The Real Estate Canary Has Something to Say

By Joel Litman, chief investment strategist, Altimetry

Everyone remembers when Bear Stearns collapsed…

But almost nobody paid attention to the canary in the coal mine a year earlier.

Bear Stearns’ undoing officially stemmed from unexpected swings in the credit markets in 2008. The housing crisis led the subprime credit market to implode. Large asset managers just weren’t prepared.

And those unexpected swings hit Bear Stearns’ hedge funds… hard.

The collapse took much of the market by surprise. And yet, issues were already arising as far back as 2007. The subprime mortgage market was seeing loads of delinquencies. The market value of those mortgages started to go down.

Even though the economy is doing OK today, regular readers know we’re seeing similar concerning rumblings in real estate…

One of the first warning signs was a near-run on the Blackstone Real Estate Income Trust (“BREIT”) in late 2022. Right as investors started getting uneasy, the fund put up “gates” to stop the run. Its new rules stated investors could only take out 5% of their holdings per quarter.

And BREIT isn’t the only real estate canary to start singing lately…

Last month, news came out that another large property investor had to throw up gates for its $10 billion fund…

Investors were rushing to withdraw money from Starwood Capital’s Starwood Real Estate Income Trust (“SREIT”). SREIT drew more than $1.3 billion of its $1.55 billion unsecured credit facility to meet the liquidity drain.

With less than $300 million of undrawn cash, SREIT is in danger of running out of credit and cash in late 2024.

This REIT is private… So like Blackstone (BX), it can stop withdrawals and stay away from selling too many assets.

Yet this hasn’t done much to calm investors. They see that a lot of real estate valuations have started falling… and they want out.

Both SREIT and BREIT are part of much larger corporations, and they’re both still plodding along. Even though neither has gone bankrupt, they’re both under duress.

Investors have largely ignored the warning signs… just like they did when Bear Stearns’ funds collapsed.

Bear Stearns was unprepared for the subprime market to blow up. Most of its positions were leveraged… meaning when they lost money, Bear Stearns owed far more than it initially put up. The bank experienced extreme losses and didn’t have enough credit insurance.

Lenders got scared, since they were the ones financing Bear Stearns’ leveraged investment strategy. As the subprime mortgage market – their collateral – dropped, they demanded even more collateral to keep supporting their loans.

The fund didn’t have enough cash, which just exacerbated the issue. By August 2007, things had gotten even worse…

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Many quant strategies unwound at once during the “quant crash.” These portfolios were run by computers that traded near-automatically. As the stock market started dropping, some funds automatically liquidated to prevent further losses… causing a chain reaction of selling.

Investors once again shrugged it off as a contained incident, and the market almost fully rebounded in late 2007.

Even more important, Bear Stearns’ High-Grade Structured Credit Fund collapsed… losing more than 90% of its value. And its Enhanced Leverage fund lost pretty much all of its $600 million.

No one thought anything of it when those funds blew up… until nine months later, when Bear Stearns blew up as well.

After that, the entire system ended up on the verge of collapse.

A similar canary is singing today… and this time, we’re listening close.

Just a year after BREIT’s pain, Starwood is in the exact same situation. And that shows a broader issue possibly arising.

Whether or not the market recognizes it, the real estate sector is struggling. Private investors are quietly trying to get out of these real estate funds… and the funds are trying to slow them down.

These funds are dipping into – and nearly depleting – their available credit to pay off redemptions. If they run out of credit, they’ll either have to slow investor withdrawals further… or they’ll have to sell assets to drum up the cash.

Real estate hasn’t seen a true reckoning this time around. Based on these pre-shocks, it may only be a matter of time.

Regards,

Joel Litman
June 11, 2024

‘Phantom Debt’ Is Piling Up

By Joel Litman, chief investment strategist, Altimetry

If you look at the average FICO score, the U.S. consumer is in great shape…

FICO is the most widely accepted consumer credit score… It’s used by 90% of the country’s top lenders to help them make decisions on loans. Basically, anyone with a credit card has a FICO score.

It typically ranges from 300 to 850, with anything below 580 considered “poor” and anything above 739 considered “very good” or “exceptional.”

According to the latest FICO report, the average score is 717. That’s smack in the middle of the “good” range… and just one point off the all-time-high average score.

That paints a picture of consumer resiliency… Yet, there are also clear signs that the consumer is doing not so great.

Consumer-staples companies like Target (TGT) and Starbucks (SBUX) are reporting poor earnings. Starbucks missed expectations for both revenue and earnings, with those figures down 2% and 15%, respectively, in the second quarter. And Target is still hurting from inflation… It also missed earnings expectations and warned investors not to expect better results in the next few quarters.

Consumer-staples companies are good indicators of consumer health because they sell products that consumers buy on a daily basis… So if they’re suffering, it’s a sign their customers are, too.

There’s a clear disconnect between today’s average FICO score and what these companies are reporting… and it’s because there’s a certain type of debt that credit-ratings agencies don’t include.

Credit ratings don’t tell the whole story…

Consumers are piling up on what’s called “phantom debt”… otherwise known as “buy now, pay later” (“BNPL”) loans.

These loans allow consumers to pay for a lot of online purchases in interest-free installments.

So instead of paying $100 up front for a pair of shoes online, you can divide your purchase into multiple equal payments over a few months.

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BNPL loans technically aren’t debt… but they’re a way for consumers to delay paying for goods.

And customers don’t have to get approved in the same way they do for an auto loan, so “debt” generated by BNPL purchases never shows up on your FICO score.

These loans are stacking even more obligations on people’s plates, and folks are starting to fall behind on their payments.

That said, while credit scores may not include BNPL purchases, these loans can’t hide from every metric…

Delinquency rates include all loans that are past due…

That makes them a much better indicator of consumer health.

They take into account mortgage balances, which increased by $190 billion in the last quarter… and total household debt, which rose by $184 billion.

Delinquency rates also include BNPL loans. And they’ve been on the rise as more and more folks have relied on these types of loans…

According to data by the New York Federal Reserve, 90-day-plus credit-card delinquency rates rose from 8% to nearly 11% in the last year.

These types of delinquencies are the most serious. And the fact that they’re rising signals that folks are holding off on paying their bills as long as possible… whether or not the credit agencies see it.

Moreover, auto and other severe loan delinquency rates are also rising. Overall, it’s just not a great look for the consumer.

And it’s clear that BNPL is contributing, as its market has been growing every year since 2020.

BNPL purchases totaled $33 billion in 2019… climbed to $300 billion in 2023… and are now expected to reach nearly $700 billion by 2028.

Recent Bloomberg News surveys also show that 43% of people are behind on their BNPL payments… and 28% of folks were late on other debt because of their BNPL payments.

So while the average FICO score may tell the story of a healthy consumer, keep in mind that those credit metrics don’t take into account phantom debt.

Consumers’ obligations are piling up. Credit-card delinquency rates are at the highest level in more than a decade. And that’s likely to limit consumer spending going forward.

Regards,

Joel Litman
June 10, 2024