Guest Post: Tranche Warfare

Today we have a special treat, a guest post from my friend Mark Marasciullo, one of the savviest commercial real estate owners and operators on the east coast.  Mark is the managing partner of New Canaan Partners in Greenwich, CT.

The below is a look at the state of the commercial real estate business and some macro insights from an insider who has seen everyone’s cards – the banks, the lenders, the Fed and the investors.  Enjoy!

– Josh Brown


Tranche Warfare |noun|: a quaint colloquialism for how the commercial real estate (CRE) cycle is playing out thus far in the “recovery”.  The entire notion of it is rather amusing – tranche being a slice of the debt capital structure, warfare meaning the game that a bunch of buttoned down, largely pampered MBA types are playing.

What’s a tranche?  With the emergence of CMBS (commercial mortgage backed securities) many lenders originated loans and then bifurcated the loan into an A note (senior tranche) and B note (junior tranche).  In some instances there was even mezzanine debt subordinate to the B note and in various cases the B note was split into multiple strips (i.e. B1, B2, B3 and so on), all of which are tranches.  Typically the A note was sold to a trust, which was then securitized in the form of CMBS.  I just looked at deal where the A note holder is completely trapped, the inter-creditor agreement between the A note and B note holders dictates that the A note may only sell its position to a party in the existing capital structure.  In other words, the B note holder has the position senior to it (i.e. the A note) cornered, and will dictate the outcome for the asset.  In cycles past the lender and borrower fought it out when the market corrected itself, this time the various lenders are warring amongst themselves.

When CRE crashed in 2008, it crashed hard, with pricing down some ~40% across the country.  However, CRE is a localized business so some markets, DC and Manhattan come to mind, are much stronger than the rest of country and asset pricing hasn’t fallen quite as far.  Most of the equity invested in CRE from 2004 thereafter was wiped out almost instantaneously, though many of those losses have not yet been recognized.  Moreover, a plethora of these assets were leveraged at loan to costs (LTC) in excess of 80%. What’s left for debate is which tranches of the debt capital structure are impaired (worth less than 100 cents) and which are worth PAR (100 cents).  In theory, any piece of the capital structure behind the first $0.60 (on the dollar) has been lost, but again that’s to be determined on an asset-by-asset basis, and this is where the tranche warfare is under way – the inflection point between the good debt that be can taken out at loan maturity, and the bad debt that cannot be taken out at loan maturity, which for all practical purposes is now the equity.

From a macro standpoint at issue is will we have deflation, where debt is destroyed, or inflation, wherein debt is created?

The case for Deflation: The total credit market debt to US GDP ratio historically runs at 155%, in 1930 it peaked at 260% and as of March 2009 it was an astounding 375%.  In other words, as the chart shows we are now 1.5x more leveraged than we were in 1930 (yikes).  Seemingly, this chart would suggest that we are about to enter a financial winter unlike any other seen in this country since the Great Depression of 1930-1933.  Furthermore, this implies we are about to enter a deflationary period, as debt/money is destroyed through the painful, yet necessary deleveraging process to purge the system of all the rotten debt.  Scared yet?  Yeah, me too.

The case for Inflation: The Federal Reserve is so terrified by the prospect of deflation, the last serious bout of which resulted in the Great Depression, that it is betting our currency’s future on their ability to keep the ponzi going.  Recently some at the Fed have even suggested they might target higher inflation rates; proof positive that come hell or high water they are determined to ignite inflation to win the war against deflation.  In fact, as illustrated in the accompanying chart, the Fed nearly tripled the monetary base during the financial crisis in an attempt to spur more lending (i.e. debt).  I would suggest they consult their counter parts at the Japanese Central Bank, and ask how well that’s worked in Japan, over the last 20 years (while they are at it they may also ask for a good Koi Pond guy because right now we are all turning Japanese).

  • “The definition of Insanity is doing the same thing over and over and expecting different results” – Albert Einstein

In short, the backdrop is so decidedly deflationary that central bankers worldwide are printing money at a breakneck pace in an attempt to reignite inflation.  Personally I believe we will be trapped in deflation for some time, maybe 3+ years, after which we will have a bout of inflation (best of both worlds!).  That said, like you I have no idea, if I did I’d already be sipping fruity drinks in the Virgin Islands somewhere.  “Looking good Billy Ray!  Feeling good Lewis!”

Confused yet?  Me too, so perhaps a little historical perspective will enlighten us.

The Last Virtuous Cycle

When I got into the commercial real estate business in 1993 the mantra of the day was “stay alive till ’95” because the CRE markets were toast.  That was the nations first jobless recovery (an oxymoron in my opinion) and the CRE capital markets were broken: lending was non-existent, capital was scarce and balance sheet lenders were dealing with failed borrowers.  1995 did arrive, and sure enough the capital started to flow again.

The years 1995-1998 were robust for the CRE capital markets.  Back then, when the free markets still existed, to some extent anyway, pricing was based upon the underlying economic fundamentals.  The markets worked; the early 1990’s CRE implosion had given way to a wealth of new investors and entrepreneurs who were making good money cleaning up the mistakes of the last cycle.

Capital Flows & Liquidity Drive Pricing, Not Fundamentals

In October 1998 Long Term Capital Management, a Greenwich based hedge fund, had levered itself 100:1 and required a bailout.  Apparently, the system had become so intertwined one big, bad trade could bring it all down.  Fortunately, Mr. Magoo (aka Alan Greenspan) stood ready to fire up the printing presses, flooding the system with liquidity, which gave birth to the dot com bubble.  And then in what seems like throwing the gas on the proverbial fire Mssrs. Geithner, Summers and Rubin decided Glass Steagall was arcane and unleashed what would one decade later become hell.  This was the last time CRE investments were based on fundamentals instead of liquidity.

When the tech wreck hit, CRE was healthy because unlike the 1980’s the 1990’s were a disciplined development cycle (i.e. the markets weren’t overbuilt) and leverage hadn’t been so pervasive. (Un)Fortunately, Mr. Magoo was there again to flood the markets with liquidity, only this time he’d tapped his inner geisha and decided to reduce the federal funds rate all the way down to 1% by July 2003.  Now fundamentals didn’t matter at all, there was so much liquidity no one could lose.  Shortly thereafter in 2004 the CEO of Goldman Sachs, Hank Paulson (aka Mr. Bazooka with a TARP), lobbied Bill Donaldson of DLJ fame, but then chairman of the SEC, to raise the leverage ratio for primary dealers from 12:1 to 40:1.  Imagine that, no Glass Steagall, ridiculously high leverage caps and money printers running the Fed – who could lose?  In a word, everyone – and eventually we all did.

  • “The nine most terrifying words in the English language are, ‘I’m from the government and I’m here to help.’” – Ronald Reagan

Extend & Pretend, Delay & Pray

2003 through 2007 witnessed the real estate bubble, CRE and resi, which hopefully we will never witness again (sorry campers but bubbles aren’t healthy, especially credit bubbles).  Then it all began to unravel in 2008:

  • large bank failures, check
  • dramatic market crash, check
  • socialization of losses (and of course privatization of profits) – check
  • unemployment comparable to the 1930’s (U6 = 17%) – check
  • helicopter ben put – big, BIG, check

Surely there had to be a silver lining to this crash, right? I believed the virtuous cycle that I’d waited for, the one that would provide me a path to prosperity was just around the corner.  Well what a difference two years makes because a funny thing happened on the way to prosperity: Helicopter Ben Bernanke discovered his inner geisha and cut the federal funds rate all the way to 0%.  Further, our “leaders” at the fed, treasury, congress, white house decided that they had to bail out the system (i.e. their system, and really that of the moneyed interests who’d failed us so miserably) or risk waking up the masses to the problems they had helped create.  You see Washington and Wall Street were, and still are complicit in the crime, even as they point fingers at one another.  It’s almost like Bonnie and Clyde in divorce court, if only it was that amusing.

Unfortunately, this is NOT playing out like the early 1990’s CRE cycle in any way, shape or form.  In many ways, it is playing out like Japan after their credit bubble burst in 1990 (and every year since) – extend/pretend, delay/pray, inflate/wait, hope/nope.  The system is so insolvent and so devoid of leadership that problems are not being solved – we’re merely “kicking the can down the road”.  I wish I could see clarity on the horizon, but instead of adding transparency to the system the Fed has simply made it more opaque thereby exacerbating the pain and drawing it out over an extended period of time.  They tell us that if we just make credit cheaper and flood the system with liquidity, rising asset prices will save us all (hmm, where have I heard that before?).

So this brings us back to Tranche Warfare.  There are some who see the disconnect between the fundamentals and the overabundance of liquidity, and others who never saw fundamentals as important because capital flows do indeed dictate pricing.  On the one hand you have the deflationistas who don’t see how we can destroy so much debt and money without deflation.  On the other hand, you have the inflationistas who are convinced that the money printing antics of our central banks will ignite inflation, maybe even hyperinflation.  These two schools of thought are at odds in Tranche Warfare – some investors walk away and say this asset will be deflating for years so I won’t throw good money after bad, while others double down on their bets because they see inflation as the problem staring us in the face, and hard assets like CRE are a good hedge against inflation.  Both camps have compelling arguments.

Truth be told there’s no good pricing metrics to say who’s in the money and who’s not.  My guess is the Tranche Warfare will carry on for years because the only floor under asset pricing is the printing press run by Chairman Bernanke, and I don’t think this country has the socioeconomic fabric to withstand too many years of Japanification but the market can stay irrational longer than you can stay solvent.

At the present time what I’m seeing is just more cheap and easy credit pushing people further and further out on the risk curve, which always reminds me of a sitcom I grew up watching and I didn’t fully understand until we had a serious, protracted economic dislocation.  Of course, the sitcom of which I speak is none other than Good Times:

Keeping your head above water, making your way when you can.

Temporary layoffs, Good Times!

Easy Credit Rip Off, Good Times!

Scratching and Surviving, Good Times!

Hanging in a chow line, Good Times!

Ain’t we lucky we got ‘em….Good Times!

Here’s the good news, at some point this will come to a head, the Fed will lose control and I believe we will have that virtuous distressed cycle.  It won’t be easy but it is necessary.  When, why or how that will happen is anyone’s guess.  Getting there seems to be toughest part of the journey, but make it we shall and it will be capitalism and a return to free markets that saves the system from total oblivion.  See you on the other side.


Thank you, Mark!

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