Canary in a Coal Mine


Before I got into the real estate business, I had the pleasure of working on Salomon Brothers’ trading floor as a junior analyst. It was a year before the crash of 1987, and I was assigned to the repo desk. Like others, I hoped to be on the mortgage desk with Lewis Ranieri or the junk bond desk where Michael Milken was making headlines for rival Drexel Burnham. The repo desk happened to be right next to the desk of the immortal CEO John Gutfreund, who was constantly smoking a Cuban cigar right alongside the traders. He advised me, “Don’t worry kid, if there is a problem in the financial system, the repo desk who will be the first to know about it.” Gutfreund turned out to be prescient, as the traders were finding it increasingly difficult to find counterparties in the summer of ‘87. The traders were frantic trying to balance the firms’ books each night and the company’s overnight borrowing rate soared. Back then, the Fed wasn’t propping up the market by injecting liquidity. The increased overnight rates were eroding Salomon’s profitability. More importantly, it foreshadowed problems in the financial system as counterparties were becoming skeptical of the questionable collateral being offered to repo buyers. As Gutfreund predicted, the repo desk issue foretold the crash which occurred that October and thus truly was the canary in a coal mine.

I tell this story because it is eerily similar to what’s happening today. 

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Three trillion dollars worth of repurchase agreements is going through the repo desk each day. For the lenders, it allows them to get yield on idle cash and enables banks and broker-dealers to get needed financing by loaning out securities they hold in return. It also has the effect of influencing the $16 trillion U.S. Treasury market. Central banks use the repo market to temporarily extend credit in tight markets and stabilize financing costs. This is crucial in times of crisis. It’s perplexing that the imbalances have been happening recently in a relatively complacent market and why the imbalances show no signs of letting up since first occurring in the week of September 16th. During that week, overnight trading rates spiked from 2 percent to 10 percent. Various theories as to why this happened emerged, including abnormally low reserve balances, more stringent liquidity requirements, quarterly corporate tax payments and increase in net Treasury issue. The Federal Reserve solved the problem by injecting funds directly into the system to soak up the shortfall. This allowed the Fed to keep interest rates artificially low. This a problem because the Fed is, in some cases, taking back securities that aren’t credit quality in exchange for cash. And by injecting money into the system ($75 billion in repos), the Fed is expanding its balance sheet once again, whereas for the last two years it was attempting to reduce its balance sheet. 

What does this mean for real estate? If this trend continues, the system would not have much of a safety net in the event of an exogenous event. The Fed could always solve it by injecting still more into the system, like in 2009 (TARP anyone?). However, a short squeeze or liquidity crisis could cause a lesser capitalized financial institution to fail. The more practical risk is a spike in interest rates or a “risk-off” mentality which could adversely affect real estate values. It’s telling us that something isn’t quite right in the financial system — another black swan in what’s starting to become a flock of swans. We had the inverted yield curve (which predicted the last seven recessions), the trade war with China, the rent regulation changes in New York City, and the flight of foreign capital. Somehow, real estate has been relatively sanguine to most of these changes. Meanwhile, the stock markets are making new highs. So why worry? I’m not recommending any action to clients currently. However, all prudent investors should keep a keen eye on the larger financial markets. Real estate values would be negatively affected in the event of an unexpected and prolonged downturn. This would be primarily due to reduced leverage levels and increased borrowing rates, which would affect all leveraged returns, and thus cap rates.

Dan E. Gorczycki is a senior director in the debt, joint venture, and structured finance group at Avison Young, New York LLC.