According to a recent article in the Baltimore Sun rents are up more than 6% over what they were last year in the Baltimore metro area. If you count the drop in various concessions — like waived application fees or initial free rent — then the increase is even more.

There is a drag on the rental market, however: the regretful buyers who now need to rent out the homes they can’t sell.

Lois Foster, a Baltimore real estate agent who helps people find homes to rent and manages properties for owners-turned-landlords, said she’s seeing rents of $200 to $500 less a month than owners could have gotten two or three years ago. There’s just a lot of competition, she said.

The gild is off the buying lily. All the credit that oozed out of the banks found its way into the national psyche. There it gave off a funny smelling gas that puffed up hopes and dizzied senses.

Stock prices were the first beneficiaries. Fattening 401(k)s danced 1920’s-style energetic jigs with dreams of early retirement. Even as those 401(k)s and those hopes tired and finally dropped dead on the dance floor, the Fed held down interest rates and more funny air kept the nation high. People pinned new hopes on — and sent reams of borrowed new money into — real estate.

That’s come to the sort of end you’d expect. While government cheerleading and easy credit drew in increasing numbers of bigger fools, the rental market found itself a lot emptier. All the people who really couldn’t afford to buy and who should have been renting were too busy buying on greater margins and not renting.

Some hotspot cities like New York and Boston saw their rental markets surging along with their real estate markets…but third-stringers like Baltimore… “Cohan, with Southern Management, said some competitors were offering as much as three to four months of free rent to get people in the door in 2008 and 2009. Not anymore.”

It’s no wonder that they were having such a hard time. The real estate market started to crater in 2006, but the ship of public opinion doesn’t exactly turn on a dime. You don’t undo nearly a century of brainwashing at the start of a downturn. By 2008 and 2009, renters were still considered to be socially backward and intellectually impaired…maybe even in need of corrective medication.

Upon finding out that a person was renting, someone else was likely to voice sincere worry: “What’s wrong with him? Is he marginally employed? Illiterate? Dead?”

Being a renter was worse than gauche. For men it was worse than driving a beaten up old car. Even $7-an-hour female filing clerks were all getting mortgage approvals for $200,000 homes. Any man who couldn’t (or wouldn’t) score a mortgage was parading his lack of fitness to breed. To rent instead of own was to advertise your status as a loser, not the kind of sire any sensible woman would settle for. Your only hope was to troll among hipsters and other car-less, urban trash. A corpse could get a mortgage, but a renter couldn’t get a date.

But now opinions are changing, as they must. Reality can only be ignored for so long. According to a 2010 study o the Joint Center for Housing Studies of Harvard University, between 2004 and 2009, the number of renter households rose nearly 10%.

From the article “The Echo Boom: A New Wave of Market Change” on Wrightwood.com (emphases mine)…

Certainly, most young people rent apartments in their first years out of college, but there are reasons to believe that this generation will be renting far longer than their parents did.  They have the largest college debt load in history – averaging over $20,000 per student.  They also face a very different labor market from their parents: a fifth of them will likely be self-employed following the trend for all employers to offer more and more short-term contracts.  Renting may make economic sense, not just when they are beginning their careers, but for many more years to come. Since the end of World War II, the trend was for more and more young families to purchase a home in the suburbs, leaving rental apartments to young singles.  Based on the economics today, that trend may shift towards renting throughout their lives.

And from a July, 2010, article “Rise of the Renting Class”…

In May, U.S. Housing and Urban Development Secretary Shaun Donovan testified before a House committee that the financial crisis proved the need for a better balance between ownership and rental housing. And HUD senior official Raphael Bostic last week told the Washington Post: “In previous eras, we haven’t seen people question whether homeownership was the right decision. It was just assumed that’s where you want to go,” Bostic said. “You’re not going to hear us say that.”

Left to its own devices, the market pretty efficiently figures out who ought to own and who ought to rent. Those who can afford to do so buy a home because under normal circumstances, buying a home is not any more of an investment than renting one.

So the policies from DC that got their start under that busybody Herbert Hoover to “encourage” homeownership were never a good idea.

The article continues…

Hoover signed the Federal Home Loan Act, and in 1933, Franklin D. Roosevelt created the Home Owners’ Loan Corporation to provide low interest loans.

And the government was just getting started: a flurry of legislation was passed over the ensuing decades, helping veterans, minorities and the populace as a whole secure mortgages. But it appears the pendulum has swung.

“The government shouldn’t blindly encourage homeownership,” says Joe Gyourko, real estate finance professor at University of Pennsylvania’s Wharton School. “If the government does anything the government should encourage people to make the right decision.”

Owners don’t pay the landlord, but they pay taxes and maintenance costs on their house, and Gyourko says those costs can end up being roughly the same.

As far as buying a house as a smart long-term investment, Gyourko says that’s not always true. He says between 1975 and 2008, the price for houses of similar quality and size appreciated an average of about 1% per year after inflation. Investors could have earned more by buying Treasury bills.

Turns out that under most circumstances, homeownership is just another form of consumption. You need a place to live. So you can pay rent, out of which the landlord collects some small profit after mortgage, taxes and maintenance…or you can “buy” your house, or more accurately saddle yourself with debt and pay the mortgage, taxes and maintenance yourself.

But when you have meddling federal policies to encourage it…coupled with ever-increasing amounts of central bank credit to fuel the bidding…prices tend to rise enough to make generations sing in unison “housing always goes up!”

It took generations for this debt-addled Ponzi scheme to collapse; years of government meddling finally coupled furiously with easy credit from the central bank. The result is a veritable orgasm of tumbling prices. We’re in the shame and regret phase that follows these sorts of things. Stay tuned for more.

So as house prices start to reflect how little credit is available to buy house, then buying a house starts to look like a good buy.

Houses are still real things with great utility. They’re bad buys when they’re the objects of debt-fueled speculative mania…but they are still real assets, the sort of things that maintain their value as paper money goes to its intrinsic value.

As we’ve said in these pages many times before, however, you may want to be careful exactly where you buy.

Auto-suburbia is losing its utility and its desirability. More from “The Echo Boom: A New Wave of Market Change”:

One overlooked issue in particular about the Echo Boomers will have a meaningful impact on all forms of real estate…they don’t drive.  According to a report by Kiplinger, motorists aged 21 to 30 now account for 14% of miles driven, down from 21% in 1995.  As quoted in that report, William Draves, president of Learning Resources Network pointed out, “This generation focuses its buying on computers, BlackBerrys, music and software and views commuting a few hours by car a huge productivity waste when they can work using PDAs while taking the bus and train.”

This certainly doesn’t bode well for the automotive industry, but it also may not help real estate strategies that rely on communities and suburbs that can only be navigated by car.  The Baby Boomers fueled the growth of cities that revolve around cars, but the Echo Boomers are likely to flock to places where they don’t have to drive every day.  This could be a significant drag on low-density communities without mass transit and a boon to older, more compact cities.  The exurbs don’t hold as much attraction for this new generation as they did their parents.

Few emergent trends to keep in mind when making investment decisions:

• There are a lot of them – over 80 million people that have to live, work and play in some form of real estate,

• They are gravitating to urban centers even more than their parents,

• They are more plugged into the Internet and social networking than anyone before,

• They are renters, and

• They don’t drive.

I wouldn’t go run to buy up all those abandoned subdivisions that sprung up in the cornfields.

The baby boomers will scratch their heads at that one. There may even be a snort of derision or two from that crowd. Suburbia and exurbia is all that they’ve ever known.

I’d go with productive farmland…or housing that doesn’t require a car. You know: the old downtown that used to be built before the government threw its weight behind the growth of automobile suburbia.

Sincerely,
Gary Gibson
Managing Editor, Whiskey & Gunpowder

January 5, 2011

Forget Buying in the Suburbs and Go Rent in the City was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But the investment seasons turn. Today some smart investors are once again saying you should a buy house. John Paulson is one of them.

You may know him as the man who turned the greatest trade of all time. Betting against the housing market, he netted a cool billion dollars for himself in 2007. One fund he managed rose 590% that year. Today, he is one of the richest men in America.

His advice today is very different. “If you don’t own a home, buy one,” Paulson said. “If you own one home, buy another one, and if you own two homes, buy a third and lend your relatives the money to buy a home.”

That’s a strong endorsement. It sounds similar to the advice another investor gave his audience in 1971, at the dawn of another inflationary age. It was Adam Smith (George Goodman) on The Dick Cavett Show. Here is a snippet from that conversation:

Smith: The best investment you can make is a house. That one is easy.

Cavett: A house? We were talking about the stock market. Investments…

Smith: You asked me the best investment. There are always individual stocks that will go up more, but you don’t want to give tips on a television show. For most people, the best investment is a house.

Cavett: I already own a house. Now what?

Smith: Buy another one.

It was good advice. In the 1970s, U.S. stocks returned about 5% annually, which failed to keep pace with inflation. Still, it was an up-and-down ride. In 1974, the stock market fell 49%. But here are the average selling prices for existing homes in the 1970s as inflation heated up:

• 1972   —   $30,000

• 1973   —   $32,900

• 1974   —   $35,800

• 1975   —   $39,000

• 1976   —   $42,200

• 1977   —   $47,900

• 1978   —   $55,500

• 1979   —   $64,200

You can see that housing held up pretty well. And think about the effect of a mortgage on 80% of that house in 1972. That would mean $6,000 in equity, a sum that went up fivefold in eight years. It’s hard to find a better inflation fighter than that. Granted, today’s market is different, but still.

Apart from this, you might also reflect on the fact that it is quite absurd today to think that anyone can buy an average house for any of these prices — and that, too, is the point. The average price today is $257,500 — even after the great collapse in the last few years.

“If you have a 7% mortgage and your house is worth half a million dollars,” Adam Smith writes, “you may gripe about shoes and lamb chops and tuitions like everybody else, but your heart isn’t in it.” Your heart won’t be in it because you’ll be in fine fettle with your house.

Of course, you can do a lot better than 7% today. For the first time, the rate on 30-year mortgages slipped below that on the 30-year Treasury bond. You can get a 30-year mortgage at little more than 4% today.

Factoring in mortgage rates, housing affordability is back to where it was in September 1996. Then mortgage rates were 8% and the average price of a home was $171,600. As Murray Stahl writes: “One can actually buy a home for a monthly payment that is not very many dollars different from the monthly payment one would have needed in September 1996, when rates were significantly higher.”

Adjusted for inflation, Stahl points out that the payment for an average-priced home today is about 30% lower than it was 14 years ago.

The advice of Paulson and Smith starts to make sense now, doesn’t it?

Essentially, real estate is a way to buy now and pay later. It is a way to short (or bet against) the dollar. And the case for housing extends to other property types, too. Owners of quality real estate are getting deals on mortgages that we are unlikely to see for a generation.

Regards,
Chris Mayer
Whiskey & Gunpowder

January 5, 2011

Cheap Houses Hedge Inflation Risk was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

This is why things like auditors and listing requirements and boards of directors are so important. This is why due diligence is important: asking questions, talking to people on the ground. They give some assurance to investors that what they see is real and not a fraud.

Sometimes the lines can be very fuzzy. And sometimes the taint of fraud dogs a market, making all the stocks of that market cheap, whether they are fraudulent or not. Such a market is also very susceptible to rumor.

I think the market for the U.S.-listed China-based companies has that taint. That explains the very cheap multiples that many such companies trade for. I’m talking about price-to-earnings ratios of 5–8 times for companies growing 20–30% a year.

But investors will have to be careful, as there seem to be a lot of questionable apples in the bin. And they will have to do quality due diligence to stand up to rumor and extreme price volatility.

There have been several cases of fudged numbers. I wrote about Fuqi Intl. before. It is a China-based jeweler whose stock trades on the Nasdaq. The stock dropped 37% one day in March after the company announced it would have to restate past results. The stock has continued to drop since. The stock was $30 per share and is about $6 today.

There have been other grim casualties. But the pace of digging up scams seems to have quickened. I’ve been trading e-mails with my Beijing contacts for weeks. One veteran hedge fund manager, who would like to remain anonymous, told me how he was “very worried.” There are too many scams, which is not good for the market. He said, “Another big development is these detailed negative research reports. There are three–four quality reports coming out each month from different outfits. This is compared to maybe only two–three reports all of last year!”

A company called China Marine Food has recently been fending off challenges to its accounting. A website called Chinese Company Analyst performs detailed financial analysis of Chinese companies. In a highly detailed report, it contends that China Marine Food is a fraud. I can’t do justice to the report here, but here is a damning snippet:

“I question how [the company] could generate $7.6 million of revenue, $1.7 million of net income and $1.2 million of operating cash flow in its first five months of operations with (i) $44,000 of startup capital it received from its original founder, [and] (ii) $414 of capex…”

China Marine Food dropped more than 20% on the day these allegations came to light. The stock has continued to fall. The company has defended its accounting. It may or may not be a fraud, but the evidence seems to suggest that all is not quite as it seems.

Most recently, another case has come up with Orient Paper. This is a company I put on my watch list after one of my Beijing contacts told me about it. It seemed to have great fundamentals and traded very cheaply.

I never looked at it in detail, but I remember thinking it seemed fishy that the stock of an operating company could go from $1.50 to $15 within a year. That just doesn’t happen. Resource companies can make that kind of leap — you have a new discovery or the underlying commodity takes a big jump. But it is rare that a basic operating company involved in something like paper becomes a ten-bagger in a year’s time.

On June 28, a company called Muddy Waters released its “inaugural report” on Orient Paper contending that it was a fraud. The stock closed at $8.33 before the report. It dropped 13% that day, but the snowball was only just getting started. Two days later, the stock hit $4.11.

But this is one where the line is:

Fuzzy.

The Muddy Waters report is detailed. The authors of the report talked to suppliers. Some of the suppliers offer a very different view of Orient Paper’s capacity than what Orient Paper claims. Muddy Waters tried to track down customers. Some of these they found did not exist or were small mom and pop shops. Yet Orient Paper reports millions of dollars in sales from such customers. Muddy Waters tried to match SEC filings with tax filings in China. They claimed to find major discrepancies. There are pictures of site visits showing old machines. There are other observations about the number of employees and trucks and more.

It all adds up to a pretty damning dossier.

Yet there is another side. Rick Pearson, one of my Beijing contacts, also visited Orient Paper. In fact, he was on the same site visit as the Muddy Waters’ crew. More incredibly, Pearson knows the authors of the Muddy Waters report, both old classmates of his.

Pearson wrote up his views for TheStreet.com. He has a totally different view of the company. He bought the stock after the report! As he writes:

I was quickly on the phone to the company, to its IR firm and to other major investors who own the stock. Everyone was equally shocked by the report, and the company vowed to respond immediately. I know a number of investors who have toured ONP, met management and invested in public and private offerings by the company. The investors have all expressed interest in buying at these levels.

Pearson was also critical of the due diligence of his former classmates, who apparently asked few questions of management on the visit and didn’t speak Mandarin. He felt like they were there to “check a box” to say they’d visited the company.

Pearson’s piece must’ve helped settle the market, because it rose 44% the day his piece came out, to back over $7 per share. (The fact that the stock moved so much during this whole period shows how little investors really knew about the company. This is why I say you have to have strong due diligence. Otherwise, you’ll wind up locking in losses on the merest rumor, to which Chinese companies seem susceptible at the moment.)

So what does all this mean? I don’t know if Orient Paper is a fraud. I have a lot of respect for Pearson’s research and expertise. He was a former investment banker. He lives in Beijing. He speaks Mandarin. And this — U.S.-listed, China-based stocks — is his métier.

I suspect that Orient Paper’s accounting is not entirely up to snuff. I suspect it’s probably not a high-quality company (that doesn’t mean that you can’t make money in it). I don’t really know. As I say, I have not done my own due diligence on Orient Paper.

But the point of this piece is really to show you how tricky the market for U.S.-listed China-based stocks is right now. It also helps explain the low valuations we see. Don’t just assume that a China-based stock is a bargain because it trades for 6 times earnings and is growing 30% a year. It may not be quite what it seems.

Regards,
Chris Mayer
Whiskey & Gunpowder

August 2, 2010

Successful Investing in China Despite the Risks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Why? Because I figured the day would come when the boys from DeBeers would be unable to keep their artificially high price on one of the most common carbon formations, that’s why. Diamonds are beautiful, but they aren’t really scarce. The IDC has controlled availability for a very long time but the more we tolerate falling standards and increased governmental interference the less anything is safe to count on.

Diamonds aren’t hard to find. They aren’t particularly hard to mine. The real problems are keeping the miners (official and amateur) from stealing them, shipments from being high-jacked, and iron-clad control of the price.

I lay the latest silly soap opera out below, but unless you have a taste for the usual suspects saying the usual things and looking perhaps sillier than usual, I’d quit reading as soon as I grasped that it doesn’t matter who is right (if anyone is), but that the threat to your investments, if they include diamonds, is that the man who brought you the Zimbabwe currency coup has more or less control of an estimated 25% of the world’s unmined diamond supply, and he says calmly that he’s going to sell them on the black market. He’s got a nice supply of mined diamonds, plenty of diamond sands, and an agreement with diamond cutters, so your decision is whether or not to sell investment grade diamonds and dump jewelers’ stocks, or just to mark your calendar to see where diamond prices are in time for your wife’s birthday.

Mugabe’s opposition is the bleeding hearts crowd serving, I conjecture, as a mask for the no doubt terrified diamond cartels, although they are dreadfully earnest, of course. Be of good cheer, the Big O is on top of this one. Obama says he will forbid diamond imports into the USA! Another great call, Barry. The threat is that cartel control will be loosened to some extent and the price of diamonds fall somewhat. Even considering we’re dealing with Robert Mugabe, surely he has enough sense to see that he can’t afford to knock too much off the price of diamonds because he’ll be one of those with the most diamonds to sell. Although…perhaps that doesn’t matter when you have a quarter of the world’s supply…he can make up in volumn what he loses in price.

The howls world-wide are not about upsetting every diamond buyer, cutter, and vendor on the planet or dealing every jeweller from Harry Winston to Zales a crushing blow via depreciation of inventory, but about alleged “human rights” violations. Contemporary thought holds that people have a right to cross some boundaries in search of what they want, such as the border between Arizona and Mexico and into poorly-guarded diamond fields.

Suppose those were your diamond fields, looking like giant ant-lion hills, and 30,000 “unauthorized” (“undocumented?”) “miners” descended on them. (I put “miners” in quotation marks because it requires no skill to sift lumps out of sand.) I don’t think you even need to channel the leader of Zimbabwe to figure out you would do what it took to get those thieves out of your diamonds, particularly since all they have to do is sift through sand and pick out dull grayish pebbles. I doubt many of us would worry about public opinion or being gentle. Do we hear anything about how those are Zimbabwe’s diamonds, or that their leader is responsible, one can only suppose, for preserving such a vital asset in a country whose currency is a joke? Only from those who are not admirers of Mr. Mugabe. Never mind worldwide economic tremors, gotta protect the “right” of people to steal. But which people? I was amused by an indignant report from in country that “The troubled African nation is rich in diamonds and other natural resources. However, critics of Mugabe say his economic policies have contributed to precipitous economic decline.” Not only that, but they have charged “smuggling by members of the elite close to President Robert Mugabe and his party, ZANU-PF.” No! Say it isn’t so! The President, his brother, and his friends have had their fingers in the till? Whoever heard of such a thing? We sure don’t put up with goings on like that in America.

I’m still with Zimbabwe’s President, Robert Mugabe; he may have messed the fiat money up brilliantly, and anyone with any sense supposes he has some nice off shore bank accounts, but having somewhere between 25 and 30% of the diamond supply and selling it for the benefit of his people (and himself, and his advisors, friends, and anyone else bright enough to cut himself into the action, with the people coming last) should buy him a lot of forgiveness. I don’t know what Robert’s plan is, but I know what I would do in his position. We spiritual descendents of robber barons aren’t dumb, you know. You let the big guys buy you off, of course. For massive amounts of boodle. No matter how many guards are hired or glossy seals are affixed to formal agreements, you can always renege on them later.

Mugabe is (you should pardon the expression, considering the allegations) sticking to his guns.

Philimon Bulaway reports for Reuters: “A defiant Mugabe told lawmakers diamond sales have ‘huge potential’ to revive the shattered economy. He says Zimbabwe can account for one-fourth of the world’s diamond supply. ‘Let there be no doubt whatsoever about our resolve to sell our diamonds for the benefit of our country and its people,’ Mugabe said in a speech to open a new session of parliament (back in February. Ed. note)…With Zimbabwe now projected to contribute around 25 percent of the global diamond output, there are huge prospects for the diamond sub-sector to emerge as a major driver of the country’s economic turnaround.” Mugabe commented quite recently that the country will sell the diamonds, “even without clearance,” a reasonably polite way to say “on the black market.” An admirably blunt follow-up statement was, “We can sell our own diamonds our own way, any way.” It just hit me: he may view money like a Keynesian, but he’s got a good grasp of “what’s mine is mine.”

The second meeting of an international do-gooder commission in less than a month is due in St. Petersberg’s, but President Mugabe announced recently that the country would go ahead with diamond sales despite not receiving authorization from the world’s diamond control body. Here’s where we have to sort out WHICH diamond control body, because there are two, now. DeBeers and so forth have been keeping the price of diamonds artificially high since the days of Cecil Rhodes in large part by restricting supply rigorously and limiting the number of those authorized to buy and sell. The new bully/busybody on the block is a group formed after the civil war in Sierra Leone rising twenty years ago where diamonds were used to fund the participants. This lead to certain stones being referred to as “blood diamonds,” and the result was the Kimberley Process, a program that attempts to guard against the illicit sale of gems that finance those conflicts. The gems now come with certificates attesting they were sold by authorized sources, not guerilla bands. Another layer of bureaucracy, and, we old hands suppose, taxation. Who ever heard of free stamps/certificates?

“Governments, industry executives and human rights groups signed onto it,” and whyever not, with something for everyone? Governments get more power, the industry makes more money, and human rights groups feel all warm and fuzzy. Zimbabwe hasn’t received certificates that allow it to export diamonds which come from its “controversial” Marange (mare-AN-gay) fields, controversial primarily because of the actions purportedly taken to get the claim jumpers out of the sand pits, since January. Bulaway notes, “The Kimberley Process diamond certification scheme has not authorized international sales amid allegations of killings, human rights violations and corruption in the massive diamond fields discovered in eastern Zimbabwe in 2006.” One basic problem is that the Kimberly Process deals with diamonds that are used to fund insurrection and invasions, not those which are being squabbled over internally by a country’s government and assorted people who cannot resist dull gray pebbles in sand pits that do not belong to them. Any excuse is fine for the leaders of the left to expand regulations, so they are glad to stand up for those alleging “continuing human rights abuses in Marange and smuggling by members of the elite close to President Robert Mugabe and his party, ZANU-PF.” No, those don’t have anything to do with the case, but that’s how movements and governments grow.

Enter Briggs Bomba, director of campaigns at Africa Action, a Washington-based non-profit group purportedly worried that black market diamonds would touch off an international crisis. Fear not, he has a solution: “With or without KP certification, there is a market out there that diamonds from Zimbabwe can go to. So, what I see as the way forward is to really to speed up the process of making sure that whatever is outstanding in terms of Zimbabwe’s meeting the KP requirements is resolved speedily and Zimbabwe is allowed to sell diamond through the KP process.” Nice office, manages to make a khaki shirt and paisley tie look like a uniform, interesting accent (“MAN-i-uh,” for example, instead of “mane-ee-uh”) and I wouldn’t buy a used car from him.

AA and others say that without certification so called “conflict diamonds” “would re-enter the international market in large numbers and the Kimberley Process would become meaningless.” Yup, next thing you know we’ll be overrun in diamond-financed terrorists, diamonds being so easy to steal, and all. “In the extreme, some experts say, the US, the largest consumer of diamonds, could bar diamond imports,” and sure enough, Obama just threatened that very thing. And he meant it to sting, by jingoism. No, dears, I have no idea what happened to America not being arrogant and interferring in the internal affairs of others. However it may be, “the Obama administration opposes any attempt to export Marange diamonds without certification by the Kimberley Process,” having spare time on its hands.

“We look for Zimbabwe to make further progress implementing the necessary steps to bring the Marange diamond fields into compliance with Kimberley Process minimum requirements,” State Department Spokesman PJ Crowley pontificated. Do ALL of these people believe in fairies and taking the word for the deed? Do they ever listen to anyone else? The KP bunch in Tel Aviv said last month that Zimbabwe had met the minimum requirements. They stated specifically that certification was not approved, “even though a KP monitor said Zimbabwe met the minimum conditions for certification.” Run that by me again? They agree that Zimbabwe met the minimum conditions, but nobody is satisfied? “Some say the international community should make an effort to understand the political reality of Zimbabwe and engage with its leaders.” Bizarre. Meaningless. My best guess is that this is a power play by Mugabe (who has most of the right on his side) that the IDC is trying to stay well away from, hiding behind beards and useful idiots.

“Let’s not get caught up in the false polarities that characterize Zimbabwe discussions where it’s Mugabe mania or Mugabe phobia. The challenge is how we break an objective path that brings back ordinary people to the center of discussion and how they are affected,” Bomba said. (Remember him? From the “non-profit” action group located in Washington, D.C., where real estate and salaries are so cheap?) Ordinary people haven’t got any business in the discussion, and they aren’t really affected. If Mugabe sells some diamonds, he’ll trickle down a bit, but nobody takes “the little people” seriously in Africa any more than they pay attention to the Silent Majority here. Bomba says he “fears that if the diamonds are sold in the black market, without KP certification, it will be difficult to monitor the revenue from those diamonds which should directly benefit the people of Zimbabwe, not a few corporations or government officials.” Don’t you love these high-minded types? This has nothing to do with profits, monopolies, or taxes. It’s about the children.

My best guess is that Bomba’s group is getting a nice present from De Beers and that nobody much expects more than a very few, very carefully selected people of Zimbabwe to benefit, the important part being to restablize the system–that is, restore the diamond monopoly first, and then stabilize Zimbabwe enough so that Mugabe can be president as long as he wants to and then retire elsewhere with a steamer trunk of cut stones.

Which puts us back to where we were at the end of the fourth paragraph. You can pour sparkling stones out of your little chamois pouch and ponder whether the price will go up or down. You can peer at your stocks in big or fancy jewelers–if you still own anything that dangerous–and decide whether or not to get rid of them. My preference is to keep a casual eye on the diamond market and plan on upgrading your wife’s solitaire that you bought her when you were young and not nearly as successful if prices fall.

If the diamond market ever really gets away from the cartel, the average modestly nice stone will run about $5/carat–or perhaps $20, considering velocity and when creating $1.3 TR out of static electricity finally bites us in our checkbooks.

Regards,
Linda Brady Traynham
Whiskey & Gunpowder

July 14, 2010

Zimbabwe Threatens Black Market Diamond Sales was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

My interest in Andy was due to the fact that he has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects — such as shopping centers, apartment communities, office buildings, and warehouses — from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming.

Back in 2007, however, what most intrigued me about Andy was that he had been almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people that think they know what’s going on, and those who actually know — Andy very much belongs in the latter category.

In fact, he initially refused to speak at our event, only agreeing very reluctantly after I had hounded him for several months. The reason for his refusal, I later found out, was that he had spoken at several industry events before the real estate collapse and had been all but booed off the stage for his dire outlook.

The happy ending of this story is that Andy’s speech at our Summit was a rousing success, and he enjoyed it so much that he has now spoken at several, and has kindly agreed to sit for periodic interviews to keep our readers up to date on the latest developments in this critical sector. So far, Andy’s real estate forecasts continue to come true. 

As you’ll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation’s biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate.

David Galland

No one has been more right on the housing market in recent years. So, what’s coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well?

MILLER: I don’t think so.

For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the U.S. were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

If it’s true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn’t help a homeowner whose property is worth less than the mortgage. So when the supply of government-facilitated loans dries up, it’s going to put the home market in a very, very bad place. 

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.

The public doesn’t have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It’s huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can’t get people to focus on it, and it’s very esoteric, it’s very hard to understand. But it’s not something the bond market won’t notice. The government can’t keep doing what it has been doing to support mortgage lending without pushing interest rates way up.

Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that’s exactly where they’re headed. So anyone who’s comforted by current statistics on single-family homes should look beyond the data and into the dynamics of the market. What they’ll find is very alarming.   

On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money.

MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the U.S. Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that they were going to remove all the caps on the agencies.

So what about commercial real estate?

MILLER: When I saw what was happening in the housing market, I liquidated all my multifamily apartments, shopping centers, and office buildings. I liquidated all my loan portfolios, and I’m happy I did.

Then it occurred to me in 2005 and 2006 that the commercial world had to follow suit. Why? Because it’s a normal progression. Obviously, when single-family homes decline in value, multifamily apartments decline in value. And when consumers hit the wall with spending and debt, that’s going to have an impact on retailers that pay for commercial space.

Furthermore, the financing for retail properties had gotten ludicrous. The conduits were making loans that they advertised as 80% of property value when they originated them, but in reality the loan-to-value ratios were well over 100%. And I say that to you with absolute, categorical certainty, because I was a seller and nobody knew the value of the properties that I was selling better than I did. I had operated some of them for 20 years, so I knew exactly what they were bringing in. I knew what the operating expenses were, and I knew what the cap rates were. And, you know, the underwriting on the loan side and the purchasing side of these assets was completely insane. It was ludicrous. It did not reflect at all what the conduits thought they were doing. They were valuing the properties way too aggressively.

I became very bearish about the commercial business starting in late ‘05. In fact, I think I was in Argentina with Doug Casey, sitting on a veranda at one of the estancias, and he and I were lamenting what was going on in the real estate business, and I said there was going to be a huge adjustment in the commercial market.

Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash? 

MILLER: I think the first thing that changed was that people learned that prices don’t go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don’t think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate.

But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in fantasy land for 10 years. And that was the first change — a mental adjustment from Alice in Wonderland to reality. 

Today it’s clear that commercial properties are not performing and that values have gone down, although I’ve got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is.

Right now there are an awful lot of banks that do an awful lot of commercial real estate lending, and for about a year now you’ve been telling me that you saw the first and second quarter of 2010 as being particularly risky for commercial real estate. Why this year, and what do you see happening with these loans and the banks holding them?

MILLER: It’s an educated guess, and it hasn’t changed. I still think that it’s second quarter 2010.

The current volume of defaults is already alarming. And the volume of commercial real estate defaults is growing every month. That can only keep going for so long, and then you hit a breaking point, which I believe will come sometime in 2010. When you hit that breaking point, unless there’s some alternative in place, it’s going to be a very hideous picture for the bond market and the banking system.

The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe. I will get to that in a minute. But they can influence the speed with which it all unfolds, and I’ll give you an example.

In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn’t have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.

That’s very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they’ll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them. Now, that’s horribly destructive.

Just to be clear on this, let’s say I own an apartment building and I’ve been making my payments, but I’m having trouble and the value of the property has fallen by half. I go to the bank and say, “Look, I’ve got a problem,” and the bank says, “Okay, let’s work something out, and instead of you paying $10,000 a month, you pay us $5,000 a month and we’ll shake hands and smile.” Then, even though the property’s value has dropped, as long as we keep smiling and I’m still making payments, then the bank won’t have to reserve anything against the risk that I’ll give the building back and it will be worth a whole lot less than the mortgage.

MILLER: I think what you just described is accurate. And it’s exactly a Japanese-style solution. This is what Japan did in ‘89 and ‘90 because they didn’t want their banking system to implode, so they made it easier for their banks to sit on bad assets without owning up to the losses. 

And what’s the result? Well, it leaves the status quo in place. The real problem with this is twofold. One is that it prolongs the problem – if a bank is allowed to sit on bad assets for three to five years, it’s not going to sell them. 

Why is that bad? Well, the money tied up in the loans the bank is sitting on is idle. It is not being used for anything productive.

Wouldn’t banks know that ultimately the piper must be paid, and so they’d be trying to build cash — trying to build capital to deal with the problem when it comes home to roost?

MILLER: The more intelligent banks are doing exactly that, hoping they can weather the storm by building enough reserves, so when they do ultimately have to take the loss, it’s digestible. But in commercial real estate generally, the longer you delay realizing a loss, the more severe it’s going to be. I can tell you that because I’m out there servicing real estate all day long. Not facing the problems, and not writing down the values, and not allowing purchasers to come in and take these assets at discounted prices — all the foot-dragging allows the fundamental problem to get worse. 

In the apartment business, people are under water, particularly if they got their loan through a conduit. When maintenance is required, a borrower with a property worth less than the loan is very reluctant to reach into his pocket. If you have a $10 million loan on a property now worth $5 million, you’re clearly not making any cash flow. So what do you do when you need new roofs? Are you going to dig into your pocket and spend $600,000 on roofing? Not likely. Why would you do that?

Or a borrower who is sitting on a suburban office property — he’s got two years left on the loan. He knows he has a loan-to-value problem. Well, a new tenant wants to lease from him, but it would cost $30 a square foot to put the tenant in. Is the borrower going to put the tenant in? I don’t think so. So the problems get bigger.

Why would the owner bother going through a workout with the bank if he knows he’s so deep underwater he’s below snorkel depth?

MILLER: It’s always in your interest to delay an inevitable default. For example, the minute you give the property back to the bank, you trigger a huge taxable gain. All of a sudden the forgiveness of debt on your loan becomes taxable income to you. Another reason is that many of these loans are either full recourse or part recourse. If you’re a borrower who’s guaranteed a loan, why would you want to hasten the call on your guarantee? You want to delay as long as possible because there’s always a little hope that values will turn around. So there is no reason to hurry into a default. None.

So that’s from the borrower’s standpoint. But wouldn’t the banks want to clear these loans off their balance sheets? 

MILLER: No. The banks have a lot of incentive to delay the realization of the problem because if they liquidate the asset and the loss is realized, then they have to reserve the loss against their capital immediately. If they keep extending the loan under the rules present today, then they can delay a write-down and hope for better days. Remember, you suffer if the bank succumbs and turns around and liquidates that asset, then you really do have to take a write-down because then your capital is gone. 

So here we are, we’ve got the federal government again, through its agencies and the FDIC, ready to support the commercial real estate market. They’ve taken one step, in allowing banks to use a very loose standard for loss reserves. What else can they do?

MILLER: Well, obviously nobody knows, but I can guess at what’s coming by extrapolating from what the federal government has already done. I believe that the Treasury and the Federal Reserve now see that commercial real estate is a huge problem.

I think they’re going to contrive something to help assist commercial real estate so that it doesn’t hurt the banks that lent on commercial real estate. It’ll resemble what they did with housing.

They created a nearly perfect political formula in dealing with housing, and they are going to follow that formula. The entire U.S. residential mortgage market has in effect been nationalized, but there wasn’t any act of Congress, no screaming and shouting, no headlines in the Wall Street Journal or the New York Times about “Should we nationalize the home loan market in America.” No. It happened right under our noses and with no hue and cry. That’s a template for what they could do with the commercial loan market. 

And how can they do that? By using federal guarantees much in the way they used federal guarantees for the FHA. FHA issues Ginnie Mae securities, which are sold to the public. Those proceeds are used to make the loans.

But it won’t really be a solution. In fact, it will make the problems much more intense. 

Don’t these properties have to be allowed to go to their intrinsic value before the market can start working again?

MILLER: Yes. Of course, very few people agree with that, because if you let it all go today, there would be enormous losses and a tremendous amount of pain. We’re going to have some really terrible, terrible years ahead of us because letting it all go is the only way to be done with the problem. 

Do you think the U.S. will come out of this crisis? I mean, do you think the country, the institutions, the government, or the banking sector are going to look anything like they do today when this thing is over?

MILLER: I know this is going to make you laugh, but I’m actually an optimist about this. I’m not optimistic about the short run, and I’m not optimistic about the severity of the problem, but I’m totally optimistic as it relates to the United States of America.

This is a very resilient place. We have very resilient people. There is nothing like the American spirit. There is nothing like American ingenuity anywhere on Planet Earth, and while I certainly believe that we are headed for a catastrophe and a crisis, I also believe that ultimately we are going to come out better.

Regards,
David Galland
The Casey Report
 
Andy Miller is the co-founder of the Miller Frishman Group (MillerFrishman.com), which includes three companies serving different sectors of the real estate market – from mortgage brokerage and banking, to the building, management, and marketing of commercial real estate across the United States. His firm is currently deeply involved in the distressed real estate business, assisting lenders across the nation with their growing portfolios of non-performing loans.

February 10, 2010

An Insider’s View of the Real Estate Train Wreck was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Not even I, dear reader, chained by love twelve, fourteen, and more hours a day to my magical window to the world, a cyborg of mind and machine, can keep up with all of the stupidities, deliberate destruction, insider deals, power plays, empire-building, and redistribution of wealth into the hands of the least able and most corrupt going on in Washington, Chicago, New York, the “great” banking houses, new additions to the slime pool, and foreign capitals, so I cannot put my finger on a sponsor or a bill number at this time.

I know only that there will be another Smoot-Hawley because there must be a new round of high tariffs and protectionism. This is one of the universal decrees of history and only the details change, and then only slightly.

Those of you who keep in the loop with the Whiskey Bar’s Ranch Correspondent–particularly through private and group correspondence–know that more and more I am to be found in Philosopher mood than Analyst fervor these days; analysis tells us what is wrong and what may come to pass. Philosophy tells us why it is wrong and how it is wrong, and offers faint possibilities of identifying key factors which can skew the classic equations of oppressors occasionally.

Why must there be another Smoot-Hawley, an action that seems devastating to the point of suicidal in a nation that has destroyed its industrial base through catering to the prophets of Baal, Unions, and crooked politicians? Because that is the last major source of rapine and manipulation left to the in-crowd around classics such as debasing the currency, setting the Sheriff of Nottingham on the people, and King John conspiring with the nobles. They have mortgaged the future, devoured the stored goods of the past, turned much of the seed corn into Ethanol, and are busy reducing as many as possible to the sick concept of “economic justice” where no man may have more than another–except the elite, of course. Forget good King Richard; he isn’t around this time, and neither is Richard of Locksley or even an Ivanhoe.

If you are surprised…why? I told you months ago what must come to be because it is the same war we fought 160 years ago for the same reason. Beneath what may have appeared to be colorful banter I was quite, quite serious, my dears. It is quite bad enough being Designated Cassandra without being dull about it, too, but I never joke about the evil loose in our world again.

In the late Eighteen Fifties, as now, politicians faced the same problems (of their own making) and had the same limited range of solutions. Congress was–as is usually the case–under the control of the power brokers and opportunists. As usual, it had been too free-handed with tax revenues. As usual, the true producers had ignored the snares set to bind them. “We’ll just work a little harder.” “They’ll never pass that; the people won’t stand for it.” “Any Johnny Reb can whup six to ten Yankees.” Sure, kids, you keep on thinking that and think about how more heavily we are taxed, millions of pages of restrictions that cause our businesses to fail, and how worthless our beleaguered fiat currency is.

There were only two solutions: close the United States out at the Mississippi and rape those in captivity at their leisure, or inflate their way out of the problem. The latter course was chosen, as it always is, because it offers more opportunities for enrichment. The immediate problem was to raise revenue to maintain control and line pockets further, and our founding fathers, in their great wisdom, had limited fund-raising to taxes and tariffs on goods. Life is far simpler for King John these days. In that halcyon time Uncle Sugar was not able to impound over a third of a man’s wages before they were handed over. A man’s wages could not be touched at all. Consequently, the “solution” was to raise import and export duties, thus robbing those who wished to sell products in the USA and those whose livelihoods depended upon exporting crops.

Do not be naive and bleat about “the industrialized North;” there are always little “arrangements” to be made, the kind that are expressed these days as “excepting corporations doing business in American Samoa,” so that Nancy Pelosi’s power base of the Star Kist empire is not subject to inconvenience and sees the wisdom of supporting her always, or the special favors being arranged for Monsanto, the connection there being how Representative Rosa DeLauro’s husband keeps Kobe beef on the table, and guarantee enormous bonuses slipped quietly in a budget bill so that politicians can rail against them dramatically later–and courts agree they must be paid. The fuss over raw milk–far, far safer and more nutritious than the odd fluids hawked by Borden–is designed to ensure that you either buy milk and other products from Agribiz or you do without; it is to deny you the right to possess your own cow…and your own garden…and your own chickens, beef, and sheep. The sheer cruelty and audacity takes my breath away, the concept of denying as basic a right as ever existed, that to hunt, gather, and engage in agriculture, and doing it in the name of “safety.” Starving to death is a very unsafe activity. The trick is that the restrictions will not harm the big fellows at all but will make it impossible for small farms and individuals to sell or even use what they raise.

The situation only appears to have changed due to FICA and a host of “taxing authorities,” fees, fines, sales taxes, federal and state income taxes, head taxes, and so forth. Funds have dried up significantly (tax revenues were down 17% earlier this month and I anticipate on the order of 22% losses by January) in a time when both New York and California are openly bankrupt and most other states are teetering on the edge of being unable to meet unfunded mandates and deliberate vote-buying schemes and graft. The system is floating momentarily on a flood of fiat money not even the government pretends to believe is other than very transitory. Timmy Geithner’s ugly product isn’t quite “use it once and throw it away,” but the gilt comes off each new issue very quickly and reduces the value once stored in older currency. The “Bernanke” ($100 bill) of today does not buy what an Andrew Jackson did a quarter of a century ago.

We are gearing up for the Tax and Tariff War Between The States all over again, with precisely the same causes and actions. No, of course I do not know if some portion(s) of these “united” states will attempt to withdraw from a contract that benefits only one side, although quite a few are rattling the Tenth Amendment. I do not recommend it, because this time all of the troops are under the control of Washington, as well as control of communications, utilities, transportation, the courts, the media, and the treasury. Open rebellion, no matter how justified intellectually and under the Constitution, would very probably end as Pancho Villa’s final irregular cavalry charge into a nest of the new Thompson machine guns did.

The great “moral” camouflage fluff this time is socialized medicine, amnesty, racism, domestic “terrorists” and the machinations of foreigners turning out “man-made disasters,” and the general moral degeneracy of producers. Same old war, same old issues, same old outcome, and time to hide the smoked hams and plow horses because this time the March to the Sea will be a matter of closing the interstates. Starve those rebels into submission and destroy everything under the slogan of “Never again!” Dictatorship will prevent the threat to freedom posed by “dissidents,” Obama and Janet Napolitano are the ones who define dissidence and “civil unrest,” and the Supreme Court just ruled that those who rebel against the USA are stripped of basic rights (“torture being an accepted part of…”) and “personhood.” You will have neither rights nor Constitutional protections if you protest if Washington declares there is a war, martial law, or that you are guilty of sedition.

What happens when people are forced to act to their own detriment? Eventually they go out of business, move, or are crushed. How does gpvermemt stop them? Close the borders. (Penalties for investing currency outside the nation, penalties for emigrating, literal demands that anyone seeking to leave must have a Passport–a “privilege,” not a “right”–or a “Trusted Traveler Document.”) You mandate an annihilatingly expensive new “health care” program with fines and jail sentences. By what economic insanity can having some portion of medical expenses paid ever be considered worth as much as 20% of a family’s income? I am forced to pay for Medicare, and in this, the year I have been most ill in my life, the actual outlay for my “free” medical insurance is still $400/office visit plus a co-pay. I would be far better off simply paying the doctor $100 in the first place, but that option is denied to me. Those who are old or have chronic conditions may need coverage against myriad problems, but the average family neither needs nor can afford any such thing. We may insure against our car needing a new motor, but we do not seek insurance to cover fill-ups and oil changes. Socialized medicine is not about “health,” it is simply a very imaginative grab for power and funds to keep the national socialists in power.  Announce a host of new taxes and increase fees, fines, and requirements for “stamps.” The outrage over the Stamp Act wasn’t against raising postage; it was about requiring the sort revenue stamps which seal my cigarettes and bottles of Maker’s Mark.

What will be the outcome of increasing taxes and government “giveaways” in a time of falling employment and expansion of the “entitled class,” in a similarly foolish and shakey world eager to destroy our fairy gold and exploit our dependence upon foreign goods? Gloom, desolation, and increasing loss of liberty culminating in a world of food shortages and repressions. All the while those who grow rich shrieking “climate change” labor relentlessly to finish bleeding out the corpse of America for the “benefit” of third world nations and tax us relentlessly to force a 17% reduction in our standard of living lest the dreaded Carbon Footprint Monster destroy the polar ice caps, a much bigger piece of nonsense than asserting the existance of the Yeti and the Little People. Al Gore is the Abominable Snowman, and it pays very, very well. Today here are many new devices of economic depression and a population brain-washed by “free” public schools and the MSM, but Smoot-Hawley, whatever it is called at any given time, is a tried and true method of putting the hands of some into the pockets of others to the detriment of those not filling their coffers or increasing their power. It will prove irresistible.

The most immediate action you can take is to inspect your portfolio carefully and analyse your business needs. Are there duties/taxes/tariffs which could be levied which would make your business more expensive to conduct? Can you stock amply parts made abroad? Are there political costs which could damage the ability of an investment to remain perceived as profitable? Current P/E values are such that I can’t think of a single traditional sector–commodities do not count in this area–where any company is likely to provide a genuine ROI. Just as silver is valued, traditionally, at between 16:1 and 30:1, making it a magnificent choice at 65:1, just so we do not buy shares in companies that at best will return a tiny fraction of the cost in the best of years.

If you can’t eat it, store dense amounts of current value in it, or protect yourself with it in some way or another, don’t buy it. Not for your stockmarket portfolio, and not in your personal lives.

What you snatch from the spreading fires may have to last you a very long time.

Regards,
Linda Brady Traynham

December 29, 2009

Smoot-Hawley Must Ride Again was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Folks, I think its time. Clearly, the government(s) have gone completely bezerk with our money. It’s time to do something about it.

What are our options? Clearly, one is armed revolution. I don’t know about you, but I’m too old and fat to participate. If you wish to go that route, know that you have my best wishes. However, PLEASE don’t go the way of other armed revolutions and institute a more oppressive state than the one you overthrew.

Another option is to move. Again, I’m old and tired. I’m tired of moving. Furthermore, I cannot help but recall Ken Hamblin’s book “Pick a Better Country”. Overall, I just don’t know where to go. True, it may get to the point where other places ARE indeed better, but not quite yet. Furthermore, if we can turn things around here, it could be a lot less trouble than moving—particularly if I can get YOU to do the work.

Voting the bums and thugs out is always a possibility, but there are several things wrong with it. One is it takes too much time; another is that they have managed to Gerrymander the districts so that their re-election is fairly certain. Not only that, but it appears that even if we throw them out as we did in 1994, we just get a new crop of bums and thugs.

The problem seems to be money. Now, we all have (some) money, but Congress’ money problem seems that they have too much, so they have to find a place to spend it.

I once calculated that the average person in this country pays over 2/3 of their pay in taxes. The reasoning went something like this.

Tax freedom day is about April 1 or so. That’s about 25% for federal tax. Add in 15% Social Security and Medicare and you end up with a total of about 40% federal tax. Using the figures of 6% state income tax, 2% sales tax, 5% payroll tax (unemployment, disability, etc.) 6% property tax, and 1% gas tax yields a 20% state tax rate. That’s 60% total combined federal and state tax rate. Then add in marriage license, hunting/fishing/dog licenses, hotel tax, motel tax, phone tax, building permits, driver’s license, car registration, parking meters, traffic tickets, and any and all of the various and sundry other “miscellaneous” taxes and you easily reach 2/3. (Of course, that does not include the costs of complying with the tax laws or the added costs of products since taxes are included in their prices.)

Upon recalling that paper, I have concluded that there IS a way to fight the beasts—starve them. Cut off their money supply.

I suggest that we engage in a REAL “tea party”; a REAL tax rebellion. No, I’m not advocating anything illegal like refusing to file or pay taxes. Nothing as inane as sending tea bags to Congress. I’m not saying commit fraud or up your exemptions. Committing fraud to avoid taxes is like shooting a cop to avoid a traffic ticket.

What I AM advocating is that you take an active interest in your taxes. There are thousands of tax loopholes that you can legally take advantage of and decrease your tax bill. I am not advocating tax evasion; I AM advocating tax avoidance. (The difference between tax avoidance and tax evasion is 5 years.) These tax strategies were placed in the tax code so others could use them. There is no reason why YOU cannot also use them. (Do you know that you can rent your house for two weeks and not claim the income? Sam Nunn, Senator from Georgia, has a home in Athens, Georgia which he rents out for two weeks during the Master’s golf tournament. How “fortunate” for him.)

If you need $100 more each month and you get a part time job, you will have to earn $200 in order to have $100 “left over” for your expenses. On the other hand, if you can find a tax deduction strategy or “loophole” that will allow you to keep $100 of your money, you keep the whole $100.  For most people, since their marginal tax is about 50%, reducing their tax bill 10% will give them a 5% raise. However, since they pay no taxes on that money and get to “keep it all“, it is effectively a 10% raise. That raise is good every year, year after year after year.

I suggest that you go to Barnes and Noble, Amazon, or even Good Will or The Salvation Army and pick up a book (or two) on tax avoidance. There have been many written and I won’t recommend one. Try to pick one that is a “cookbook” in that it describes what can be done in a recipe format. As you read them, you can determine if each one is “right” for YOU. Some will obviously not be relevant. Some will clearly be applicable. You may have to consult a tax professional to determine if you can use some of them.

The first book you use will probably yield about 10 courses of action that will reduce your tax liability. The second will probably yield about 5 more, in addition to repeating some from the first. The third book will probably yield one or two.

Here are some of the courses of action you may consider to reduce your liability.

Do you like to go to garage sales? Try buying all the clothes left over on Sunday afternoon. Value them according to fair market value (there are books to help you do this) and give them to Good Will. Take a deduction at FAIR MARKET VALUE. You will find that for $10, you have purchased $300-$400 of charitable tax deduction. Don’t forget to deduct the mileage to obtain the clothes (going to the garage sales). Make it a family outing. Have some fun and starve the bums.

Do you have a business? If not, you should. Try AMWAY or a similar organization. Use your garage to store the products, and take off a percentage of your electricity, rent, insurance, phone, repairs, mileage, etc. on your home as “business expenses”. Since you must make a profit 3 out of 5 years, fold the business after 2 years, and open up a different one (e.g. Mary Kay Cosmetics, Shaklee). By the time IRS gets around to audit you in three years, all physical records are gone with no hope of reconstruction. YOUR paper records will be the only source of information. Not only do you starve the bums, but who knows, you may be the next Bill Gates.

Do you have kids? Do you want them to go to college? Have the government subsidize their expenses. Have them advertise on the radio for your business. Pay them $2,000 or so. Normally that income would be considered family income and be taxed as part of your tax. However, since they have “earned income”, they qualify for an IRA. You get to deduct the “advertising expense” and they get a college fund that compounds tax deferred. At withdrawal time (college), they will have little income and they will pay little taxes. Since they are using the money for education, there is no penalty. This should be a traditional, not Roth, IRA. (Note #1: If you have no business, you can still pay the kids to do chores, and get the IRA. It just won’t be deductible. In such a case, use a Roth. Note #2: Since these are “retirement funds“, they do not count when determining “need“ in terms of student aid. Note #3: $2,000/yr for 16 years at ten percent is over $70,000.)

Speaking of college, one of the saddest stories I’ve heard (many times) is the story of the parents who carefully “put away” for their kid’s college fund by investing in a mutual fund. When college time came, they sold part of the fund and gave the money to the kid. Someone should have told these folks that they should have given the STOCK to the kid as a gift. The way THEY did it, they paid taxes on that money. Had they given the stock to the kid instead of the money and had the kid sell the stock, no taxes would have been due.

IRS says you cannot deduct commuting costs. However, if you have a business, you may deduct the costs of obtaining materials and supplies for that business. As such, each day, do not drive directly to work. Drive to a nearby store and pick up something for your business (e.g. a pencil). Do the same on the way home. As such, the costs of travel from the store to your home/business are not deductible, but the costs from your home/business to the store are. If there is a post office nearby, renting a post office box to get “business mail” will also work.

Going on vacation? While you’re there, apply for a few jobs. In doing so, your vacation becomes tax deductible as “searching for employment”.

Going on a cruise? Find one that gives “investment classes” and deduct the cruise as “investment expense”. In like manner, if you wish to take a trip to a certain city, buy stock in a company that has stockholder meetings in that city—then deduct as investment expenses going to the meetings. Traveling to find investment property has possibilities. Want to travel? Write a book and travel to research material—business expense.

Forming a church has certain benefits, though it is somewhat complicated and takes a bit of work. Tax laws pertaining to “farming” and “commercial fishing“ are “interesting“. Ronald Reagan paid little taxes due to his “ranch” in California.

There are MANY such “loopholes”. It’s your money—until you send it off to the various governments. I know you are concerned—IRS has deliberately cultivated such an attitude on your part. You need not be. One should consider the procedure for (e.g. income) taxes. If there is any doubt about whether or not to take a deduction, you should take it. What can happen??

1. The computer could simply pass it through—no problem

2. It could be kicked out for human review

a. the human could say, “This is acceptable”—no problem

b. the human could say, “I need an explanation”, and write for one

3. You write the explanation and tell them what you did

4. The human gets the explanation

a. the human says, “This is O.K.”—no problem

b. the human says, “This is NOT O.K. Pay up.”

5. You say, “O.K. here’s your money.” BUT you’re in no worse a position as if you didn’t take the deduction in the first place.

The worst that can happen is that you end up paying a few bucks in interest. Penalties are seldom assessed unless there is fraud or unreported income.

As an example of the attitude IRS has cultivated in the population, let me ask this question. “What happens if you are a month late filing your income tax?” Many folks stay up to all hours on April 15 in order to get their tax form in. No one has ever said what will happen if you don’t, but the whole country has been terrorized into thinking something horrendous will happen to them.

In actuality, it IS stated what will happen. You have to pay interest on any money owed. First of all, when you consider the deluge of mail coming into IRS on April 15th, do you REALLY think they have someone there checking the post marks? If you’re a week or two late, trust me, no one will notice. Second, if you owe no money (i.e. more was withheld than your tax liability), there is NO penalty. Third, assume you’re a month late and owe $1,000. At 6% (presently set at 5%) penalty, if you are a month late, the penalty is one half percent of $1,000 or five bucks!! Hardly worth staying up all night for.

If you own your home, you should protest your property taxes. It takes very little effort, and generally your assessed valuation will be reduced up to 10% with little or no conflict. The reason is that it is not worth their time to go through the formal hearing procedure for such a “little amount” of money. If you fail, you have lost nothing. If you do not fail, you can easily save as much a $1,000/yr. With the present situation in real estate, property valuations are being routinely lowered.

State governments generally get their money from their citizens (not corporations) in three ways—income tax, sales tax, and property tax. If you show me a state where there is no income tax, I’ll show you a state where the property taxes and/or sales taxes are quite high. Given a choice, the “trick” is to move to a state where the high taxes do not “hurt” you as much as you benefit from the other lower rates.

For example, Oregon has no sales tax. If you are a senior citizen that has purchased all the major items you intend to purchase, this is not as big a benefit as it would be for younger folk. Property taxes and income taxes in Oregon are high. If you want a “nice” house, you will pay dearly in property taxes.

Texas has no income tax. If you are working for minimum wage, this is of little benefit to you, but the high 8.25% sales tax is particularly onerous.

New Hampshire has no sales tax and no income tax; however, the property tax is quite high. New Hampshire would be tax heaven if you don’t mind living in a single wide trailer or a camper.

If it is possible, you should live on the border between two states with different tax exemptions and play one off against the other. For example, you could live in Vancouver, Washington (no income tax) and shop over the Columbia River in Oregon (no sales tax).

If you have an IRA, you should realize that when that money “comes out”, it will be taxed as ordinary income. It is MY recommendation that people should have traditional IRAs as long as their tax bracket is above 15%. Use a Roth IRA if your tax bracket is 15% or below.

During the years before exhausting the traditional IRA, quickly estimate your tax liability/rate before December 31. You will have some “lean” years—medical expenses, capital losses, lay off, etc. If your tax bracket is 15% or less, transfer as much as you can from your traditional IRA to your Roth without raising your tax bracket. Hence, you are putting money into your IRA and saving 30% tax, then transferring it to your Roth and paying 15% tax. In particularly lean years, you may well pay NO tax on the transfer.

If your IRA is “sizeable”, you may consider moving to a state where there is no state income tax. Such a move may effectively “increase” your IRA by the amount of the state tax you would pay—as much as 10%. You may consider moving to a state with no income tax for one year, converting any remaining money in your traditional IRA to a Roth, then moving back to your “home” state. A year’s “vacation” in Nevada might be worth pursuing in and of itself, in addition to saving enough money to pay for it. (While there, look for a job.)

So folks, it’s up to you. It may take a bit of work, some study, but the rewards are there. Not only do you starve the beast, but you can use the money to feed yourself a bit better. Remember, once done, the results are good until they change the tax laws. You continue to save with no added effort year after year after year.

Regards,
Tony De Maio

December 22, 2009

Starving the Tax Beasts was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

But underneath the elation over Dow 10,000 lies the palpable feeling that this rally is to be “rented,” not “owned.”

As cool weather descended upon the Northeast U.S., risk appetites started to wane. At the beginning of October traders and investors finally sobered up. Were they second-guessing whether government spending could actually kick-start a sustainable recovery? Both stocks and corporate bonds sold off sharply.

Then today I woke up to these headlines:

“Stocks Climb as New Week Starts for Wall Street.”

“Hasbro 3Q profit rises 8.8 pct on cost-cutting”

“PetMed Express 2Q earnings rise 12 percent”

Here’s why you shouldn’t believe the hype…

Cost Cutting Does Not Equal Top Line Growth

Over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are simply disconnected from reality.

Sell-Off at the First Sign of Trouble

The bulls are now enjoying their victory lap after having bid the Dow Jones industrial average above 10,000 last Wednesday. It’s puzzling to see “investors” happy about buying into a market that’s clearly overvalued. A rational, disciplined investor would be fearful about buying today, after prices have been jacked up by an unprecedented seven-month rally.

Bulls see any cautious sentiment-that “rented rally” feeling-as a source of more untapped buying power, but I see it as a reflection of weak hands being the marginal buyers; at the first sign of disappointment, they’ll look to sell. My read of the sentiment surveys is that patient value investors are skeptical and bearish, while momentum investors are bullish simply because prices have been going up.

Fund Managers Won’t Ride to the Rescue

Despite the popular sentiment that “fund managers gotta keep buying into year-end to avoid underperforming,” which would keep this market in the stratosphere, the odds heavily favor lower stock prices in the coming weeks and months.

Data from reliable sources like TrimTabs show that not only is the labor market far weaker than advertised, but net inflows into stock mutual funds have slowed to a trickle, occasionally turning into outflows. This tends to give mutual fund managers itchier trigger fingers, since cash balances in equity mutual funds are already near record lows.

Pensions aren’t going to ride to the rescue either, since they were, with 20/20 hindsight, overinvested in stocks in 2007.

Buying Momentum Could Run Out

Momentum players face the prospect of having nobody-aside from another momentum investor-willing to buy their expensive stocks at today’s prices. Patient, disciplined investors are only willing to buy at much lower prices. This could lead to an air pocket where the market could correct dramatically and quickly, without an obvious catalyst — not that there is a shortage of bearish catalysts, ranging from bank failures to home foreclosures to a crisis in fiat money.

Some pundits point to corporate mergers and acquisitions as reasons to be bullish, ignoring that fact that most deals occur closer to the peak of markets, and most deals destroy shareholder value, because the buyer overpays.

Corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is telling. In a word, the approach toward capital structure is “defensive.” Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.

Most investors, however, have permanently dialed down their risk appetites, and therefore will not chase this expensive market. Those buying stocks at today’s valuations—especially U.S.-centric finance and retail stocks—will have a very hard time finding someone to pay an even higher price in the future.

Will Government Solve the Problem? No.

The big questions back at the beginning of the month: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: As we see with “cash for clunkers,” government stimuli simply steal demand from the future.

Another big question is how will policymakers respond to a sluggish-to-nonexistent rebound in hiring?

The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs. [Count on this-Ed.]

But more importantly — because this is not yet a mainstream view — the real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.

The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not – that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it-debased by the Fed’s inflation, of course-back into your other pocket.

Where you stand on this will determine your expectations for the future performance of most stocks (ignoring special situations). I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.

I’d recommend you adjust your portfolio accordingly.

Regards,
Dan Amoss

October 19, 2009

This Stock Market Rally Is Rented, Not Owned was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

According to USA Today — I know, not the most hard-hitting rag out there — contestants on shows like America’s Got Talent and Deal or No Deal have undergone a dramatic change in the past year.

Instead of dreaming of building a mansion or retiring early, the poor saps that go on those shows are now just hoping to win some kind of money to keep afloat. On Deal or No Deal, the percentage of unemployed prospective players jumped from just 5% of its total applicants to 20%.

Who Wants to be a Millionaire’s host, Meredith Vieira, claims that her contestants no long play for big prizes. They’re there to collect a few mortgage payments or to help pay off credit cards.

Apparently, the market’s recent fake recovery hasn’t ended this game show contestant trend. Vieira notes, “There’s still a sense of need, as opposed to want.”

This could spell disaster for marketing these shows. No one wants to watch desperate people cashing out early so they don’t have to move.

“Mustn’t Watch TV” aside, you shouldn’t be surprised by the still-pathetic situation out there. After all, one of the favorite buzz phrases on CNBC is “lagging indicator.” Forget that the phrase is an oxymoron for a moment. It’s applied to – more than anything else – unemployment numbers.

We have seen a slow down in job losses, which is to say that we aren’t losing jobs in this country as fast as we were. July even saw a slight increase in employment. I suspect a portion of that tiny bump is due to people giving up. If you aren’t applying for jobs, you no longer count.

We like to think of unemployment as a percentage. But it’s important to put the actual number of would-be-workers into perspective.

We have about 14.5 million unemployed people in the U.S. — at least 14.5 million reported unemployed people. Of those, we have a significant amount that has been in that situation for more than half a year.

As this chart shows, that’s the most people on the dole since the Second World War:

This begs the question: if we do ever recover, where will these new jobs come from?

Where’s Our Next Bubble?

Speculating about which industries will provide future jobs is still damned near impossible. Could Obama’s “green tech” jobs ever come to fruition? Possibly, but it won’t be in the near future. Right now, no one can even afford those kinds of products.

Even with amazing developments in turbine technology over the past few years, it still costs about 67% more for wind power than it does for coal or nuclear power. So for electrical engineers, there might be jobs in the R&D stage of this “green revolution.” For the majority of the 14.5 million unemployed, however, that’s of no help.

It’s doubtful that we’ll see a real recovery in manufacturing jobs. That’s one segment in serious trouble. We didn’t even see it recover during the boom from its 2001 lows.

Technology is one area with some potential. Americans’ need for the latest digital toy hasn’t dissipated in this rough economy. Sure, no one can afford new plasma TVs, but just take a look at AT&T’s iPhone 3G sales this summer. Pretty impressive.

We aren’t going to stash our life savings into Apple, but we are keeping our eyes peeled to see what comes next.

The energy sector, of course, needs a recovering economy to be of importance. It’s certainly not going to lead us out of our recession. Once we do recover, however, drills will once again meet the dirt and create some jobs. But right now, we’re seeing a lot of abandoned wells across our country.

We could always just pile back into the financial services industry and pretend the past two years were a dream. Unfortunately, that’s quite possible knowing how forgetful that crew is.

Wherever new jobs come from – if they come at all – and no matter which industry leads the way, we need to keep a careful watch over every sector. As you can see in one of our favorite charts, if you know which sectors are heading in which direction, you stand to make a lot of money:

There’s no doubt we’ll replace the financial bubble with another one – just like we did with the tech bubble in the 90s. So…where’s our next bubble?

Regards,
Jim Nelson

September 7, 2009

Recovery and Jobs; Where’s the Next Bubble? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Right now, the market has priced bank stocks for perfection, but the earnings outlook remains bleak. Investors are excited about the wide yield curve that’s enabling banks to borrow at ultra low rates and lend at much higher rates. But starting a few years ago — and going forward a few more years — losses on loans made during the bubble will matter more than the wide yield curve. More bank failures, capital shortfalls, dividend cuts and shareholder dilution are in the cards for most bank stock fans.

Because bank stocks usually act as a canary in the coal mine, a continued bear market in banks translates into a continued bear market in most other stocks. The evidence tells me we’re experiencing a bear market rally, not a new bull market. The promoters of the idea that this is a new bull market are ignoring one of the worst enemies of stocks: uncertainty. Right now, especially considering aggressive government policies, uncertainty about the future business environment is very high.

As regular readers of Whiskey & Gunpowder know, the government’s land grab is going to make things worse. It seems that there’s no end to the threats facing corporate profits, which will make corporate loans that much harder to pay back. This is not a garden-variety recession. It’s more like a depression, so the so-called economists parroting the “recession is over” message will have a rude awakening soon enough.

Let’s briefly consider the sentiment toward overall market. Aside from the investor sentiment polls, you can tell how bullish investors are by the multiples they are willing to pay for stocks. And right now, after the sharpest 5-month rally since the 1930s, the market is trading at valuations that require a strong economic recovery, and a return to credit bubble conditions. The rally was powered entirely by P/E multiple expansion, not earnings growth. That sort of rally would be justifiable if corporate revenues and earnings were about to soar, but they’re not. Most earnings surprises were due to cost cutting, rather than top-line growth, which is like burning your furniture to stay warm.

The market is not even that cheap when you consider how artificially inflated earnings were at the 2007 peak. Financial earnings made up 18% of the S&P 500’s earnings in 2007 — much more if you add the “earnings” from the finance divisions of industrial conglomerates like GE and GM. Any claims that the S&P 500 is cheap because 2007 somehow represents “normalized earnings power” are bogus. The corporate profit margins and earnings won’t return to that level for many years.

The talking heads are getting more creative in their rationale for owning stocks right now. Most money managers seem to be thinking: “I don’t believe in this rally, but I’ll ride it until it looks like it’s over, and then I’ll sell.” This is the type of dangerous crowd psychology that consumes most people during bubbles. When enough investors share this Ponzi sentiment, and nobody’s investing on the basis of sober, rational fundamental analysis, the result is sometimes a crash.

Bank Accounting: Educated Guesses about the Future

This brings us to the poor quality of earnings, particularly at commercial banks. Accounting — especially the accounting that produces income statements at banks — is more art than science. It’s as much opinion as it is fact. Bank executives have a lot of leeway in how and when they recognize credit losses. As you’d imagine, some of them have more creative imaginations than others. Some are actively engaging in “extend and pretend,” a practice in which banks refinance deadbeat borrowers to avoid reporting loan losses.

Banks make loans expecting to receive interest and principal payments in a timely fashion. Banks book revenues, expected credit and operating costs, and profits associated with every loan upfront. But as we’ve discovered, the credit costs, or losses, often wind up being much larger than originally expected. When this happens, banks must dramatically ramp up their “loan loss provision” expense, which cuts into earnings, often pushing earnings into the red.

So the ultimate credit costs associated with bank revenues often take a year or more to be reflected in earnings and capital cushions. That’s why regulators require banks to maintain an “allowance for loan losses.” This allowance is a contra account on the asset side of a bank’s balance sheet, and its purpose is to absorb credit losses from loans as they run through the default and recovery phases. Loan losses, net of recoveries, deplete the allowance. Banks can rebuild their loan loss allowance by booking larger provision expenses, but this process cuts directly into earnings.

The chart below shows how under-reserved banks are right now, so they still have a ways to go in accounting for the losses on loans made during the bubble. These numbers are the combined figures for over 7,000 U.S. commercial banks insured by the FDIC. In blue, you see the combined loan loss allowance climbed to $156 billion by the end of 2008. In red, you see that noncurrent loans — the raw material for credit losses — had soared even faster to $200 billion by the end of 2008, and are still climbing sharply. As a rule of thumb, to remain well capitalized, and to prevent their allowance from shrinking to dangerously low levels, banks should book provision expenses in line with the increase in noncurrent loans.

But since the credit crisis began, this has not been happening. As the green line shows, the ratio of loss allowance to noncurrent loans for the entire banking system has fallen below 100%. To rebuild the industry wide loss allowance back up to an adequate level, provision expenses will have to rise faster than delinquencies. Some banks can only catch up by raising new capital from investors. Those banks that are too far behind, and cannot raise capital, will be taken over by the FDIC. All of this translates into a strong headwind for bank earnings over the next few years.

Recall that bank executives have lots of control over the timing of loss recognition. Evidence that banks are delaying loss recognition is springing up all over the place. For instance, some banks that provided unsecured revolving lines of credit to highly indebted REITs have waived some restrictive loan covenants. In residential mortgages, we’ve seen lots of instances where banks are stringing along underwater homeowners with modifications that do little more than kick the can down the road.

It would make more sense to restructure mortgages on underwater properties where the bank receives a property appreciation right in exchange for a large reduction in mortgage principle. This makes more sense from a societal perspective, and would help accelerate the return to a healthier, less “zombified” banking system. But this idea is not popular among bankers, because doing so would force the bank to immediately recognize lots of losses, which could cut heavily into the bank’s capital.

This state of bank accounting is not limited to the U.S. In fact, in some instances, the accounting at some foreign banks is even more detached from reality than it is in the U.S. For readers of Strategic Short Report, I recently uncovered a non-U.S. bank that’s been especially tardy in disclosing its credit losses. It’s a very attractive short sale right now, especially because the market loves this bank, and is totally ignoring the wave of credit losses to come in the near future.

Regards,
Dan Amoss

August 13, 2009

Bank Accounting Fudges Loan Losses was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.