The historic low in long term interest rates likely occurred in July 2012. Now we are facing increased volatility in interest rates and long-term interest rates will climb. This situation seems obvious to all the players in the capital markets.
So, with the almost certain prospect of rising interest rates, why are the life companies still aggressively pursuing long-term, fixed-rate commercial real estate loans?The current monetary policy of a zero-interest Fed Funds rate and successive Quantitative Easing’s is a form of price controls; artificially decreasing the price of capital. This manipulation of the free market for capital shifts earnings from investors to borrowers. Companies have artificially high earnings because their bond costs are artificially low. Leveraged real estate investors enjoy an even bigger subsidy, since their degree of leverage is generally higher than that of corporations.
In the face of what is often called the Fed’s policy of “Financial Repression”, why is anyone willing to play on the lending side of a rigged game? The reason: As rates were falling long-term bonds were very profitable. The low yield from the stated interest rate was more than made up by the appreciation of the market value for these bonds as rates fell.
The rigged market has created a bond bubble
The ride has been good, but investors admit that the risk to return ratios are out of whack. As in any bubble, we know the situation will reverse, but as long as we are convinced a greater-fool will buy from us at a higher price tomorrow, we convince ourselves we are not one of the fools. If greed keeps us in the game too long, we are proven foolish. The trick in any bubble is to sell before the crowd begins to sell.Given this competition to not be the last one still sitting, even rate stability can drive bond holders to race for the exit door. We saw this in the mini-panic caused by some very mild words from Ben Bernanke in June:
“Tapering” = Quantitative Easing will slowly, eventually end.We all knew this, but bond investors fled and both interest rates and spreads jumped. 10-year Treasury Swap yields were 2% on May 27th and 2.75% on July 9th. CMBS spreads increased as the same time. Since there is no good way to lock in an interest rate on a CMBS mortgage, 10-year fixed-rate CMBS mortgages that were getting signed up in the high 3% range were closing (if they closed at all) in the low 5% range, many times with the dollar amount of the loan drastically reduced.
In the midst of this, the life insurance lenders were an island of stability. They honored their commitments holding rates on loan applications where rates were locked and continued quoting loans and taking new loan applications generally at the same spreads as before the mini-panic.A savvy real estate investor, John McNellis (who has known me since I had hair), asked during this confusion in the capital markets: “If the life companies know that interest rates will be rising, why don’t they just pull out of the market and wait to put their money out when rates will be higher?”
I had my own theories, but I posed John’s question to a few of Newmark Realty Capital’s life insurance lenders. Here is their feedback:
- Life Companies are Investors not Speculators: Market timing investing does not work for life companies, especially now when holding cash is so costly. Chief Investment Officers (CIO’s) who try to time the market can be successful several time in a row, but one miss can cost the CIO his job. No one gets fired for matching the terms of assets and liabilities. Life companies have various product lines, many of which have long liability durations that pair well with long-term fixed-rate mortgages. The CIO’s job is simply to make a profitable spread between the long-term asset (the mortgage) and the long-term liability (the annuity or insurance product). If they just stay constantly in the markets they hope to average out over time. If not, they can sell or close out the line of insurance business. Because of the low-rate environment, Met Life announced they planned to get out of multiple lines of business this year.
- Mortgages do not have to be marked to market: Bonds are actively traded securities, as such accounting standards require them to be “marked-to-market”. Mortgages are much more illiquid and are generally held to term. Thus, mortgages just sit there on the balance sheet at their face value. Bonds can be very profitable when overall rates are falling as these securities increase in value. But the reverse will be true as rates start to rise. Over the last 30-years constantly dropping rates has created a tailwind for life companies as their bond portfolios rose in value. During this time (my whole career) the bond group was treated as the A-Team in the investment departments of most of Newmark’s insurance company clients. In the last few years this reversed. CIO’s are giving their Mortgage Department first billing. They are being told; “Find good mortgage deals and we will find the funds.” Mortgages’ avoidance of potential mark-to-market losses as rates begin to rise is a big factor.
- Call Protection. Mortgages can be a better match for long-term liabilities than bonds. The lender gets to write the documents in a mortgage and the borrower gets to write the documents in a bond. Thus fixed-rate commercial mortgage loans have the type of call-protection (generally yield-maintenance prepayment formulas) that is lender-friendly versus the borrower-friendly call options in a corporate bond. High-rate corporate bonds have a tendency to pay off when the corporation’s credit improves or when overall interest rates decline. Commercial mortgages generally keep their yield until very close to the due-date.
- Better Loss History. Most life companies have a system to equate a mortgage’s risk level to an equivalent bond, with targets usually somewhere in the range of BBB+/A-. Most life companies have fond that their mortgage portfolios have a loss history 15 to 20 basis points better than that bond equivalent. Also, a defaulted bond gives you a total loss, but even a vacant building taken back by the mortgage department has some value.
- Better underwriting and access to information with a Mortgage versus a Bond. In mortgage underwriting there is less need to rely on third-party underwriting and valuation. Most life companies underwrite mortgages themselves directly from the underlying leases and only use appraisals as a final check, simply a closing item. The specter of partiality by the Rating Agencies clouds the bond world (see prior blog posts). Likewise the creativity of corporate accounting is an ongoing challenge, with off-balance sheet entities and hidden derivative risks a real concern.
As the Fed calms the capital market with talk of postponing the end of QE3, it seems the question is not are the Life Companies back? They never went away!