It's gut-check time. It's time to admit that this financial crisis has now exceeded anything we've seen since the Great Depression. This is worse than the Russian default crisis in 1998. It's worse than the savings and loan meltdown in the 1980s. Neither of those resulted in the massive nationalizations the U.S. government had to undertake in September. It's time to stop saying that we're dealing with a short-term blip.
We're faced with nothing less than a restructuring of the financial system. The model of independent investment banks is now dead. Bear Stearns is gone and now controlled by JP Morgan Chase. Lehman Brothers is in bankruptcy and in the process of liquidation. Bank of America is buying Merrill Lynch. And Goldman Sachs and Morgan Stanley have converted to bank holding companies.
The ramifications for commercial real estate are severe because the thing that's taking these institutions down — not to mention insurance giant AIG — are securitized bonds. It's true that commercial real estate is just one component of the larger universe of securitized assets. But the model is the same across all assets. And the model of securitization in its current form is not likely to survive this credit crisis.
Commercial real estate pros can talk all they want about how commercial mortgage-backed securities (CMBS) are being unfairly assessed in the current panicked climate. That may be true. It seems highly unlikely that CMBS pools will ever see the amount of defaults, delinquencies and foreclosures that are hitting residential mortgage-backed securities pools. Unfortunately, this crisis is no longer drawing any distinctions. All securitized debt products have become suspect and unsalable.
No matter how strong we might believe CMBS to be, it doesn't change the fact that backlogs of bonds are choking bank balance sheets. It doesn't change the fact that everyone is terrified of some institution — say Lehman or Merrill — selling some of its bonds at fire sale prices. That would trigger a devastating new round of writedowns as other holders of debt revalued their holdings through the “mark to market” process. That's what the bailout plan being discussed in Congress as we went to press is designed to stop. It's telling that the same voices that talk about the strength of commercial real estate debt one minute and the next are talking about the necessity of a bailout and arguing long and hard to make sure that CMBS are also eligible to be bought by whatever Congress eventually comes up with.
However, even if the bailout works and liquidity returns to the system, the fact that the problem has gotten this severe and done such damage to the financial market means it will have lasting effects. Will Wall Street enable the same model that brought the financial system to its knees and destroyed the investment bank model to resume?
We're betting that the answer is no. And since securitized debt had come to account for about 70 percent of all commercial real estate financing, that's a huge issue for our sector. Unless new finance sources emerge — covered bonds perhaps — the volume of investment sales and the cap rates we saw in 2006 and 2007 will be hard to match for a very long time.