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How We Got to the Credit Crisis The current capital market credit crisis was perpetrated by a confluence of factors, including a potent period of fear winning over greed; a near collapse of due diligence in the credit markets (a.k.a., more money than brains); a mismatch of short-term capital and long-term liabilities (and subsequent margin calls); and a critical error made by the Fed in setting monetary policy. As a result, credit markets will gradually rebalance over the next twelve months, as greed re-harnesses fear. However, the overall U.S. economy will continue to thrive in 2008, due in large part to government spending.
The Subprime Mortgage Market and the Valuation of Subprime Bonds This paper describes the current state of the subprime mortgage market and provides an historical context for the market dynamics that led to the present environment. The authors introduce a model to estimate the market's expectations of future losses on pools of subprime mortgages, using the market prices of the ABX indices. The model shows that the market is expecting roughly 30 percent losses on 2007 originated loans, 20 percent to 25 percent on 2006 originated loans, and around 15 percent on 2005 vintage loans. At these levels of losses, most BBB-rated securities are wiped out in all vintages, and the securities should be valued as interest-only (IO) values (no return of principal). Many newer A-rated and AA-rated bonds are also expected to take losses. Nevertheless, even though correlations amongst security performance are high, there is some dispersion, and pockets of better-performing bonds do exist, which can have impact on the valuations of super-senior CDO tranches.
The Premature Pricing of Commercial Real Estate Distress This paper discusses the premature pricing-in of commercial real estate distress, particularly up the capital structure. Spreads on higher-rated CMBS classes have reflected loss expectations comparable with or beyond those seen in the commercial real estate recession in the late 1980s/early 1990s. However, the authors find that underlying commercial real estate fundamentals remain firm and comparisons with subprime are overstated. They conclude that despite downside risks to recent vintage collateral from a weakening economy, it is too early to price in such a level of base-case losses. The prolonged period of CMBS spread compression came to a dramatic end in 2007, as spreads widened and the credit curve steepened. However, underlying commercial real estate fundamentals largely were steady, and delinquencies stayed in check, with some signs of weakness in recent-vintage collateral, especially in multifamily. The gradual decline in property values is expected to continue given the repricing of debt and the effect of decelerating economic growth on rent projections.
Re-thinking our Financial System Global financial markets are in disarray. Commercial banks, both in the United States and abroad, have taken massive write-downs. So are investment banking firms, which are further challenged by bleak prospects for their securitization businesses, which have been their primary earnings engines. The Fed is trying to balance the need to encourage liquidity so as to avert a deep recession, while managing the risks of inflation and a highly devalued dollar. The economy in many respects seems to be reasonably healthy, yet there is a real risk that a dysfunctional financial system could cause a severe recession. Securitization is experiencing its first real test. Clearly there will be modifications and adjustments. Yet there will surely continue to be a significant role for securitization. This is a time for thoughtful regulatory oversight, not the time to throw the baby out with the bathwater.
Face-to-Face Places Networked computers are changing settlement patterns faster and more radically than did earlier forms of transportation such as railroads, airplanes, or even automobiles. The result is what the author refers to as the Santa-Fe-ing of the built environment. The central feature of this settlement pattern are villages that, thanks to technology, are highly urbane and highly conducive to face-to-face contact, while being widely dispersed and only marginally urban in terms of size. This combination of equal and seemingly opposite effects—dispersion and urbanity—is taking place far beyond our old ideas of urban or even suburban, and emerging faster even than was the case with the automobile suburbs. Santa-Fe-like growth is showing up in places far beyond any metropolitan area: the Big Sky Country of Montana, the Gold Country of the California Sierras, the Piedmont of Virginia and North Carolina, and the mountains and coasts of New England.
Evaluating the Decision to Own Corporate Real Estate The traditional decision analysis currently used by most corporations to decide whether to own or lease their operating real estate is fundamentally flawed, resulting in much more corporate-owned commercial property than is economically justified. Most firms currently lease space if the present value of future rent is less than the present value of the cost of self-ownership, net of depreciation benefits and expected property appreciation. However, the correct model for the own-versus-lease decision must compare the present value of profits the corporation expects if they lease, with the present value of expected profits if they decide to own real estate.
How Should Commercial Real Estate Be Priced? When it comes to real estate pricing, most investors revert to the cap rate because it's simple, and it's the norm of the industry. But a correlation analysis indicates that cap rates have been largely unresponsive to alternative rates of return available to investors, with the exception of BBB bonds, over most of the past 25 years. Other pricing tools such as the Capital Asset Pricing Model; a comparative analysis with assets of similar credit risk; and the Gordon Dividend Growth Model provide much more elegant, yet still simple, alternatives to evaluating real estate pricing.
The Half-Life of Buildings This article provides a discussion of the factors that affect the “greatness” of a building over time. The examples described include Boston City Hall, the Martin Luther King, Jr. Library, the Chrysler Building, and 30 Rockefeller Plaza. The author concludes that both taste and function play a role in this process. Architectural tastes change every thirty or forty years. It is inevitable that even a “great” building will at some point be considered “old-fashioned.” It helps if a building is functionally as well as aesthetically outstanding. Another major variable of great buildings is whether the architecture captures people's affection. It is not enough that a building be popular with the general public; it must also be loved by its owners (the taxpayers, in the case of public buildings). If owners love a building, they will put up with a certain degree of dysfunction—no building is perfect—and they will take the trouble to maintain it, make repairs, upgrade obsolete technological systems, and spruce it up every twenty to forty years.
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