REITs, CDS Spreads and Bear Markets

Includes: BXP, DDR, ICF, IYR, VNQ
by: Jim Delaney

Bull markets, they say, climb a wall of worry. Bear market rallies . . . I don’t know what they say about them, but if this is the former, there most certainly seems as if there is enough to worry about and if it is the latter, my vote would be to something along the lines of “bear markets are like walking on eggshells.”

Unemployment and its effect on the much mentioned U.S. consumer, headlines tomorrow’s market activity. Will “cash for clunkers” be the Cinderella story of this recovery and revive Joe Sixpack’s desire to lever and spend or will the stimulus, which is still having a more potential than kinetic effect burn off like starter fluid on a brick?

One area of the economy that seems poised to feel the effects of what ever the current rally turns out to be is commercial real estate. The major banks, we’ll call them the TALF 10, had a majority of the exposure to residential mortgages due to all of the securitization that was going on. Commercial mortgages on the other hand are usually originated and held on the books of the same institution and as such are naturally diversified across many, albeit smaller, banks.

The Moody’s Investor Service Commercial Property Index fell 7.6% in May (the latest month for which data is available) putting it 28.5% below year ago levels and 34.8%% below the October 2007 peak. The real world effect of this is that as of July 31st 69 banks had failed in 2009 alone and even Sheila Bair would be hard pressed to recite every name on that list from memory. Ever heard of the First State Bank of Altus? Me neither but before it went bust it had assets of $103.4 million. That should frame things for you.

Developers Diversified Realty Corp. (NYSE:DDR) is said to be issuing two bonds totaling ~$600MM which are expected to become the first TALF eligible securities. The commercial mortgage portion of the TALF program does not seem to be meeting the same success as the residentially focused initiative as various regulatory wrinkles and rating agency downgrades continue to hinder the effort.

If following the “smart money” is any indication it is interesting that Mort Zuckerman is selling shares in Boston Properties Inc. (NYSE:BXP) to buy new printing presses for his other venture, The Daily News. I guess nobody told Mort about Web 2.0.

A recent analysis by the WSJ showed that “U.S. banks have been charging off soured commercial mortgages at the fastest pace in nearly 20 years,” and “could reach about $30BN by the end of 2009.”

From all of this, one would expect the CDS spreads on REITs to be widening and their equity prices falling but that’s where the worried walk on the eggshells starts. There are 21 REITs in the CEC universe and at present the CEC Portfolio is long 14 of them. Keep in mind that CDS level movement is the main driver of the buy/sell decision in the CEC Strategy but also that the negative correlation that is empirically evident must also exist in real life for positions to be initiated. In other words CDS levels and equity prices must be moving in opposite directions before a stock is bought or sold.

Since the CEC Portfolio is long that means that the CDS was falling and equity prices rising when the positions were initiated. Risk management takes care of existing positions but the important point here is that the CDS market does not seem to agree with the media regarding the major REITs at the moment.

This should not be too hard to comprehend because the media, for the most part, does not agree the S&P 500 should be at 1,000 right now either.

A wall of worry or walking on eggshells . . . . tune in tomorrow!