I told you, didn’t I? Tacky of me to say, to be sure, but I have harping on this for the better part of a year. Interest rates will remain elevated for a very long time and the halcyon days of 2021 are but a memory, not to be reprised any time soon. It’s time, perhaps gone time, to reconcile ourselves to this inescapable reality.
Indeed, it’s time not just to reconcile, but to embrace. I promise, we’ll eventually see it’s not that bad.[1] Channel your inner Professor Venkman on crossing the streams, “I love this plan!”
Tighter credit conditions are going to be with us for a while. Not forever, nothing is, but remember there’s precious little difference between a secular change and a very long cycle when you’re in the middle of it. This is a long cycle. The low interest rate environment of the past eighteen years was aberrational and the credit curve we’re seeing today is actually much more consistent with long-term patterns in the US economy. This should be your base case.
Reconciliation begins by traveling along our own Cheap Money Anonymous chapters’ twelve-step process. We have gorged on low interest rates and become dependent upon them. Ending that dependency is going to be painful. It begins with a clear-eyed view of first causes and progresses from self-knowledge through despair, recriminations, anger and to ultimately to acceptance. Understanding why higher interest rates will be with us for a considerable period of time and rejecting any notion that something magical will happen rather soon and restore our long-enjoyed low interest rate environment is critical. One needs to take this on board to competently plan for survival during a high interest rate interregnum.
The primary player in this little drama is sovereign debt and the rapid increase in the price of all debt driven and led by the overhang of sovereign debt. It’s not war, pestilence, oil prices, nor indeed is it the remarkable performance of the US economy. Sure, those things contribute to elevated rates, but the real deal here is the extraordinary level of sovereign debt across the world. As Warren Buffet (sort of) once observed, when the tide goes out, we’ll see who’s been swimming naked and as war and the oil shock recedes and our economy cools, sovereign debt will still have its pants on and will be driving the interest rate and inflation story.
We’re awash in sovereign debt. The last worldwide estimate I saw was $350 trillion. The US alone has sovereign debt of over $40 trillion and that probably understates it by $10-15 trillion once you add in all the off-balance-sheet stuff that, at the end of the day, is the responsibility of our Federal government (and it gets even worse if you add in the trillions of dollars of debt issued by state and local governments). Remember, all this sovereign debt sits atop a vasty pile of private US debt (estimated to be $45 trillion!). All of that debt needs to continue to attract investor dollars. The sovereign debt that is supposed to be risk free, anchors and drives the pricing of all of that public and private debt and absorbs investor dollars that would otherwise be available to service private debt. The excess of sovereign debt is the blasting cap that is triggering the massive repricing of the enormous keg of both private and public debt that we are beginning to see today.
Blaming everything and everybody (but, of course, not ourselves) for higher interest rates is largely a political parlor game. It’s the war, we say; it’s oil, it’s the failings of the Biden Administration, it’s the failure of the Trump Administrations, or both. It’s climate change, it’s AI or the collapse of industrial America. All convenient villains, but broadly this is noise. The game is designed to keep the folks from asking hard questions, about public spending thereby avoiding the necessity of our political leaders having to make hard decisions. Our problem, put simply, is that government expenses exceed revenue and when that persists for long enough, misery ensues. (Dickens made this point in David Copperfield a century and a half ago.) None of our political class want to confront this reality because they so enjoy handing out goodies to the folks and are aware that they’re running out of other people’s money to pay for it. They want to be liked; they want to be loved and fiscal rectitude is broadly inconsistent with that.
Moreover, we’re hearing constantly that the economy is actually in pretty good shape and the stock market, of course, remains buoyant. So, folks, don’t bother your pretty little heads about debt. Debt is not a problem, Debt is not on the agenda because as we just said, it doesn’t matter. All this does is demonstrate that momentum is a wonderful thing and the economy and the consumer can withstand higher interest rates, at lease for a while, but that doesn’t mean the problem is not there, that it’s not real and that it’s not material.
The canary in the mine are the denizens of the bond market, those unlovable and unsympathetic investors who have to service that huge midden heap of debt. They have figured out, that we have a problem and are currently experiencing their own Emperor’s New Clothes moment with respect to excess debt as it becomes increasingly undeniable that the overhang of sovereign debt is the true cause of our fiscal distress and the harbinger of further problems for our economy down the road. Shockingly, bond buyers are demanding more yield to hold this paper and that’s dragging the entire yield curve up building in very real distress across both public and private markets (I really haven’t a clue why SOFR has been sticky, but I don’t think it will stay that way.) I don’t see that trend reversing any time soon.
Higher for longer won’t be horrible for everyone. There are always winners and losers, but it surely will be horrible for the commercial real estate markets which float atop, and is entirely dependent upon, something in excess of $5 trillion of mortgage debt and other ancillary indebtedness. As this is, as usual, all about me, I’m not even thinking about the winners but viewing this higher-for-longer trend as an unalloyed bad thing.
Everything is cyclical. This is a cycle. At some point it will end and the price pressure on debt will reverse. But how and when? It’s unlikely that it will be ended by an act of responsible governing by our gloriously elected representatives. Fiscal probity is not going to erupt any time soon. Without such an admittedly implausible Saul of Tarsus moment, the credit curve will remain elevated until something really unpleasant fixes the problem for us. (There’s been a lot of happy talk from both sides of the aisle about growth that will bail us out of this problem. Oh, please, more magical thinking.)
Obviously, a rip-roaring recession, a really deep one, that sweeps across the globe would probably do it (a cure that well might be worse than the disease), not something to look forward to, is it?
Waiting for something horrible to happen, something that will materially change the contours of our debt markets and financial landscape, isn’t a plan. There really is little (nothing?) that we as business people can do about it, except find a way to run our businesses as profitably and successfully as we can in this new environment. Think Monty Python’s Always Look on the Bright Side of Life for comfort here.
For the moment, the commercial real estate market is doing, well…okay. I would argue, however, that this is less the glow of ruddy health and more the cruel flush of fever. The disease of a rapid change to materially higher interest rates is baked in, but has not yet felled the patient. Right now, we’re getting closer to the point where we’ve hoovered up all the really good deals at good pricing with good valuations. Soon, and for a considerable period of time, that might leave slim pickings. The interregnum is coming.
We’re understandably perplexed by the illusion of decent transactional volume and the appearance of some really good deals getting done. Deals are getting done where fresh capital has been brought to the table and the assets have traded at fair value. (By the way, spreads are ridiculously skinny and at least to me it doesn’t look like investors are getting paid for risk.). However, there are hundreds of billion dollars of assets that need to be repriced before they’re even close to refinanceable. True distress (delinquencies, post maturities and watchlist status, etc.) is just the ugly tip of the debt iceberg. That bigger problem is the vast number of assets out there that haven’t been repriced and haven’t been recapitalized and just haven’t yet had to engage with market realities. The market, writ large, is just not fully reconciled to the new reality and is unlikely to become so for a while. When it does, the howling will get louder and louder and our political class will work harder and harder to fool the folks with misdirection.
Kicking distressed assets down the road in exchange for a modest amount of borrower accommodation is not helping. Sure, I understand why it happened in the past, indeed why sometimes it worked, but it’s not going to work this time. To the extent it’s happening because someone believes (or is prepared to pretend to believe) that better credit conditions are still just right around the corner (magical thinking), it’s bad. The assets in need of accommodation aren’t going to get better (it doesn’t help that we all suffer from an immediacy bias: If something bad is going to happen, I’m pretty sure I won’t be happening this quarter). As interest rates remain elevated (and perhaps go higher), even more assets will need to be repriced and those assets which have already received accommodation will need to be repriced again. Buyers and sellers will need to acknowledge the higher interest rate environment. They will have to take on board that higher cap rates are reality. Borrowers will have to get over the sticker shock of coupons that are hundreds of bps higher than they’ve gotten used to and reconcile with loan proceeds that will be considerably smaller (triggering the need to infuse substantial new capital to make the deals pencil).
If the economy softens even a wee bit (which is hardly just a remote possibility, it is?), that softening is not going to suppress heightened interest rates. Heightened rates are driven by macro supply and demand dynamics and a bit of economic weakness won’t change that. Softening will, however, mean that net income will not keep pace with higher interest rates even in cases where it has been doing so to date. That will make things much worse much faster.
We’ll soon need to confront an interregnum where financeable opportunities will diminish. The interregnum will not end because interest rates have come back down, but will only end when the markets become fully reconciled to the new rate environment. That’s going to take some time, but it’s a wait we can live with if we properly prepare our institutions for these choppy waters. Remember, sometime soon(ish), the cycle will end and we’ll again make terrific commercial real estate loans in this new environment.
Preparing for a period of suppressed transaction volume requires lending institutions to be disciplined and to a certain extent be creative. On the discipline side, don’t underwrite on the assumption that cap rates and coupons are coming back in. Don’t bet on magic. Certainly, if there are some good loans out there to be made, make them when you find them, but chasing deals by slashing spreads, embracing delusional borrower projections and business plans and waiving covenants, etc., is ultimately self-destructive. Don’t catch the falling knife. Build up a fortress balance sheet. Be prepared to tolerate sub-optimal financial results for several quarters (years?). Lock in long-term, match term financing, even if expensive. End initiatives that aren’t winners. If you have wandered outside your core competency, those are probably the initiatives you want to close down. Shrink your at risk assets. Look hard at all of your loans, even those that are performing and remember that this is a time when your first loss will be your best loss. Bring in new capital, if possible. (It might be necessary to return investor money and certainly open-end funds might not have a choice. This will increase the need for fresh capital.) Raising new money in tough times is not an amiable exercise, but if you can find long term capital that’s prepared to deal with realities, it might be time to grab it.
Be very careful about trying to right-size the team for the interregnum. It will be very tempting to do so, to try to match expenses with falling revenues. Unless you must, however, don’t rip your team up, don’t flush your human capital in a doomed effort to get lean and mean for this new environment. You really can’t cut your way to profitability. Reassign folks to a distressed debt desk. Use the period of lower transactional activity to invest in AI (I don’t know what it does, but I’ve been told it does really good things) and infrastructure. Find useful things for the folks to do, recognizing that good times will return. If necessary, have the team dig holes and fill them up again.
Look hard at the possibility of acquisitions. Yes, I know it’s kind of counterintuitive in the time of diminished opportunities, but the impact of the interregnum will be felt in a very variable way across players in our marketplace. There will be some that tolerate it well and others that simply can’t tolerate it at all. To the extent you’ve got dry powder, this might be a good time to consider hoovering up some other platforms or at least the assets of the platforms which are in serious distress.
What else can be done? I don’t know, but it’s time to get creative. Many of our industry participants will find a way. Waiting for interest rates to revert to the halcyon days of 202
[1] Let me take a moment to be clear that I’m writing this in a hurry before the data makes me look silly. But, hey, Churchill got away with that and I suspect I will, too. If I’m wrong here, I doubt anyone will remember next month, and I surely won’t remind you of that fact.