I'm sure some of you already saw it, but wanted to share the blog post Tom Barrack published Sunday. Not the most controversy-free personality, but food for thought. Everything below the link is a quote.
https://medium.com/@tombarrackjr/preventing-covid…
Based on my own personal past experiences I would like to share with you some thoughts on how to alleviate the potential blockage in the commercial mortgage market which is beginning to raise its perilous head. Addressing this major looming crisis in liquidity in a coordinated manner will be essential in averting a crisis in credit and a long term economic recession.
Consider, for example, the American hotel industry — a sector that was hit particularly hard during the 2008 financial crisis. From January 2008 to January 2009, hotel occupancy dropped to less than 60%. This reduction in occupancy caused the losses of hundreds of thousands of jobs supported by the hotel industry, including direct jobs at hotels as well as indirect jobs supported by hotel employee wages, the hotel-related supply chain, and ancillary spending by hotel guests. Currently, in the dawning hours of the COVID-19 crisis, hotel occupancy rates are approaching 0% and are likely to remain at those levels for the foreseeable future. Even assuming an optimistic estimate of 25% hotel room occupancy in the coming months, job losses are projected to total between 2.8 and 3.5 million — a roughly eight-fold increase compared to the 2008 financial crisis.
Below are My Suggestions for Partial Solutions:
- Support for CARES (“Coronavirus Aid, Relief, and Economic Security Act”)
* Encourage Congress to provide an amount up to $500 billion to the Secretary of the Treasury to support programs or facilities for the purpose of providing liquidity to the financial system including the purchase of obligations from issuers and secondary markets, as well as making loans or other advances secured by collateral or entering into repurchase contracts as permitted under Section 13(3) of the Federal Reserve Act.
2. Regulatory Streamlining
- The strong leadership in the SEC could investigate a temporary holiday on mark-to-market rules which would free up billions of dollars in liquidity overnight. Unlike the 2008 crisis when collateral values were inflated by overleveraging, pricing in the pre-COVID economy was very efficient. But mark-to-market rules have, in the past week, wreaked havoc on repo transactions.
- Suspend the requirements under US GAAP for loan modifications related to COVID-19 that otherwise would be classified as a TDR. Furthermore, suspend any determination of a loan modification as a result of the effects of COVID-19 as being a TDR.
- Current Expected Credit Losses (CECL) / FASB Update №2016–13. We are in the middle of the rollout of FASB’s new CECL rule; its impact is incredibly procyclical, which is not helpful at a time when we need lending to flow, not diminish. A suspension of CECL to at least 2024 will allow banks and non-bank SEC filers to make billions of dollars available to borrowers by releasing regulatory capital from their balance sheets.
- Liquidity Coverage Ratio (LCR). Prudent bank regulators have in recent days encouraged banks to use their liquidity and capital buffers and the Fed’s discount window to provide assistance to their customers, but more can be done to allow banks to forbear on repoing collateral without triggering LCR violations. The fractured bank regulatory environment — Fed, OCC, and FDIC — should be streamlined for faster future decision-making.
+1. Read this one Sunday and was intrigued. Mortgage REITs have fallen pretty hard (in line with the worst performing equity REIT sectors) so I've been digging in a bit to understand if there's an opportunity there.
Apologies if this is a stupid question - but is the concern that a small uptick in defaults is going to results in insolvency due to the high leverage in these REITs? Or is this just a liquidity & mark to market issue where perceived losses are going to create a liquidity crunch that will result in selling assets into a tough market and a spiral into insolvency in that way?
I guess a couple of follow up questions/points regarding taking advantage of potential investment opportunity here: (1) if the concern is just defaults, what kind of industry exposure do these guys have to assets that have potential default risk (hospitality, retail)? and what kind of default rate would it take to sink the ship? and (2) Barrack is connected to Trump admin - anyone following how much if any of his suggestions have made it into the stimulus bill and/or any of the fixes the fed is proposing?
I think they have liquidity problems (supposed to pay out 90% of taxable income). So they can't meet their margin calls on top of some having default risk.
you don’t have to pay much out if you don’t make money due to your losses though
These are all very valid questions to ask In Canada, we do not have these problems.. yet. Our biggest acquisition players (REITS & Pension Funds) are still active, & major Lenders are still participating on a deal by deal basis.
What Barrack has said, though, makes sense. I think it is great right now to suspend mark-to-market accounting, because these valuations make no sense as it is a highly volatile market susceptible to daily changes even though the fundamentals are strong.
Good questions and I think the concern is your latter point -- if all the banks that have repo lines out to non-bank lenders (mortgage REITS and debt funds) decide to simultaneously MTM the repo line due to (a) accounting rules and (b) wanting to reduce exposure to CRE because of COVID fears, that will cause a a massive liquidity crunch. One stat I thought was interesting was that in 2019 $42.5B of mortgage REIT loan originations were financed with $20B in repo borrowings.
Tough to give a specific default rate, but hospitality and retail exposure would certainly be the most concerning and first asset classes to default, IMO.
Also I think the feds provided guidance on Sunday for the accounting stuff. I don't think Barrack will get his wish on the TDR one - loan modifications due to COVID can still be classified as TDRs. But I think they relaxed the criteria for what types of loan modifications classify as a troubled debt restructure (i.e for borrower requests to defer principal/interest payments, if it is 90 days or more that usually classifies as a TDR. Sounds like they relaxed this to "long term," which isn't specific, but usually means up to 120-180 days).
As Kirk said wisely “let them die”. Almost as wise as Spock’s saying “the needs of the many outweigh they needs of the few”.
I think that for Real Estate folk it may be helpful to do an asset level example. Below is an example of an asset level transaction via Debt Fund executionto illustrate what can happen.
Office Bridge Loan: L+300 (assume that L was at 250 when loan was originated and the floor was set at that level) 80% LTC 4.5% DY in, 9% DY out 90% of the deal was sold into a CLO with a net borrowing cost of L+200 resulting in the Debt Fund generating L+1300 returns Sponsor Strategy: Office lobby is very large and building is dated with deferred maintenance thus occupancy and current rents are below market. The plan is to perform TLC on the interior and exterior, shrink the lobby and increase net rentable area, add outdoor amenities and features and upgrade building systems to improve efficiency. Result: Work was performed diligently and on-budget. One of the current tenants left due to impending rent hikes dropping DY to 4%. Market softens so rents fall and vacancy blows out. The only way forward is to lease at a lower rate and achieve 5% DY or hold out for the market to recover and sit at 3.5% DY. Given market conditions, cap rates rise and the valuation of the building changes the LTV to 115%. Since the loan was non-recourse, the sponsor decides to cut their losses and default.
Given this scenario, the Debt Fund has 2 options, sell at a discount and wipe out their position or get it leased up to 5% yield which is still profitable enough to make their CLO payments. This becomes a liquidity event where if the Debt Fund had access to funds, they would go with the latter option. However with margin calls and mark to market, the Debt Fund may be forced into taking the prior option forcing them into bankruptcy. If the market turn is terrible enough that leasing the building to at least a ~L+180 level of yield, the Debt Fund becomes insolvent.
Thanks for spelling this out with an example. Could you please clarify what the above two lines mean?
Debt funds borrow themselves. So say they put out $10 mil, in this example 90% of it is going in to the CLO (ie borrowing $9 mil). On the $9 mil, their returns are 100 bps (300 from origination-200 from CLO costs) and for the $1 mil they'yre holding themselves, they get a coupon of 5.5%. Note that they only have $1mil of their dollars out the door but get an additional return on the additional $9 mil they lent out by borrowing.
DY is Debt Yield which is NOI/Loan_Amount.
To piggyback off of Dick Whitman 's comment. It's a leveraged position which calculates much in the same way the levered returns are calculated on an acquisition.
The official calculation goes as follows: Net_Rate = LeverageBorrowing_Cost + Debt_Fund_Return(1-Leverage) L+300 = .9(L+200) + .1(L+Debt_Fund_Spread) 300 = 180 + .1Debt_Fund_Spread Debt_Fund_Spread = 1200
Or conversely (typically how I calculate these on the back of the napkin/how @Dick Whitman explains it): Levered_Return = Unlevered_Return + D/E_Ratio(Unlevered_Return-Borrowing_Cost) Levered_Return = L+300 + 9(L+300-(L+200)) Levered_Return = L+300 + 9*(100) = L + 1200
Another way of looking at Debt Fund CLO operations is that they effectively fabricate themselves a mezzanine position within the capital stack using their superior access to cheap capital within the capital markets.
Doesn't sound like Tom's too optimistic: https://www.bloomberg.com/news/articles/2020-04-06/barrack-gives-up-on-…- re-fighting-politics
Also thought this article was interesting: https://www.bloomberg.com/news/articles/2020-04-07/oaktree-elliott-amon…
How are people buying these for 50 cents on the dollar? Is liquidity really that tight? Also, Fortress selling theirs to an affiliate? That's got to be an issue, right?
Reading this did anyone also hear he was close to bankruptcy at one point when COVID first started? Not sure if I read it here or heard it from someone, anyone have any insight into that?
Not sure where I heard it, but they just defaulted on like $3 billion+ of loans.
Doubly interesting in light of the fact that Colony is already defaulting on debt.
Said it before, will say it again: a business that doesn't have enough cash on hand to withstand a single month of adverse economic conditions is being poorly run.
Agreed, it's shocking.
Tell that to Silicon Valley! :P
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Whistleblower: Wall Street Has Engaged in Widespread Manipulation of Mortgage Funds
https://www.propublica.org/article/whistleblower-wall-street-has-engage…
> Some of the world’s biggest banks — including Wells Fargo and Deutsche Bank — as well as other lenders have engaged in a systematic fraud that allowed them to award borrowers bigger loans than were supported by their true financials, according to a previously unreported whistleblower complaint submitted to the Securities and Exchange Commission last year. > > Whereas the fraud during the last crisis was in residential mortgages, the complaint claims this time it’s happening in commercial properties like office buildings, apartment complexes and retail centers. The complaint focuses on the loans that are gathered into pools whose worth can exceed $1 billion and turned into bonds sold to investors, known as CMBS (for commercial mortgage-backed securities).
> The result: Many properties may have borrowed more than they could afford to pay back — even before the pandemic rocked their businesses — making a CMBS crash both more likely and more damaging. “It’s a higher cliff from which they are falling,” Flynn said. “So the loss severity is going to be greater and the probability of default is going to be greater.” > > After lobbying by commercial real estate organizations and advocacy by real estate investor and Trump ally Tom Barrack — who warned of a looming commercial mortgage crash — the Federal Reserve pledged in early April to prop up CMBS by loaning money to investors and letting them use their CMBS as collateral. The goal is to stabilize the market at a time when investors may be tempted to dump their securities, and also to support banks in issuing new bonds. (Barrack’s company, Colony Capital, has since defaulted on $3.2 billion in debt backed by hotel and health care properties, according to the Financial Times.)
> Flynn eventually found a lawyer and, in February 2019, he filed the whistleblower complaint. The complaint accuses 14 major lenders — including three of the country’s biggest CMBS issuers, Deutsche Bank, Wells Fargo and Ladder Capital — and seven servicers of inflating historical cash flows, failing to report misrepresentations, changing names and addresses of properties and “deceptively and inaccurately” describing mortgage-loan representations. It doesn’t identify which companies allegedly manipulated each specific number. (Spokespeople for Deutsche Bank and Wells Fargo declined to comment on the record. The complaint does not mention Barrack or his company. )
This seems analogous to broader debt market where definition of income has loosened during the most recent cycle. EBITDA add-backs (or looser definitions of NOI in this case) definitely add risk to the system, but do they amount to fraud? And if rates keep going lower, does it matter? Not trying to be obtuse, but the liquidity (or lack thereof) in capital markets seems to be a more significant near-term concern than properties' financials. Not even the most conservative lender underwrote a note to perform in an environment where your shopping center is collecting 30% of rents...
Also, article seems to focus on Barrack for political reasons - his arguments about vulnerabilities in the mreit/cmbs market are essentially unrelated to these allegations of "liar loans"
I mean... it wouldn't surprise me if there was also widespread fraud. I agree that most of what is being described here probably falls under the aegis of "irresponsible underwriting" rather than outright fraud, but I guarantee you there are more cases than there should be of egregiously bad decision-making that could reasonably be described as fraudulent.
Also, it gets politicized because a guy who has the ear of the President lobbying for relief for a specific asset class in which he personally needs a bailout is certainly blurring the lines between the political and the economic.
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