Refinance Risks at Home and Abroad – July 11, 2016

Risks at Home – The Fed

If there’s one thing that the Fed is good at, it’s sending markets into a panic. And then calming them. And then sending them into a panic again. And then calming them… you get the point. We affectionately refer to this as “The Fed Cycle”.

Fed Cycle

Markets dislike volatility. The Fed has tried to limit volatility through forward guidance since the Great Recession ended in 2009. Unfortunately, despite the best intentions, the Fed often creates the volatility it is trying to prevent. The most recent Fed Cycle began following the FOMC’s December meeting. The Fed offered hawkish forward guidance (Fed Threatens Hike) that conflicted with weak economic data released just weeks later, causing market disruptions and a rise in volatility. The mismatch between the Fed’s forward guidance and relative economic expectations cause CMBS spreads to widen by as much as 100 bps (Markets Tank).

Markets breathed a sigh of relief in March when the Fed revised their rate hike forecast downward (Fed Delays Hike), more in line with the markets’ perceived strength of the economy. Markets calmed and CMBS spreads tightened more in line with those offered in late 2015, completing the cycle (Markets Recover).

On May 18, 2016, the Fed released the minutes of their April meeting, which revealed a surprisingly hawkish Fed. In the minutes, many Fed members expressed concern that the market was mispricing the likliehood of a June hike. This caused yields along the curve to spike and volatility to rise. This kind of disconnect between market expectations and Fed rhetoric caused spreads to widen before, could it happen again?

CMBS Spreads

The graph above shows the real world effect of the most recent Fed Cycle and it’s effect on CMBS spreads. As you can see, once the Fed gave hawkish forward guidance, the markets responded by rapidly pushing spreads out. Once the Fed lowered their rate hike forecast, markets settled and brought spreads back in.

However, it’s worth noting that the Fed is not the only threat to CMBS spreads. The new risk retention regulation going into effect later this year is expected to increase borrowing costs, which could compound uncertainty around Fed action.

A recent article from Commercial Mortgage Alert (June 24, 2016) suggests that borrowers could start seeing increased loan spreads as early as Labor Day. The risk to lenders is that they close a loan in October or November, but can’t securitize until January, when the higher costs could reduce or wipe out the profit. Several CMBS experts have said that lenders could lift spreads by 10-15bps starting in September, tacking on additional increases as we approach the deadline.

Risks Abroad – The Brexit Referendum

The recent Brexit referendum caused one of the biggest market disruptions since the Great Recession.  While a departure from the EU will likely create a drag on UK GDP, the market’s reaction was driven by the fear that other EU member will follow suit.  A shared currency and a shared central bank can no longer be taken for granted, casting doubt about the entire Eurozone experiment.   If the UK departure is just the first step to an unwinding of the entire Eurozone experiment, what are the possible ramifications?

In a classic flight to safety move, the US 10yr Treasury yield plummeted 0.33% overnight and since then has been trading within 0.10% of the all-time low.  This could play out in the CMBS market by a general widening of spreads as investors demand a greater return for risk.  Banks could begin pulling back, underwriting only the safest of assets or through more conservative requirements.  In a more dramatic scenario, lending could dry up entirely as bank stocks are punished and commercial real estate values fall.

The Bottom Line

Loans maturing over the next eighteen months have heightened sensitivity to lending appetite, wider spreads, and increased regulation. Many borrowers have been defeasing over the last two years to take advantage of low interest rates. Perhaps the risk going forward is the availability of capital, not just the cost of capital. The experts at Medalist Defeasance can help you quantify this risk so you can determine if now is the right time to refinance.