WeWork, too big to fail

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Good morning. The two-year Treasury yield is back above 5 per cent. The five-year is scraping against its highs for the cycle, too. Inflation risk is still out there. If you are a big buyer of medium-term Treasuries, email us your buy case: [email protected] and [email protected].

Your periodic CRE grind update

Yesterday brought a couple of meaty stories about everyone’s favourite slow-motion car crash, commercial real estate. From the FT came news that WeWork wants to pay less rent:

WeWork is seeking to renegotiate nearly all of its leases around the world . . . David Tolley, chief executive, told landlords that dialled in [to a business update call] that WeWork expected to exit some “unfit and underperforming locations” but would remain in most of its buildings.

In a statement after the call, he said WeWork was “taking immediate action to permanently fix our inflexible and high-cost lease portfolio” . . . 

As recently as the first quarter of this year, WeWork accounted for almost a quarter of new leasing activity in New York, but several industry members have sought to play down the impact of a potential bankruptcy. “It’s a small part of the market,” one said. The company occupies about 6.4mn sq ft in a Manhattan office market that is 414mn sq ft.

The Wall Street Journal had a long read, with lots of crunchy statistics, about how CRE still threatens US regional banks:

Trillions of dollars in [CRE] loans and investments are a looming threat for the banking industry — and potentially the broader economy. Banks’ exposure is even bigger than commonly reported. The banks are in danger of setting off a doom-loop scenario where losses on the loans trigger banks to cut lending, which leads to further drops in property prices and yet more losses.

Loyal Unhedged lenders will be aware of our view that the CRE mess is probably not an existential threat to many banks — if a deep recession can be avoided. But CRE loan default writedowns are likely to take a big bite out of bank profits and equity for reasons that these two pieces elucidate.

The WeWork story makes it clear, once again, that floating-rate loans are not fully insulated from interest rate risk. In a higher rate environment, some tenants cannot meet their lease obligations, and so some asset owners will not be able to meet their loan obligations. Renegotiations or defaults follow. Lenders’ interest rate spreads over their cost of funding will tend to compress when rates rise fast. 

Lesson two, from the WSJ story: low loan-to-value ratios are not guarantees against loan defaults.

In January, a developer defaulted on a roughly $60mn loan from Bank OZK after construction costs escalated, the bank said. The loan was considered relatively safe because it was far below the building site’s value of $139mn in 2021. In December, a new appraisal put the property’s value at $100mn.

The bank is effectively stuck with the property. 

This loan started out with an LTV of 43 per cent; even after a haircut, the LTV was still 60 per cent. But the borrower decided that the loan wasn’t worth paying. Defaults happen long before the equity in a CRE project disappears.

The two stories raise an interesting question: from the point of view of banks exposed to CRE in cities where WeWork remains a significant presence, is the company too big to fail? In other words, is it better for the landlords to renegotiate with WeWork so that it can stagger on, rather than refuse and increase the odds of bankruptcy, putting its $13bn in existing lease obligations at risk? The company accounts for about 1.5 per cent of Manhattan office space. The market for office assets is near frozen, and financing is already scarce. Perhaps a high-profile WeWork bankruptcy shocks the market, sending valuation down another leg, triggering more defaults. I don’t know. But if I was one of WeWork’s landlords, or those landlords’ banks, I would be thinking about it. Hard.

More on private funds

We talked last week about the Securities and Exchange Commission’s new rules for private funds. Among other things, they impose standardised quarterly disclosures for fees and performance while limiting “side letters” — better treatment for some investors but not others. The SEC argues that even big-boy institutional investors need baseline disclosures when investing in fast-growing, but opaque, private funds.

Several readers wrote in to cheer the new rules. One, Larry Pollack, highlighted a principal-agent problem bedevilling the industry. That is, for pension fund managers (the agents), returns are less important than easy compliance or low volatility, even if that prioritisation doesn’t serve the interests of pensioners (the principals). Our reader writes:

I’m libertarian-leaning and a pension actuary who did a stint in asset management (though not private funds).

I believe the SEC rules are probably needed. Not primarily because the private fund managers have some sort of asymmetric knowledge advantage or the buyers are rubes [ie, fools], though both are likely true to some extent. 

Instead it’s because . . . US public pension fund [managers], which supply a lot of the capital to private investment funds, pretty much like the way things are. As long as the private investment funds can pretend to virtually guarantee higher returns, lower volatility, and non-correlation with other asset classes, the agents buying those funds on behalf of the pension plans gain career success that they’re likely willing to pay for at the expense of their taxpayer and plan participant principals. 

If the new rules shine more light on what’s really going on through better disclosures and audits, it would ultimately benefit the pension plan principals who otherwise don’t have the wherewithal or knowledge to monitor their agents.

This is an important point, though we’re unsure how big a dent the rules would make. More transparency on performance and fees could allow for greater comparability between different private funds. Maybe that helps keep pension fund managers accountable. On the other hand, optimistic marks are the crux of private capital’s “volatility laundering”, and the rules don’t appear to affect that. (Let us know if we’ve missed something here.)

The rules do help overcome a collective action problem, adds Andrew Park at Americans for Financial Reform, where each individual private fund investor is incentivised to push for side deals, rather than banding together to negotiate much better terms for all investors. Which may be partly why the private funds industry is now suing, arguing in a filing last week that the SEC is wrongly helping out investors who don’t need it:

The commission has not shown any need for the intrusive rules it has adopted. Investors in private funds are among the largest, most sophisticated investors in the world . . . These investors know what they are doing and have many options for where to invest their money. If the longstanding, widely used business arrangements of private funds are really in need of a government overhaul, as the commission claims, these investors would not increasingly be placing their money in private funds. 

One might note that while the agents may be some of the most sophisticated investors in the world, the principals — average retirees — are not. Still, as we discussed last time, this public policy debate about the virtue of protecting the sophisticated has reasonable arguments in both directions.

However, the core of the lawsuit is about procedure, centring on whether the SEC has the authority to regulate private funds. The SEC points to powers bestowed on it by Dodd-Frank. The industry’s petition counters that such authority was only meant to protect retail investors. Brian Daly, a partner at Akin, explains:

The petition is saying that the fair reading of [the relevant sections of Dodd-Frank] is that Congress was envisioning additional protections for purchasers of securities, primarily retail purchasers. It’s a grant of rulemaking authority to protect purchasers from unsavoury sales practices. The petition says that’s being stretched beyond all recognition into something regulating a whole different part of the market — regulating the economics of an advisory relationship, nothing to do with the sale of securities.

Private funds are waiting to see if the courts will issue an injunction blocking the rules. If not, efforts to comply will have to begin soon; funds cannot just rely on the SEC losing. That could come in a matter of weeks, Daly says. Private capital may soon change before our eyes. (Ethan Wu)

One good read

The author of a new book on FTX takes some shots at Michael Lewis, who also has an upcoming book on FTX.

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