Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: Wall Street braces itself for November, trouble in commercial real estate, and a look at exponential-growth bias.
Wall Street Braces Itself
Investors are gearing up for a shaky election season. Polls and prediction markets suggest a Democratic sweep, but the widespread use of mail-in ballots in key swing states raises the risk of delayed results. Trump has refused to commit to a peaceful transfer of power, while Hillary Clinton has advised Biden not to concede under any circumstances.
As we’ve discussed previously, October and November VIX futures imply an unprecedented spike in volatility around November 3. The immediate concern is that a contested election would catalyze a sell-off in financial markets, which, in the event of social unrest, could persist even after a victor emerges.
Wells Fargo strategist Christopher Harvey told CNBC that a contested election would push stocks down 10 percent, a risk that has depressed equities in recent weeks. And Harvey is not alone: His view reflects a market consensus, according to the Wall Street Journal:
Whether fueled by a slow or contested counting process, futures and options prices show that an ambiguous election result is now the stock market’s baseline expectation, while those tied to Treasurys and gold are signaling one of the most active Novembers on record, traders said.
While the short-term outlook is perilous, the long-term economic effects of the election are less clear. A Biden administration would likely stimulate the economy through increased deficit spending, but the Democratic nominee’s proposed tax hikes and new regulations could outweigh the effects of more spending. Goldman Sachs analysts estimate that Biden’s tax plan would decrease corporate earnings by 12 percent. On the other hand, trade tensions, which weighed on markets through Trump’s first term, would likely recede under a Biden presidency.
Perhaps more consequential than the policies themselves are their second-order effects, specifically on monetary policy. A successful fiscal expansion could increase yields on U.S. Treasuries and lead the Federal Reserve to raise interest rates sooner than expected, which, though in some respects a positive sign, would hurt stocks and could forestall an expansion.
In any event, markets seem unwilling to look past November for now. Traders are scooping up everything from currency derivatives to precious metals to protect against political risk.
Trouble in Commercial Real Estate
As we have by now long since discovered, an economy cannot just be switched off and on. Switch it off, and it will unravel in ways that are unpredictable and cannot be reversed “just like that” (any older British readers will understand the reference.)
My own best guess is, as discussed in earlier Capital Notes, that the death of the office has been wildly exaggerated, but that’s not to deny that offices in what are (were?) prime city centers are in trouble, particularly those that hosted industries, such as finance, where working from home is relatively easy. Much of Manhattan comes to mind.
Writing in the New York Post yesterday, Steve Cuozzo noted that there had been some return to the office by Wall Street types, but mainly at senior levels:
“Most companies want their people back sooner rather than later. But they don’t want to be seen as bullying them,” said a major leasing broker who didn’t want to be named. “They’re hoping that having some rainmakers and traders come in first will provide a comfort level for everyone else — and praying there isn’t a bad virus outbreak.”
As first reported in The Post, Citibank also stepped up its Manhattan return timetable and expects to have 30 percent of its staff back in its metro-area offices by Oct. 5, most of them at its 388 Greenwich St. headquarters.
And to put this in some sort of perspective: “CBRE reports only a gradual uptick in office occupancy from around 8 percent in August to above 11 percent last week at the 20 million square feet of properties it manages in Manhattan.”
But commercial real estate’s woes are not confined to offices. To take other obvious examples from across the country, there are malls and hotels.
The Financial Times, again from yesterday:
Commercial properties hit by the economic effects of coronavirus could have lost as much as one-quarter of their value or more, laying bare the scale of the damage being wrought across American malls, hotels and other commercial buildings.
Evidence emerging in the commercial mortgage-backed securities (CMBS) market from recent appraisals also raises questions over the value of the collateral backing commercial mortgages throughout the financial system.
Properties that have gotten into trouble are being written down by 27 per cent on average, data from Wells Fargo shows. New appraisals are triggered when a commercial property owner starts to have trouble paying the mortgage, and the loan is handed to a “special servicer” that could eventually seize the property on behalf of CMBS holders.
As the FT observes, there are concerns about what this could mean directly for the banks:
US banks are increasingly worried about being repaid on loans secured against commercial property, as offices, malls and hotels continue to stand empty.
The darkening outlook of banks is laid bare by disclosures on so-called criticised loans, which are flashing warning signals about a borrower’s ability to pay.
Among the 10 banks with the largest increases, criticised loans rose by 62 per cent in aggregate in the second quarter, but criticised commercial real estate loans rose by 144 per cent, to $26bn, according to an analysis by the Financial Times.
The banks with the largest total increases include JPMorgan Chase, Bank of America and Wells Fargo, three of the four largest banks in the US by assets. Criticised loans at those banks are now equivalent to 9, 13, and 25 per cent of tier one equity capital — the core measure of a bank’s financial strength — respectively, according to S&P Market Intelligence…
A criticised loan is considered equivalent of debt rated CCC or lower by a credit agency.
CCC is, of course, very deep into junk territory.
But back to CMBS (collateralized mortgage-backed securities), a class of security that was, of course, at the center of the financial crisis.
Writing in the Financial Times on Friday, John Dizard (an NR alumnus, incidentally, from way back when) wrote:
The major banks are far more risk averse and better capitalised than in the past crisis, and the housing industry is prospering from the refinancing boom made possible by Fed easing. Since the Lehman/2008 crisis, risk has been moved off bank balance sheets and into securitisation markets.
That is why I think it is more likely that the coming financial crisis will be triggered by the market’s rejection of a few classes of securities. Something like this happened in 1929 with the collapse of pyramided securities holding companies.
So to find the point of vulnerability in the US financial markets, I believe we have to look for the least legally flexible credit securities that can move the fastest from low risk to visibly defaulted.
Those would be the commercial mortgage-backed securities (CMBS), particularly those floated in the market between 2012 and 2017. Because they are (mostly) not held on bank balance sheets, there is no bank that can decide, say, to amortise their principal and interest payments over a longer timescale. Unlike almost all collateralised loan obligations, CMBS cannot have any substitution of collateral. Meaning you cannot move a few bad assets to the sponsor’s own balance sheet and replace them with performing assets that can be added to the CMBS collateral pool.
A CMBS manager generally holds small amounts of cash that are intended for maintenance or replacing necessary equipment or fixtures and furniture in shared areas. These “FF & E” pools typically will amount to about three months of assumed rent receipts.
Since the Covid-related economic crisis in March, the trustees for many CMBS bonds backed by troubled properties have allowed FF & E accounts to be used to pay enough principal and interest to avoid having the CMBS collateral from going into default. But that three months of cash has run out in many cases, particularly for hotels and malls. In the first weeks of September, there has been a rapid increase in the number of CMBS going into “special servicing”, ie a sort of formal default.
Without getting too deeply into the weeds here, the Fed can, these days, help by buying “agency” CMBS (securities backed by Freddie Mac and Fannie Mae). Those, however, mainly relate to multi-family housing. The central bank’s ability to buy non-agency “private-label” CMBS secured on commercial properties is restricted to those that are AAA-rated, and that is not where the trouble is likely to lie. Private label is a much smaller market than it was before the financial crisis, but still…
Around the Web
Even in the rarified world of hedge funds, having the right diploma can make give you a leg up:
Hedge fund managers with prestigious degrees aren’t necessarily smarter than their peers. But they do use their networks and the reputations of their alma maters to better structure their funds and deliver higher returns, according to new research published in the fall Journal of Alternative Investments…
According to the study, these funds not only delivered higher returns on average, but also lower risk, higher Sharpe ratios, and higher alphas, or returns above a benchmark.
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A deal between Argentina and its creditors is failing to buoy the country’s bonds:
On August 31, Argentina clinched near-unanimous approval from its bondholders to restructure $65bn of foreign debt after months of sparring. The country’s sovereign bonds began trading this month, and have already fallen towards distressed levels.
One note, set to mature in 2030, is now trading at roughly 40 cents on the dollar, having debuted earlier this month at just over 50 cents. Another approximately $20bn in bonds maturing in 2035 slipped as low as 35 cents on the dollar last week. It now hovers around 37 cents. According to calculations by Morgan Stanley, the initial performance is the worst for any newly restructured emerging-market bonds in the past 20 years.
George Yarrow on two types of exponential growth bias:
Exponential growth bias (EGB) is one of a long list of cognitive biases identified by psychologists and perceptions of it and its prevalence have come to play a significant role in the development of policy responses to Covid-19.
In brief, the bias is seriously to underestimate the future values of something that is growing at a constant proportionate rate. Its existence has been well attested in research stretching back over several decades and a classic illustration is an ancient puzzle: Put one grain of wheat/sand on the first square of a chess board, double it on the second, keep doubling until the 64th square and then ask how many grains there will be on that last square. The numbers just race upwards in a way that most people cannot get their heads around.
At the opening of the encounter between the British public policy making establishment and the SARS-CoV-2 virus, a view was formed that the public would significantly underestimate the rate of spread of the virus and hence underestimate its risks. In effect, there was an assumption that the public would exhibit EGB. From this it was deduced that risk-avoiding social conduct taken of their own volition would be too low for the good of the community: the public would be insufficiently fearful…
In reality, and like sorrows, cognitive biases tend not to come as single spies, but in battalions. Most of us are subject to several, but there is one, hitherto largely unidentified bias that appears highly relevant for understanding our current situation. I will refer to it as Type 2 Exponential Growth Bias, to distinguish it from the familiar EGB (henceforth Type 1 EGB). It is simply defined as a tendency to ‘see’ or infer an exponential curve (or something broadly similar, a curve that is rising and bending upwards) where no exponential curve exists or is likely to exist.
An immediate implication of this definition is that it is a bias whose incidence is likely to be limited to that class of people who have some familiarity with, although not necessarily a full understanding of all, the properties of these curves/functions. To imagine an exponential where none exists it is necessary first to have some view of what an exponential curve looks like, and possession of such a vision is not ubiquitous…
Read the whole thing: It helps understand the approach taken by quite a few governments to COVID-19, and not in a reassuring way.
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