The capital markets grew more uncertain every day heading into the fourth quarter. The government's seizure of Fannie Mae, Freddie Mac, and AIG, the bankruptcy of Lehman Brothers, and the disappearance of Washington Mutual, Wachovia, and Merrill Lynch, raised the economic fever to a crisis.

The single-family market meltdown that began last year has spread like wildfire, incinerating subprime lenders and the government-sponsored enterprises (GSEs) before leveling century-old financial institutions that weathered the Great Depression but could not survive 2008.

As of early October, the collapse of large financial institutions—and the impact of the government's proposed financial industry bailout—was still too raw for many in the industry to digest.

But taken together, this disruption of the capital markets means more pain in 2009 for affordable housing developers. Many predict that fewer projects will get done next year as debt financing grows more costly, construction financing proves elusive, and low-income housing tax credit (LIHTC) prices diminish further.

As Goldman Sachs and Morgan Stanley teetered on the brink of collapse, Congress wrestled with a $700 billion financial industry rescue plan, an unprecedented government intervention intended to avoid a further run of bank failures. While Congress bickered, the Dow Jones Industrial Average dropped 777 points, its largest single-day collapse, and short-term interest rates such as the Securities Industry and Markets Association municipal swap index and London Interbank Offered Rate (LIBOR) spiraled out of control.

“My personal view is that we are about halfway through this global credit contraction,” says Wade Norris, a principal with Eichner & Norris, a Washington, D.C.-based law firm that specializes in tax-exempt bond finance. “And as the global capacity for lending continues to shrink, the price of lending will continue to rise.”

The 800-pound gorilla in the room is the LIHTC market. The reduced investing appetite of Fannie Mae and Freddie Mac, which accounted for more than 40 percent of the market, hobbled the rate of affordable housing production this year. Add to that the uncertain fate of AIG's SunAmerica division—another active tax credit buyer—and the problem could only get worse next year.

The remaining tax credit investors now have the luxury of cherry-picking only the strongest deals in the strongest markets, while many deals in secondary and tertiary markets get scuttled. Tax credit pricing is averaging about 85 cents per $1 of tax credit nationally—down from an average of 95 cents in 2007—and is expected to decline further in 2009.

“We're hearing from equity providers that the market's going into the high 70s to mid-70-cent range in the first quarter of next year,” says Sean Thomas, director of planning and preservation for the Ohio Housing Finance Agency (OHFA). “But we still don't know where the floor is yet.” A 15-year veteran of OHFA, Thomas calls 2008 “probably the toughest year I've seen for affordable housing developers.”

Four percent deals done through taxexempt bond financing have been affected more than 9 percent deals. Some state housing finance agencies are reporting large portions of unused tax-exempt bond allocations as investors shy away from most new-construction 4 percent deals. Even when there is investor interest, the deals are difficult to pencil out as credit pricing continues to fall, increasing the need for gap financing (for more on the tax credit equity outlook, see page 26).

“Acq-rehabs are going to be strong, because you could have some in-place income that allows you to deliver units more quickly. But new-construction bond deals are going to be extremely challenging next year,” says Phil Melton, a senior vice president focused on affordable housing at Grandbridge Real Estate Capital. (for more on the tax-exempt bond market, see page 28).

Related Affordable, which owns more than 11,000 units in the Northeast and Florida, finances the lion's share of its transactions through tax-exempt bonds. But the company anticipates a difficult environment heading into 2009.

“The pricing went from 98 cents nine months ago, down to the low 80s today in some of our markets,” says Mark Carbone, president of Related Affordable, in late September. “We have a healthy pipeline for next year, but I just hope we can close them all, or at least some of them.”

Betting on debt

It's not just LIHTC pricing that makes for an uncertain future; the price of bond credit enhancements from Fannie Mae and Freddie Mac have been rising all throughout 2008.

Fannie Mae exited the market a few times this year, unable to figure out how to price risk appropriately, given its liquidity situation and the shaky capital markets. Freddie Mac also briefly exited the market, and raised its rates significantly when it returned. Freddie Mac doubled its liquidity fee from 25 to 50 basis points and also jacked up the application fee for variable-rate bond transactions by a factor of 10 to 1 percent, up from 0.1 percent of the loan amount.

Short-Term Liquidity Dries Up
The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index Three-Month Treasury Bill
Sept. 3 1.63 June 16 2.04%
Sept. 10 1.79 July 16 1.35
Sept. 17 5.15 Aug. 15 1.8
Sept. 24 7.96 Sept. 17 0.03
In late September, short-term liquidity dried up as bond buyers held their breath, waiting for the federal government to bail out the troubled financial services sector.

Related closed a few tax-exempt bond credit enhancements through the GSEs earlier this year with spreads of about 50 basis points, for an all-in rate of approximately 5 percent. The company was quoted spreads of up to 150 basis points in September, for all-in rates in the low 6 percent range. “It makes some deals infeasible,” Carbone says.

Carbone believes the government's bailout of Fannie and Freddie will refocus the GSEs on their core mission of providing liquidity for affordable housing. “When the smoke clears, which might take a few months, I think Fannie and Freddie will be required to provide even more affordable housing credit enhancement than in the past,” he says.

Pricing on debt for 9 percent deals from the GSEs has also increased. Unfunded forward commitments for 9 percent deals are pricing with spreads at about 400 basis points, while a funded forward commitment is coming in around 340 basis points, for an all-in rate of between 7.7 percent and 7.1 percent, respectively, as of late September.

Prices for short- and long-term debt had been rising at the GSEs throughout the year. Freddie Mac, along with Fannie Mae, had provided sub-6 percent fixedrate debt for 9 percent LIHTC deals through the first half of the year, but as of early September, that figure was closer to 6.5 percent. Many expect these rates, as well as those of forward commitments, to hover within 25 basis points of their present levels next year.

Construction financing was the hardest debt to procure in 2008, and the spate of recent bank failures will make it much more difficult to find construction debt. The impact of the government's rescue plan remains to be seen, though it may provide relief by taking troubled assets from banks, freeing up their balance sheets. Still, the outlook for commercial banks is grim, as many expect smaller banks to suffer the fate of Wachovia and Washington Mutual.

“We expect the banks to contract even further this year and the first part of next year,” says David Cardwell, vice president of capital markets for the National Multi Housing Council. “There's a lot of expectation that there's going to be some bank failures during the fourth quarter and into 2009, especially the smaller and regional players.”

Established developers with bank relationships will still have access to capital, but many newcomers will be turned away in 2009.

Insurance companies are expected to continue cherry-picking deals next year as they have throughout much of 2008. Insurance companies may be a driving force early in the year, as they were in 2008, before filling up their coffers and growing more selective. Spreads should be competitive in the early part of 2009 from insurance companies, though the firms will, as always, favor low leverage deals.

The turmoil may force tax credit developers to turn again to the Federal Housing Administration (FHA), which enacted some significant changes this year to make its multifamily programs work better with tax credits. The FHA's flagship Sec. 221(d)(4) program offers 90 percent loanto- cost, a 1.11x debt-service coverage ratio, 40-year amortization, and is non-recourse.

The rate race

For a time in late September, the short-term bond market had all but collapsed. Buyers were nonexistent as interest rates for seven-day variable-rate bonds spiraled from 1.8 percent in mid- September to 7.96 percent two weeks later. The bond market held its breath, waiting for the federal government's bailout package to pass.

LIBOR, a benchmark used to set many short-term loans like construction financing, also spiraled out of control after the bailout bill's initial defeat, rising 431 basis points Sept. 30 to an all-time high of 6.8 percent. The 10-year Treasury has stayed relatively stable heading into the fourth quarter, at about 3.8 percent. But many expect the benchmark rate to rise in the winter as a result of the government's financial services rescue plan, before stabilizing in the first half of 2009.

As of press time, the capital markets outlook for 2009 hinged on several unknowns. What effect will the government's bailout bill have? Was the collapse of Lehman, Wachovia, Washington Mutual, and Merrill Lynch a signal of the market's bottom, or the beginning of further pain? Will Fannie Mae and Freddie Mac continue to provide the same level of financing in 2009 that they did in 2008?

“We're in brand new territory,” says Don King, a director at CWCapital who specializes in placing agency debt. “And nobody knows where this is going.”

— with additional reporting by Liz Enochs