Revenge of the Variable-Rate Commercial Debts

Most people in finance today cut their teeth in the era of Easy Money, when history books were thrown out the window. But that era is over.

By Wolf Richter. This is the transcript of my podcast on Saturday, June 24, THE WOLF STREET REPORT.

The good old Federal Reserve is now talking about hiking its policy interest rates toward 6%. Measures of underlying inflation have not come down in about seven months; what has come down a lot are energy prices; and they have pulled down overall inflation measures, such as the headline CPI. But core inflation and services inflation remain red hot.

In terms of the Fed’s policy interest rates, the top of the range is already 5.25%. The Fed is now talking about more rate hikes on top of that. There are not many people left in finance that were already decision-makers in finance last time the Fed was hiking rates in direction of 6% under the strain of red-hot inflation.

Most people in finance today cut their teeth during the period of Easy Money, when history books were thrown out the window and the new doctrine was established that the Fed’s policy interest rates would always be near 0%, and that inflation would never raise its ugly head again, and if the Fed were to hike rates again, it would do so only by a little and only briefly.

They learned this lesson – the wrong lesson, as it turned out – when the Fed timidly hiked its policy rates by 2.25 percentage points over a three-year period, from near 0% in December 2015 to 2.5% in December 2018, only to pivot months later and cut rates again.

By January 2020, so before the pandemic, rates were back at 1.75%, and by March 2020, they were back near 0%.

That was the only rate-hike experience for a lot of the decision-makers at institutional investors that are buying those securities. This includes banks, bond mutual funds, pension funds, etc. And other people that knew better years ago forgot about it by now.

People in finance today who were already decision-makers during the last major rate hike cycle from June 2004 through June 2006, when the Fed raised by four and a quarter percentage points, from 1% in June 2004 to 5.25% in June 2006, well, those people are now 45 and over. They should have known, they’ve been through a milder version of this. But they discarded that experience, for the new belief in the new era of permanently low interest rates and permanently low inflation.

And that hiking cycle from 2004 to 2006 occurred on much lower inflation than today: core CPI topped out at 3% in June 2006. And that hiking cycle progressed at a much slower pace than the current cycle.

There are not many people left who worked in finance when core CPI was 5% or higher, as it is today. There was a brief burst of that in 1990, and there was a lot of it in the early 1980s and before, but those people are now in their 60s and 70s.

Many of the hotshots in finance today cut their teeth when the doctrine was that inflation would never come back, and if it came back just a little, that the Fed could easily squash it, and that it would squash it, and that the Fed’s policy interest rates would nearly always be closer to 0%, and would only rise slowly and only a little bit, to maybe 2.5%, and only briefly, because market turmoil – such as the 20% dip in the S&P 500 in 2018 – would “force” the Fed to pivot.

This phenomenon, the belief in the new era where interest rates can never significantly rise again, has led to some truly interesting decision making over the past 15 years that is now causing all kinds of havoc after the Easy Money ended to the surprise of these people that knew that it would never and could never end.

This thinking that the Fed’s policy rates would always be close to 0%, and would top out at something like 2.5%, well, this thinking has now blown up four major banks: Silvergate Capital, Silicon Valley Bank, Signature Bank, and First Republic.

Decision makers at these banks had loaded up on pristine long-term Treasury securities and government-guaranteed mortgage-backed securities. But because they’re long-term securities, their prices fell when interest rates went up, and prices fell a lot, when interest rates rose a lot. This left the banks with huge potential losses – the so-called unrealized losses – on their balance sheets, and when big depositors figured this out, they yanked their uninsured deposits out, and the banks collapsed.

And this problem – based on decisions made a few years ago to load up on long-term securities when yields were really low – is still hammering a bunch of other banks.

This thinking that interest rates will never rise significantly, and that inflation will never rise, and will therefore never force the Fed’s hand, is now also blowing up Commercial Mortgage-Backed Securities (or CMBS).

These are mortgages that are secured by commercial buildings, such as office towers, shopping malls, apartment buildings, etc. These mortgages were sliced into different pieces, and often combined with other mortgages, and bundled into mortgage-backed securities, that were then sold to investors. So banks got rid of them; and the holders are now your bond mutual fund, pension funds, life insurers, publicly traded mortgage REITs, etc.

Because no one really expected interest rates and yields to shoot up this far, and this quickly, many of the underlying mortgages are variable-rate interest-only mortgages.

A variable-rate commercial mortgage means that the mortgage interest payment is going to go up with interest rates, based on a formula. And so over the past 15 months, these mortgage interest payments have doubled or more than doubled, and suddenly the already struggling rental income from office towers and shopping malls can no longer pay for the interest payments that have doubled.

At the same time, the market prices of these properties have plunged below and often far below loan value, and the landlords say, forget it, and they walk away and let the lenders, so the holders of the commercial mortgage-backed securities and other mortgage investors, have the properties. And these properties will have to be sold at huge losses for these lenders.

This started playing out last year, and is now coming into full bloom.

The landlord can just walk away since these are non-recourse loans, and all the lenders get is the collateral. The landlord only loses the money that they put into the building.

So that’s the problem with variable-rate commercial mortgages – no one expected those payments to double, and when they doubled the loans implode.

Variable-rate mortgages were very popular with investors – folks that never went through a period of big rate increases and big inflation, folks that thought that only small and brief rate increases would be possible.

The idea that the Fed’s policy interest rates would shoot up to over 5% and stay there for who knows how long didn’t apparently occur to them. And that landlords would see their mortgage payments double within a year, that apparently didn’t occur to them either. And that therefore, landlords would just walk away from the properties didn’t occur to them either.

But when rates were low, those variable-rate mortgages were great for landlords because they came with a lower interest rate. And when rates rise only a little bit, they’re great for investors.

By contrast, fixed-rate long-term debt falls in market price when rates rise. This was the problem that took down the banks.

But with variable-rate debt, the interest payments go up with interest rates, and so market prices tend not to fall when rates rise. So if short-term rates had risen only to 2.5% and stayed there for a few months, those investors would have looked like geniuses – making more interest income and maintaining the value of the securities. And they were counting on looking like geniuses.

But when short-term interest rates went over 5%, and the rates on those mortgages went to 7% or 8%, from 3%, then the borrower suddenly couldn’t or wouldn’t make the loan payment, and now those geniuses had a default on their hands, and instead of earning higher interest income, they’re earning zero interest income, and they’re stuck with the collateral that’s suddenly worth a lot less than the loan value.

Landlords were able to hedge some of their exposure to variable rates moving higher, but didn’t do enough of it because they too didn’t expect rates to rise by this much, and they didn’t expect for higher rates to last this long. Plus hedging can get expensive.

And a lot of these commercial mortgages are interest-only mortgages, with terms such as 10 years or shorter, and when the 3% mortgage comes due, it needs to be refinanced at 7%, while at the same time, the commercial property values have plunged. Landlords aren’t going to do that either, but instead, they say, forget it, and they’ll walk from the property.

Landlords – even the biggest landlords in the country – have already walked from numerous trophy properties, such as office towers from Manhattan to Houston, and from huge malls across the country, and from apartment buildings.

This is now playing out in real time across the country, and we discussed some of the biggest cases, some of the worst foreclosure sales, and some of the biggest losses on Wolf Street.

So far, this has hit investors, and not banks. Banks have apparently shed the riskiest loans, backed by the most overvalued properties. Eventually, they’ll get hit. But it seems the worst stuff out there has been shuffled off to investors.

This issue of higher interest rates that decision-makers had not envisioned and had not prepared for because they never expected that it could actually happen again, is now hammering overleveraged companies too.

These are junk-rated companies that have borrowed large amounts, usually in form of leveraged loans that have been sold off to investors, and you guessed it, these leveraged loans come with floating rates that go up with interest rates. Many of these companies were subject to leveraged buyouts by private equity firms, and were just loaded up with debt in the process. Interest payments were already a struggle before rates shot up. And now it’s getting really tough for them.

We have already seen bankruptcy filings by major companies through May jump to the highest level since 2010, though this is just the beginning.

All kinds of floating-rate debt is getting in trouble because neither the people in finance that worked on issuing that debt, nor the investors that bought this debt in its various forms, expected that interest rates would ever significantly rise again.

This belief that interest rates could never and would never significantly rise again has led institutional investors – bond funds, pension funds, life insurers, etc. – to chase after interest-only floating-rate debt.

These investors figured that floating-rate debt would protect them from a drop in value when the Fed hikes rates because the rate of floating-rate debt is pegged to Libor, or now SOFR. And when the Fed hikes, holders of floating-rate debt earn a higher interest payment, and the market value of the debt remains unscathed.

So that was the theory, based on the theory that inflation could not resurge, and that the Fed would not and could not hike rates to more than 2.5%, and that the Fed would be trapped, or whatever, if it hiked, and that it would have to pivot and cut rates before they go higher.

But that theory on inflation and the Fed’s rate hikes turned out to be just another bad theory, based only on the 15-year period of Easy Money, and not based on the period with actual big inflation and much higher rates. And because very few decision makers today worked in finance in the late 1970s and early 1980s, or even in 1990, and few of them were decision-makers in 2005, essentially no one was prepared for this.

This includes the policy makers at the Federal Reserve itself. They were not prepared, they blew it, they completely misjudged this inflation; they too thought that it would be just transitory or whatever, and go away on its own, and they kept telling the world still in early 2021 that the Fed would continue with its money-printing and would continue with its zero-percent interest rate policy at least until 2024. They totally blew it. Fed chair Jerome Powell is old enough to have seen first-hand the big inflation in the late 1970s and early 1980s, though he was just a young lawyer at the time, and he discarded any lessons he might have learned at the time.

Now they get it. But the damage is being done.

This 15-year period of Easy Money, of ultra-low interest rates and money printing, globally, will go down in history as one of the craziest periods ever – a period of consensual hallucination, a period when these goofballs imagined that the economy was immune to inflation and would never see higher interest rates again, and that unlimited wealth, instead of massive inflation, would somehow spring from money-printing and ultra-low cost of capital. This was the transcript of my original podcast on Saturday, June 24, THE WOLF STREET REPORT.

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