It would be a stretch to expect an early return to normal – at least not to what we used to call normal. The destruction of balance sheet wealth and the damage to both the financial infrastructure and to confidence in the financial system will have lasting effects. Normality as we used to know it, required easily-available credit and, on the other side, a willingness of consumers and businesses to borrow. This decade’s boom was characterized by a massive credit overshoot, fueled by misguidedly optimistic assumptions on the part of both borrowers and lenders. The pendulum has now swung the other way, and the credit environment will represent a structural headwind to economic growth in the next several years.
This has been a balance sheet recession, triggered by the bursting of a credit bubble. That is much more serious than the more typical downturn that is caused by a tightening in monetary policy designed to slow an overheating economy. If tight policy is the principal cause of a recession, then growth should bounce back quickly as soon as the policy noose is loosened. Recoveries associated with financial crises are generally much weaker than those following other downturns because balance sheet problems can take a long time to rectify. As a result, unemployment is higher and interest rates stay lower during these recessions. The current recession may officially end in the third quarter of this year, but for many people, it will not feel as if an expansion is underway.
Global equity and bond prices will face a critical test in the second half of 2009 – whether reflationary efforts will translate into an international recovery process. Reflation assets have rallied sharply in anticipation of a stabilizing world economy, thereby removing much of the undervaluation in risky assets witnessed at the height of the financial crisis. However, the world economy is still feeble, the recovery process remains preliminary, and investors are still very frightened. Thus, there is an intense economic standoff between reflationary forces and debt-deflation pressures, creating corrective pressures on global securities. The 2008 Great Recession was a huge deflationary shock which needs to be counterbalanced by aggressive monetary easing. The risk for financial markets is that the muted consumer recovery is delayed. Any hesitation on the part of any central bank to stop expanding money supply or prematurely roll back stimulus could create huge problems.
Ultimately, reflationary policies will win, allowing global bond and equity prices to move higher. The U.S. investment grade and equity markets have rebounded to levels consistent with a bad recession, i.e., prices have not yet factored in an economic recovery. Major developing countries – Brazil, Russia, India, and China (the BRIC countries) in particular – are leading the global economic recovery process; emerging markets have rallied explosively since the lows of March. The U.S. economy will probably enter a cyclical recovery phase later this year; if so, security prices will move higher to reflect this.
An additional issue that needs resolution will be the recognition of commercial real-estate losses, especially amongst regional banks. Commercial Mortgage backed Security (CMBS) losses on 2005-2008 vintages will be 12-15% and bank losses may exceed this. Construction losses at banks may be 25% or more – implying total Commercial real Estate (CRE)/construction losses of $250 billion. Cumulative losses on bank loans may exceed that on CMBS for the following reasons:
- Banks (especially community banks) took on more risk to achieve better spreads
- Banks tend to focus on transitional properties which tend to suffer more in downturns
- A large portion of banks’ CRE was originated at the peak (‘05-‘07)
- CRE Delinquency rates have been 2-3x higher than that on CMBS
Losses taken to date at the banks have been relatively modest because lower interest rates have allowed interest reserves to last an additional 1-2 years and banks have the ability to extend current loans – hoping to ride out the storm. Banks are less than half way through recognizing construction losses and 20% or less for commercial real estate. This has huge implications for those closed-end funds exposed to real estate.
Michael Ashley Schulman, CFA
Hollencrest Capital Management