Emergency Economic Stabilization Act (EESA)

Government Intervention:
Start of a Corrective Process - No Quick Fix

The passage of the revised Emergency Economic Stabilization Act (EESA), which includes the Troubled Assets Relief Program (TARP), did not immediately ease interbank lending but is expected to begin relieving financial sector uncertainty and the logjam in the commercial paper market in the months ahead.

Lenders and investors have so far looked beyond the passage of the rescue bill and focused more on evidence of further economic weakness and financial sector troubles, which are now spreading through Europe. Since the legislation passed, a massive equities selloff has ensued globally. Borrowing from the Fed by commercial banks and bond dealers increased 60 percent last week to $348 billion, exceeding levels reached after the 9/11 attacks. In addition, the three-month LIBOR rate rose to 4.33 percent, up from 4.21 percent, showing that banks are still hoarding cash. Although it will take time to work through, the government measure is a critical first step in thawing credit markets.

Aside from the philosophical and political debate regarding why the financial system is in crisis, a systemic solution was required to reverse the domino effect of ballooning uncertainty in the global financial system. The time pressure to pass a broad-based measure became a factor of containing the degree of uncertainty among banks, restoring interbank lending and reducing investor pessimism; these factors have led to a near stoppage of capital flows in recent weeks.

The Fed and Treasury Department’s attempt at one-off fixes to address the rapid de-leveraging of financial markets and unwinding of troubled assets eventually gave way to a broad-based rescue plan. The package has been controversial from the start due to the potential taxpayer liability and has sweeping implications for future regulation; however, the depth of the issues left the Fed and Treasury Department with little immediate choice.

While the broad-based rescue package is not an end-all solution to the current crisis, it represents a critical first step in stabilizing the financial system globally. Due to the complexity of financial instruments used in recent years and the interconnectedness of the financial sector globally, the true magnitude of potential risk in the marketplace will remain difficult to quantify for some time. This creates a question as to whether the $700 billion rescue package will ultimately be enough.

The delay in passing a rescue package did have implications for the commercial real estate market aside from just exacerbating financing constraints. These include the potential damage to the economy above and beyond what would have been the course of the unfolding downturn. This is the result of the credit freeze on commercial paper and other forms of short-term financing that companies of all sizes rely upon.

The EESA is aimed at addressing the hundreds of billions of dollars of illiquid assets clogging the financial system through TARP. The legislation passed by Congress will fund the $700 billion rescue package in installments. Furthermore, an oversight committee will be created and salary curbs are to be placed on compensation packages for executives of companies that sell assets to the Treasury. The EESA also includes tax cuts for businesses and households, and provisions to reduce potential taxpayer liability, such as a plan to recoup any net losses to the taxpayers directly from the financial industry after five years. It also increases the FDIC’s guarantee on covered deposits to $250,000. In addition, the EESA restates the SEC’s authority to suspend mark-to-market accounting if it deems necessary. If this practice is suspended, institutions would be able to avoid using fire-sale pricing in their accounting for some difficult-to-trade assets, potentially reducing writedowns in the short term.

The EESA will not stave off insolvency for all institutions, as the number of banks on the FDIC’s watch list is on the rise, increasing from 90 in the first quarter to 117 in the second quarter. The number of additional institutions that will face liquidity issues is likely to be greater.

• The TARP portion of the EESA is aimed at troubled assets – mostly mortgage-related – that are difficult to price and trade, and have ended up weighing down institutions’ balance sheets.
• The government has the capacity to purchase these investments from financial institutions and hold them until the market thaws. It is most likely to use a reverse auction to allow institutions to compete in their pricing and sale of assets. Theoretically, this approach could result in some level of returns for taxpayers or at least minimize the downside. The post-9/11 bailout of the airline industry ultimately netted taxpayers an estimated $130 million, while the Chrysler bailout in the late 1970s resulted in a $300 million return for the Treasury.
• Once credit markets recover, the government ideally would be able to sell the assets purchased as part of the TARP, recouping some portion of the taxpayers’ investment. As a result, the ultimate cost of the plan to taxpayers is unknown. As a point of reference, once the clean-up of the Savings & Loan (S&L) crisis was complete at the end of the 1990s, the total cost to taxpayers was approximately $124 billion, or approximately $268 billion adjusted for inflation. The current financial crisis is greater in magnitude due to the complexity of its drivers. While the run-up in the housing market and the ensuing downturn are at the root of current problems, the total scale of the crisis remains unknown due to the complex financial instruments and derivatives that were used in recent years.

The government has become more cautious about bailouts for individual firms, but it is making extraordinary efforts to restore liquidity and shore up confidence in the broader financial markets.

• The Fed has been instrumental in coordinating global support for the economy and financial system from foreign central banks. The Fed recently increased its currency swap lines, providing foreign central banks with greater access to U.S. dollars. In addition, central banks around the globe have been pumping liquidity into the marketplace in an attempt to ease interbank lending rates and liquidity concerns. These measures will only work if banks return to normalized lending.
• By refusing to rescue Lehman Brothers, the Fed and Treasury Department sent a message that the government was not a one-off bailout facility for every ailing financial company; unfortunately, Lehman’s collapse may have increased the magnitude of the current crisis since many funds and major institutions had significant exposure to the firm. Although the government proceeded to rescue American Insurance Group (AIG), it did so based on its assessment that the company’s collapse could have caused significant devastation to the global financial system.

Economy and Financial Markets

The U.S. economy – already facing significant headwinds – will be further challenged by the latest turmoil in financial markets.

• Financial sector job losses will be greater than anticipated, particularly in New York and other markets with high concentrations of financial activities employment. Most companies entered the economic downturn relatively lean, and job cuts were below trend until recently; September figures reflected further economic weakening with the loss of 159,000 positions, the largest monthly decline since 2003.
• The latest woes on Wall Street and throughout the global financial system have exacerbated the credit crunch, further limiting the availability of credit to businesses and consumers, which in turn will hinder spending. Lowerrated companies will face much greater difficulty securing short-term funding, while even highly rated corporations have experienced a run-up in borrowing costs. During the week beginning with the Merrill Lynch and Lehman announcements, the volume of commercial paper outstanding contracted by more than $52 billion, its greatest weekly decline recorded year to date.
• Exports, which have helped to offset the drag of housing on the U.S. economy, are likely to slow as the global economy downshifts, reducing demand for goods and services worldwide.
• A large share of the economic stimulus checks were spent in the second quarter, leaving minimal support for third and fourth quarter GDP. The recent meltdown on Wall Street and its effects on the economy may place more pressure on the government to consider another round of stimulus by early next year.

On the positive side, oil prices are again well below peak levels registered earlier this summer, which should give the Fed more flexibility as inflationary pressures ease. The headline rate of inflation declined slightly in August due to falling energy prices, and September inflation figures should reflect further easing if the dollar and oil prices stabilize in the near term. Many investors in oil futures who relied on borrowed money are being forced out of the market as credit availability tightens. Furthermore, investors are increasingly fearful that financial market turmoil will result in additional slowing of the global economy, thereby reducing overall demand for oil.

Long-term interest rates are low again, as investors continue to flock to the safety of U.S. Treasurys amid growing economic uncertainty. Following the Lehman and Merrill Lynch announcements and due to post-bailout jitters, the yield on the 10-year Treasury slipped below 3.5 percent; however, it has fluctuated in a band of approximately 40 basis points in recent weeks, as investors have been quick to react to changing conditions. Long-term rates are expected to normalize between 4.0 percent and 4.5 percent once the current crisis passes. However, the benefit of low rates will not be felt until banks and other institutions begin lending again.

Uncertainty is causing significant volatility in financial markets despite the Securities & Exchange Commission’s temporary ban on short-selling of nearly 800 financial stocks. Failures of top financial institutions at rapid rates have injected a new level of fear into the marketplace, creating an environment where investors will continue to act quickly to avoid further losses.

The Chicago Board of Options Exchange Volatility Index (VIX), which measures the expected volatility of S&P 500 index options over the next 30 days, recently increased to a record high, surpassing its previous peak reached when the markets re-opened following the 9/11 tragedies. The index first spiked following the rejection of the initial version of the EESA by the House of Representatives but rose to a higher level after the passage of the revised rescue package, as concerns regarding the state of the global economy intensified. This is pushing more capital to the sidelines, which may eventually benefit commercial real estate once the worst of the economic issues pass.

Commercial Real Estate Financing

High-profile defaults – primarily highly leveraged deals that closed at the market’s peak – should be differentiated from otherwise healthy fundamentals and low delinquency rates among most core, Main Street commercial real estate assets. Overall, commercial mortgage delinquency rates remain near record lows but are expected to rise, reflecting weakness in the economy. As a result, there will be additional distress; however, assuming financial markets begin to normalize, the magnitude of the downturn should not be severe enough to cause wholesale distress in the commercial real estate market.

Capital remains constrained, with borrower requirements and underwriting adjusting to increased risk in the marketplace. Debt-service coverage ratios have increased to 1.25x to 1.30x and downpayment requirements have increased to an average of 30 percent to 45 percent. These indicators are in line with long-term averages; however, lenders have become extremely sensitive to quality.

Tighter lending standards will prevail over the foreseeable future, and spreads are expected to remain volatile through the next several quarters.

• After the Lehman and Merrill Lynch announcements, portfolio lender spreads for apartment properties increased 30 to 40 basis points, then rose another 20 to 25 basis points when the initial EESA failed to pass a House vote; they currently range from 275 to 300 basis points over the 10-year Treasury. Apartments are a bright spot in Fannie Mae and Freddie Mac’s portfolios, and the agencies continue to lend on quality deals. Agency fixed-rate spreads have also risen since the Lehman and Merrill Lynch announcements to 275 to 300 basis points over the 10-year Treasury.
• Best-of-class retail assets are able to garner financing at around 300 basis points over the 10-year Treasury. Lending rates are up roughly 40 basis points from before the Lehman and Merrill Lynch announcements for less-desirable retail properties, with the average currently around 345 basis points over the 10-year Treasury.
• Since the Lehman and Merrill Lynch announcements, office loan spreads have increased approximately 25 to 30 basis points, ranging from 300 to 345 basis points over the 10-year Treasury. Markets with high concentrations of financial services positions will face added scrutiny among lenders.

Impact on Commercial Real Estate Market

In the short term, further economic weakness will be reflected in higher vacancies. However, limited construction during the past cycle should keep vacancy rates below prior-peak levels, with the exception of retail, assuming the downturn is not significantly deeper or longer than expected. Longer term, the dropoff in construction activity and an economic recovery should bring commercial real estate supply and demand back into balance.

Market and submarket selection are critical in the current environment. In New York City and other financial centers, office owners will experience reduced demand for office space, and Wall Street job losses are likely to negatively impact other commercial real estate sectors. For New York City, the effects will be most pronounced Downtown. Direct job losses from the Lehman bankruptcy and the takeover of Merrill Lynch could total 15,000 financial services positions in New York City alone. Ultimately, each Wall Street position eliminated could translate to the loss of an additional two to three jobs for the New York City economy. Fortunately, New York City has become one of the tightest markets globally, entering this downturn with strong fundamentals.

Bankruptcies and mergers among financial institutions are intensifying the office market downturn. Financial activities employment accounted for 6 percent of all jobs as of August 2008, which is in line with the long-term average. The most recent period of significant contraction in the sector occurred as a result of the dot-com bust and 9/11 tragedies, when financial activities payrolls slipped to 5.8 percent of total nonfarm employment. From 2000 to 2002, the U.S. office vacancy rate nearly doubled to 16 percent. However, this period was not only marked by the dot-com bust but also significant levels of contraction following the late-1990s economic boom.

If financial activities’ share of total employment drifts back down to 2001 levels, this would translate into the loss of another 236,000 positions in the sector. Markets other than New York City with high concentrations of financial sector jobs include Jacksonville, Charlotte, San Francisco, Salt Lake City, Minneapolis, Phoenix, Dallas/Fort Worth, Fort Lauderdale, Tampa, Denver, Columbus, Orange County, San Antonio and Philadelphia.

The current environment is marked by a flight to safety among lenders and investors. Lenders are increasing equity requirements as concerns regarding defaults and declining property values intensify, creating a gap between high-quality assets and markets, and lower-tier investments. Cap rates for higher-quality assets in primary markets have moved up the least, while the most adjustment has been among lower-tier properties in secondary and tertiary markets and submarkets.

The credit crunch and expanding buyer/seller expectations gap are hindering transaction velocity and will further pressure prices in the short term; however, tighter financing is also resulting in a significant dropoff in construction starts. Although the Fed has expanded its lending facilities, allowing institutions to use a broader range of collateral when borrowing from the central bank, many banks remain hesitant to lend and are maintaining capital to shore up balance sheets. As a result, the financing climate is expected to remain tight, limiting the availability of capital for commercial property transactions and new construction. Insurance companies are also likely to face capacity limitations, further reducing capital flows into the sector.

High-profile Wall Street assets that may be distressed comprise a small share of the overall market. There is still some uncertainty regarding the future for Lehman Brothers and AIG’s real estate-related assets. It is estimated that more than 90 percent of the real estate transactions that Lehman provided equity or debt capital for since 2001 took place from 2005 to 2007, representing $31.5 billion of assets. The majority of Lehman’s activity during this time period was in Washington, D.C., Reno, Los Angeles, Atlanta, Boston and Manhattan. Prices peaked during this period, potentially resulting in discounting if the assets must be liquidated quickly. The bulk of the troubled portion of these portfolios are related to residential real estate and commercial paper.

There is a significant difference between "distressed" assets and the vast majority of properties that report healthy occupancies and cash flows. Of particular concern are owner-occupied and singletenant properties, particularly in secondary/tertiary markets, which have become more vulnerable to owner/tenant defaults, as many small- to mid-sized companies have been hit hard by the freezing of the commercial paper market. Additionally, distress is more likely among high-leverage deals closed at the market’s peak, failed conversions and speculative development projects.

There is plenty of equity in the market, as commercial real estate values doubled from 1997 to 2007, and a substantial volume of cash remains on the sidelines. Beyond the current financial market turbulence, investors will be looking to redeploy capital. The price expectations gap between commercial real estate buyers and sellers will take time to narrow. However, the sector’s advantages as a hard-asset class with favorable long-term returns, an inflation hedge and relative stability against an extremely volatile stock market will attract a new round of capital. More clarity on the economic direction and redefined pricing will have to materialize as precursors for the emergence of this next cycle.

Recent Events Summary

Charlotte-based Wachovia, which is suffering from heavy mortgage-related losses and a falling stock price, has reportedly accepted an offer from Wells Fargo after rejecting an earlier bid from Citigroup to acquire its banking operations. Banking industry woes are spreading across the globe, with two major European financial institutions failing in recent days. Government action has become more swift, with the European Union choosing to allow individual countries to act.

Failure of the initial EESA to pass a House vote placed additional strain on the economy and financial markets. Failure of the original bill sent financial markets into a tailspin; at the end of the trading day, the DJIA had lost nearly 780 points, its greatest single-day point loss in history, though not the largest decline on a percentage basis. Recovery followed but more sell-offs reflect the fragility of investor confidence.

Banks’ reluctance to lend to one another has created yet another hurdle for the financial industry around the world, hindering normal operations. In a well-coordinated effort, central banks have banded together to help thaw an interbank lending freeze. In response to skyrocketing interbank lending rates, central banks around the world are injecting liquidity into the market to ease pressure on the already fragile banking system. Additional and more direct Fed intervention in the commercial paper market and interbank lending may become necessary.

Seattle-based Washington Mutual was seized by the government as its mortgage-related losses mounted, its stock price slipped and customers withdrew nearly $17 billion in deposits over a 10-day period; the bulk of the bank’s operations have been sold to JP Morgan Chase. Washington Mutual’s downfall marks the largest bank failure in U.S. history, and uncertainty within the banking industry persists.

The Wall Street investment banking industry has been fundamentally changed, as Morgan Stanley and Goldman Sachs will be converted into traditional bank holding companies. The transition will place what were the final two major Wall Street investment banks under the supervision of bank regulators. The transition allows the firms to avoid mark-to-market accounting practices, or the valuation of assets based on current fair market value. In today’s market, many assets have become difficult to trade and therefore price. As a result, mark-to-market accounting can lead to significant writedowns and add yet another layer of uncertainty for investment banks, fueling investor fear. Furthermore, as commercial banks, Morgan Stanley and Goldman Sachs will be able to rely on funding from customer deposits.

A handful of money market funds “broke the buck,” sparking more broad-based government intervention. Money market mutual funds are typically among the safest investments and are required to invest conservatively, generally in lower-risk short-term securities; however, they are not FDIC insured. It is uncommon and alarming when a money market fund “breaks the buck,” or its net asset value falls below $1 per share. This occurred within the past few weeks for a handful of funds, including one of the oldest in existence, sounding yet another alarm for financial markets. To shore up investor confidence and prevent a run on money market funds, the Treasury Department announced it would guarantee deposits in these funds, which are estimated at nearly $3.5 trillion, for a one-year period given that the funds pay a fee to participate in the program. The guarantee only protects existing investments, preventing the potential for mass withdrawals from commercial banks to participate in these funds, which generally provide higher yields than standard savings accounts.

The government initially rebuffed a rescue of American Insurance Group (AIG) but reconsidered due to potentially disastrous repercussions that the company’s failure could have on the global financial system. The government is providing AIG up to $85 billion in funding at a steep interest rate of 8.5 percentage points above the 3-month LIBOR, and is taking a 79.9 percent stake in the company. The AIG credit facility has a term of 24 months and is designed to allow AIG to meet its financial commitments while selling off several of its business units in an orderly manner.

Barclay’s agreed to purchase a large share of Lehman’s securities business. The deal includes Lehman’s Manhattan headquarters building and two data centers in the Northeast, and it should provide a reprieve for 10,000 of Lehman’s 26,000 employees. However, it is unknown how many of the 12,000-Manhattan-based positions this figure includes.

Merrill Lynch opted to accept a $50 billion offer to be acquired by Bank of America following the government’s announcement that it would not back a rescue of Lehman. It is unknown how many of Merrill Lynch’s New York City-based work force will be affected, though an announcement by Mayor Bloomberg suggested local job losses may be minimal.

Lehman Brothers filed for Chapter 11 bankruptcy protection amid mounting real estate-related losses, resulting in significant fallout for other financial firms and exacerbating the crisis. In the days leading up to the announcement, the 158-year old company failed to secure much-needed funding from foreign sources and was unable to find a buyer after the government refused financial assistance.

The U.S. government seized control of mortgage giants Fannie Mae and Freddie Mac. The collapse of one or both of the companies would have had devastating effects on the mortgage and housing market, in addition to the broader economy and global financial system. Combined, the governmentsponsored enterprises hold or back $5.2 trillion in residential mortgage debt, or roughly half of the total outstanding. Fannie Mae and Freddie Mac hold or guarantee approximately 36 percent of outstanding multi-family loans and have continued to fund these transactions, as their apartment portfolios have low delinquency rates and generally conservative underwriting.

U.S. Financial Crisis: How Did We Get Here?

The financial sector deteriorated rapidly during the past few weeks, elevating the capital markets turmoil of the past year into a crisis. Troubles have been building for some time. Given the unique and complex nature of the current financial crisis, many investors may be asking how we ended up in this situation.