Debt Burdens

Sorry for those who took umbrage at my last blog (State of Denial), but facing up to reality is the first step towards recovery. Despite the few outliers, most people in the industry understand the parlous environment and are taking steps to get through the next several difficult years. As noted before, those in jeopardy are limited to the group who overpaid and over-leveraged during the 2005-2007 period when prices were spiraling out of control. The only difference between sub prime borrowers and many of these commercial investors is the commercial investors fashioned themselves as much smarter. Otherwise, owners in well-leased portfolios with rational leverage will navigate sagging fundamentals albeit taking some significant haircuts along the way.
 
So the lesson that our Depression era parents and grandparents learned and we are learning again is that larding on debt is a dangerous enterprise. The really scary thing about the current economic crisis is how the government prints money and ratchets up budget deficits to stratospheric levels. Most economists say we have little choice under the circumstances, but the resulting greater debt burdens, they acknowledge, dig a bigger hole for us to get out of over the longer term. Indeed, the national debt suddenly doubles to over $12 trillion and our treasury bills no longer look like the safest place to park money anymore. In fact, China and other big international t-bill buyers begin to signal slackening appetites for treasuries.
 
As a result of perceived greater risk, interest rates on t-bills have no where to go but up to attract buyers. And that means all borrowing rates will follow suit. In addition, instead of funding defense or health care an increasing share of our IRS payments will go to servicing the much larger national debt. Tax cuts--ha, ha, ha. Taxes will necessarily increase substantially to pay this burden. And for those of you who thought we could have five years of tax cuts during war time and come out ahead, well I guess you were buying real estate in May 2007.
 
So higher interest rates and higher taxes translate into a slower growth economy and lean times for the foreseeable future. It obviously won't be a great time to borrow--lenders will necessarily be much more credit conscious, and those interest rates will boost debt service costs. So we have all the more reason to deleverage and raise cash now.
 
Our grandparents knew something all right.

Comments

[kinpowell]

apparantly you can't distinguish between the personal debt & government debt -go back & read Heilbroner's Primer. There is no evidence to date & quite to the contrary US paper is in demand as a safe haven. There are enough $s off-shore $ to fund $5T deficit that will accumulate over the next 5yr. The trick is to tell the world in advance how we will reduce the externally hel debt of the US at our earliest moment.

[Beverly Merchant]

Fixing our broken system requires changing the way players in the system are rewarded. Specif-ically, rewards should be given on a qualitative rather than quantitative basis.

That’s much easier said than done, of course, which is why we keep repeating these problems, especially in commercial real estate investing and lending. Changes were made coming out of past downturns but the fundamentals driving the system haven’t changed. Lenders got in trouble in the past because they gave money away too readily. Instead of addressing the motivation for making bad loans, blame was put on the appraisals done to justify the loans and the government instituted tough standards for appraisal reports. Those rules were as useful as mandating quality literature. Appraisals became filled with even more boiler plate, attractive tables and mountains of data. But there is no way to guarantee that the data is accurate and the interpretation of it is wise. And, most important, if the value concluded is not what the lender wants, the appraiser looses that client because the success of a loan officer is measured by the volume of loans made rather than their quality.

So, what is the solution?

First, kill all the brokers, to paraphrase Shakespeare. As a commercial real estate broker myself, I’m not really recommending eliminating the role of brokers but the system of rewarding brokers and other deal-makers needs to be revised. Most brokers now work on commission and only make money if a deal closes. Whichever side they represent, some brokers are going to pressure their clients into making bad decisions such as lending to an unqualified borrower or buying at too high a price. If a broker or dealer was instead paid on an hourly fee basis with a bonus for a successful transaction, there might be fewer bad loans or buyers paying too much. This change is especially needed on the residential side where the market is less sophisticated and with non-real estate businesses that occupy commercial real estate.

Second, require a hold period. Lenders often do this for commercial real estate by forbidding prepayment of the loan for a period and then imposing a stiff penalty for paying prior to the expiration. Also, lenders to condo developers may prohibit buyers from reserving more than one unit in order to block speculators. The practice of “buying” units for resale prior to taking possession results in empty buildings if the market turns down, as we can see. The speculator doesn’t have the money to close. The best investors retain ownership for an extended period and earn returns based on the income produced by the office building or shopping center rather than the property’s increased value.

Third, is a “well duh!” Greatly limit securitization of mortgages and eliminate derivatives. As long as a lender can repackage a bundle of loans and make a tidy profit selling shares in the package, the quality of the loans being made is not their concern. Lenders need to “own” their deals and suffer the consequences of poor underwriting. Also, the slice and dice securitizations so distance the capital from the collateral that there is no practical recourse, as has been thoroughly demonstrated.