John B. Levy sees a familiar pattern emerging as the credit crunch unfolds, and it tells him that spiking mortgage rates may be just around the corner for commercial real estate. That's precisely what happened following a global crisis in the bond markets in 1998, says the principal of real estate investment banking firm John B. Levy & Co., and a former longtime columnist for NREI.
“This reminds me a lot of the Long-Term Capital crisis,” states Levy. Hedge fund Long-Term Capital Management went into a tailspin in 1998 and was rescued in a bailout orchestrated by the Federal Reserve Board, shaking confidence in investment markets. What reminds Levy of 1998 are the recent diverging paths of Treasury yields and the spreads lenders add to the benchmark rates that determine interest rates on commercial loans.
Mortgage rates shot up beginning in the second quarter this year, when spreads increased about 25 basis points. The 10-year Treasury rate soon headed in the other direction, dropping from a June high of 5.32% to 4.53% on Sept. 19, the day after the Fed's half-point cut in the overnight Fed funds rate.
Even with spreads holding their wider stance, mortgage rates have come down with the drop in the 10-year yield. That harkens to 1998. When the market grew suddenly averse to credit risk, investors called for more stringent underwriting and commercial mortgage spreads ballooned. As investors moved capital into the security of Treasury bonds, the 10-year Treasury rate fell to a low of 4.16% in October 1998 from 5.5% four months earlier.
“As a result, from a borrower's point of view the cost of debt was relatively unchanged,” Levy says. “But immediately after that, when things recovered, the cost of debt skyrocketed.” In 1999, investors began moving money out of Treasuries, and the 10-year Treasury rate shot up to 6% by June, nearly 200 basis points higher than its October level.
A similar scenario is occurring today as widening spreads are offset by falling benchmark interest rates. “The cost of mortgage debt hasn't changed all that much, although admittedly the leverage available has changed in that there's less than there used to be,” Levy says. If the pattern continues, Levy says, interest rates will move quickly when they begin to rise, taking mortgage rates with them. What's the lesson to be learned from 1998? “Don't wait to borrow,” Levy says.
The Mortgage Bankers Association projects a 10-year Treasury yield of 4.8% in the third and fourth quarters, rising to 5% by the fourth quarter of 2008. “Without a doubt, one of the reasons Treasury rates are where they are today is a lot of investors have gone to the safety of the Treasuries,” says Jamie Woodwell, MBA's senior director of research.
When the economy begins to recover, borrowing costs will only go up, says Levy. “If you're waiting to access the market until the market comes back, if you look at the historic precedent, waiting will cost you money.”