Tim Geithner’s TALF Meets Adam Smith’s Free Market

by REIT Wrecks on April 14, 2009

While commercial real estate lobbyists are busy trying to convince Treasury officials to incorporate five-year loans into the Term Asset Lending Facility, the TALF has been busy distinguishing itself as the latest example of the efficacy of central planning. Unfortunately, TALF loans of almost any duration are unlikely to reverse the trend of declining commercial real estate values – that has become a mathematical certainty. Indeed, Adam Smith’s infamous invisible hand remains hard at work, and it is demonstrating once again that economic well-being is the result of rational self-interest, not that of government decree.

Smith published The Wealth of Nations in the auspicious year of 1776, and last week three ivy league academicians offered what could be the latest appendix. In a study entitled The Pricing of Investment Grade Credit Risk During the Financial Crisis, the economists used mathematical models to examine credit spreads over time. They concluded rather anti-climactically that “improved investor appreciation” of the risks embedded in structured products is the main culprit for spreads that are now stubbornly wider than the Gulf of Alaska, not the lack of credit. They go on to assert that “policies that attempt to prevent a widespread mark-down in the value of credit sensitive assets are likely to only delay – and perhaps even worsen – the day of reckoning”.

However, the TALF cannot be blamed for postponing the day of reckoning in commercial real estate – it would have to be relevant for that to be the case. In fact, TALF still refuses to venture where all lenders fear to tread: long-dated subordinated and unrated tranches of ABS/CMBS paper. Liquidity at these levels is essential for the securitization markets to be recuscitated. Investors who bought these tranches before the crisis are still stuck with the financial equivalent of lead balloons, and there is no way to cleanse their balance sheets of these “legacy assets” without effectively blowing themselves up. With no new buyers for these subordinated tranches, the CMBS market cannot be revived.

While the debate over exactly what’s wrong with TALF is relatively academic, the market is not waiting around for the last word. The Fed reported that requests for TALF loans dropped 64% last month. Meanwhile, capitalization rates continue to rise and will almost certainly exceed the 20 year national average of 8.3%. Rising cap rates will perpetuate continued deflation in commercial real estate, and many equity investors who bought at the peak please pass the charmin will be wiped out. Interestingly, public REITs are now trading at an approximately 200 basis point discount to the private market, which may indicate that the creative destruction in commercial real estate is nearing its logical end – without any real help from the TALF.

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