that the amiable portions of all cycles end.  Not news.
  • The folks who regularly provide estimates on CMBS structures for 2014 were right.  We will see something in the range of $80-90 billion, which seems like a comfortable place to be right now.   Lifecos, GSEs, banks large and small and non-banks are lending at a pretty good clip.
  • There is a very real and substantial over capacity of capital chasing transactions.  That seems unsustainable.
  • Spreads on traditional B piece continuing to drop into and through the 14% range.  Man, that’s an awful lot of work to put a modest amount of capital to work.  And risk and reward will only grow more asymmetrical as the cycle deepens.  The B buyer looks to me to be the canary in the mine.  We need to watch this market closely.  What happens if there is a B piece strike?
  • The CRE securitization or CRE CLO market is growing.  There is a need for durationally matched financing for portfolio accumulators of financial assets.  This is that, and increasingly there seems investor appetite for the product.  We anticipate a continued (slowish) penetration of ramps and reinvestment features into the market over the year.  We are already seeing it in a smallball sort of way.  When true reinvestment becomes doable (and we have lots of ideas about how that can happen), this market will expand rapidly to provide leverage for floaters, non-stabilized loans with future funding components and indeed fixed rate assets held as portfolio assets.
  • The Volcker Rule is one of the more horrible destroyers of capital formation in our market.  It was poorly thought through, it is rife with unintended consequences, it is reducing the liquidity in all fixed income marketplaces (because who in this regulatory gotcha environment can really tell the difference between prop trading and making a market?).  That’s bad.
  • The Volcker Rule is good for CRE securitization because these deals are largely outside the ambit of the Volcker prohibitions.  It will push investment dollars into the market sector.  Go figure.
  • We are witnessing a secular change or a secular rotation from the resurrected banking sector to the non-regulated banking market (I refuse to use the term “shadow market.”  See my prior blog on my concern that names matter in our polity and shadow banking is a bad name).  This means more funds will flow into specialty finance companies who have significant advantages in nimbleness and the inapplicability of punishing, bewildering and capital-destroying regulation.  These new lenders function at a disadvantage in terms of cost of funds and access to liquidity when compared to banks.  Nonetheless, the non-bank market will continue to grow rapidly over the next several years.
  • The underlying real estate markets are healthy.  After years of suppressed growth, lots of green arrows now and for the foreseeable future.
  • Everything said about life in the U.S. is truer in Europe.  European securitization has been moribund for many years, which I’ve always found curious.  Since losses on European securitization were far lower than in the U.S., the market didn’t dive head first into the bubbling vat of subprime mortgage securitization and their banking system has grown, if anything, less able to meet the needs of a growing economy than the U.S.  Not to beat the dead horse, and we’ve written quite a lot on this in the past, I do not believe that many European banks are as well capitalized as the miscellany of government regulators say they are.  I do not believe they have adequate liquidity.  I think that their enormous appetite for sovereign debt, born of a devils’ bargain between state and bank which miraculously allows banks to carry sovereign debt without capital charges means that the middle market (and for this purpose I will include all of commercial real estate in the middle market) will be starved for leverage from the banking marketplace.  And that all seems to be broadly accepted in governmental circles across Europe.  We’ve seen Mr. Draghi publicly announce that securitization isn’t so bad after all.  Just last week, Clara Furse, an external member of the Bank of England Financial Policy wrote an op-ed piece remonstrating with European authorities to take another look at securitization and endeavor to encourage it as opposed to crush it, because it simply is needed.  As Ms. Furse points out in her piece, bank lending to businesses in the UK remains substantially lower than it was five years ago.  Finally, the European Central Bank in conjunction with the Bank of England has issued a paper entitled the Impaired EU Securitization Market:  Causes, Road Blocks and How to Deal with Them.  While I’m not sure the paper hits the nail on the head, much like the blind cat and the dead mouse, eventually a solution that works will be found.

So net/net, we remain pretty bullish on the market for the near and middle term.  Memories of the downturn remain vivid and searing but to paraphrase Saint Augustine, Dear Lord, makes me cautious and conservative, just not yet.