Odd Lots - Tom Barrack On The Crisis In The Commercial Real Estate Market

Episode Date: April 6, 2020

The commercial real estate market has been clobbered in this crisis, as restaurants and stores virtually shut down entirely throughout the month of March. On this week’s Odd Lots episode, we speak to Tom Barrack, the CEO of Colony Capital, on the crisis facing the industry, and what he feels needs to be done further to prevent the industry from going into a tailspin.See omnystudio.com/listener for privacy information.

And welcome to another episode of the Oddlots podcast. I'm Tracy Alloway. And I'm Joe Wisenpaw. So Joe, I feel like we've hit probably all the major crunch points in the big market sell-off recently except one. I'm not convinced entirely that we've hit all of them, but I do think we have hit several of the major crunch points. Okay, the big ones. Okay, that's fair. The big one. Okay. All right. But there is a pretty big one that is looming that we haven't talked about yet. And that is what is going on in the mortgage market. That's correct. We've, you know, it's kind of interesting because, you know, there's a lot of compare and contrast to the 2008-2009 crisis. We know that 2008-2009 crisis more originated within housing and mortgage. and then spread outward. This one was more exogenous,

but eventually they kind of converge with some of the same pressure points because if the economy shuts down, people can't pay their rent at their mortgages. Right, exactly. And we've already seen, well, people who can't actually pay their rent and some companies that are also saying that they just won't pay their rent.

So Subway and that mattress company, whose name I forgot, mattress firm, Is that it? I think they said that they weren't going to pay their rent either. So clearly we're sort of getting to a point in time where there is going to be a big confrontation between landlords and their tenants. But the other thing that's happening is just widespread chaos within the financial system for mortgages itself. So we've had mortgage bonds, both residential and commercial, just plummet in value. And we've also had this thing where, as, the bonds plummet in value, big banks start making margin calls on funding that actually financed those

bonds. Yeah, that's exactly right. And of course, this too brings to mind prior periods of stress because there's always the question of, well, how do you make a mark in an asset during a period of extreme distress? What's fair? When are margin calls appropriate? These are These are very difficult questions to answer, especially in some of the, you know, very illiquid, more esoteric parts of the market where there just may not be an obvious mark to go on during a period of extraordinary illiquidity. Right. And at the moment, large parts of the mortgage market are basically illiquid.

So today we have the perfect person who's going to talk about this with us. We're going to speak to Tom Barrack. He's the CEO of Calling Me Capital, one of the biggest real estate investors out there. He's also written a post upon medium. Everyone should go check it out that sort of talks about the troubles in the mortgage market and also some suggestions from him about how to ease the pressure. So we're going to get into it. Tom, welcome to the show. Thanks so much for coming on. Thanks, Tracy. Great to be with you and Joe. So I guess just to begin with, could you maybe give us some color on what the mortgage market

or the real estate market actually looks like at the moment? Yeah, of course it's in chaos, as is most of our lives. While we have this intersection of two crises, the unforeseen and unknown coronavirus and COVID-19, and for the first time in anybody's memory or history, a cessation of revenue. So when we look at the setting that we're in, a banking system that became well-heeled and structurally much different than the banking system that was the subject of restructuring in 2008. And maybe it's worthwhile just to look at the great financial crisis, which everybody uses as a metric against which to have some historic perspective as to what happened. then and what we might do now, but a very different set of situations. The 2008 financial crisis really started in 2007 from an oversupply of everything and exogenous structural defects

and financial instruments that were being created and were sent around the world, these weapons of mass destruction, which bundled mortgages which which gave individuals of residential consumption an addiction and the same in the commercial mortgage markets and the same in the corporate markets so that collapsed without wasting too much time on on why and when had some of the same resolutions in that the the Fed and the Treasury had to step in along with the arsenal of other regulatory bodies so when we think about the liquidity and banking. We today have a banking system and we have a non-bank system. We have

Main Street and we have the capital markets. And for real estate and most of your listeners are too young to remember, but prior to 1990, there was really no capital markets. Real estate was an investment by individuals. There was very little shared participation in commercial real estate. Lenders were life insurance companies pension funds primarily and your local bank would make a loan to you on a commercial project based on your business. But REITs had been invented but not widely utilized and there really was no such thing as commercial mortgage bank securitization. So on the capital market side, if you thought in four quadrants, you have public and private equity and you have public and private

debt and what we're what we're watching today is the public side the benefit side of the public which you had liquidity you had transparency you have brought participation you had higher yield so that the individual mom and pop was able to participate in things that they're too for they had never had the opportunity and therein lies the benefit and there end lies the problem today is that liquidity, which allows you to vote with your feet on a daily basis, doesn't really work well for real estate when it's repositioned. Because the market for an asset, if you just think about a clearing price and things that everybody can touch of your house,

if you have a willing buyer and a willing seller, still it takes months. For a commercial property, even longer. So to be able to trade away evaluation in an hour or an afternoon in a unforeseen and unintended crisis is difficult. So if we just take the commercial mortgage market in general, in the United States, it's about $5 trillion in loans. and those loans are held by banks, insurance companies, mutual funds, reeds, other institutions, endowments. And what happens to them is non-bank banks, and maybe we stop there for a minute, a non-bank bank bank is a commercial mortgage weed, a BDC, another institution who originates commercial mortgages, pulls them together and creates. tranches of securitizations. Why does that happen? Why do banks not do that? After 2008, the regulatory environment for banks changed dramatically. And Dodd-Frank, which was a needed and worthwhile

addition to the regulatory sector, put severe capital regulations and restrictions on the normal banking sector. And they needed greater equity levels, greater enhancements. So if, if, If we look at it as oil and vinegar and say that the oil is the securitization part, and what the marketplace needed was more credit enhancement. So it needed the vinegar on top so that in the event of a crisis, the first loss period would be the vinegar. And after the 2008 great financial crisis, the amount of vinegar necessary for those credit enhancements became dramatically increased, as did the structural component of these securitizations.

So all the safety toggles that were built in them too complicated for us to talk about now. but the rating agencies and the structures of safeguards for master servicers and special servicers. But that was the key to the liquidity in the commercial real estate lending market. So you now had intermediaries who were originating these loans because the banks no longer wanted to do it. Dodd-Frank created a regulatory environment for the banks of the FDIC, the OCC, the SEC,

and the Fed that put unbelievable restrictions and transparency on the regulatory framework of what they could do and what they couldn't do. So they wanted to be much safer. Residential was easier and that you had Fannie and Freddie and the FHA, you had quasi governmental entities that could acquire these securities and create liquidity, but that didn't exist on the commercial side. So the shadow banking industry, which is the framework of what we call non-bank banks, the loan market, remember this is mostly for small and medium-sized enterprises. So it's for the fast food franchise.

It's for the car wash. It's for the little office building. It's for a retail operation who don't have access to large commercial loans. The gigantic office can be a subject for a security. but also direct investment on the private side for life companies, mutual funds, pension funds, etc. So part of what we're dealing here, if you took four quadrants of real estate, we have a public market. So the public market are reets on the equity side and securitizations on the debt side. And we have a private market is you own your house, you own a building and you get a loan from a life company.

And on the private side, none of those are tradable except a tribal treaty. On the securitization side, everything is tradable and you vote with your feet every hour. So if you own shares in a reek, you can trade it any day of the week. If you own securitization bonds, you can trade those every day of the week. That's the good news and the bad news. So what we've come into now is in going back to our oil and vinegar example, The commercial mortgage reits and the non-bank banks originate and bundle all these loans. They package them into securitizations with levels of credit enhancement from AAA to triple B minus as investment grade.

They sell those bonds through broker dealers that end up all over the world, right? They end up with life companies, endowments, hedge funds, corporate treasuries. and mutual funds and ETFs. And then the originator, let's say the commercial mortgage rate at the time, in order to keep the liquidity moving, the availability of going to the marketplace and create more loans, goes to their primary bank and takes the equity portion of what they have and the securities underneath it and they enter into what they call repurchase agreement.

And the repurchase agreement basically pledges all of those securities that the bundler has and says, we're going to lend you against that base X percent of what they call that borrowing base, basically. And we'll value those securities on a daily basis. The terminology of mark to market is that they'll take those securities. or those loans, sometimes their whole loans, and they'll mark them to market on a daily basis, and lend to that originator a percentage of that. I want to get into a bit on this sort of market to market question, but before we go any further, I would just like to real quickly, for listeners who don't know, maybe they only know you

from having watched your speech at the 2016 Republican National Convention or a few times on TV. As you talk about this ecosystem for real estate, where's your role so people understand your perspective as the CEO of Colony Capital? Where do you play in this entire mix? So Colony Capital is a New York Stock Exchange public REIT with over 50 billion in assets in a series of silos. We're an owner of legacy businesses and the usual food group. groups, hospitality, healthcare, industrial. We also are the largest shareholder and a commercial real estate reed,

a lender called CLNC. And in the last two years, we've switched to digital owners and providers of solutions and funding to the digital world. So radio cell towers, microcells, fiber networks, data centers, and smart logistics. So we have 19 off the world. We're globally balanced and we've been turning our asset focus

from legacy assets over the last two or three years. We've been selling substantial amounts of our legacy assets because prices have been quite year and in our opinion. So we've sold about $12 billion of legacy assets and we've invested that in the digital framework. We have 16 silo digital companies and about 25% of our balance sheet is digital. So the framework of looking at this and my personal point of view is the world of of real estate, by the way, which just to give you a broad view, if you took in America, if you took real estate ownership, real estate services, and all of the affiliates around it,

it's about 60% of the GDP of America. It's huge. And the underpinning of that are owners of real estate suppliers of capital and all the businesses that function within them, but it all functions in two markets, the Main Street market and the Wall Street market. So Colonies' perspective as an owner of of bricks and a sponsor of clicks is to keep that echo system moving as an owner and a receiver of income and a provider of both debt and equity to small and middle-sized businesses and a solution provider to the big digital logos. So in selling our own book, so to speak, the point of view here is I think that the universe of people like us have a front row seat to the interconnections on a global basis and how quickly it can go south.

And it goes south, it's not necessarily good for anybody's business. It's not good for our business, but we have four or five billion dollars of liquidity and, you know, we'll survive. The people who don't have the liquidity and can't survive are the small and middle-sized businesses, regardless of how good the SBA loans are and how good the unemployment benefits may be. So that's really our concern. So can we talk a little bit more about how it's going south? You were just discussing repo funding for commercial mortgage-backed securities and the mark-to-market idea.

What are you actually seeing when it comes to mark-to-market pricing at the moment? What's happening in that market? Yeah, I mean, that's a great question, Tracy. what's happening is there is no market. So market to market works when you have a smooth and functioning ordinary market. At a time like this, there are just no bids for those securities. So spreads widen a bank trading desk. So there's an individual based in Delaware, let's say for a major bank, who's valuing these multi-billion dollar businesses on a daily basis and has a has a manual saying this is this is what you do on a daily basis and if there's an impairment or if there's a threatened impairment or if there's a cessation and revenue anywhere then you you value this bond this way and they go to a broker dealer and they ask for a price well the broker dealers don't have any money either because it's completely stopped right the system has stopped

so there's no bid so if they happen to market let's just take hypothetical that you had a double A bond in which the day before there was a nebulent market. And now it's not that there's a market at a spread of 30 basis points or 50 basis points, but there's a temporary cessation of bids as there is in the marketplace, just saying there is no bid. And the valuation of that bond, everybody believes that when business comes back, not necessarily to normal, but when revenues return, whatever that is, whether it's 60, 90, 120, 180 days, that bond will come back to parity.

But that temporary mismark of that bond causes the bank to take those securities. And when they take those securities, or you have to come up with cash to rebalance their loan against what they thought the value was. Well, of course, the originator can't come up with the cash either because it's a falling knife. So everybody's trying to catch a falling knife. And in 2007, it took a couple of years to clear those falling knives because it was a question of credit and value. Today, the reason that you hear so much dismay in the financial marketplace of saying,

don't use the market to market, just forbear. forbear for 60 days. Let this pass and you won't have these unnecessary wipeouts, which are starting at the top of that intermediary, causes severe indigestion at the banks. Everybody says what great shape the banks are in. If this continues, the banks may not be in that great shape because they're swallowing all of these unmarketable pieces of death.

And most importantly, the small and middle-sized borrower who has this is on the ropes at a time where they just need a break. So what's been happening in this market market is everybody's been begging for a regulatory timeout. Now, it's happened on the residential side. So in governmental agencies, with Fannie and Freddie and the FHA, let's go to forbearances to the individual, and then we'll figure out the debt stacks on top of that. On the commercial side, it hasn't happened

because it's unbelievably complicated. So the care has empowered the Secretary of Treasury, Steve Mnuchin, who's sensational, with $450 billion, that he can lever 10 to 1 at the Fed window. And part of the discussion is what can the Fed buy along the securities railroad that will help? So TALF, one of these acronyisms from 2007, which is actually in existence, is the ability of the Treasury with their funds lever 10 to,

one to buy advance or lend against these securities so that it will create a market. It'll create an artificial market with some haircut. But since the Fed has a 30-year perspective, it's not like a bank who's saying, I'm going to value this to today's value rather than what they call a marked to model rather than a mark to market. So it's complicated, but if you just looked at it as pletka, it's pletka. plumbing, the pipeline is fine. There's a clog in the system. The pipeline isn't broken. And if you clear that clog for five or six inches, five or six inches, meaning maybe that's two or three or four

months, on the other end, the pipeline will continue to flow. If you don't, the whole system could crack. You know, the U.S. real estate market is $16 trillion. And if you take all the securitizations, the Main Street and the Wall Street pieces, maybe it's 12 trillion, but it's the window to a derivatives market, right? All these structured products rely on each other. So I think what people are missing is the fact that from the little person who has a fast food restaurant that can't pay to the most sophisticated Korean life company who's been buying structured financial instruments, this could be a fiasco if you don't get liquidity in the system.

So I think everyone agrees that this crisis, this recession, whatever we're calling it, is unlike anything we've seen before because, as you put it, the complete cessation of revenue, which is partly part of the public health crisis. We need everyone to stop doing things for a period of time. So we agree on this. There is a, the cynical view would be that, well, look, 2008, 2009, there were all. also calls at that time for the suspension of mark to market accounting for similar reasons. What is a good time to take a mark? It's always going to be difficult. You talked about the

inherent liquidity mismatch between some of these vehicles that people own versus the liquidity of the underlying products. What do you say to cynics that would say? You're always going to say that. You're always going to say this isn't the right time to take a mark because it'll come back. at some point. Yeah, and Joe, look, it's the right question. But here's the simple answer to me is, in essence, what's happened, it's an eminent domain act. So we can talk about how terrible what we're dealing with on a virus and a disease and a crisis, that is, and how you respond to it.

But the bottom line for these people is the government said, don't go to work. They didn't say if you go to work, you're going to get sick. They didn't say if you go to work, you're going to die. They said, stop. So when you do that, that's fine. And the consequence is a social consequence for all of us, right, in which we're all saying, for the greater good, we are going to protect a percentage of deaths by stopping the economy. Now, that is a debate in itself.

The way to do it is to say, great, the consequence of that is we're not going to, unnecessarily have another set of unintended consequences as a result of that, including deaths, by the way, by having a financial system that we're saying the only thing that doesn't stop is the consequences of our own actions, the government actions, and stopping commerce. It makes no sense. So we all have to pay that price. The Fed, right, our kids are going to pay the price. And by the way, the stimulus bill and Congress did a great job.

The administration has done a great job. But it's going to be the first in several. Right? This was three. We're going to have a four. We're going to have a five for sure. So the point is if you are going to pay for it anyhow. So the aftermath of 2008, when they went back and they looked at TARP over a much longer period of time, the mark to market then was as a result of the vagaries of the industry.

So supply demand was absolutely out of sight. And the lack of regulatory confines on the investment banking system was part of the problem. So in a market, which is adjusting as a result of the vagaries of the capitalistic system, it makes sense. When you have a government intervention that says stop, it makes no sense. So just on this question of moral hazard, which is the theme that we're really touching on right now, we have seen the Federal Reserve provide basically unlimited term borrowing for the banks. But part of the issue here seems to be that that liquidity isn't necessarily making its way into the non-bank financial system. Is that part of the problem? And how would you go about fixing it? Yeah, Tracy, absolutely. That is part of the problem. So the banks have zero borrowing costs and they have all the liquidity that they need. The Fed is opened up to them in every aspect. The banks, in turn, looking down this pipeline to everybody, have not figured out how to comply with the regulatory framework from a series of regulations. regulators, if you look at a chart of a depository bank, there's probably 10 regulating agencies. So the protocol of going from there to forbearance, right, which is the magic word.

Everybody wants a forbearance. So a tenant who's living in an apartment wants a forbearance for 90 days, 120 days from their landlord. The landlord then in turn wants a forbearance from their lender, that intermediate packager. The intermediate packager then wants a forbearance from its prime bank. And the problem is the regulatory requirements don't exist in a czar, right? There's not one person. And by the way, it's happened. So there's all sorts of interagency memos going around saying, lighten up on foreclosures,

go slowly on mark to markets, encouraging people to have this dialogue. But the regulatory framework within the banking industry is so complicated that they haven't been able to get the wiring correctly yet. And it's a fast-moving train. So I think that they'll get there. But since there's no plenary one-stop shopping on top of all of them, you have to get all these agencies and accounting rules to agree. So you have FASB, you have the SEC, you have the FDIC, you have the OCC, you have the Fed,

you have the Treasury, and you have state superintendents, all with a different, very complicated set of regulatory requirements, which don't move instantly. So I think that they'll get there, and I think the banks are very aware that they need to figure out a way to have a pass-through of the benefit and the largesse that they're getting from the Fed all the way through to the little borrower. But it takes time and it's frightening. Just to be clear, it's your view that, I mean, you mentioned we're going to need around four of the stimulus and around five and so forth. But at least under current law, do you believe that a sort of system-wide pause button is at least legally capable, even if there's extraordinary complexity and difficulty of coordinating among all the different regulators? Look, from the cheap seats, just from, I'm a user of capital and a beneficiary of the capital system. and I've looked at other countries around the world

and how they've responded, and none of them are great. But I think what history has shown us, that if you have an indication and a statement saying that you're covered, whatever it is, so if you're a tenant and you're paying rent and you can't pay rent, don't worry, you don't have to pay it. If you're paying interest and you can't pay interest, don't pay it. If you're receiving a check for $1,000 a month and have been cut off, you'll get $800 a month.

But that bill, whatever that bill is, is cheaper than what we're going to end up paying. So if you look at the GDP of Americans said it's $4.9 trillion a quarter, something like that, and said to keep this moving, and we don't know how long that it goes, but to keep it moving for everybody and price is not as complicated as how you do it, right? Because even with the SBA loans and looking and saying, how do you get those to people quick enough or the unemployment checks, how do you do it fast enough? But I think at the end of the day, we'll look back and say,

if you would have plugged this hole for everybody and said you're going to do it for 60 or 90 days. And then the crisis science, which I'm not in a position to even weigh on these, the doctors and the scientists are doing an amazing job. But whatever the comeback drill is, we need one, right? We have to have a comeback story. And the comeback story is containment and a process of those who are healthier, those have been infected in certain areas coming back.

How long does that take to come? You can't stop the GDP of America for seven months. It's impossible. So to me, the other crisis is the Fed coming out and saying, we can do it all and we'll do it all. They're trying to do it in steps. And I understand the legislative, the legislative dilemma is everybody wants to make sure that whatever,

whatever solution is applied equally to, all, that the aftermath of what happened in 2007 or that perception of crony capitalism, or that it's only the big financial players who benefit from this, and the fact cat executives and investment banks are going to get gigantic bonuses and the big corporations that are bailed out are going to get more stock grants. Nobody wants that. So it's complex, but I think it's, at the end, it's going to cost us the same either way. And I'm just a believer of the Fed saying, we'll open up the window and buy as wide a variety of securities as we can. Because if we bolster, if we bolster that just in our little world in real estate, if you bolster it at the

bottom, it all rises to the top. The investment grade, the big investment grade companies don't need help. They can still access the market. It's the other companies. So, If you said, great, here's what we're doing, and you have to keep your people employed at 80% of their salary, and you have to continue with benefits, and you have to continue with X. I think you start to solve the problem. It's just, it's massively frightening to all of us who are sitting on the precipice of this financial tsunami. And we're going to see more, right? It's April 2nd today. payments between April 2nd and April 11th, they're going to tell us a lot.

Who's going to pay and who's not going to pay? And when they don't pay, what happens? Can you imagine some? I mean, a governor or mayor of any city is not going to honor an eviction of the tenant. So what does the landlord do? Nobody pays? Nobody's going to get thrown out. Right?

It's the same. The resolution, the bankruptcy courts can't handle the amount of bankruptcies that it can be. They're going to have to have a cessation on the process. so it's easier to keep the plumbing moving and avoid the unintended social consequences of what I'm about if people can't function. I think that's actually a good place to leave it. Good. Will you guys send me the solution?

Yeah, what we figured out? We'll shoot you an email. Yeah. We'll try it. Thank you so much, Tom. A really great conversation. And we appreciate you coming on. No, you guys are great.

It's great catching up with both of you. Stay safe. Thanks, you too, Tom. Cheers, you too. So, Joe, I found that conversation really fascinating. Tom is probably the perfect person to really talk about the intricacies of the mortgage market at the moment. And I think what comes through the most is that it's not as simple as everyone just saying, oh, we're not going to pay the rent for two or three months.

There is this sort of complicated network or ecosystem that is attached to the cash flows from that rent. Well, absolutely. And of course, we got into this a little bit in our recent episode with Zoltan Poser and Perry Merling, just about this sort of overall, you know, the complex web and why just be, if you for, if you offer forbearance for one entity, then that's another entity on the hook. And I think what interested me is not just this idea of like a systemic wide pause and whether it's theoretically possible, but the, as he described, the web of different regulators around the world or at least around the country at a minimum that would have to agree on that. There's not even, there's no entity maybe the Fed could come close us, but there's no one even in a position to unilaterally declare that,

even if that were seen as a, the best way forward at this point. Right. And I think his point about just sort of keeping things going in the interim might be the cheapest and easiest solution in the long run. Sort of makes a lot of sense at this point, especially when you're talking about something as heavily legaled as U.S. real estate. He mentioned the bankruptcy system just then. We know that a lot of the mortgage servicers are already full up because a lot of people have been refinancing their mortgages at ultra low rates.

The idea that now we're going to be having a bunch of loan workouts or bankrupt processes, you could see that easily, easily overwhelming the system and really making life harder for a lot of people. Yeah, absolutely. And of course, you know, a sort of a large firm that has a lot of lawyers and accountants can navigate this. You know, there's also a lot of sole proprietor, commercial real estate, landlords out there. There's just people who own a home and might rent it out to someone else who don't have that capacity, but they also aren't going to have the capacity to do an eviction. They probably wouldn't even want to go into the person's house or into the tenant's house in a health crisis to do that. So without some sort of systemic wide ability to,

again, hit this pause button, the other avenues that we typically deal with, or the other avenues that we typically deal with for bankruptcies will clearly just get overwhelmed and we'll pay for it one way or another. Yeah. I think in sum, everything in the mortgage market right now is just really, really messy. That's my overriding conclusion from this conversation. And I know, you know, some of the things we've recently talked about, I thought it was interesting, Tom dropping a reference to what is it, the Korean structured notes, right? Or the Taiwanese life Oh, yeah. Buying these.

So previous odd lots that we now have to revisit very soon because you said at the beginning, we've cut all the, we've hit all the big themes, although we still haven't done the EM angle, which I think is really big. But we've hit most of the big themes, and now we need to get into the micro themes because there's just so many aspects of this mess to discuss. All right. We've done macro. The micro is coming up very soon.

But let's leave it here for this particular episode. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allowway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallworth. And you should follow our guest on Twitter. Tom Barrett. He's at Tom Barrett, Jr., J.R. And you should follow our producer on Twitter. Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast on Twitter, Francesca Levy, at Francesca Today, as well as all of the Bloomberg podcasts under the handle at podcasts. Thanks for listening. Thank you.