Mereja

Author: Dan Amoss

  • A Free Market In Chains

    If left to its own devices, a truly free market would have already corrected many of the imbalances of the late, great credit bubble. Instead, US policymakers at the Federal Reserve and the Treasury Department have been trying to re-inflate the credit bubble by pumping trillions of dollars of fresh credit and currency into the financial system. The Fed is still maintaining these Keynesian tactics, despite the increasing possibility that inflation and other adverse outcomes will result.

    Kansas City Fed President Thomas Hoenig is one of the few policymakers who appear to grasp the following simple economic truism: There is no free lunch. In his April 7 speech “What About Zero?” Hoenig says, “Low rates, over time, systematically contribute to the buildup of financial imbalances by leading banks and investors to search for yield.” In other words, Hoenig doesn’t want to be complicit in the ZIRP (zero interest rate policy) experiment the Fed is currently conducting.

    “The search for yield involves investing in less-liquid assets and using short-term sources of funds to invest in long-term assets, which are necessarily riskier,” Hoenig continues. “Together, these forces lead banks and investors to take on additional risk, increase leverage, and, in time, bring in growing imbalances, perhaps a bubble and a financial collapse.”

    Hoenig has the courage to speak up about long-term consequences. This is a refreshing contrast to what passes for judgment among other Fed governors, whose votes reflect short-term thinking and ignorance of the long-term consequence of ZIRP.

    The rest of the Fed’s academics point to the alleged benefits of zero interest rates and deficit spending, while remaining either blissfully unaware of – or intellectually dishonest about – the unseen costs of these policies. A good example of this myopia was on display when Alan Greenspan testified in front of Congress last week. Even after the 2008 crisis, Greenspan still refuses to acknowledge the destructive economic distortions that his Fed policies nurtured.

    The unseen costs of “easy money” policies are hard to identify or measure, but that doesn’t mean they don’t exist. By definition, the Federal Reserve is giving a subsidy to someone anytime it provides credit that costs less than the private-market cost of capital. And, by definition, a subsidy is an expense that someone else must bear.

    In today’s post-crisis economic environment, the Fed’s ZIRP policy provides a very direct and obvious subsidy to the nation’s largest financial firms. These firms borrow from the government at low rates of interest, then loan the money back to the government at much higher rates of interest. In the first instance, only a handful of privileged financial firms may borrow money from the government at low, preferential interest rates. But in the second instance, we, the taxpayers, must bear the cost of the high rates of interest the government pays back to the financial firms.

    Meanwhile, in order to fund our growing national deficits – which are caused partly by the subsidies our government provides – political leaders in the US are making up for the lack of domestic savings by importing the excess savings of the rest of the world. Foreign creditors are financing our deficit-spending by buying Treasuries. But global savings don’t come free; they come in exchange for claims on the future productive capacity of the US economy. The US is selling claims on its assets in exchange for propping up an unsustainable status quo.

    Academic economists come up with overly simplistic reasons why this process can continue indefinitely, including the old standby, “Japan has done it for 20 years, and its bond market yields are still low.” Not all countries have the productive captivity and competitiveness that Japan has. Greece does not, and its government debt hasn’t turned out to be sustainable.

    China has its problems and bubbles, but at least its government’s make- work projects are adding to the productive capacity of its economy (physical and intellectual capital that will exist, even after the world abandons its unworkable currency and government debt systems).

    In China, politicians try to do everything they can to promote economic growth that adds to its productive base. In the US, politicians are doing everything they can to redistribute wealth, no matter the economic consequences. And all the while, the line of phony capitalists seeking subsidies in Washington, DC is growing longer. The more corporate subsidies the US government hands out – whether it be to banks, health insurance companies, or auto makers – the faster the government undermines its own creditworthiness.

    Treasury yields could rise sooner than most investors expect. Not because of inflationary pressures, or because of the Fed hiking rates, but because of the simple mechanics of overwhelming Treasury supply and falling creditworthiness. Bond investors know that a surging supply of Treasury securities is on the way. So these investors might become much less eager to pay high prices (low yields) at future bond auctions.

    In short, the federal government’s eyes have become much bigger than the taxpayers’ stomach. The illusion that the US government has unlimited resources will come to a painful and decisive end in the form of higher Treasury yields…and much lower profitability in the US financial sector.

    Dan Amoss
    for The Daily Reckoning Australia

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  • Forcing Private Sector Savings into Public Sector Debt

    History shows that when the governments grow desperate to finance deficits, they get creative.

    During WWII, the US government needed investors to buy an unprecedented amount of Treasury bonds. Commercial banks loaded up on Treasuries, which limited the amount of credit that could be granted to the private sector. It may have been the patriotic thing to do, but the real returns from war bonds were very poor. Napier said, “That’s the type of society [the US and the UK] had to run to sustain our government debt. And I’m suggesting to you that these are exactly the sorts of things we have to look out for in our future.”

    Napier then summarized one of the conclusions that economists Carmen Reinhart and Ken Rogoff reached in their book This Time is Different. Financial crises morph into fiscal crises. But the thing that has yet to frighten investors is the next stage: financial suppression. This is the process of forcing private sector savings into public sector debt. Most investors will tell you that this is impossible. But Napier ticked off two potential tools the government could use to strong-arm investors into Treasuries:

    1. Capital controls: An example of this comes from the UK in the 1970s. For most of this decade, the yield on UK government bonds was below inflation. The government wouldn’t let investors take money out of the country.

    2. The “Buffett tax”: Political leaders would say, “We love capitalism. It is the best thing America has ever had. And we would really, really like to promote it. And the best way we can promote capitalism is to get all you capitalists to invest with a long-term holding period.” The idea would involve a 4% “transaction tax.” This effectively forces shareholders to engage more deeply with corporate executives, rather than trading shares aggressively. The authorities would say, “This is a wonderful thing because Warren Buffett does it. And if Buffett does it, it has to be good. So as of tomorrow, we’ll have a 4% ‘Buffett’ tax for the trading of all financial instruments except for government debt.”

    Napier says the government can’t get away with inflating away its debt in a free market. If it were attempted in an aggressive fashion, yields would soar, making the process self-defeating. So the government will make the Treasury market a “less free” market. In other words, it will stack the deck in favor of Treasuries, to the detriment of all other financial assets.

    But the authorities should know that this type of action would have huge consequences for global financial markets. A big driver of the global economic growth over the past three decades has been the liberalization of capital. Capital could easily migrate across borders to seek out the highest risk-adjusted returns. Today, the international flow of capital is just as important as the flow of international trade. Capital controls, if they get too onerous, could wind up leading to a 21st Century version of the Smoot-Hawley tariff.

    As distasteful as it is, investors must pay close attention to politics and policy. “We’ve spent our professional careers analyzing supply and demand,” Napier explained. “Now, we must analyze supply, demand, and government. [During the 2008 financial crisis], the government didn’t like what supply and demand were doing; supply and demand were inducing deflation and creative destruction, so the government stopped it.”

    Napier thinks that the catalyst to end the unsustainable status quo of the developing world financing US trade deficits will be inflation in the emerging markets. Emerging economies believe that they can export their way to prosperity, but they cannot. “40% of the world’s population has a great plan to get rich by selling stuff to 14% of the world’s population,” Napier observed. “That can work for several years, and it has – particularly if 14% of the world’s population is prepared to gear like crazy to buy all of this stuff.”

    Now that US consumers are deleveraging, Asia’s mercantilist economic and currency policies aren’t as effective as they once were. These countries will not be focused on undervaluing their exchange rates forever. If aggressively debasing your currency were a guaranteed road to high growth and low inflation, paper money would have a much better reputation among historians.

    The downside of this currency policy is that it can lead to inflation at the local level. Eventually, the supply of existing and new money will overwhelm the growth of productivity in China’s industrializing economy. These emerging markets will have to eventually allow currencies to rise to prevent inflation from getting out of control.

    We’re seeing more examples of rising imported commodity prices hurting Chinese industry. The price of iron ore is soaring, thanks to China’s aggressive infrastructure investment and its suppressed currency. International iron ore markets are so tight that supply contracts are switching from yearly to quarterly pricing adjustments. The Financial Times this week reported on this evolution in the pricing of iron ore, which will feed through to higher steel prices: “The new price system will lift the cost of iron ore to Asian steelmakers to about $110-$120 a tonne during the April-June period, up between 80 and 100 per cent from the $60 level at which the 2009-10 annual contracts were settled.”

    If China allowed its currency to appreciate, it would pay less to import iron ore and other crucial imports like oil. A strengthening Renminbi would increase demand for imported oil, which translates into more expensive oil for US consumers. A few years from now, Washington, DC may come to regret its push for China to appreciate its currency.

    Napier also addressed the subject of Europe, Greece, and the Euro. He said, “The creation of a single currency is not an economic event, it’s a political event. Unfortunately, the ten guys in Europe who run this currency have all got Ph.D.s in economics.”

    Napier then told us about his experience working in Hong Kong in 1998. That year, the French senate sent a delegation to Honk Kong to investigate the Asian financial crisis, and consult Napier about the evolving project that was the Euro.

    The French delegation was convinced of the merits of establishing the Euro, because it would supposedly bring lasting peace along with economic integration. WWII was still a searing memory. The delegation asked whether the Euro would help “iron out the inefficiencies” across Europe. Napier replied, “The things you call ‘inefficiencies’ here in Hong Kong are the things in France you call ‘culture.’” He knew that currency integration without political integration wouldn’t work.

    Napier fears that the political will to save the Euro is forcing “economic deflation” in Greece and the other spendthrift countries within the Eurozone. Those running the ECB may rightly note that wages in Greece might decline to achieve a healthier Eurozone equilibrium. But Napier believes that if too much harsh austerity is imposed on the Greek economy, the democracy in Greece might be destroyed in the process. Napier points out that democracies very rarely deflate. They instead devalue their currencies and push new money supply through the channels of commerce.

    Napier is concerned that “the ECB will not change its mind on hard money until it destroys one of the democracies in Europe.” Then came the most shocking thing Napier said in his hour-long speech: a prominent Greek businessman confidently assured him that the United Nations will be running Greece by September. If so, this should keep fear in financial markets at healthy levels through this spring and summer. Greece is not resolved, yet the markets appear to believe so.

    When asked for a forecast of the best potential asset class over the next decade, Napier’s replied: “A basket of Asian currencies.”

    Dan Amoss
    for The Daily Reckoning Australia

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  • The Shiller P/E Ratio

    “The last time that [America] had no government debt, you had a Scottish president. His name was Andrew Jackson. Not only did he pay off the national debt, he also abolished the central bank and tried to close down all the commercial banks.”

    – CLSA Strategist (and Scotsman) Russell Napier, March 24 CFA Society speech

    I had the good fortune to attend a speech by Russell Napier last week. Napier is a stock market historian. But he’s not just an ivory-tower academic; he operates on the front lines of the investment management business as an analyst for the brokerage firm CLSA. Napier’s been in the trenches of the global financial markets for several decades.

    Napier’s speech, which echoed themes from his excellent book, Anatomy of the Bear, stressed the need for investors to understand the long- term trends in stock valuations.

    Secular, or long-term, bull markets are best defined as a period of rising valuations, he explained, while bear markets are the opposite. Near bull market peaks, investors become so optimistic that they pay silly earnings multiples for stocks. A simple way to view a P/E multiple is the “payback period” for the return of the capital you part with in order to buy a stock. The higher the starting PE ratio, the longer the payback period.

    Napier’s discussion of cycles in stock market valuation is based on the work of Yale Professor Robert Shiller, and his now-famous “Shiller P/E ratio.” The Shiller P/E ratio is calculated as follows: divide the S&P 500 by the average inflation-adjusted earnings from the previous 10 years. Here is a chart of the Shiller P/E going all the way back to 1880:

    Long Term Shiller P/E Ratio

    It’s the best P/E ratio to use over long stretches of history, because it smoothes out the extreme peaks and valleys in earnings, giving a better framework for thinking about future S&P earnings power. The mean and median Shiller P/E since 1880 are both about 16. Today, it’s about 22. At the last four major bear market bottoms, in 1921, 1932, 1949, and 1982, the Shiller P/E fell below 10. This is a far cry from bouncing sharply off of 15 – which is what happened at the March 2009 bottom.

    Valuation is the main reason why I expect the bear market to last several more years into the future – probably somewhere in the 2015- 2020 timeframe. I think we’ll get there through some combination of falling stock prices and modest earnings growth.

    Rapid earnings growth – along with rising valuations – drove the great 1982-2000 bull market. The sprint up to the 2000 peak was, in hindsight, the biggest stock market bubble in history. History shows that bubbles are nearly always corrected over very long periods. The next decade will surely be especially turbulent, because that’s when markets and politics will sort out what the inevitable train wreck in the US entitlement programs will look like.

    How much will entitlement promises be financed by currency debasement? How much are Baby Boomers willing to sacrifice in terms of medical rationing? Or higher retirement ages for Social Security? These are the big questions of our time. The one thing that’s certain is that it won’t be painless. Most entitlement recipients expect a standard of living that the welfare state can simply not afford.

    In his speech, Napier’s dry humor nailed the situation: “For 120 years, the US borrowed money to kill people [in wars]. Now, it’s borrowing money to keep them alive.”

    As it turns out, demographic trends are a crucial driver of both politics and markets. Napier cited a study that Professor Shiller and a few of his graduate students conducted to discover a data series that fits closely with the Shiller P/E ratio. The study revealed that demographics heavily determine stock market valuations. It compared the number of 40-year-olds with the number of 20-year-olds through time. If the number of 40-year-olds grows faster than the number of 20-year- olds, valuations rise. If the number of 20-year-old grows faster than the number of 40-year-olds, valuations fall.

    In statistics jargon, the “r-squared” of this variable, in explaining valuations, was 0.79. That’s very high, meaning the demographic trends are important in determining long-term stock market returns. Over the next several years, the number of 40-year-olds will decline, due to the lower birth rates between the Baby Boomers and the Boomers’ kids. So the Shiller P/E ratio is very likely to fall.

    Napier’s talk concluded with his outlook for stock valuations. He said, “I fully expect to be here in five or six years telling you to buy US stocks at 6 times earnings – at a time when the geopolitical decline of America is on the front page of every newspaper; at a time when you have capital controls; at a time when the government is manipulating the debt market.”

    Dan Amoss
    for The Daily Reckoning Australia

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  • The Case for Higher Treasury Yields…and Lower REIT Prices

    The prospect of rising Treasury yields will pressure REIT valuations. “Yield instruments” like REITs are priced to yield a “spread” over Treasuries. So prices of yield instruments usually fall when Treasury yields rise. I am anticipating this exact scenario.

    I’m a bear on Treasury bonds. Prices should go down and yields should go up as the creditworthiness of the US government deteriorates. Right now, with the 10-year yield at 3.64%, investors are assuming that the future direction of inflation and budget deficits will remain under control. Treasury bond bulls will argue the following points about inflation, federal deficits, and the existing stock of Treasuries. I’ve listed the bullish consensus view in bold type. My responses, listed as the alternative view, will follow each consensus view:

    Consensus view on inflation: “High unemployment and low manufacturing capacity utilization will keep inflation fears in check. So those folks expecting inflation fears to push Treasury yields higher in 2010 are a few years early.”

    Alternative view: Outside of the panic liquidation conditions of fall 2008 or the Great Depression, rising prices are hard-wired into the US economy. If investors panic once again and desperately seek to hold cash, the Fed can team up with spending addicts in Congress to create new US dollars in limitless quantities. The past two years have proven this out.

    The issue isn’t whether the government can satisfy demands of investors looking to liquidate assets and hold dollars. As long as Treasury yields remain low, the government can create limitless amounts of new credit to satisfy investor demand for default-free government liabilities (Treasuries and paper money).

    Instead, the real risk facing financial markets over the next few years is whether investors will remain willing to hold cash and Treasuries at low yields. Cash has no intrinsic value beyond the belief that it can be exchanged for goods and services. The value of Treasury securities depends on investors’ willingness to hold them, despite the near certainty that trillions in new Treasury securities will flood the market over the next decade.

    The high unemployment/low capacity utilization argument is theoretical, antiquated, and based on a fairly closed, manufacturing-oriented economy. In this theoretical economy, unemployed workers continually bid the price of their labor lower until supply and demand for labor reach equilibrium at lower prices.

    Today’s US labor market does not work that way. The work force is very specialized. A laid-off automotive engineer is not likely to underbid the salary of nursing graduates for an open nursing position. Instead, those who have left the labor pool are collecting unemployment benefits without contributing to the aggregate supply of goods and services. When the claims on goods and services grow faster than actual supply, prices rise. The conditions for hyperinflation arise when an economy’s productivity collapses and supply of government liabilities overwhelms demand (as confidence in the value of those paper government notes collapses).

    The Federal Reserve promotes the “low capacity utilization” case for low inflation so it can keep subsidizing the wounded banks with easy money. But the market could lose confidence in the Fed’s theory if the CPI remains stubbornly high at the same time as unemployment remains high. The market would express this view by selling off long-duration Treasuries, which increases yields. If this happens, the Fed will have to tighten policy to restore the market’s confidence in the integrity of paper dollars. Fed tightening would lead to a reacceleration of the unwinding of the commercial real estate bubble.

    Consensus view on Treasury supply required to fund budget deficits: “Even though US household savings may absorb just a few hundred billion in Treasuries in 2010, foreign investors and US banks will buy enough to keep yields from rising.”

    Alternative view: Several sources estimate that the US Treasury must auction roughly $2.5 trillion in new securities in 2010. Some of the proceeds will retire maturing securities, while the balance will finance the budget deficit.

    The majority of the Treasury securities auctioned in 2009 were bills with very short maturity. The average interest rate paid on the Treasury bills auctioned over the past year is roughly 1%. But recently, Treasury auctions have been weighted more toward the longer maturities. Supply could overwhelm demand, causing prices to fall and yields at auctions to rise.

    Because banks are choosing to defend their souring bubble-vintage loans, and writing them off slowly over time, they won’t have the capacity in the “hold to maturity” section of their balance sheets to absorb as many Treasury securities as the market expects. If banks had flushed most of their bad loans off their balance sheets in 2009, they would have capacity to absorb perhaps hundreds of billions in Treasury securities in 2010. But they didn’t.

    There is a scenario in which domestic demand for US Treasuries could exceed new supply in 2010: another stock market meltdown similar to the one in late 2008. If enough investors flee stocks in a panic and invest the proceeds into Treasuries, yields could go down.

    But considering that the government has committed its balance sheet to bailing out the financial system, that scenario is unlikely. More likely is a scenario in which investors question the integrity of the US balance sheet. The way to do that is to sell Treasuries. This scenario would be negative for the stock market, likely sparking the next leg of the secular bear market – a leg that involves several years of the S&P 500 trending gently lower under a rising interest rate environment. But it wouldn’t likely involve a 2008-style panic liquidation of stocks.

    Consensus view on the existing stock of Treasuries held by foreign investors: “Year after year, Treasury bears predict that foreign appetite for US Treasuries will weaken, but they keep buying. Foreign central banks will maintain their appetite for Treasuries because they have to keep their currencies cheap or pegged to the US dollar.”

    Alternative view: Foreign investors must be willing to hold Treasuries at a yield that compensates them for the risk that inflation and interest rates might go up in the future. If these investors fear that future inflation, interest rates, and deficits will remain dangerous, they won’t buy more Treasuries until yields rise to higher levels.

    A financial market that’s evolved to a state at which it requires a perpetually growing inflow of new money to remain stable is a Ponzi scheme. The market for tech stocks in 2000 and real estate in 2006 had evolved into a Ponzi.

    Those who argue that foreign creditors will never sell Treasuries because it’s “not in their best interest” should explain why investors sold tech stocks or housing when they were in bubbles. Surely, it wasn’t in the best interest of tech bulls to sell. Selling meant prices would fall, thereby damaging the value of tech stock positions. But they sold aggressively, because they perceived it to be in their best interests.

    The situation of foreign creditors holding an unpayable mountain of debt of a trading partner is a classic “prisoner’s dilemma.” A prisoner’s dilemma is a situation in game theory in which two parties might not cooperate even if cooperation is in their best interest. China and Japan might both conclude that buying more US Treasuries is not in their best interest. If they both stop buying at the same time, prices will fall and yields will rise.

    This scenario, by the way, is the reason that the responsible American public is opposed to Keynesian deficits as far as the eye can see. Just because Keynesian pro-deficit policies plug a theoretical hole in “aggregate demand” doesn’t mean they are sustainable or wise. The public understands that Keynesian deficits are unsustainable. The cumulative effects of these deficits – which are never offset by surpluses during the good times – ultimately destroy confidence in both the government bond market and the currency.

    When the Japanese government hits the debt wall in the next five years and Japanese bond yields spiral upward, it will prove the foolishness of Keynesian policy.

    Here is where the existing stock of US Treasuries comes into play. Japan already owns $750 billion worth of Treasuries. When the Japanese government hits the debt wall and yields rise, the Bank of Japan will likely print new yen to fund the government. If so, the value of the yen could collapse, which would force the Japanese Ministry of Finance to sell some of its $750 billion in US Treasuries in order to defend its currency.

    It remains to be seen how long the government and the central bank can keep savers involved in this Ponzi scheme. This scenario – if Japanese savers abruptly lose confidence in their government’s ability to service its massive debt load with taxes and bond market proceeds – is how Japan could shift quickly from deflationary conditions to hyperinflation.

    Japan is several years ahead of the US in the transformation of its government bond market into a Ponzi scheme, so we should consider it a canary in the coal mine.

    Aside from Japan, the appetites of two other huge Treasury investors are waning. The Chinese are rolling their maturing notes and bonds into buying shorter maturity bills. And the Social Security trust fund is not far from being in the position where it’s a net seller – rather than a net buyer – of Treasuries. With unemployment stubbornly high, less payroll taxes are flowing in. With lower payroll tax inflow in 2010, the trust fund has less of a surplus to invest into Treasuries. When demographics switch the trust into a deficit position, it will become a net seller, rather than a buyer, of Treasuries.

    All of these factors argue convincingly for rising Treasury yields in 2010 and 2011. The consensus does not seem concerned about these factors. As of Jan. 20, the FTSE NAREIT Equity REIT Index yields 3.72%. This is roughly equal to the 3.64% benchmark 10-Year Treasury yield. Over the past 20 years, the average spread of the NAREIT index over Treasuries was 100 basis points, or 1%. Removing the influence of the 2005-2007 REIT bubble takes the historical average spread closer to 300 basis points over Treasuries.

    So not only are REIT valuations at risk from rising Treasury yields, they’re also at risk from rising spreads over Treasuries. Considering that REITs are in a prolonged post-bubble environment, it’s reasonable to assume that REIT spreads over Treasuries will rise to 300 basis points or more. Assuming both factors – rising Treasury yields, a rising spread of REIT yields over Treasuries – the REIT index could easily fall 50% from current levels.

    Regards,

    Dan Amoss
    for The Daily Reckoning Australia

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  • REITs… A Thing to Avoid

    The commercial real estate crisis may be the most anticipated crisis in history. But just because it’s widely anticipated doesn’t mean that the crisis won’t be destructive for REIT shares. Since most REITs are richly valued, the slow-moving commercial real estate crisis will ensure that future returns disappoint.

    Consider the valuation of REITs versus the S&P 500, which itself is overvalued. Despite being 25% below its late 2007 peak, the US stock market – measured by the S&P 500 index – is very expensive. The “Shiller P/E ratio,” developed by Yale professor Robert Shiller, measures the S&P 500 against the average S&P 500 earnings over the previous 10 years, adjusted for inflation. It’s a much more robust measure of valuation, considering the fluctuation of corporate earnings, and the fact that after bubbles, much of the earnings booked during the boom are written off during the bust. Consider that the earnings booked by Citigroup and other big banks near the peak of the bubble were largely written off during the bust. Therefore, a 10-year average of earnings is a better indicator of true earnings.

    The Shiller P/E ratio for the S&P 500 Index is now 21 – up dramatically from 13 at the March 2009 lows. This 21 P/E is higher than at almost any point in stock market history, outside of the late 1920s bubble, the late 1990s bubble, and the market peak in 2007. The S&P 500 is overvalued based on the Shiller P/E, but corporate earnings are supposedly going to soar in 2010, right? Well, even if you believe the optimistic 2010 estimates, the market is still more than fully valued on that metric.

    Ditto REITs.

    Commercial real estate – and the REITs that hold commercial properties – began to deflate rapidly in late 2008. But the Fed stepped in with bailout funds and easy money to halt the deflation…and even pumped the bubble back up a bit. The nearby chart shows the results of the Fed’s handwork. REITs of all shapes and sizes more than doubled off the stock market lows of last March, while the Bloomberg Hotel REIT Index more than tripled. (We’ll come back to this chart a little later).

    Hotel REIT Price Trends

    This rally has the look and feel of a dead-cat bounce, which means that it provides an attractive short-selling entry point.

    REITs soared as the bubble inflated from 2000-2007, then crashed when the bubble popped in 2008 and early 2009, and then launched a dead cat bounce when the Fed flooded the system in mid-2009 with massive injections of liquidity and cheap credit. Now REITs are priced at bubble valuations – valuations that bear little resemblance to economic reality.

    This bounce has postponed a healthy purge of assets in which old capital invested by foolish speculators during the bubble would have been wiped out – clearing the way for new owners to assume title to real estate at reasonable prices. When central banks prop up deflating bubbles with super-easy bailout cash, the bubble investors don’t liquidate their overly inflated assets. They hang on and hope for a turnaround.

    But bubbles always deflate…always. Government intervention merely muffles the hissing sound for a while. This story played out in the Japanese real estate bubble that peaked in 1990, and it’s happening with the US commercial real estate bubble that peaked in 2007. Capital becomes trapped in a dead asset class, thereby stretching the bubble’s resolution out over decades.

    Toward the end of 2009, it became clear that “extend and pretend” had become the official policy at most banks that hold commercial mortgages. We won’t see a cleansing flush of hundreds of billions in underwater properties changing hands to new owners. Instead, properties will be dribbled out of the foreclosure pipeline at a slow pace. This measured pace of foreclosures will add to the chronic glut of property that will be quickly listed for sale into any bounce in demand.

    Some of the best short-selling opportunities in the REIT sector may be in the hotel REIT sub-sector.

    It’s not a stretch to expect the hotel business will be ugly for a long time. Corporate and leisure travel is in the midst of a depression. And leveraged hotel owners built or acquired too many hotels near the peak of the commercial real estate bubble.

    Now many hotel owners are desperate to generate cash in order to pay down debt and retain titles to properties. Some are slashing nightly room rates below break-even levels. You know from the growth of Internet hotel booking services just how much more competitive and transparent hotel pricing has become over the past decade. Unless competitors are willing to match the pricing of the most desperate hotel owners, healthier competitors will suffer lower occupancy.

    Some levered hotel owners, like Sunstone Hotel Investors, are abandoning their equity in some properties to salvage others. In the fourth quarter of 2009, Sunstone defaulted on several nonrecourse mortgages held against 13 of its properties and turned the title over to its lenders. Sunstone calls this a “deed-back,” but it’s really a strategic default.

    Sunstone’s lenders will probably keep and operate the hotels, rather than dump them at a distressed price. The behavior of Sunstone and its lenders shows how many hotel owners and lenders are putting off the necessary liquidation of underwater properties with bloated cost structures. The industry still needs to make more progress on downsizing, slashing operating costs, shrinking mortgage sizes, and lowering room rates to match demand. Until it does, the industry’s returns on capital will not consistently exceed its cost of capital.

    Hotel REITs are highly sensitive to perceptions about the near-term health of the hotel business. Trends in occupancy and room rates shape perceptions about earnings. Hotel REITs own portfolios of hotels and outsource the management to companies like Marriott for a fee.

    Because of the relatively fixed costs of paying management companies a fee for operating hotels, Hotel REITs operate with high operating leverage: A 20-30% decline in revenues can translate into a 50-75% decline in operating income. Also, unlike offices or retail REITs with sticky long-term leases, the cash flow for hotel REITs adjusts quickly to changing conditions on a day-by-day basis.

    Over the past nine months, hotel REITs have soared on the perception that corporate and leisure travel will rebound strongly in 2010 and 2011. Analysts have forecast a sharp rebound in earnings.

    But I’m not buying it. In fact, I’m selling it.

    Regards,

    Dan Amoss
    for The Daily Reckoning Australia

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  • Two More Reasons to Sell Treasury Bonds

    Two more reasons to sell US Treasury bonds: Fannie Mae and Freddie Mac.

    These two giant mortgage lenders are poster children for the dangers of wrapping government guarantees around the credit markets. With help from the state-sponsored banking system, these two government-sponsored entities (GSEs) perverted the process of credit intermediation and artificially suppressed the cost of mortgage loans over many decades.

    This perversion of mortgage finance explains why house prices grew faster than household incomes for roughly a decade ending in 2006. With the broad recognition that the GSEs were insolvent in late 2008, the artificial suppression of mortgage rates was about to come to an end. That is, until the Treasury and Federal Reserve doubled down on their commitments to throw good money after bad. Now, permanent manipulation of mortgage interest rates has become official government policy. The cost of this policy will be even higher federal deficits in the future.

    Government guarantees temporarily hide risks, which results in foolish capital allocation throughout the economy. This game can last until the activity collapses under its own weight (like housing in 2007), or until the government itself runs out of financing options at affordable interest rates.

    Just like Medicare policies influence the practices of health insurance companies, Fannie and Freddie mortgage-backed security (MBS) guaranty policies influenced the underwriting behavior at mortgage brokers. Therefore, no one should be surprised that mortgage brokers fudged numbers to shoehorn borrowers into “conforming” mortgages. These brokers generated huge profits by unloading massive amounts of underpriced credit risk into the Fannie and Freddie MBS pipeline.

    Mortgage expert Mark Hanson described the triumph of automated mortgage underwriting over prudence in a December 2009 issue of the Mortgage Pages:

    During the bubble years, the GSEs looked at [debt-to-income ratios] secondarily to credit score, [loan-to-value ratios], and cash reserves as measured by liquid cash and 70% of retirement [assets]… During the bubble years, if the LTV was low enough and/or score and cash reserves high enough, the system would approve virtually anything.

    Many lenders, especially the big banks, had…underwriting “trainers” that would go around to the various mortgage branches and teach underwriters how to “trip” the systems in order to achieve automated loan approvals when a declination was certain, or simply get fewer approval conditions on a loan that was borderline. Getting a loan approval out of…a borrower with a 100% [debt-to-income ratio] – with limited documentation required on the automated findings – was not uncommon.

    The poorer-than-expected quality of the mortgages inside of the MBS that Fannie and Freddie guarantee will lead to hundreds of billions in credit losses. The frequency and severity of these credit losses over the next few years will take Wall Street by surprise.

    These credit losses will blow huge holes into the GSEs’ balance sheets, overwhelming their thin slices of capital several times over. When this capital vanishes, the US Treasury Department will float more government debt and use the proceeds to refill the capital shortfalls.

    On Christmas Eve, the Treasury delivered a lump of coal to US taxpayers: It eliminated caps on future equity injections into Fannie Mae and Freddie Mac. Let’s not kid ourselves. These capital injections are not “investments.” No rational investor would be injecting equity into the GSEs right now. Rather than demand a reasonable risk-adjusted return, these injections will just keep the GSEs’ loss-plagued balance sheets solvent.

    Consider the situation by visualizing Fannie’s and Freddie’s balance sheets. Since the beginning of the financial crisis, the Treasury and Federal Reserve have teamed up to reinflate the assets and equity of these institutions. The Treasury pumped new equity (in the form of preferred stock) into them as needed, while the Fed used newly printed money to buy up the GSEs’ debt and the mortgage-backed securities that the GSEs guarantee. Thanks to these shenanigans, the market prices of the assets on the GSE balance sheets appear to be holding up. But make no mistake; despite the Fed’s actions, the real underlying value of these is being eaten away by credit losses.

    On Jan. 12, Amherst Securities published a study on the estimated losses Fannie and Freddie will absorb as foreclosures flow through the credit loss pipeline in the coming years. Using a database of 29 million active prime mortgages from First American CoreLogic, Amherst estimates that the GSEs will ultimately suffer $448 billion in cumulative credit losses. Amherst explains the likely distribution of these losses:

    These gross losses will be distributed across four categories – write- downs already taken by Fannie and Freddie and reflected in their loan loss provisions, future credit losses to be taken by Fannie and Freddie, losses absorbed by mortgage insurers, and losses absorbed by originators through put backs. Fannie’s loan loss reserves total $66 billion: $57 billion for MBS guaranty losses, $9 billion for loan losses. Freddie’s loan loss reserves total $30 billion: $29 billion for MBS guaranty losses, $1 billion for loan losses. The remaining $352 billion of losses will show up across the other three categories (Fannie and Freddie future losses, mortgage insurers, and originator put backs) over time.

    If Amherst is accurate in its projections – which I expect, given the quality and independence of its research – then Fannie and Freddie have built allowances to cover a mere 21% ($96 billion divided by $448 billion) of the losses they’ll ultimately have to absorb from the housing bubble.

    It’s no wonder the Treasury Department lifted the bailout caps on Christmas Eve; it’ll be the only entity willing to plug the GSEs’ deepening capital holes.

    What does this mean for the markets? It translates into very bad news for complacent stock market bulls and junk bond junkies.

    The lifting of the GSE bailout limits strengthens the case for rising Treasury yields in 2010. Rising Treasury yields are bearish for the stock market because higher yields offer better competition for investors’ dollars. Rising Treasury rates also increase the cost of capital for all companies.

    The elimination of limits on Treasury’s capital infusion into Fannie and Freddie is a de facto nationalization. We’ll see a gradual transformation of these hollow zombies into new branches of government. They’ll implement the official agenda for housing, with little regard for prudent lending standards. This could severely degrade the creditworthiness of US Treasury securities.

    The government will probably stick to its dishonest, Enron-style accounting; it won’t officially consolidate Fannie and Freddie assets and liabilities onto the federal balance sheet, but many foreign creditors will. These creditors will demand higher rates to compensate for the rising risks of investing in US Treasuries…and that means bond prices will fall…eventually.

    Dan Amoss
    for The Daily Reckoning Australia

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