Greenspan on U.S. Economy: Cliff Ahead

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I was sitting on the front row of the Bloomberg Washington Summit last week when Alan Greenspan took the stage. He’s getting older, but his comments and ideas are still smokin’ hot. I was about eight feet from him, and I could feel the heat. It’s always great to hear someone offer informed opinions in a frank manner that you can understand. He’s not always right, but that’s because he is an economist. Everyone knows it’s a hit-or-miss profession. He was interviewed by Tom Keene.

When asked about the economic outlook for the country, AG dropped these little nukes:

There is a huge fiscal cliff out there that is largely due to kicking the can down the road.

Our current Congress is unwilling to do anything to solve our problems that will cause any pain. We aren’t going to get out of this mess without some pain.

Simpson-Bowles will get passed. The only question is whether it is before or after a bond market crisis.

When his allotted time ended, I wanted to give him a standing ovation. But you don’t do that sort of thing in DC. Let’s expand on each quote.

The fiscal cliff he is referring to happens at midnight on New Year ’s Eve. When the glittering ball in Times Square drops down the pole and lights up, the U.S. economy rolls off the cliff. The laws of the land regarding taxes have already been passed. The grinding wheels of higher taxation engage. The tax rates for income taxes, capital gains taxes, dividend income taxes, excess profits taxes, estate taxes and withholding taxes all go up. This will crush the American economy.

Other economists at the Bloomberg Summit said the same thing. Alice Rivlin was pretty clear when she said, “We will have an economic catastrophe if we don’t do something by the end of the year.” She used to be vice chair of the Federal Reserve System.

Vince Reinhart is the Chief U.S. Economist for Morgan Stanley. He estimates that the tax increases will cause U.S. economic activity to fall by 5 percent. His comment was, “We have dug a 5 percent of GDP hole for 2013 on Dec. 31.” Tim Adams used to work for the Treasury Department. He estimates the fiscal cliff will be 4 percent of GDP.

Several panelists also commented that we will have another debt ceiling crisis by January.

As you can see, the news from the Bloomberg Washington Summit is not good. As I have been warning everyone for the past five years, Congress has created a witches brew of poison for the U.S. economy. Time is running out for some adults to walk into Congress and start to make the decisions that need to be made.

We need to begin the credible process of balancing the U.S. budget. We don’t have to balance it in one year, just have a credible roadmap codified in law that proves to the world that we are willing to live within our means. Simpson-Bowles is the roadmap. So is the “Ryan Plan.” Another is the Rivlin-Domici plan. The roadmap has been written, we just have to have the courage to adopt it.

But Americans don’t like austerity any more than the Greeks do. We like farm subsidies, mortgage interest deductions, defense spending, tax deductions for contributions to the symphony, and on and on and on.

And we like our health care and Social Security retirement plans. Who cares if nobody can pay for it? Just print more money and assume more debt. Let the next generations pay for it.

Ultimately, we will have to compromise as a country. Taxes will have to increase a little, and spending will have to be cut a little. You don’t need a Ph.D. to know these things. The tooth fairy is dead. You have to pay for the services you consume.

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Austerity is So Yesterday

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Austerity has been the buzzword in global economics for the past year. It’s just a fancy word for living within your means. Lots of European countries have been talking about how they need to reform and stop running up so much debt every year.

It appears to me the concept of austerity in Europe is dying rapidly. The voters don’t want it. They are used to getting things from their government, and they don’t care how they get it. Who cares if you have to borrow? Who cares if the European Central Bank (ECB) has to print money to buy your government bonds because no sane investors will? Just give me my benefits!

Governments that were leading the charge for austerity are crumbling by the week. Over the weekend, Francois Hollande was elected president of France; economic issues were key in the defeat of incumbent Nicolas Sarkozy. The president of the Netherlands is going to step down, too. Nobody likes a leader that looks like the Grinch who stole Christmas. It’s so much easier to get elected when you are wearing a Santa suit.

It appears that the word “austerity” is out. Look for the word “nationalistic” to replace it.

What does all this mean?

  • Look for bond ratings agencies to start downgrading European debt again. As austerity goes out the window, the risk of getting repaid on existing bonds goes down.
  • Look for European governments to have trouble finding investors who will fund their spending habits, so the ECB will have to buy more government bonds.
  • Look for European banks to have trouble selling their bonds, too. So the ECB will have to buy more bank bonds as well.
  • Look for the ECB to have to print HUGE amounts of money to buy government bonds AND bank bonds.
  • Look for the International Monetary Fund (IMF) to be called into action when it’s clear the ECB doesn’t have enough ink to print enough money.

Keep in mind that the American taxpayer is a big contributor to the IMF. So strap on your seat belt. If you pay taxes in America, you will be buying European bonds whether you like it or not.

As the European economy and investment climate continues to deteriorate, investors in Europe will continue to move money out of the Continent and into greener pastures around the globe. Actually, the European debt crisis is causing investors from all over the world to move money to the United States. This will have two key impacts for real estate:

First, increased foreign investment in U.S. Treasury bonds will keep interest rates low on commercial and residential mortgages.

Second, foreign investors will continue to have a keen interest in U.S. real estate as well. Condos seem to be a particularly popular investment for foreigners seeking to park money safely in America.

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Lessons from Henry Paulson (Part Three of Three)

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In two previous posts, I listed eight lessons I garnered from reading the former Treasury Secretary’s book entitled On the Brink. Here are the last four lessons from that great book.

NINE

In the United States, Merrill Lynch was the first big bank to be rocked. On Oct. 24, it announced the biggest quarterly loss in its history — $2.3 billion — and CEO Stan O’Neal resigned less than a week later.

We are numbed to the sound of large numbers. In late 2008, a $2.3 billion dollar loss was staggering. Now when Fannie Mae announces a $5.7 billion quarterly loss, it is barely noticed. The fact that Fannie has now drawn more than $112 billion in bailout funds from taxpayers seems like no big deal. We can even tolerate a budget deficit of $1.5 trillion without flinching. The value of a dollar is gradually melting away.

TEN

. . . the stimulus represented a huge political and legislative accomplishment, and President Bush signed it into law on Feb. 13 after a remarkably quick two-week passage through the House and the Senate.

We seem to have forgotten that our Congress can be bipartisan when they want to be. It just takes a massive national crisis for that to happen. It seems unlikely that they will work to balance the budget until we once again stare into the depths of a new financial abyss.

ELEVEN

The firm under the most intense pressure was Bear Stearns . . . its shares had fallen from $77.32 to $62.30, while the cost to insure its bonds had nearly doubled. . . .

Paulson refers often in the book to major declines in the prices of stocks of financial institutions. Clearly, he views these price moves as serious warning signals. All of us should do the same thing. If the stock price of any major institution falls precipitously, be alert. The Fed and the Treasury may not be saying anything, but the market is screaming.

TWELVE

A Bear Stearns failure wouldn’t just hurt the owners of its shares and its bonds. Bear had hundreds, maybe thousands, of counterparties — firms that lent it money or with which it traded stocks. These firms — other banks and brokerage houses, insurance companies, mutual funds, hedge funds, the pension funds of state, cities and big companies — all in turn had myriad counterparties of their own. If Bear fell, all these counterparties would be scrambling to collect their loans and collateral. To meet demands for payment, first Bear and then other firms would be forced to sell whatever they could, in any market they could — driving prices down, causing more losses and triggering more margin calls and collateral calls.

Have you ever heard the phrase “systemic risk”? The above is one definition of the concept. It’s also referred to as “financial Armageddon.” This is why our government has declared that some firms are too big to fail. The implied warning to the American taxpayers is that some of our banks can virtually wipe out our economy if they fail. Our government in 2012 has identified eight institutions in the United States that are too big to fail. Comforting, isn’t it?

These banks are known as Systemically Important Financial Institutions (siffies). The American banks include Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, State Street and Wells Fargo. American taxpayers need to be cheering for these banks to be very profitable because our financial leaders have determined that our financial system will collapse if one of these banks fails.

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Lessons from Henry Paulson (Part Two of Three)

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In my last post, I listed four lessons gleaned from reading the former Treasury Secretary’s book On the Brink. Here are four more.

FIVE

When Lehman Brothers began sinking, they started to seek investors to help them weather the storm. One of those investors was Warren Buffett.

Paulson notes that, “an investment by Warren Buffett would send a strong signal to the credit markets.”

This reminds me of October 1929, when the stock market was collapsing. After several days of hard decline, John D. Rockefeller was called out of retirement to physically show up on the exchange during trading hours to purchase stocks. It was a media stunt designed to “mold” investor perceptions that everything on Wall Street was OK. If John D. was buying, then the little guy should be doing the same thing. Of course, anyone who followed Rockefeller’s advice that day was absolutely crushed in the coming days and months.

SIX

The stock market was weakening rapidly in 2008. On April 10, the Senate voted 84 to 12 in favor of a $24 billion bill of tax cuts and credits designed to boost the housing market.

Sometimes we get the feeling that Congress is polarized and can’t work together. But when the stock market swoons, bipartisanship comes into vogue.

SEVEN

Paulson notes that in July 2008, Lehman Brothers put out a research report that Fannie and Freddie might need as much as $75 billion in additional capital, causing Freddie’s stock to drop off a cliff.

Both stocks rebounded somewhat the next day, as a result of assurances from their regulator, the Office of Federal Housing Enterprise Oversight.

This is another example of a government agency feeding bad information to the public to mislead them. Then Paulson himself decides to provide the public with more “guidance.”

I made two public statements myself that week in support of the GSEs. Each time the market steadied for a while then resumed its downward tilt.

(Editor’s note: GSE stands for government sponsored entity. Typically when someone refers to GSE, they are talking about Fannie Mae and Freddie Mac.)

EIGHT

As Fannie and Freddie stock prices were collapsing in 2008, the Treasury was running out of options to manipulate public opinion and stop the decline. Paulson notes the difficulty in approaching Congress for money and authority to “fix” Fannie and Freddie, when another government agency had just given them a clean bill of health.

We were in an awkward position. The GSEs and their regulator, the Office of Federal Housing Enterprise Oversight, had said that the companies were adequately capitalized for regulatory purposes, but the market was skeptical.

I bet it would be very hard to convince Congress or any informed taxpayer in the country to give you unlimited power and budget to save the mortgage finance system when the agency charged with regulating them has recently said they were “well capitalized.”

So keep this in mind when you hear these phrases in 2012. Just because someone in Washington says a bank is well capitalized doesn’t necessarily mean that it is.

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Lessons from Henry Paulson (Part One of Three)

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Over the past decade, I have had a professional interest in observing how the Federal Reserve, the Treasury Secretary and the President have interacted to shape the economic environment in America.

Public statements about the economy from these individuals are made with deliberation to shape the confidence and economic behavior of American consumers and investors. I have found over the years that reading memoirs of prior Fed chairs and Treasury secretaries can give you added insight to help interpret the speeches delivered by the current cast of economic leaders. With that goal in mind, I enjoyed reading On the Brink written by previous Treasury Secretary Henry Paulson.

In the book, Paulson writes about how our government responded to the collapse of Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac in 2008.

Here are four things I learned from the book.

ONE

In fall 2008, the Fed and the Office of the Comptroller of the Currency realized that Fannie Mae and Freddie Mac had a negative net worth. But this wasn’t made public. The author states, “We’d been operating in secrecy and had managed to avoid any leaks for several weeks, which may be a record in Washington.”

This is what I’ve been trying to tell people for the past five years. The average person in America has to realize that the public utterances of federal government officials are designed to manipulate public perception. They should not be relied upon for making investment decisions. To find out what really is going on, you have to go directly to people in the industry.

TWO

No matter what the problem, large or small, there is no such thing as a quick solution when you deal with Congress. Frankly, you cannot get important and difficult change unless there’s a crisis, and that makes heading off a crisis quite challenging.

This is what most Americans are coming to believe about the current Congress. They believe that Congress will never balance the budget until we get so far in debt that we have a debt crisis similar to Greece. How big must the crisis get before Congress will have the courage to begin to balance the budget? As we can observe in Europe, voters don’t like AUSTERITY. My guess is that the American voters are no different.

THREE

The GSEs wielded incredible power on the Hill thanks in no small part to their long history of employing – and enriching – Washington insiders as they cycled in and out of government.

The failure of Fannie and Freddie could have been avoided if the American people would have listened to Alan Greenspan and then Treasury Secretary John Snow who warned that the two mortgage giants posed a big risk to the U.S. economy. But FRANNIE was protected by their own gigantic lobbying budget and political support from other trade groups. Here is another example where warnings are ignored until the crisis is upon us.

FOUR

In mid-July, in testimony before Congress, Ben Bernanke cited estimates of subprime losses reaching $50 billion to $100 billion. (By early 2008, losses from subprime lending had reached an estimated $250 billion and counting.) 

The Federal Reserve is full of brilliant economists and researchers. What this shows is that even the smartest people can occasionally be very wrong in their analysis. It’s just part of economics. Sometimes the weatherman makes more precise forecasts. If you hear an economist say his forecasts are right 50 percent of the time, he’s bragging, lucky or both.

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Celebrating Victori(a), Texas!

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The latest Tierra Grande includes my article (“China’s Crisis, America’s Hope?”) describing how the crisis in China could represent an opportunity for American manufacturing. In the time since I submitted the article, much has been published about the surprising growth in U.S. manufacturing.

We need to celebrate the success of Victoria, Texas, in competing globally and winning the business of Caterpillar Inc. The heavy equipment manufacturer chose Victoria over other global locations to construct a $200 million state-of-the-art facility for assembling excavators to be sold in the United States. The state of Texas can learn three important lessons from Victoria’s example.

Texas is globally competitive. For far too long, Americans have carried an inferiority complex about manufacturing in this country. Yes, many mid- and low-skilled positions were lost to cheap Asian labor between 1983 and 2002 — a total of 3.3 million according to the U.S. Bureau of the Census. However, high-skilled manufacturing added 1.2 million jobs in that time.

Now that the cost advantage in China, the “world’s factory,” is rapidly disappearing, it is time for the world’s most productive manufacturing employees (Americans) to seize the opportunity and win back business. Victoria’s experience gives us a model for how Texas can compete and win back manufacturing business for the Lone Star State.

Build it, and they will come. Logistics! Logistics! Logistics! Dale Fowler, president of the Victoria Economic Development Corporation, said that logistics played an important role in Caterpillar’s decision to locate in Victoria.

In the press release announcing the new facility, Gary Stampanato, the vice president responsible for excavators, commented that, “Based on our comprehensive review of possible locations, Victoria’s proximity to our supply base, access to ports and other transportation, as well as the positive business climate in Texas made this the ideal site for this project.” Victoria didn’t just promise to build the necessary logistical infrastructure. It was already built.

It is time for the Texas commercial real estate industry and local governments to work together to build an infrastructure that is more advanced than the infrastructure in China. If Texas can create a supply chain that is more efficient than our Asian competitors, then manufacturers will find it easy to relocate high value manufacturing jobs to this state.

(Skilled) Help Wanted. To attract high value manufacturing jobs to Texas, we need to have highly skilled workers. Young Texans making career decisions need to be shown modern day images of clean, advanced manufacturing facilities with challenging work.

The days of dark, dirty, menial factory labor are a thing of the past. The factories we want in Texas require math, science and computer degrees. Take note of these quotes from the March 26, 2012, Texas Manufacturing Outlook Survey published by the Federal Reserve Bank of Dallas.

We are not seeing enough people applying for our open positions, and most are not qualified. We have talked to others in our industry; they too are not seeing enough qualified applicants to fill open positions.

We have maintained jobs for more people than we needed over the past couple of years because we didn’t want to lose good, trained employees. [Editorial comment: Job Security!]

We have had openings for skilled workers (toolmakers, robotics technicians, etc.) for over a year and cannot fill the positions.

Finding qualified employees with good work habits (come to work every day on time, for example) is the biggest problem we face on a day-to-day basis.

While we see strong growth and ample sources of potential employees, we are investing in technology to equip our plant for the increased volume while keeping our labor force steady. [Editorial comment: But it will take additional highly skilled employees to build, install and maintain the new technology.]

There are many other examples of companies relocating manufacturing jobs from overseas to high technology facilities in the United States. Every week I read of another company making that decision.

Texas is blessed with a great geographic location and tremendous potential for logistics by land, air and sea, not to mention a boundless supply of inexpensive natural gas. There is no reason we cannot create a manufacturing industry that is the envy of the world. “V” for victory! “V” for Victoria!

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Extend-and-Pretend Continues

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The commercial real estate industry is waiting for the market to clear. It is waiting for the banking system to flush troubled real estate assets into the hands of investors. Since 2007, the Federal Reserve and the FDIC have been unable to allow this to happen.

Many commercial real estate lenders and investors are wondering how long the extend-and-pretend regime will last. Unfortunately, the end does not appear to be anywhere in sight as we enter second quarter 2012.

Here is the latest example. On Feb. 24, HUD announced a legal settlement with one of the largest mortgage originators in the country. Flagstar Bank agreed to pay $132.8 million in damages and penalties for false certifications on FHA loans it made. HUD notes in its announcement, “With today’s settlement Flagstar has accepted responsibility for its conduct, and committed to reform its business practices. . . . ”

Here is where the extend and pretend shows up in this story.

Yes, Flagstar agreed to pay $132.8 million to the United States in damages and penalties. However, they only have to pay $15 million in 30 days. The balance of $117.8 million won’t have to be paid until Flagstar can meet “certain financial benchmarks.”

Here comes the punch line from the HUD announcement. “The settlement payments represent the maximum that Flagstar can pay, consistent with its banking regulatory requirements and other requirements, including capital requirements imposed by the Office of the Comptroller of the Currency and the obligation of its parent holding company to satisfy its obligations in connection with the Troubled Asset Relief Program.”

So, here is the bottom line. A huge bank made false certifications on a large amount of FHA loans they created. The government caught them and fined them. But the bank can’t pay the fine and remain solvent. The fine really is just a “hope note” that won’t be paid until the bank can earn enough profits to pay it back.

We have a long way to go before the commercial real estate market clears.

Here is the link for the HUD announcement if you wish to read more.

P.S.

Take a look at Flagstar’s stock price performance. After hitting a high of more than $280 in 2004, the current price is 86 cents. I wouldn’t hold my breath that this fine will soon be paid.

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The Fed’s Support of Stock Prices

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In the past two years, I’ve noticed an interesting new phenomenon. Whenever the stock market drops, the actors of my favorite soap operas that play continuously on CNBC and Bloomberg immediately begin to speculate when the Federal Reserve will “do something.”

The punch line in these cliffhanger TV shows usually goes something like, “The stock market decline has led traders to assume that the next version of quantitative easing (QE) is just around the corner.” QE is just a fancy way of saying the Fed will print money and buy something to make the price increase.

It’s interesting to see how dependent stock market investors have become. It seems to be another case of how we like Capitalism when we are making money, but we embrace Socialism when we are losing money.

Here is where these stock traders are getting their confidence (and dependence) on the Fed. These words come from the Fed publication The Federal Reserve System: Purposes and Functions, Chapter 2 (emphasis added).

Beyond influencing the level of prices and the level of output in the near term, the Federal Reserve can contribute to financial stability and better economic performance by acting to contain financial disruptions and preventing their spread outside the financial sector. Modern financial systems are highly complex and interdependent and may be vulnerable to wide-scale systemic disruptions, such as those that can occur during a plunge in stock prices. The Federal Reserve can enhance the financial system’s resilience to such shocks through its regulatory policies toward banking institutions and payment systems. If a threatening disturbance develops, the Federal Reserve can also cushion the impact on financial markets and the economy by aggressively and visibly providing liquidity through open market operations or discount window lending.

Let’s see how QE has worked out so far.

On Monday Nov. 24, 2008, the S&P 500 closed at 851.81. The next day the Fed announced it would print money and buy up to $600 million in Treasury and mortgage debt. Nine months later the S&P had risen over 20 percent.

On March 18, 2009, the Fed announced it would print more money and buy more mortgages and Treasury debt. They announced they would buy another $850 billion in mortgages and another $100 billion in Treasuries. The day before this announcement, the S&P closed at 778.12. A year later, the S&P had risen nearly 50 percent to 1166.

On Nov. 3, 2010, the Fed announced it would purchase another $600 billion of longer-term government debt. The day before the announcement, the S&P was at 1197, and today it sits at nearly 1400 — up 17 percent.

So, you can see why Americans like it when the Fed prints money and buys financial assets. If we own stocks, they are making us richer. The following chart tells the story.

 

Just how much money can the Fed print, and how much debt can it buy in this fashion? In theory, there is no limit. The Fed is set up to be politically independent. In practice, the real limit would occur when Congress becomes alarmed enough to challenge the Fed’s independence.

Could the Fed print another trillion dollars without running afoul of Congress? This is almost a certainty. Could they print another $4 trillion? Probably. It’s really hard to say just how much money the Fed could print before political pressure becomes intense enough to stop it.

The Fed isn’t the only party keeping a keen eye on the stock market. Former Treasury Secretary Henry Paulson refers to the stock market continuously in his book On The Brink. I was curious to see how much of a decline in stocks has to happen for the Treasury to take notice. Here is a sample of Paulson’s comments.

Page 64 (referring to July 2007).  “That Friday, the Dow Jones Industrial Average, which had passed 14,000 for the first time in mid-July, fell nearly 400 points, its second-biggest one-day drop in five years. I could sense a big storm brewing.”

Page 129 (referring to April 2008) “. . . on April 11. That day the Dow plunged 257 points . . .”

Page 226 (referring to Sept. 15, 2008) “A little more than an hour before, the Dow Jones Index had closed at a two-year low. It had fallen 504 points, or 4.4 percent – the worst one-day point decline since the markets reopened after 9/11.”

Page 246 (referring to Sept. 17, 2008) “The markets were in near chaos. Stocks were plunging – the Dow was on its way to a drop of 449 points, or 4.1 percent.”

Page 260 (referring to a later date in September 2008) “In the last hour of trading, while we were in the White House, the Dow, down more than 200 points, surged 617 points to gain 410 points, or 3.9 percent, on the day.”

Page 321 (referring to Sept. 29, 2008) “Stocks had begun the trading session down sharply, then gone into free fall as the vote mounted against TARP. The Dow had posted its largest one-day point decline ever, almost 778 points or 7 percent…Overall, more than $1 trillion in stock market value was wiped out – a jarring one-day record.”

Page 334 (referring to Oct. 6, 2008) “Once our markets opened, the reports were equally frightening: the Dow fell sharply – in little more than an hour it was off 578 points, or 5.6 percent.”

Page 338 (referring to Oct. 7, 2008) “ . . . the Dow tanked again, falling 508 points, or 5.1 percent. . . . I didn’t know how much more stress the system could bear.”

Page 351 (referring to Oct. 10, 2008) “The Dow plunged 8 percent or 680 points . . . in the first seven minutes of trading, then rebounded by 631 points in the next 40 minutes. After slumping again, it roared up 853 points. . . .”

Page 409 (referring to Nov. 21, 2008) “NBC announced that Obama had picked Tim Geithner as his Treasury secretary. The markets exploded upward, with the Dow jumping 7.1 percent. . . .”

Page 416 (referring to Nov. 24, 2008) “The Fed also announced that it would buy up to $100 billion worth of debt issued by Fannie Mae. . . .” “The Dow appeared set for another strong session. Over the past three days, it had surged 927 points, or more than 12 percent.”

Page 421 (referring to Dec. 1, 2008) “. . . the National Bureau of Economic Research announced that the U.S. was officially in a recession…The Dow plunged 680 points, or 7.7 percent. . . .”

These excerpts show a 2 percent drop in one day is barely on the radar screen. A 4 percent decline in one day will catch serious attention. Declines about 6 percent to 7 percent in one day are clearly systemic events that will likely to cause a response from the Fed and the Treasury. If several days of decline of this magnitude occur, the likelihood of Fed intervention is almost guaranteed.

Therefore, the moral of this story is this: If the stock market begins to decline again this summer and fall, look for the Fed to announce another purchase of mortgages and Treasuries. This will drive the interest rates on mortgages and Treasuries down and keep interest rates low through the end of the year.

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Talking Dirt (Again)

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A few days ago, I made a presentation at the national convention of the Realtors Land Institute in Denver. Land brokers from all over America attended, and I had a great opportunity to get a sense of the current trends in the land market.

In my mind, the land market has three subgroups: agricultural land, recreational property and transitional land.

Agricultural land includes cropland and pasture for cattle. Ag land produces income to the owner; it can be categorized as an investment.

Recreational land describes properties purchased, not for income, but purely for enjoyment. A small acreage in the woods of Minnesota, or a lakefront property in New York or an arid place to hunt birds are examples. These properties are toys. You buy a toy just because you can. You buy a toy just because you want to. You buy a toy so you can have a good story to tell.

Transitional land is purchased for its development potential. This is typically land on the suburban fringe that is likely to become the next housing subdivision or the next industrial park.

Therefore, when someone asks, “How is the land market these days?” you have to recognize that each of these three categories is behaving very differently.

Farmland is on fire. Since Federal Reserve monetary policy has just destroyed any opportunity for savers, investors are searching for other “alternative investments.” In my mind, cropland is a viable alternative to owning gold. If the United States ever collapses into hyperinflation, food will retain its intrinsic value similar to gold.

Cropland has been increasing dramatically in value for the past three years. The neighboring farmer is often the buyer at these higher prices. Many sales are for cash. No leverage here. Quality cropland can still be purchased with an expected return of 4 to 6 percent. Pastureland has also increased in value but not at the same pace as cropland.

Recreational land is still languishing from the aftermath of the Great Recession and the periodic collapses that occur in the stock market. People buy toys when they feel confident that they have enough savings to support their business and their retirement plans. The Fed zero-interest policy is hurting this market. With heavy stock market losses in recent years and bonds earning virtually nothing, people anticipating retirement are ramping up savings significantly.

The expected returns on retirement portfolios have dropped dramatically in just the past three years. Retirees are hit even harder. Interest income on their portfolios has been crushed. Many retirees are re-evaluating how they spend their income because the government has stripped their assets of earning power.

It’s difficult to make any generalizations about price trends in this land sector. Some prices are reported to be down 40 percent from peak levels, but other properties haven’t seen that decline. However, transaction volume is way off. When properties aren’t selling, it’s hard to ascertain price trends.

I don’t expect recreational transaction volume to pick up until the United States is clearly experiencing a sustainable economic recovery and interest rates return to “normal” levels. According to Ben Bernanke, this might not happen for “an extended period of time.”

Transitional land is starting to awaken from a long and deep slumber. If you haven’t noticed, homebuilding has been almost nonexistent for the past three years. Who wants to own land for the next subdivision when you can’t predict when anybody would want the lots that you create?

The banking system has flushed many broken subdivisions back into the market after foreclosure. Banks don’t want to “extend and pretend” with these alligators, which voraciously eat cash every day. Some of these subdivisions have been sold to investors for “zero” value for the lots to investors who realize they will have to add huge capital improvements to complete the subdivision and don’t know how long they will have to hold the lots before they can be sold.

This is not true for all transitional land. In some areas of the country, jobs are being created and local economies are improving. Housing demand is gently increasing in these cities, and there is talk of “lot shortages” for desirable locations.

Industrial demand is picking up some energy too. Housing developers and industrial developers sometimes compete for transitional land. Don’t get me wrong, we are just in the very earliest stages of recovery in transitional land. In other parts of the country, land that was purchased by a developer has been foreclosed and sold at a huge loss to a farmer to put it back into crop production.

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Troubled Commercial Real Estate Loans in the Banking System

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Recently I served on a panel of speakers at the Information Management Network’s Bank and Financial Institutions Special Asset Executive Conference on Real Estate Workouts in New York City. The topics of the event were related to the disposal of troubled real estate assets that are owned by banks or are in the process of becoming owned by banks. A wealth of information was provided by the presenters, and what follows are some of the themes that were discussed.

The good news is that it is clear that troubled commercial real estate is starting to be sold by banks to private investors. It’s too early to say that the era of “extend and pretend” is over, but some product is beginning to flow. Banks are starting to sell properties in secondary and tertiary markets, and investor money is starting to move into those markets as well. For the past two years, most investor focus has been on the “gateway cities” of Boston, New York, Washington D.C., and San Francisco. Prices have risen dramatically in these cities, and returns have gotten low. This is the impetus for investor interest increasing in the rest of America.

There is still concern about the large volume of CMBS loans that were made in 2007 that will mature this year and need to be refinanced. The vast majority of these loans were made in the first half of 2007, so the refinancing pressure will be strongest in the first half of 2012 as these loans mature.

This worry about refinancing maturing debt has been around since 2009. But so far, there have been few examples of big failures to refinance or extend these maturing loans. Many are being extended for another two or three years. Often the borrower is asked to add more cash by paying down the loan. Some borrowers that are unable to come up with extra cash are “marrying up” with private equity firms who supply the funds. These funds have a high required rate of return.

The yield requirements for rescue capital has become more reasonable in the past year, down from 20-25 percent to more like 15-19 percent. This is why private equity is starting to play a role.

Some owners commented that when you take on a private equity partner, you feel like you really don’t own the property anymore. But the alternative is to lose the property to the lender. Private equity is available, but the cost is high.

Some banks still are in the extend-and-pretend mode because many don’t have the budget to write off the real estate losses when a foreclosure occurs. The banker must decide whether it is better for the bank to foreclose and take an immediate loss or to extend the loans and hope the market prices rebound and reduce any expected loss.

The capital markets were completely dead a few years ago; now there is some liquidity in secondary markets. Hopefully, it will bring more deal volume in 2012. As the general financial markets improve, the number of deals coming out of banks will increase. Private equity is stepping in to rescue these deals.

The consensus of the speakers at the event is that extend and pretend has been a success for the banking system. As prices stabilized and increased in some cities, the expected losses on real estate loans has also stabilized or gone down.

Stabilized asset workouts are treated very differently compared to loans on “half-built” properties. Extension is probably a good policy for the stabilized properties that generate cash flow. Prices are firming, and expected losses are diminishing. But half-built properties are another matter. These properties are not generating income, only costs. Banks are much more likely to be willing to sell these properties and get them off their books. Commercial real estate investors should view these broken properties as an immediate investment opportunity. If you are waiting for quality buildings with quality tenants to be sold by banks, you may be waiting for several years.

The investor panels at the conference expressed a common theme that I’ve heard for the past two years: “I can’t buy anything because of all the irrational bidders out there.” There is a lot of money trying to buy troubled commercial real estate from banks and CMBS special servicers. Prices are high, and yields are lower than expected.

Some of the bankers reported that extend and pretend is getting harder to do because of recent changes in accounting regarding troubled debt restructuring (TDR). If a real estate loan is identified as a TDR, then it’s classified as a nonperforming loan. If they extend a loan and it gets classified TDR, then they have to write down a loss.

Property values have increased substantially in gateway cities. In all other markets, appraisals are still flat or declining.

Restructuring a troubled commercial real estate loan usually means extending the duration, collecting a fee and requiring the borrower to put up more equity cash investment. The initial borrower often doesn’t have the cash so they have to marry up with rescue capital.

Another topic of interest among the panelists was the concept of the discounted payoff (DPO). Suppose a borrower has a $1 million loan that is maturing, and the bank doesn’t want to refinance it. The borrower may make an offer to completely pay off the loan at a discount. Some banks have a real aversion to offering a DPO to a borrower because it sends a bad signal to all its loan customers that you can pay off at a discount. However, banks may not have an aversion to accepting a DPO from a third party. In this case, the bank will actually sell the note rather than foreclose on the property. Some banks will allow the borrower a DPO in conjunction with a note sale. If the borrower is the highest bidder for their note, then they can buy it from the bank at a discount.

Some real estate loans are buried deep in the banking system under a loss-share agreement with the FDIC. Typically, this happens when a “good” bank acquires a “bad” bank. The good bank didn’t really want the bad loans, so the FDIC offers to protect them from losses when they ultimately foreclose on these troubled loans. But the FDIC is in no hurry to foreclose and sell these troubled properties now. Panelists noted it’s difficult for banks to sell notes where they are under a loss-share agreement. Banks with loss-share agreements don’t really want to sell notes. The FDIC has not signaled the all clear yet to flush the real estate assets.

One panelist offered an extensive overview of the CRE market. The $20 billion in private equity funds raised in 2011 is looking for U.S. real estate deals in all land uses. Transaction volume picked up in 2011. While prices increased substantially in gateway cities, prices are still on average 40 percent less than the 2007 peak elsewhere. Distressed sales were 25 percent of all 2011 CRE transactions.

Smaller banks are hiring consultants to evaluate their CRE portfolios and estimate their expected losses. There is a lot of thinking and planning but not much execution in moving troubled real estate loans off the books. There is pressure coming from the FDIC to recapitalize and get bad loans off the books. Banks that are struggling with capital ratios still are hesitant to sell, but healthy banks have taken write-downs (and charge-offs) for several years and are now in a position to sell troubled loans.

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