Archive for March, 2010

Current state of commercial real estate market

Saturday, March 27th, 2010

After reading reports from investment banks, talking to buy-side insiders, and reading a Congressional Oversight Panel Report (http://cop.senate.gov/documents/cop-021110-report.pdf), I’ve listed below some thoughts and issues for all investors to consider:

1) The current theme in Commercial Real Estate (CRE) is for borrowers and special servicers (they deal with servicing problem CMBS loans) to “pretend and extend.”  Borrowers want to renegotiate loans and special servicers/banks are reluctant to liquidate loans (capital ratio hit or outright loss recorded).  Volumes on liquidations are currently low (source: BarCap).

2) 50% of CRE loans are held by banks/savings institutions (source: BarCap) with $1.2 trillion maturing by 2012 (includes non-construction and development loans).  CMBS investments are back-ended in terms of when they mature (2015-2017).  The Net Operating Income Debt Yield of less than 10% (especially prevalent in 2015 – 2017) hints that re-financing is under pressure and Net Operating Income on CRE is still declining (deals with fixed rate CMBS securities).  Sources: BarCap, Federal Reserve, FDIC SDC.

3) Currently (12/09), hotel, retail and multi-family CRE has seen the largest rise in delinquent loans.  For now, office and industrial CRE have delinquency rates 1/3 to 2/3 lower than other CRE sectors.  Loans that are floating are showing less pressure in delinquency, and the market is pricing construction vs. stabilized loans much differently (source: Federal Reserve).   Currently (9/09), only hotels are experiencing cash flow problems, with longer leases in the other CRE sectors providing some relief (unknown for how long).

Bottom line:  The CRE market is moving slowly toward the new reality.  Losses are being managed to extend the pain through government involvement via the TALF and PPIP programs, versus short, crisp price adjustments.  The CRE market will be dealing with the excesses created during the 2005 – 2007 period for a long time.

Always Asking, Never Assuming™

Christopher Holtby

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Uncertainty, confusion & risk of mortgage bonds in bond mutual funds

Friday, March 26th, 2010

As with any other bond, a mortgage bond provides the investor with a return of principal and income.  The uncertainty is the timing of the return of principal.  The confusion is how the Federal Reserve, Congress and the GSEs (Fannie, Freddie, FHA) are involved in the mortgage market.  The risk is the involvement of the Government, which affects mortgage bond prices in a way that is counter to an investor’s expectations for such investments.

Any investment security comprised of mortgages, whether a straight pass-through (common in the 1980s through the mid 1990s) or the more common securitized mortgage bond, has different tranches of either credit quality or maturity prepayment periods.  The demand for mortgage backed securities (known as MBS) is highly sensitive to interest payments (if rates go up, prepayments will be slower = bad), as well as swings in the US Treasury market (part of hedging process) and the interest rate swap market (also part of hedging process).   Sudden changes in these characteristics are bad for MBS holders.  Over the last year, in part because the Fed purchased $1.2 trillion of MBSs, the volatility of these characteristics has been low.  Banks and asset management firms have been large buyers of MBSs, and have partly replaced the declining purchases of the Fed over the last 5 months due to flood of investors wanting more bonds in their portfolios.  When sudden changes occur (discussed above), which were last seen in 2003, buyers of MBSs experience the sharpest losses as more mature investors rebalance the extension risk (seen as slower repayments) by quickly selling MBSs or Treasuries.

The spread difference between Fannie Mae’s current coupon and comparable US Treasury 30 year bonds is 0.60% (source: FT).  In late 2008 it was 2.20%.  Because there is a scarcity of comparable AAA bonds, apart from US Treasury bonds, the yield pick-up is enticing for investors.  The dynamics of the MBSs are very complicated, with pension funds and insurance companies investing one way, and hedge funds typically creating asymmetric trades, together with the sprinkling in of Fed influences.  For example, MBS participants entered into trade swaps to protect against a drop in the Fed’s buying of MBSs by March 2010.  These trades assumed that swap rates would increase faster than Treasury yields.  This would provide a gain and a hedge against the loss on the MBS portfolio.  Yet because MBS spreads have not widened compared to Treasuries, investors, en masse, have been reversing those trades.  While this strategy has worked well over the last 10 years, Fed participation in the MBS market has changed everything.

Bottom line:  Whether you understood everything written here is not the point.  The lessons from history are simple – if you stretch for yield you will most likely be disappointed by the final outcome.

Always Asking, Never Assuming™

Christopher Holtby

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China’s moral hazard

Friday, March 19th, 2010

There is a strong relationship between the Peoples Bank of China (central bank) and the commercial/state owned banks.  This relationship is loosely similar to the relationship between the US Federal Reserve and US commercial banks.  As China has a centrally planned economy, the size of allowed loans, the reserve requirements, and the industries permitted to receive loans are mandated by Beijing.  The banking system is evolving.  Reporting and transparency are still suspect at the provincial bank level.  This is to be expected of a country adapting and growing at rates never seen before in modern history.

The financial sector in China has been liberalized over the past 10 years.  Economic participants (financial, commercial and household) are allowed to use a more western-market style of allocation for capital (aka cash).  In 2009, Chinese central planners encouraged banks to increase lending (around Rm 9,600 billion = US $1.6 trillion).  Red hot property markets and vast overcapacity in industrial production has not materially dampened lending in 2010.  An analysis done by the China International Capital Corporation shows that a large stockpile of loans has been taken but, as of yet, remain unused by Chinese companies (around Rm 1,200 billion = US $176 billion).  Even if the PBoC continues to increase bank reserve requirements, the corporate sector can continue to invest due to these loans taken but not allocated. 

Chinese households do not have same range of investment options in comparison to their western counterparts.  If inflation expectations continue, Chinese households are limited to allocating their cash to either stocks or real estate.  According to Chinese authorities, it does not not appear that depositors are leaving banks en masse.

Bottom line:  There is no such thing as a free stimulus lunch.  China, like western countries, has to monitor and to navigate the same constraints posed by capitalism.  Chinese investments will be affected by the timing/allocation decisions by corporations (due to US $176 billion of unused loans) as well as household inflation expectations.   

Always Asking, Never Assuming™

Christopher Holtby

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Tax risks for non-cash charitable contributions

Wednesday, March 17th, 2010

The case of Newton J. Friedman et ux. v. Commissioner provides a recent ruling on the tax complications that can arise from non-cash charitable contributions. 

The couple in question made two non-cash charitable contributions in 2001 and 2002.   The returns were prepared by their CPA.  Their returns had included Form 8283, Noncash Charitable Contributions, which consisted of an appraisal and a list of the items which were appraised.  The IRS selected the Friedmans’ 2001 and 2002 returns for an examination.  The IRS decided that not only were the non-cash charitable contributions disallowed, but a 20% penalty was also levied for lack of appropriate substantiation.  The Court ruled with the IRS.

A few lessons can be learned from the fact pattern of this case: 1) taxpayers need to “obtain a qualified and timely appraisal for the contributed property” no later than the due date of the return, 2) appraisals need to be very detailed, allowing someone not familiar with the property contributed to understand characteristics of property, 3) ensure Form 8283 details how market value was calculated, the date of the valuation, and the cost basis, 4) keep very detailed records, 5) get the charity to recognize what was received, and state that no services/goods were provided, and 6) provide your CPA with all the details he/she requests no matter how annoying.    

Bottom Line:  This case provides a pivotal example of why it is important for clients to tell their CPAs everything, provide all the detailed information requested by their CPA, and to ensure that their tax advisor explains all the nuances of out-of-the-norm planning. 

Always Asking, Never Assuming™

Christopher Holtby

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Crowding out effects on corporate bond spreads

Friday, March 5th, 2010

Definition: “In economics, crowding out is any reduction in private consumption or investment that occurs because of an increase in government spending” (source: Wikipedia).   The government spends more, financed by raising taxes (reduces consumer demand) or increased government borrowing (reduces capital available to other asset classes).  Global governments (excluding China) have high single digit deficits for 2010 (US is around 10%, Spain is around 9%).  They will need to, and have indicated they will, increase taxes AND issue more government debt.  Macroeconomic schools of thought are varied on the effect on consumer consumption and the effect on financial markets when a government issues more debt than historically seen.

Analysts have calculated that around $9 to $14 trillion of government debt will need to be issued in 2010 (US around $1.5 trillion) to finance their deficits.  If governments print money (US 2009 occurrence) this will eventually lead to inflation.  If governments issue more debt than the markets deem prudent, this will eventually lead to a Greece-type of problem.   However, there is a knock-on effect to corporate bond spreads (difference between the yield on US Treasury bond with comparable maturity and the yield on a corporate bond).  The global government bond market is changing from viewing government bonds as a rate product (based on inflation differentials) to a credit product (based on credit quality of underlying issuer).   For example, an emerging market bond fund will now view corporate bonds and government bonds in the same sphere.   Corporate bonds will also have a “push” factor incorporated into their attractiveness, based on increased tax rates and reduced consumption leading to lower overall net profit margins, thus affecting their attractiveness (this is more of an emerging market story than a developed market story).   If the yields on government debt increase and the corporate/government debt spread decreases, this will make it difficult for corporations to issue the debt needed (especially relevant in the US and UK for CMBS and RMBS re-financing in 2010 - 2012). 

After the dramatic spread compression from fall 2008 highs to current spreads, corporates have an added uncertainty with regard to spread increases, not because of credit quality challenges but because of global government debt issuance.  Markets are already pricing in this uncertainty.  The relationship between government and corporate issuance should be discussed with your bond manager who invests in taxable bonds. 

Bottom line: Investing in bonds carries different types of risks than investing in stocks.  Bond investors need to understand those risks and plan for the needs they expect their bond investments to meet.  Investing in bonds is neither good nor bad.  It depends on the goals you expect the bonds to help achieve.     

 

 

Always Asking, Never Assuming™

Christopher Holtby

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