Sub-prime market: Correction or catastrophe?
It was just a matter of time before the true extent of the damage caused by sub-prime mortgage losses was uncovered. When, in February, the significant increase in sub-prime delinquencies became known, credit market watchers could only speculate about the ultimate impact.
Six months on, sub-prime’s victims are beginning to be revealed. Two Bear Stearns funds have imploded, taking Warren Spector, the firm’s co-president, with them. UBS’s CEO, Peter Wuffli, was sacked on the back of losses in the bank’s hedge fund arm, Dillon Read Capital Management, which led to the unit being shut down. According to some estimates, the world’s largest financial institution, Citi could be up to $1 billion in the hole. In Germany, state-owned lender IKB is licking its wounds and WestLB has admitted to substantial sub-prime exposure. These won’t be the only casualties.
Contagion from sub-prime has filtered into the global capital markets. Real estate financing in all guises has been affected as debt has become more expensive and equity markets less receptive. Undoubtedly, getting deals done has become more difficult, but whether or not markets are untenable for real estate transactions is debatable.
Take the commercial mortgage-backed securities (CMBS) marketplace. In the US, the market has been characterized by transactions backed by highly leveraged loans that until recently managed to clear at tight levels thanks to investor demand. Fitch Ratings had predicted US CMBS volumes would top $240 billion in 2007. That figure now seems a little optimistic and some predict volumes might struggle to match the 2006 total of $200 billion.
US CMBS spreads have already gapped out. According to Jones Lang LaSalle at the end of July, 10-year triple-A CMBS spreads were approximately 45 basis points over swaps, the widest level since 2004, and 15bp wider than levels at the end of June 2007. And deals that are usually two or three times oversubscribed are finding just enough buyers.
The European CMBS market is still dwarfed by that in the US. Loans backing the deals are still geared competitively, but nowhere near the levels seen in the US. The first half saw a record-breaking €35 billion in deals – a 94% increase over the same period last year – but European market watchers are already modifying their expectations for the second half. Although the deal pipeline is strong and originators have plenty of business to do, investors are wary and proceeding with caution. That means underwriting standards are going to tighten up and pricing is going to fall back to earth. More spread tiering is predicted as investors differentiate between deals.
Although the markets certainly do not have the free and easy feeling of a few months ago, real estate outside the sub-prime sector has been relatively stable and even resilient. Sure, a handful of deals have floundered but, in the main, business is being done. Properties might not be selling at the furious pace they have been, and not every loan or equity transaction is finding an audience. Still, the global real estate market is nowhere near a full-blown slowdown.