The credit squeeze could be bad news for highly leveraged real estate investments. Simon Martin reports
In recent years it has become fashionable to argue that the price of property is justified by the abundance of liquidity chasing the asset class. We are told that this abundance comes from a range of equity sources: China, Russia, the Middle East, the hedge fund and private equity moguls, even the equity released by homeowners. As a result, its sheer diversity makes it very difficult to conclude that abundance is at risk. This is a narrow view of liquidity, as liquidity is not just about equity. Total liquidity is determined by the combination of equity and debt. In fact, in most transactions leverage now almost always exceeds the amount of equity.
Perhaps then, given the amount of leverage now used in property transactions and the relative ease with which credit has been obtained in recent years, we should not seek comfort from the amount of equity there is in the system. Perhaps we should question how much leverage there is and seek to understand who holds the leverage and what collateral is pledged against it. The rapid evolution of the structured credit markets has made tracking leverage very difficult. This lack of transparency has not been a problem in a benign credit environment but with interest rates rising, credit markets tightening and volatility rising, the lack of transparency may catch investors out.
Evidence of the problems caused when leverage goes wrong has been emerging in the structured credit markets, where there is believed to be about US$2trn (€1.47trn) in issuance today. The most commonly issued form is collateralised debt obligations (CDOs). CDOs are made up of fractional slices (tranches) of asset-back securities, such as mortgages, car loans or debts. As I understand it if you want to sell a CDO, you go off and buy lots of tranches of asset-backed debt and package them together. The lower the quality of the debt, the higher the potential yield on the CDO. For example, if you wanted to sell your CDO to an investor seeking high returns, you might form your CDO out of multiple slices of BBB- rated credit from a variety of sources. This BBB- credit is then sliced up and stacked in layers. Each layer is then prioritised in the structure so that a first default is met by the first tranche. When the first layer is exhausted the second is drained and so on. The buffering effect thereby provides some protection for each subsequent tranche.
As a seller of the CDO you can then get a credit rating agency, based on the diversity of each tranche and the buffering effect, to assign a credit rating to each layer, which then allows a bank to price it. This is a neat trick as heavily buffered credit is then treated as ‘enhanced’ and is often given a higher rating. This credit enhancement process increases the value of your CDO security and banks a profit. This works well in a benign credit and economic environment, but suppose there is a widespread event of default in the underlying asset-backed security, as, for example, we have seen in the sub-prime mortgage market in the US. Estimates suggest that around 7% of US sub-prime mortgages are in default and close to 15% are delinquent. Given the way sub-prime mortgage-backed CDOs are structured, 8% default rates are sufficient to wipe out the equity and junior layers. A default rate of 15% would likely impact the valuation of the senior layers significantly. Further large-scale defaults in this market triggered by 2007 and 2008 resets in ‘teaser’ mortgage rates sold to high risk borrowers cannot be discounted. This might render the buffering present in the CDO almost useless. This is made worse by the fact that CDOs are very illiquid. There is no traded market price and their value is a function of their credit rating. Credit ratings are driven by a model that assigns a default probability-based historic default and recovery rates over historic cycles. Since sub-prime is a new class of lending particular to the one up-cycle, there is no historic data to feed the models for a down-cycle. Hence ratings adjustments cannot properly anticipate deteriorating credit conditions. The only benchmark of risk we have is the cost of credit default insurance. This has gone through the roof since March. The equity and junior tranches of sub-prime debt are now widely termed ‘toxic’ - heavily leveraged illiquid asset.
So what does this tell us about global liquidity? Clearly many international hedge funds and some institutions have bought this type of structured credit and now have a valuation problem. We have seen this surfacing in recent weeks, as leverage chews through the equity of investors in hedge funds managed by Bear Stearns, Cambridge Place and Cheyne Capital. Banks also clearly have some exposure to this sector as not only have they structured CDOs, many have bought CDOs and many will have leant to investors who have pledged CDOs as collateral. This could also have a major impact on the private equity industry. CDOs have been a key financing tool for leveraged buy-outs (LBOs). If, as might be expected, investors turn away from CDOs and become risk averse, we should probably expect the terms of leveraged buy-out financings to get tighter and might even see some slowing of activity in the LBO market. With bank shares riding high, hedge fund and private equity firm IPOs abounding, super-sized LBOs being executed every week and the amount of public equity in circulation falling daily, any shift in the debt market clearly has implications for the public equity market.
Without clear visibility in the structured credit markets, it will be difficult to understand the exact impact on real estate markets, but at this stage the most obvious effects on our markets will be in the cost of debt capital. Although spreads have already widened as interest rates have risen, it seems likely that they would continue to widen if the supply of credit is constrained, as the major lenders may find it difficult to repackage real estate loans and sell them into the capital markets. Banks with balance sheet issues stemming from CDO losses or collateral issues may also shut off their balance sheet. This could trigger a significant credit squeeze. A major constriction in the credit markets would be extremely disruptive for real estate given the role that debt has played in this property cycle. If you believe, as we do, that the real estate markets are already priced for future perfection, this can only reinforce the perception of rapidly increasing downside risks.
Simon Martin is head of research at Curzon Global Partners