A detour to dis-equilibrium.

Author:Woodwell, Jamie

Last year, the commercial real estate capital markets moved from a "perfect calm" to a state of dis-equilibrium--in the course of a few months. This article tracks the capital markets' course from equilibrium to dis-equilibrium and, ultimately, to some future state where buyers and sellers will once again transact routinely.


Economists use the word "equilibrium" to describe a market steady enough that buyers and sellers can come to a shared understanding of the prices and terms at which transactions will occur. To economists, markets function at equilibrium. When a shock hits a market--a dramatic shift in supply or demand--the market moves to dis-equilibrium. When that happens, buyers and sellers cannot come to terms, the market slows and little new business is transacted. Participants then adjust terms and pricing in search of a new level at which transactions can again occur. When that new level is found, trading begins again at its new equilibrium. [??] Like many aspects of the dismal science, equilibrium tends to be a largely theoretical concept, with most economists observing that few markets are ever in a true state of equilibrium. But the recent disruptions in the commercial/multifamily real estate finance markets show that dis-equilibrium can be very real, and it can have dramatic consequences as the market searches for its new level.

Equilibrium and the perfect calm

In the beginning of 2007, I categorized the state of the commercial/multifamily real estate finance market as a perfect calm (see "The Perfect Calm," Mortgage Banking, January 2007). Low interest rates and broad capital availability, strong and improving property markets, and innovation in the capital and other markets all came together to create extremely benign market conditions. Mortgage originations, mortgage debt outstanding and property prices all hit record highs, while cap rates and delinquency rates each hit record lows.


A key (and then un-noted) element of this market was that it was in equilibrium. Buyers and sellers shared an understanding of market fundamentals such that they could transact business. Not everyone agreed that the terms were "right," but the market transacted at those terms and deals took place.

Investors around the globe had increased their demands for high-yielding fixed-income investments, and as in any functioning market, firms and individuals responded by supplying products to meet the increased demand. The result was that leading up to the summer of 2007, the global capital markets provided commercial/multifamily real estate with an extremely efficient delivery of investment funds.

According to Commercial Real Estate Direct, more than $200 billion of commercial mortgage-backed securities (CMBS) were issued in 2006. Wachovia Capital Markets LLC, Charlotte, North Carolina, and Intex Solutions Inc., Needham, Massachusetts, reported that at the end of second-quarter 2007, there was almost $725 billion in CMBS outstanding.

To capture this investor demand, investment banks created new structures--such as the commercial real estate collateralized debt obligation (CRE CDO)--that more finely tailored risks and rewards, and provided opportunities for investors to choose from a variety of investment options. The demand drove a record $36.6 billion of issuance of CRE CDOs in 2006.

The growth of the CRE CDO market--with its appeal to hedge funds and other leveraged investors--helped increase demand for CDO inputs, especially lower-rated CMBS tranches, which in turn helped drive the prices of CMBS up and their yields down. At the end of February 2007, CMBS were priced at record low levels to swap rates, and the differences in yields paid by riskier securities (such as those rated BBB-minus) and less-risky securities (such as those rated AAA) were at their smallest in years (see Figure 1).

At that time, an investor in the BBB-minus security might receive a yield only 62 basis points higher than an investor in a super senior AAA, nearly risk-free security (see Figure 2).


Then came dis-equilibrium in the global credit markets.

Starting in the spring of 2007, first with the drop in the Chinese stock market and then with concerns about the single-family housing market, demand in some parts of the CMBS market shrank dramatically. Many of the investors that had been driving the market--including foreign investors, hedge funds, collateralized debt obligation managers and other institutional investors--pulled back. Others began to re-evaluate their assumptions and risk-reward trade-offs and thus the yields they would demand to invest in CMBS.

The result--following the classic rules of Economics 101 that describe the consequences of a drop in demand--was a drop in prices, which translates to an increase in yields.

But the most significant impact on the market did not come from a repricing of risk. The most significant impact came from dis-equilibrium in the market, when buyers and sellers could not find a common level at which they could transact business. The difference between "bid" and "ask" pricing was significant. Potential buyers of CMBS had one expectation of the value (and hence price) of the securities, while potential sellers had a (significantly) different expectation.

By November, spreads on CMBS had risen to their highest levels on record, as had the difference between lower-rated tranches and higher-rated tranches. On Nov. 23, 2007, Commercial Real Estate Direct reported super senior AAA spreads at 109 basis points over swaps and...

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