I’m going to tell you a story. This is the type of thing told around campfires designed to scare naïfs, who know too little, and PhDs who (think) they know too much. I don’t necessarily believe in the story, but it could be true.

Once upon a time, in a time we now call the GFC, “no doc” residential loans lit the match that caused a financial conflagration. We, in commercial real estate, were just tinder. I remember at that time assuring folks that the horrific problems in the residential space had nothing to do with commercial mortgage finance. We were careful stewards of investors’ capital and this mess had nothing to do with us. Oops.

So, why the history lesson? The question today is could commercial real estate be the match this time? There are real risks. Conditions are ripe. While all the talk is now about a soft landing, that unicorn of financial conditions, it is hardly assured. Interest rates remains extraordinarily high (at least by comparison to the past decade or so). We huddle like Schrödinger’s cat between reignited inflation and recession in the hope that interest rates will come down gently while the economy continues to flourish.

Our market has been whipsawed by radically oscillating narratives over the past several months. In September it was higher for longer. By December, things looked considerably better. Rates are coming down fast! Yippee! Soft landing city. By March: Not so fast! Higher for longer was back on the table (and recent data is not terribly helpful).

In some circles, there remains almost a doctrinal certainty that things will get better soon and all we need do is wait. Indeed, things might. We might be about to enter into the bright sunlit uplands of economic transcendence! If rates retreat while the economy remains healthy, and it all happens very, very soon, the conflagration is not inexorable.

The good news case for a soft landing and restoration of some level of normalcy in the commercial real estate finance space is not a fabulist confection. Good GDP growth, good employment levels, inflation moderating (albeit slowly). That’s all to the good. The Fed-heads are still hanging onto some level of Fed funds reduction this year. There’s surely plenty of capital on the sidelines looking for something to do. The banks may have pulled in their horns, but they’ll still be lending. Moreover, the broader economy, less sensitive to interest rates and cap rates, seems to be getting on with its reconciliation with the current rate environment, While the new normal is not as much fun as the zero-bound, it is something the broader economy can deal with. This is all noise, say the optimistic contrarians,

That’s all well and good, but come on folks, we have trillions of dollars of CRE assets that need to be refinanced this year and next, probably more than that that need to be repriced. If this debt cannot be refinanced without massive asset repricing, we have a problem. A widespread convulsive paroxysm of forced sales of commercial real estate is going to occur (it can only be put off so long by magical thinking) and only that will trigger the sort of re-equitization of properties that is essential. The experience of that sort of explosion of compelled transactions will not be amiable.

This is a debt bomb. Hey, this isn’t our fault (okay, not largely our fault). This was virtually assured by Federal policy miscues. First, the Fed ran up Fed funds rate 500 bps in a single year, somehow assuming nothing could go wrong. The run-up appears less a nuanced and calibrated effort to address the inflation problem and more an embarrassed reaction to prior policy mistakes. The Fed then seemingly ignored the well-known lag effect, kept pushing up rates and then held rates at those high levels even as inflation, as measured by many of the indices that the Fed and the market watchers pay attention to, began to relax and retrace. For the scouts among us, do you remember winter camp when you stuck your frozen booted feet too close the fire to get warm and inevitably left them there too long? The hot foot shuffle ensued. Those errors are predictable for a bunch of 13 year olds, but for the Fed? It’s a tad embarrassing. The market now appears to be reconciled to the fact that Fed policy won’t change quickly. The forward curve which, for years has housed a remarkable number of optimists, only sees SOFR at little better that 4%...well nearly forever! 4% SOFR and a flat or uninverted yield curve is not going to save our bacon here.

Exacerbating the damage from the government’s interest rate policy, the regulatory establishment has decided that this is a perfectly great time to crush banks (particularly non-bulge bracket banks) and non-banks and particularly CRE debt positions and insist on more capital, less fee income, less lending and significant regulatory pressure on the regulated institutions to dispose of commercial real estate exposures (including direct lending and warehouse lending). Can anyone say “procyclical” here?

A word has to be said (perhaps wasted) about the Basel Endgame Rules, an extraordinarily ill-suited initiative for this time and place. The Basel Endgame Rules were delivered on the back of a liquidity crisis from last spring for which the Basel Endgame capital rules have absolutely no causal connection. Just an excuse for regulators who have never seen too much capital. The Basel Endgame Rules as proposed, were a product of slavishly importing rules from Europe without the Europeans’ well-known penchant for exceptions and crafty enforcement to fit the needs of the marketplace. Okay, I get that the Basel Endgame Rules are probably a dead letter at this point, but it’s a piece of the regulatory mindset; another signal (if one were needed) that the regulatory establishment has its foot on the neck of the lending business is damned pleased with itself, convinced it’s doing God’s work. We should expect more and more intrusive regulation as the answer to almost all questions; facts be damned.

There was a brief, shining moment in the early winter when hope seemed to have transmogrified into expectations that the Fed would take Fed funds down quickly and take this cup of poison away. If that were to have happened, we could have perhaps all taken a deep breath and kicked the can down the road like it’s the GFC all over again. Now, in March, that expectation again looks like a tattered hope. The looming crisis brought to us by the juxtaposition of decades of zero-bound interest rates crashing into a multiyear period of high interest rates, exacerbated by a regulatory mistake that savage lenders’ balance sheets and constrain capital formation is, as they say, a problem. Again, anyone ever heard of procyclicality?

That’s all worrying enough within the confines of the commercial real estate finance market, but it might not be comfortably confined. As goes the old aphorism, for want of a nail, the shoe was lost, for want of a shoe, the horse was lost, for want of a horse, the general was lost and for want of a general, the battle was lost. It’s kind of evocative, isn’t it? It happened in 2007, it could happen again now.

Contagion!

Here’s how. Value destruction in commercial real estate will impact the balance sheets of both the regulated and the non-regulated institutions. Direct bank lending will retreat. In the non-bank world, we might see warehouse lending, nav financing, subscription financing and the like becoming increasingly difficult and expensive. That will threaten the business model of the entire non-bank sector which will follow the banks into conserving capital, restraining lending and investing. In the classic, non-virtuous circle, liquidity constrains values and values impacts liquidity. When the horns are pulled in, the horns are pulled in. The consumer will do its part in this little tragedy by struggling with ongoing high interest rates which will suppress consumption (which remains 70% of our GDP). Growth will be materially damaged by both the disfigured corporate and personal balance sheets.

Would the government step in through aggressive fiscal policy to fix the problem? Would the Fed aggressively drop rates to try to supply a safety net, even though both those steps might have, shall we say, negative collateral damage? Who knows, but it’s hard to build a strategy on a governmental Hail Mary.

Diminished liquidity, diminished lending and the reality that billions of dollars of CRE debt that cannot be refinanced is a problem that could cascade through the broader economy in ways we cannot envision. Perhaps the boiled frog is a potentially useful metaphor here…but remember at the end of the day the frog did die.

We could be the match this time, and take the blame.

Of course, that all might not happen. It surely need not, but the path through the very choppy waters between the Charybdis and Scylla of reignited inflation and actual recession is narrowing. Reignited inflation (and there are those who think we’ll see it) would require further Fed action exacerbating the interest rate impact on fixed income assets which could lead to the hard landing. An actual recession could result in a more rapid retracement of Fed funds but of course recession brings its own risks for the commercial real estate marketplace in terms of valuations and reduced income. We cannot assume we’re done with boneheaded regulatory intrusion, all of which is likely to make the problem worse, not better. (Further macroeconomic difficulties will simply encourage the regulatory state to regulate more aggressively and, as we know, the regulators generally view regulatory failures as simply proof that they failed to be sufficiently aggressive in the first instance). More please!

We can prepare for further economic disruption or simply hope that the soft-landing narrative is indeed correct. The latter is more amiable; the former is more prudent.

And remember, in the silver-lining department, in the lee of the GFC the big bucks were made at the epicenter of the crisis, in the residential mortgage world, where the match was lit. Something to think about.