You Have To Trade With The Flow-And Your Gut

As a trader, in this environment, there’s a credo you really need to live by. Perhaps you’ve heard the expression “I’m not married to my positions?” Well, I’ve expanded that as follows: “I’m not married to my positions-I’m just dating them casually.” The point here being that when circumstances change, your thought process needs to change and right now, in my opinion, circumstances have changed to the point where I have to close my short dollar and long S&P positions which were taken last Sunday night.

What’s turned me off to that trade is that the coming crisis in commercial real estate came into sharp focus on Wednesday.

First, Fed Chairman Bernanke told the Senate Banking Committee that said a potential wave of defaults in commercial real estate may present a “difficult” challenge for the economy, adding that one of the main problems was that the market for securities backed by commercial mortgages (Commercial Mortgage Backed Securities, CMBS) had “completely shut down.”

Second, the profit reports from two of the nation’s largest commercial lenders, Morgan Stanley and Wells Fargo, are likely to bring the market’s severe problems into much sharper focus. Morgan reported a $700M write-down on its $17B commercial property portfolio this past quarter while its CFO said he doesn’t see a light “at the end of the commercial real estate tunnel yet.” Meanwhile, Wells Fargo saw its non-performing commercial loans rise an eye-popping 69% over the same period.

I can tell you from firsthand experience that commercial lending is at a virtual standstill right now, because I recently started working at a commercial mortgage bank run by my family. Our firm specializes in the only real form of commercial lending which exists at this time; FHA insured loans for properties like multifamily apartment complexes, senior independent living buildings, and assisted living facilities. For all other types of commercial property (malls, retail strips, office and industrial buildings), unless you have access to private equity (which only the largest players do) you are virtually shut out.

Aside from the problems of commercial property owners being unable to pay their mortgages (a serious enough problem) there exists the problems with performing properties that need to refinance.

Typically, commercial loans are amortized over 20 to 25 years but the terms can be between 5 and 10. At the end of the term, the owner will owe a balloon payment to his or her bank because of the longer amortization period. In normal times, it wasn’t too difficult a problem to just refinance and avoid the balloon. Now, in the vast majority of cases, these people cannot find new funding despite the fact that their properties are still performing. And even in the rare circumstance where they can refinance, they’re facing larger down payments (lower loan-to-value ratios), higher interest rates and shorter amortization periods (which naturally make their monthly payments higher).

The net result of all this stifled lending is going to be a huge amount of defaults and foreclosures. The worst for this market is still in the future.

Now, here’s where the trading lesson is. The situation in commercial property isn’t really new- people like Nouriel Roubini have been warning on this for more than 2 years and prices have already declined about 35%. So the fact that the situation isn’t news might lead you to think that the circumstances regarding commercial property are already priced in to the market, meaning that investors have already discounted future value.

What I would say to that is when the Federal Reserve warns members of Congress in public testimony, and when banks report on the situation in black and white profit reports, the situation comes more into focus. I would also say to not overestimate the intelligence of investors-they certainly didn’t do such a great job judging how the housing situation would lead to the huge declines in equity markets.

Just to play devil’s advocate here, you might want to argue that with all the news today the market really didn’t decline all that much with the S&P only losing 0.5 points. The answer to that is as a trader, you want to do what good hockey players do-skate to where the puck is going, not to where it’s been. That’s a judgment call obviously but really, isn’t all trading when you come right down to it?

There’s another old expression you should be aware of: housing tends to lead the economy into and out of recessions. Let’s now amend that to read residential and commercial property leads the economy into and out of recessions. If that’s true (and with commercial real estate amounting to about 10% of GDP it likely is) by all accounts it would appear that commercial property isn’t about to lead the economy anywhere but down.