Core Investors Unfazed by Global Crisis and Domestic Imprudence
Sam Chandan Nov. 22, 2011, 2 p.m.
The potential for disruptions to global financial stability increased heading into last weekend. In Europe, both Germany and the European Central Bank rejected calls to expand the bailout to include large-scale bond purchases, insisting instead that the latter’s credibility depends upon its prioritization of price stability.
At a gathering of the Frankfurt Banking Conference, German Bundesbank president and European Central Bank Governing Council member Jens Weidmann said on Friday that “the economic costs of any form of monetary financing of public debts and deficits outweigh its benefits so clearly that it will not help to stabilize the current situation.”
Dr. Weidmann declined to comment when asked if the bank had furtively adopted limits on its weekly purchases of eurozone members’ government bonds. The meeting’s air of ambivalence in addressing the continent’s crisis coincided with concessions on the growth outlook. In his first public address as ECB president, Mario Draghi opened his remarks by stating that “downside risks to the economic outlook have increased.”
The positions emerging from their most recent meeting suggest that Europe’s leadership is ultimately unwilling to install a credible backstop should the crisis engulf other nations. The significance of the European threat for the global outlook is reflected in the reactivity of equity indices in the United States, where markets have been whipsawed by daily shifts in the tenor of news emerging from across the pond. After resuming a measure of normalcy, the VIX spiked during the 11th hour of the summer’s budget debate in Washington and has been elevated ever since.
Somewhat brighter economic data have not mollified investor skittishness. Over the next days and weeks, attention will also be focused on domestic affairs and the seeming incapacity of congressional leaders to achieve compromise. While debt talks remain fluid and the true state of discussions remain wittingly hidden from the voting public, it is increasingly likely that the goals set for the Joint Select Committee on Deficit Reduction in August will be abandoned.
The utter failure of America’s divided leadership is unconscionable, as is the continuing pretense of well-functioning democratic institutions. And yet, while the domestic scenario bears an uncomfortable resemblance to diegeses in the nations we condescend to instruct in governance, the market mechanisms that are critical to disciplining the latter are loathe to rebuke the United States for its shockingly myopic behavior. As the relatively safest harbor during a time of exaggerated risk and risk aversion, our markets have seen an influx of capital even though some of the most far-reaching sources of instability are rooted here. The 10-year Treasury closed the week at a yield of just over 2 percent. Meanwhile, the TED spread, which proxies for risk aversion, has risen to its highest level since mid-2010.
The desirability of American assets is not limited to the practically risk-free obligations of the Treasury. In the shadow of macro developments, core property investment and credit flows are rather robust. Investors’ determination that current prices reflect a discount on long-term cash flow and appreciation has been readily apparent over just the past two weeks. The Wall Street Journal reported last Wednesday that Equity Residential had taken the pole position in bidding for a majority stake in Archstone. The former’s $2.5 bid values Archstone at $4.7 billion—just $61,250 per unit—in a reflection of corporate structure and debt encumbrance issues that weigh on the underlying real estate. On a smaller and more idiosyncratic scale, Equity Group and Hilton’s Waldorf Astoria were reported last week to have acquired Chicago’s Elysian Hotel for approximately $95 million.
Apart from the recent litany of transactions priced above $100 million, a broader range of sales and development activity is supported by commercial mortgage lenders eager to see their resources deployed. At the extreme, Simon Property Group this month offered $1.2 billion in senior unsecured notes. The notes due in 2017 carry a $2.8 percent coupon, less than 200 basis points over the comparably termed 5-year Treasury and barely 80 basis points over the 10-year rate. The secured debt market trends are reflected in several recent originations, including a $360 million, 4.6 percent refinancing by MetLife for the Park Meadows shopping center just outside Dallas. Favorable financing is not the sole purview of the largest assets. The retired debt carried an interest rate of just less than 6 percent. In Cambridge, Mass., Marcone Capital arranged Cambridge Savings Bank’s $16 million financing for the Porter Square Galleria at just 4 percent. At 4.25 percent, JP Morgan Chase provided $6.5 million to refinance a four-building industrial asset in Burbank, in greater Los Angeles.
Property investors and lenders are necessarily assuming a degree of risk in their current activities. These risks relate to the interest rate environment and potential for inflation. While the latter may be internalized by properties with healthy fundamentals, the debt market will struggle to cope with higher interest rates should global or domestic conditions require higher baseline yields on U.S. debt. In the multifamily sector in particular, going-in spreads are no longer wide by historical standards. Apart from these capital and credit market issues, the broader threats to the economic recovery cannot be ruled out as challenges to still-fragile absorption trends. That should be cause for concern among credit risk officers and cycle-minded investment strategists, since an acceleration of fundamentals underpin the renewed tolerance for risk-taking and investors’ increasingly frequent fits of bravado.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.