We all knew that a market correction would happen, and now it has. What is the damage? Some relish the new opportunities and the prospect of more normal market conditions, as Lynn Strongin Dodds reports
Cracks in the US sub-prime market first appeared in January before escalating into a full blown crisis in the summer.
While industry experts are still debating the exact toll, all agree that the party is well and truly over for the property boom in the US and UK. Prices are falling, yields are rising and liquidity has practically dried up in the asset-backed securities markets (ABS). Real estate is still attractive as an asset class but fund managers will have to be more discerning in future.
Paul Kennedy, head of research at Invesco Real Estate, notes, "The subprime crisis has helped to put an end to riding the yield curve which has distorted the skill sets needed to enhance performance. Today's successful investment manager needs to have strong local partners, be able to choose the right types of property and then manage them aggressively. When returns are 12%-15%, a manager can afford to take his eye off the ball, but when they are suddenly 7%, this is not the case."
Although the havoc wreaked by subprime mortgages, which enables people with a poor credit history to buy a house, is a recent event, these loans are not a new phenomenon. They hit the US property scene in the early 1980s, but did not gain momentum until the last few years as interest rates fell and property prices soared. In 1996, subprime accounted for a mere 9% of US mortgage loan origination but that figure jumped to about 21% from 2004 through 2006, according to figures from Moody Investors Service. In aggregate, they totalled a staggering $600bn (€420bn) in 2006, accounting for about one-fifth of the US home loan market.
Hindsight is always a wonderful thing but the financial engineering and proliferation of credit products which are factors underlying the crisis, were hailed as innovative at the time. One of the most popular loans was the 2/28 hybrid which combined fixed rate (FRM) and adjustable rate mortgages (ARM). Borrowers enjoyed a low, fixed rate for the first two years, known as a "teaser" but then the loan became adjustable semi-annually for the next 28 years as the note rate reset to the value of an index plus a margin.
There was also a proliferation of so-called "no-doc" or "low-doc" loans to people without evidence of earnings, as well as loans for 100% - or even more - of a property's value. During the flourishing 2004-2006 period, about 45 % of subprime mortgages were ARMs or hybrids, 25% were FRMs and 10% allowed for negative amortisation.
In the UK, by contrast, the term sub-prime only applies to "adverse credit lending". Last year, the Council of Mortgage Lenders estimated that by this definition sub-prime accounted for about 6% of the UK market, although industry estimates place it closer to 9%, or about £30bn (€43bn). In both countries, the bet that many borrowers took was that house prices would continue their rise which would mean the value of their house would always exceed the size of their debt. They did not anticipate that housing prices, particularly in the US, would take a hit after a two-year campaign of rate hikes.
The other main driver fuelling the sub-prime market was securitisation, whereby these riskier loans were parcelled along with other mortgage loans into residential mortgage backed securities (RMBS). They in turn were often repackaged into collaterised debt obligations (CDOs), which were sold onto a broad range of investors including hedge funds, pension funds and insurance companies. CDOs are carved into different layers or tranches based on the returns they offer and their perceived ability to absorb losses in the event of a default. In 2006, sub-prime mortgage securities accounted for about $100bn (€69bn) of the $375bn CDOs sold in the US but the market began to crumble as foreclosures increased in the wake of plummeting housing prices.
According to the Mortgage Bankers Association, about 5% of all mortgages are delinquent in the US and the share rises to almost 15% for subprime mortgages.
The picture is likely to get worse before it improves. Simon Martin, managing director and head of research and strategy at Curzon Global Partners, an affiliate of AEW Europe, a London-based investment management company, says, "The problems today have been created by lending and securitisation practices that were not sustainable. Many investors bought securitised debt in the form of CDOs and did not realise that the assets that backed them were subprime mortgages. It was only when the first wave of defaults started to happen in late 2006 and early 2007 that people understood how the two markets were intermingled."
While there were concerns in the first quarter about a credit crisis in the first quarter, the actual trigger was the implosion of two hedge funds managed by Bear Stearns Asset Management (BSAM). Both had suffered severe losses from investing in CDOs tied to loans in the subprime mortgage market. Panic hit the UK when Northern Rock, the country's fifth largest mortgage lender went cap in hand to the Bank of England which sparked a run on the bank. Eventually, Alistair Darling, the UK Chancellor of the Exchequer, reassured the public by announcing the government would guarantee all deposits of Northern Rock account holders, and any other bank that found itself in a similar position.
By the time the third quarter ended though, the market was awash with poor results from investment banks, swathes of job cuts in fixed income and mortgage related departments, and a cloud of uncertainty.
The equity markets may have recovered but the asset-backed securities (ABS) markets including RMBS and commercial backed mortgage securities (CMBS) completely dried up. As in all crises, a flight to quality ensued as investors ran for cover, buying investment grade corporate bonds from household blue chip companies. The big question is, when will the ABS market improve? While few are willing to predict the turning point, the general consensus is that it could be years before investors are willing to buy securities backed by sub-prime mortgages. According to research from Deutsche Bank, the US ABS market has been severely impacted with year-to-date totals for the first nine months of the year lagging behind both of the past two years.
The European ABS markets, which were just coming into their own this past year, have also seen their prospects dashed. The hopes that the CMBS market would top the €100bn in 2007 is now just a pipe-dream. Deutsche Bank revealed that third quarter issuance of all asset-backed securities (ABS) in Europe - which includes bonds backed by mortgages, credit card debt and car loans as well as all kinds of CDOs was €84bn.
This is the lowest quarterly figure since the first quarter of 2006. A mere €19bn of deals saw the light in September, representing a dramatic 60% drop on the same month in 2006.
Overall, full year 2007 primary volumes in Europe are unlikely to surpass the 2006 issuance of €470bn, making it the first fall since the inception of the ABS/CDO market about nine years ago. As Andrew Currie, senior director CMBS, Europe, Middle East and Africa (EMEA) at Fitch Ratings, notes, "The €100bn CMBS market is just not going to happen. October is typically one of the busiest months and while there are a number of deals ready to go, it is still unclear as to what investor demand will be. Banks have been restructuring some of their deals but I think they are adopting a wait-and-see attitude."
Stuart Jennings, managing director RMBS, EMEA at Fitch, also does not expect the RMBS market to return to the lofty levels it was enjoying earlier in the year. "We have only seen a trickle of issuance and it is difficult to predict who will reopen the market," he says. "As in the US, the sub-prime has been one of the main issuing sectors in Europe and there have been reports that repossessions are rising.
I think in general the market for new RMBS issuance will gradually improve and stabilise. However, it will take time." Not surprisingly, the tightening of credit coupled with the uncertainty over economic outlooks has impacted property prices and transactions on both sides of the Atlantic. Property prices across the spectrum have been sliding in the US over the past year, while the UK was gradually winding down. The first major blow came in the autumn when figures revealed that total UK commercial property returns, which had been soaring over the past four years, plunged to just 3.4% in the first nine months of 2007 compared to 18%-19% returns in the previous two years, as measured by the Investment Property Databank's UK All-Property Index.
Sabina Kalyan, chief economist of IPD, which started comprising figures on the UK in 1985, says, "The market had enjoyed several years of super-normal growth fuelled by liquidity and debt. The impact of the sub-prime crisis had been severe with September being the worst month we have had on record. At the sectoral level, we saw negative monthly returns in all three - office, industrials and retail since September 1992. Industrial and retails were -1.4% while the office sector for the first time delivered -1.0%. The real driver of the slowdown has been a sharp deceleration in capital growth value."
Looking ahead, The Royal Institution of Chartered Surveyors predicts that commercial property prices will drop by 5% this year and next. This is having an impact on yields, which show a building's rental income as a proportion of its price. By the end of the second half, yields had fallen to around 4.75% as investors continued to pour into the real estate looking for enhanced performance. Industry estimates forecast that average yields could climb about 50 basis points by the end of the 2007. As Tony Dolphin, director of economics and strategy, Henderson Global Investors, points out, "Earlier this year, we saw yields on commercial property drop a little below the ten year gilt yield. You have to go a long way back to have seen this before. The sub-prime crisis was a wake up call that property prices - housing and commercial - might have been pushed too far. The bottom line is that investors have had a decade of strong 10% to 15% returns and now they may have to make do with 0% to 5%."
Despite the downturn, many industry participants believe that real estate will continue to be an important part of an institution's portfolio. Ubbe Strighagen, international director, Aberdeen Property Investors, explains, "Real estate will continue to be an integral part of a long term investments strategy. Markets will now be in a healthier state as some such as the UK became overvalued. Also, in any market where there is turmoil, opportunities arise and the challenge is to identify them and have the resources to act." John Buckley, property economist at Morley Fund Management, agrees, adding, "There is still a wall of money looking for a home in Europe as well as Asia and North America. Investors may wait a few months to see how things unfold but I do not think though that the money will disappear. In Europe, there will be more focus on France, Benelux, Germany and Nordic countries because they the economy still looks good and there are opportunities in the commercial and retail sectors. By contrast, the UK, Spain and Ireland are later in the economic cycle". In the UK, the main concerns are the health of the economy and the effect any job cuts in The City of London could have on the commercial property market. "For now, investors are sitting on the sidelines to see how the credit crisis washes through the market," says Mark Meiklejon, investment director, property, Standard Life Investments.
"Overall, the fundamentals still look sustainable for strong long term property performance. Unlike the property downturn in the late 1980's, interest and inflation rates are low and there is more transparency, cross border flows and investor sophistication."
