Announcements of write-downs tied to mortgage-related debt at some of the nation's top financial institutions continue to roll off the newswires like cars on an assembly line. In late December, Morgan Stanley reported a $5.7 billion write-down on top of the previously announced $3.7 billion hit. Only weeks earlier, UBS announced that it would take a $10 billion write-down on its U.S. subprime securities. Merrill Lynch, Bear Stearns, Washington Mutual and Bank of America also have sustained damage from the mortgage wreck.
Ultimately, losses stemming from the residential mortgage meltdown could total $350 billion to $400 billion, says Hessam Nadji, director of research services for Marcus & Millichap Real Estate Investment Services. Here's the math: The U.S. mortgage market is valued at nearly $12 trillion. Approximately 20%, or $2.4 trillion, contains either subprime or alternative documentation loans. It's estimated that 20% to 25% of those non-traditional loans will go bad.
Bear in mind that these loans are not carried on bank balance sheets, but are contained in pools of securities that can be bought and sold globally, sometimes at a steep discount. “Pick your number, 20% discount, 30% discount, to move the bad paper,” says Nadji. “When you run the math, it's a $350 billion to $400 billion loss factor worldwide.”
One bright spot: The $350 billion to $400 billion in losses represent only 3% of U.S. gross domestic product, currently $13 trillion. By comparison, the S&L crisis of the early 1990s totaled 8.5% of GDP. “From a true financial perspective, this is not a significant problem,” says Nadji. “From a psychological and underwriting perspective, it's a huge problem.”
The veteran researcher's remarks came during a Dec. 11 symposium hosted by NREI at the Princeton Club in New York to highlight the results of the magazine's 2008 Investor Outlook survey. About 140 industry professionals attended the breakfast meeting. The other featured speaker, Chris Tokarski, managing director of Countrywide Commercial Real Estate Finance, offered a sobering assessment of the state of the capital markets. He expects domestic CMBS issuance to fall from $215 billion in 2007 to $125 billion in 2008.
Tokarski sees two wild cards in 2008, the first of which is the default rate on CMBS loans. A rising default rate would cause investors to demand a higher return for higher risks, thus impeding deal volume. “There were a lot of very aggressive loans made in 2006 and 2007,” says Tokarski. “As long as those continue to perform, and as long as we don't see any cracks in the boat, we should be able to maintain.”
The other wild card is the unemployment rate, which held steady at 4.7% in November, but is up slightly from 4.5% a year ago (see chart). Tokarski expects it to rise to a range of 5.25% to 5.5% by the end of 2008. So far, defaults in the residential mortgage arena primarily have been the result of poor underwriting — job losses haven't been a big factor. But that could change, if layoffs become rampant.
Nadji expects anemic job creation of 90,000 to 100,000 monthly for the first half of the year. “This is the scenario of a significant slowdown instead of a recession,” he notes. “I will say that the chances of a recession are a lot higher today, not necessarily because of the real estate fundamentals but because of the wild cards.” The jokers include the wobbling housing market and ongoing credit crunch.
Our cover story, “Lodging Loses Altitude,” points out that the hotel sector is particularly vulnerable if corporate earnings suffer or the economy falters. Lenders are growing skittish because the hotel industry reacts the quickest to changing market conditions. “It doesn't mean we won't do deals on hotels, we're just a little more conservative,” says Tokarski. Across the property types, lenders are closely scrutinizing the financials of every company today. “It's a matter of underwriting them [the assets] properly and looking at the tenants.”
If lenders had exercised such discipline in the residential mortgage market, we'd all be better off.
Matt Valley can be reached at email@example.com.
In celebration of our 50th year in publishing, NREI will look back at the issues and faces of our industry over the past five decades. The first quarterly installment will appear in March; a special anniversary issue will appear in December.