5 Things You Need to Know: No, This Isn’t GFC Part Deux
Real estate is a symptom, not the disease.
During a stint at Minyanville, a financial news and education media company, I was fortunate to work under the tutelage of a talented editor named Kevin Depew. Depew is now the deputy chief economist at consulting firm RSM, and wrote prolifically during the Great Financial Crisis, brilliantly capturing the mood of America during that trying time. His "Five Things You Need to Know" was required reading every week, and covered topics from high finance to macroeconomics to social trends. This series is an homage to "Pep," who once quipped "I majored in philosophy, but since none of the big philosophy firms were hiring, I went into finance."
Fear and loathing is creeping back into the financial world, with whispers of world war and a presidential election that no one wants just months away.
Inflation is proving to be stickier than many hoped, as professional prognosticators eat crow while the Federal Reserve walks backs promises of lower interest rates. “Higher for longer” is keeping its foot on the beleaguered commercial real estate sector’s neck.
And as losses mount, I’m hearing rumblings about a Great Financial Crisis (GFC) redux, a replay of when problems in real estate pushed the financial system to the brink.
The GFC was a perfect storm of macroeconomic conditions mixed with human greed, brewed to perfection with financial alchemy.
1) Wait, not again! What’s happening?
In case you haven’t opened a newspaper (remember newspapers??) recently, commercial real estate has had a lousy last few years.
Interest rates are dramatically higher than anyone expected when the Fed began to raise rates two years ago, which combined with lower rents and higher operating expenses have whacked property values and pushed many owners into insolvency.
Downtown high rises across the US have seen their valuations slashed by as much as 80% as the hybrid work experiment continues to hollow out demand for office space.
Even apartment investors, which had the Midas touch during the 2010s, are in trouble, having binged on cheap debt in 2021 and 2022 to support lofty forward-looking assumptions that aren’t coming true.
2) Wait, this all sounds familiar doesn’t it?
Modern real estate bubbles are always blown with too much borrowing, inflating values past the debt level that incomes can support.
But a closer look at the GFC shows that many of the factors that led to that mess are not at play in the current one. Things are bad, but nowhere near on the scale that led to very real concerns that the financial system itself would not survive.
The GFC was a perfect storm of macroeconomic conditions mixed with human greed, brewed to perfection with financial alchemy.
Following the dot com bubble which burst in 2000 and the post-9/11 recession, the Federal Reserve took the overnight borrowing rate down to 1.0% in July 2003 from 6.5% in November 2000.
This helped spark a worldwide yield-chasing expedition in the midst of a globalization boom where investors from Europe to east Asia scrambled for return-generating options for their piles of cash.
Stateside, mortgage bankers discovered that they could lend the cheap money to home buyers and investors, which inflated residential property values across the country.
And as borrowers began to run out of income to support higher prices, lenders got creative.
All the buzzwords that most of the world learned about after it was too late (Subprime, NINA, SISA, Option ARMs and other so-called "liar loans") were invented by Wall Street as tools that mortgage originators could use to keep blowing the bubble.
Meanwhile, the mortgage backed securities industry, which until that point had been an arcane corner of the structured finance world, had its moment, feeding the globalizing world’s thirst for yield.
Eggheads on Manhattan trading desks devised inventive ways to not only package individual loans into securities they could sell to cash-rich insurance companies, pension funds, and sovereign wealth funds, but they then figured out that they could repeat the process by packaging those same securities into second derivative securities like collateralized debt obligations, or CDOs.
They then took it a step further, bundling those derivative securities again, creating CDO squareds (bundles of CDOs), which are really quite simple when you look at the structure visually.
And behind the entire Byzantine system were trillions of dollars in credit default swaps, or CDS, which were private risk-sharing contracts, which let investors bet on the likelihood that this or that security would go bust.
3) Wait, you lost me. Tell me what really happened.
It’s true, it was quite a mess, with debt layered on top of debt, risk on top of risk, and transactions so opaque that when things started going sideways, no one knew who was holding the bag.
So to truly understand the why a correction in residential property values let the worst financial crisis in a generation, you have to unfortunately understand a bit of math.
What the models missed was that lax underwriting guidelines in 2002-2006 were prevalent everywhere, pushing home values up across the country for a single reason.
In 2009, Felix Salmon published a tremendous piece in Wired Magazine on this topic entitled Recipe For Disaster: The Formula that Killed Wall Street. In it he lays out how the key assumption in the formula traders used to price bond risk revolved around the notion of correlation, or how likely one mortgage was to default if its neighbor defaulted also.
Correlations can be positive or negative and then added together to find the correlation of a basket of seemingly disparate risks.
For example the correlation between touching a hot stoving and screaming an expletive is quite high, probably close to 1 (or, 100%). But the correlation between you touching a hot stove and doing it again the next day is likely negative, the worse the experience today the less likely you are to do it tomorrow.
Correlations are basically measures of probability, and when you add them together you get the likelihood that the entire group of mortgages (in the case of an MBS) or bonds (in the case of a CDO) or CDOs (in the case of a CDO squared) will default.
Those default probabilities were based on historic mortgage data, and for the rest of financial history up until the peak 2006, defaults were not highly correlated across geographies.
Economic drivers in California pushed up home prices as people there became wealthier and they were less likely to fall behind, and those conditions were totally independent of what was happening in the real estate market in, say Alabama.
The models ingested this information and spat out the assumption that a diversified basket of mortgages across geographies was low risk, because a flu impacting one region was unlikely, historically speaking, to infect somewhere halfway across the country.
What the models missed however, was that lax underwriting guidelines in 2002-2006 were prevalent everywhere, pushing home values up across the country due to a single input.
Take away that one input, and correlations go to 1.
Kaboom.
4) Fine, the models broke. So what?
Wall Street literally ran out of ways to juice home values with creative mortgage structures in 2006, and home prices stopped going up. Without the ability to flip the house to the next buyer, and as teaser rates expired and borrowers were forced to pay their mortgage like a regular person, defaults began to stack up.
I remember sitting on the mortgage desk in the fall of 2006 when reports started coming in that huge swaths of loans were experience “first payment default.” That’s mortgage geek speak for a borrower missing their very first payment.
That’s when we knew that the gig was up.
The main difference between then and now is that correlations are not 1.
Real estate is a confounding world right now precisely because markets and property types are moving in such different directions.
Industrial is staying strong while urban office is in existential crisis. Retail, which was on death's door for seemingly the past 10 years, is coming back to life. Multifamily, which was the easiest money in real estate post GFC, is limping along with many high profile investors deeply underwater after the binge of 2021-2022.
Everyone expected higher interest rates to scorch single family homes, but prices are up and rising, as supply is constrained since owners don’t want to give up their rock bottom rates.
In other words, its complicated.
The problem in 2006 was that a single giant asset class bucked the historic trend in a major way at the same time, which the smartest guys in the room said would never happen.
5) OK, but’s bad out there - shouldn’t we be worried?
Sure, there’s a lot to be concerned about.
But real estate is a symptom, not the disease.
If you invested in real estate of any kind between 2019 and 2022, it's been a hard road. Interest rates jacked up faster than anyone expected, insurance costs are rising if you can even get a policy, and rents in some markets are well down from where they were at the top.
But there is no broad rational for real estate sinking the entire financial system. Regulators and market participants have a better sense of where risk lies, and while there are plenty of excesses to bleed off from the ZIRP, lenders are not pushing all the distress through into the market at the same time like they did in 2008-2009.
Are there other things that could sink the system? Sure, like the US Federal Government's $35 trillion in debt which is growing by $1 trillion every three months, with no real plan to fund the debt service.
That has people justifiably worried.
What is so hard to convey if you weren’t there in the glory days of the mortgage bubble was just how much of a mirage it really was.
The whole thing was built on a mountain of lies. It never really existed.
A stripper in Las Vegas could scribble six figures onto a loan application, and that number was taken at face value by in theory the smartest guys at the smartest firms 2500 miles to the east in Manhattan.
The stripper would close on the house, never live there and never make a payment, turn around and sell it to another stripper who also provided no proof of income or assets. This is not an exaggeration and I don’t mean to pick on strippers - this is what really happened.
And around and around it went, until the merry-go-round ground to a halt.