Our choicest plans have fallen through

Our airiest castles tumbled over

Because of lines we neatly drew

And later neatly stumbled over

Piet Hein, Grooks, On Problems

Don’t do this …

“If you think this country’s in bad shape,” sang Rufus T. Firefly in Duck Soup, “just wait ’til I get through with it!”  That seems to echo the glum assessments of California’s state legislators, who having already engaged in early-stage sovereign-bankruptcy gimmickry, find that violating their principles has bought them not a reprieve from hard decisions but merely a short delay in making them, as revealed in this The Orange Country Register information-oriented editorial:

Once the envy of the other 49 states, California has become the measure of failure. Historically a trend-setter, once again, as California goes, so may go the nation.

Unfortunately, it went for the other guy

As I write this, the Eurozone members are grappling with what to do about spendthrift Greece, which having recently quadrupled its budget deficit, is now pledging limited ‘austerity’ measures like freezing its rate of spending.  [Good thing we'd never do anything like that! … Oh, wait … -- Ed.]

The Pew Center on the States recently completed an extensive study of the 50 state governments and found California in the worst straits, but also discovered nine other states have joined us in a condition of “fiscal peril.”

“The same pressures that drove the Golden State toward fiscal disaster are wreaking havoc in a number of states, with potentially damaging consequences for the entire country,” concluded the study, “Beyond California: States in Fiscal Peril (pdf).”

I’ve fallen into a budget hole and I can’t get out!

As Pew put it (the Executive summary is here):

The nation is watching closely as California struggles to avoid going broke.

So far, the most-populous state—and eighth biggest economy in the world—has unsuccessfully sought a $7 billion federal loan guarantee to pay its bills –

The same trick Greece is now hopefully pursuing:

– temporarily issued IOUs to state employees and business contractors because it ran short of cash,

Personally, I think that’s a compensable taking of its citizens’ property rights, and were I in that situation, and the money enough to matter, I would sue them.  [You think I wouldn't? – Ed.]

– and started shutting state offices several Fridays a month to close the largest state budget gap in the country.

Observe that the one-day-a-month trick trims the deficit but perhaps in the least helpful way possible – it doesn’t trim the financial obligations, just adds processing delays to receiving them.

We’ll get to you eventually

California’s problems are in a league of their own.  But the same pressures that drove it toward fiscal disaster are wreaking havoc in a number of states, with potentially damaging consequences for the entire country.

The Pew Center study is really fascinating, as the Register realizes:

Those states – Arizona, Florida, Illinois, Michigan, Nevada, New Jersey, Oregon, Rhode Island and Wisconsin – share many of California’s maladies.

Three clusters: Western sand, Florida sand, and Upper Midwest snow

Some, the study found, suffer from economies that disproportionately rely on particular industries, such as housing in Florida or auto manufacturing in Michigan.

In the wider globe, people think that housing is an output of a thriving economy, so that if one grows the economy, housing naturally follows.  We know that’s false – slums are economically rational, as well as an inherent phase of rapid urbanization – and in fact, the converse is true: successful housing production drives not only the economy but also successful urbanization. 

California, Illinois and New Jersey repeatedly have used borrowing or accounting schemes to put off tough budget decisions.

The same people who excoriate credit card companies for allowing consumers running up massive credit card bills seem to have no problem doing it with their voters’ money.

Like California, Arizona, Florida, Nevada and Oregon are restricted in raising taxes or cutting spending because of voter initiatives and constitutional restraints, Pew noted.

Led by California, whose Proposition 13 is the single worst voter referendum ever in American politics: arbitrary, lacking in safety valves, discriminatory, and massively distortive.  (Even Massachusetts‘ Proposition 2½ allows for a local override, which affected cities and towns use through majority-vote plebiscite – as it should be.)  No wonder it’s politically sacrosanct – until now, anyhow.

We won – and California keeps losing!

“The recession put almost all states in a bind,” the study observed, “but California, Illinois, Michigan, New Jersey, Rhode Island and Wisconsin have a history of persistent shortfalls.”

If you cannot make ends meet when times are good, you have no business complaining when times turn against you.  You over-promised, pure and simple, and mismanaged your fiscal affairs.  Now you’re going to have to cut, and cut, and cut again.  Each cut will be painful.

The Pew study was based on data up to July 31 of this year and bluntly forecasted “states’ fiscal conditions are widely expected to worsen even when the national economy starts to recover.”

The states’ deepening fiscal problems are due to those lines they neatly drew – pledges and promises that now hogtie them and prevent responding in fiscally rational ways.

Pew evaluated joblessness, foreclosures, declining tax revenue, budget shortfalls, poor money-management and legal obstacles to raising taxes and passing budgets, like California’s two-thirds majority requirement.

From the Pew Study (reformatted by AHI)

I took the Pew data, sorted it, and reformatted it to highlight the ways in which the states have entangled themselves in red ink.

It wasn’t supposed to work like this

Aside from the tax hike caps, what stands out are (a) the scale of the budget gaps – Illinois and Arizona have shortfalls greater than 40% of their budget.  Where I come from, that’s spelled B-A-N-K-R-U-P-T-C-Y, and (b) the budgetary super-majority requirements.  They’re fine when you’re trying to curtail the growth of spending, but when you’re trying to impose cuts in spending, the minority can lash themselves to the majority and send everyone, struggling furiously, over the cliff.

TIRED SENATOR– State Senator George Runner, R-Lancaster, right, rests at his desk while Senator Mark Wyland, R-Solana Beach, rubs his temples during the debate over one of the state budget measures at the Capitol in Sacramento, Calif., Friday, July 24, 2009. Lawmakers worked overnight voting on a package of bills worked out between Gov. Arnold Schwarzenegger and Legislative leaders to resolve the state’s $26.3 billion budget deficit.

Huge public-employee pension and health care liabilities weren’t even among the factors considered, which, particularly in California’s case, threaten to bring over time absolutely crippling debts in the hundreds of billions of dollars.

That is the next great economic class crisis looming in American politics; the divide between government and non-government workers, with the former looking on in bewilderment at the anger many of the latter feel toward the expansion of government and its seemingly cushy benefits.

One of the nation’s largest unions

In short, as dark as Pew’s outlook seems, it may get much worse, particularly in California.

The Pew authors said their study was “not framed as a case for more federal stimulus,” although the Center included calls by some economists for more “help” for the states from Washington.

States, like nations and pension funds, state grew so yield-hungry and complacent at the thought of ever-renewing positive real returns from income-producing assets that they expanded their expenditures without asking themselves how they would respond if revenues dropped materially for any sustained period.  Now many states – maybe even more than half of them – have entangled themselves in political and social obligations that it is clear they cannot fulfill.  In desperation, they’re begging the Federal government for relief, but the Federal coffers are likewise empty.  Put it together and it’s clear that states will simply have to de-fund previous obligations, either directly and forthrightly, or through shadow bankruptcy.

Is the Register ready to call for such a solution?

Don’t rush me, I’m thinking about it

We find just the opposite is called for. The problem will only be aggravated by bailing out states like California that repeatedly have used poor judgment in relying disproportionately on cyclical industries, and that have borrowed excessively or employed accounting gimmicks rather than making tough decisions about which activities to stop doing, or do less of.

Exactly the debate now playing out in Euroland over Greece’s debt and budgetary problems.

Providing more federal billions, which come from the same taxpayers these states already have abused, is a circuitous way of further bleeding taxpayers rather than cutting back years of over-spending that created the “persistent shortfalls.”

Okay, you’ve told us what you don’t want done.  Now tell us what you want done.

The “too big to fail” approach to fiscal management is merely more of the same poison that made these states so economically ill. Rather than more of the same, it’s time for California and other “states in fiscal peril” to become fiscally responsible.

Meaning what?  Raise taxes?  Cut spending?  Declare bankruptcy?

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By: David A. Smith

[A full year's Month in Review available here: Dec 09, Nov 09, Oct 09, Sep 09, Aug 09, Jul 09, Jun 09, May  09, April 09, Mar 09, Feb 09, Jan 09.]

In January, aside from one little post about the invisible delights of apartment living (It’s what you don’t see), everything I wrote covered capital markets and macro policy, proving just how deeply intertwined are home asset values and fiscal economy.  The first 2010 tree I ran into was a contradictory set of housing price indicators out of which one could assemble any narrative one wanted, as I observed in Pick a direction. 

At least we don’t have to go far for help

That being unsatisfactory, I sought to provide some fearless 2010 predictions – worth every bit as much as a California promise – starting with Part 1, global macroeconomic factors:

1. Ben Bernanke will be easily reconfirmed as Federal Reserve chairman

2. After a ‘decent interval,’ the Fed will start raising interest rates

3. The recession will linger like a bad cold

4. The dollar will defy financial gravity … for the year, anyway

5. ‘Sovereign bankruptcy’ will enter the lexicon

6. Global finance will be whipsawed by sovereign-bankruptcy worries

We ended 2009 with the US economy still losing total employment.  That may not be the economists’ definition of a recession, but it’s the public’s practical definition, and the one with most relevance to housing, for when jobs and people’s earning power are shrinking, so too is their consumption of housing.

That economic weakness will be worldwide, for a 10-20% global de-leveraging simply does not happen overnight, uniformly, or predictably.  Sucking that much cash out of the financial ecosystem has external consequences – a premium on liquidity, lower asset values, and a steeper risk curve.  Nor are we done with the financial aftershocks – the multiple governmental shadow bankruptcies yet to come, for example – that will knock the props out from under people (like pensioners and public employees) who up to now have thought themselves immune.

Who, me?  Nothing wrong with me!

Of these, Bernanke’s reconfirmation [1] happened, although some may question ‘easily’ (although really, what did all the noise amount to?), and [5] has arisen (at least in the Eurozone, with Greece, although not yet here at home).  The others have to ripen, but as a portfolio of predictions, I like it.

Part 2 covered US capital markets:

7. All the big TARP banks will recover

8. In 2010, many regional banks will fail

9. TALF will be revived

10. The GSEs will be frozen in time

11. The risk curve will widen and stay wide

12. Financial and real estate service-sector consolidation will continue

Right now, global capital is scared.  Scared of lingering recession.  Scared of monetary policy.  Scared of sovereign insolvency.  Scared of the unknown future. 

I’ve got reason for being scared

When capital is scared, it ventures only a short ways from safety, which means safe nations, safe security types, safe asset classes, safe maturities – and always with a line of retreat, meaning a liquidity option.  Flight to higher-credit assets requires collateral, not counterparties, in view of the market’s loss of faith in ratings agencies and guarantors.  Every asset class will stratify, and for real estate assets, the stratification will occur by location, property quality, debt service coverage, sponsor.  Safer will be overly rewarded and riskier will be overly punished.  The gap between creditworthy haves and creditless have-nots will become more palpable and more painful.

The result is a steep yield curve and a steep risk curve.  You want to borrow money for a long period, secured by a repositioning asset, and with anything less than sterling credit?  Be prepared to pay up for it.

Is that loan proposal a joke?

It will be Ben Bernanke’s job to keep the yield curve smooth and relatively flat. 

While one shouldn’t judge solely on the froth of journalism, that the big TARP banks are now targets of populist anger suggests they have recovered (Prediction 7). 

This isn’t good for the brand

About the others, we’ll see. 

The remaining predictions are much more sector-specific.  In Part 3, housing and affordable housing, I covered the macro supply factors, and concluded that we have too many entities and not enough business for them all to do.  Major consolidation is in order:

13.  Total US households will be level, not increasing

14.  Average national home prices will rise, but weakly

15.  Rent increases will be held back by the shadow rental market

16.  2010 net housing production will be nearly at a standstill

17.  LIHTC pricing will stabilize at 75¢ or so

18.  LIHTC will lose market share to newer tax credits

19. Consolidation will squeeze out 15-20% of sponsors

Though it pains me to tell my friends this, the shakeout is long overdue.  We have too many too-small sponsors; we need more scalable Production MEEs.  We also need comprehensively to rethink the distribution of Production MEEs around the country, and how we can use legislative motivation and resource incentives to drive portfolio rationalization: capable Production MEEs spaced continuously across the national landscape, each one successfully owning a geographically logical and localized portfolio of properties.

Cover the landscape, and make best use of the resources

Whew!  Compared with all that heavy going, the month’s remaining posts are meringue indeed.   Start with a remarkable anti-defamation lawsuit brought on behalf of Rumpelstiltskin (aka the U S Government), whose case is pressed in Rumpelstiltskin’s fee: Part 1, the libels, and Part 2, the motives:

If it please the court –

Comes now my client, your honor, the United States government, affectionately known as Rumpelstiltskin – who having rendered a valuable, nay an essential, service to the fair maiden investment banks and her father the banking industry, is now being both cheated of the compensation which he demanded and to which the parties agreed, and libeled for doing so.

Lot of straw, little lady, and not a lot of gold here, is there?

The essential facts are not in dispute. 

Parties at interest in this litigation

“Prince” Charles Miller (bank)

“Dolly” Miller [not her real name], the investment banker

Cassius King (representing the retail customers)

Rumpelstiltskin (Treasury)

The defendant and alleged victim was an investment banker.  Under our financial privacy shield laws, her name must be withheld so we will refer to as Dolly Miller.  Dolly claimed that via securitization, she could spin straw (unrated mortgage instruments) into gold (ratable securities), which her father the miller (major public banks) sold to Cassius King and his extended family, at vast profits.

[I note for the record that we will be joining other parties, such as the rating agencies, in derivative actions.]

Add a bit of outrageous flattery suggesting that Great laws from little blog posts grow:

If virtue is its own reward, can an AHI post change a law? 

One blog post = one wing flap?

Though I would never claim such a thing, Dr. Zhong Yi Tong, principal analyst of the Washington DC homeownership tax credit, traces a direct link between a July, 2003 AHI report and the newly-extended national first-time homebuyer credit.  I was utterly unaware of this until December 29, when he wrote me an out-of-the-blue email connecting the dots. 

So modest he insists on a small photo

Zhong Yi’s email, from which I quote with permission, is in dark red:

Several years ago you wrote a blog post [Tax credits boost regeneration markets – Ed.] on my dissertation study on the impact of targeted homeownership tax credit program – evidence from DC.  You also used some of its information for your UK experiment.  Now it seems to me that my study on this matter might have somewhat contributed to the housing recovery for the US. 

Argh, pity me

Then pity the poor pirate who, having looted the high seas, now discovers he needs to reintegrate with civilization to enjoy the proceeds of his plunder, by Burying treasure:

Pirates have a real estate problem and a capital problem. 

We’ve got the capital, now we need the real estate!

Like highwaymen (land pirates) and kidnappers (wilderness pirates), for their business they need a work environment of vast uncharted spaces and complete lawlessness – for which the high seas often serve admirably. 

We’re ordinary fisherman … until we attack you

The pirates’ real estate problem is that, conducting their business in a place of no law – and hence no monetary or economic resources – they must nevertheless equip and base themselves in a place of monetary and economic resources – and hence of some law.

Readers who have stopped following this blog for having activated their estates will be pleased to learn that for them, Death is a bonanza:

Have you died so far in 2010?  If you have, you’re in luck!

I’m from eternity and I’m here to help you solve your tax problem

If you’re still alive in 2010, but wonder how much longer you’ll make it, then you have a decision to make.

“Now, you have a decision to make: do I feel lucky?”

Rich Cling to Life to Beat Tax Man

You mean you’re not glad to see me?

[Article published in the The Wall Street Journal on December 31, 2009.]

Nothing’s certain except death and taxes – but a temporary lapse in the estate tax is causing a few wealthy Americans to try to bend those rules.

[Snip]

As my earlier exposition suggested, there is a logical linkage between estate tax and capital gains tax.  Capital gains are payable when an asset is sold from Owner A to Owner B.  In an estate, the assets pass from Owner A to Owner B without benefit of an economic sale, but certainly within benefit of a sale for legal and tax purposes (the old owner is legally dissolved, a new one created with full protection of the law).

The idea is that you shouldn’t be able to put assets into a vehicle and pass them, generation after generation, without tax.  Legal vehicles have their force because government protects property, and the capital gains and estate taxes can be seen as a user fee for protecting wealth when it passes from the hands of a capable person to potentially less capable beneficiaries.

Finally, the month ended with another multi-part post – hey, it’s complex stuff, and all soundbites are misleading without context – on the puzzle of pay.  In January, I posted Part 1, what should happen, executive level, and Part 2, what should happen, company level:

With the economy in the tank and banks (including the Federal Reserve) making record profits, populist ire has settled on the bankers themselves. 

Were you paid a great deal of money?

Yes, we … uh …

Guilty!  Until proven innocent!

Deservedly so?  That question is implicit in a lengthy Steven Brill piece in the New York Times, a largely sympathetic profile of TARP paymaster Kenneth Feinberg.  Brill makes much of Feinberg’s flagellating bankers, as others are lining up to take their turn.  The bankers are facing a financial crisis tribunal and being bashed by the President:

“Those who oppose this fee [The proposed $90 billion tax on all banks – Ed.]  have also had the audacity to suggest that it is somehow unfair,” President Obama continued, “that because these firms have already returned what they borrowed directly, their obligation is fulfilled.”

(How naively audacious I am, to think that repaying a debt ends the obligation.)

Next you’ll be telling me I can get it from a tap

Some of the shots are truly deserved, as when Goldman CEO Lloyd Blankfein walked into a verbal door:

You mean you open it first?

Testifying to the Financial Crisis Inquiry Commission, the body established by Congress to determine the causes of the Wall Street debacle, Lloyd C. Blankfein, the chairman and chief executive of Goldman Sachs, drew most of the fire.

Mr. Blankfein parried repeated questions over his bank’s extraordinary profits and salaries. At one point, when he likened aspects of the financial crisis to a “hurricane” and similar acts of God, the commission’s chairman, Phil Angelides, a Democrat and former California state treasurer, cut in to say, “Acts of God, we’ll exempt. These were acts of men and women.”

Score one for Chairman Angelides!

How do you like me now?

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[A full year's Month in Review available here: Dec 09, Nov 09, Oct 09, Sep 09, Aug 09, Jul 09, Jun 09, May  09, April 09, Mar 09, Feb 09, Jan 09.]

A blog is pointillist – sparkly bits of insight (we hope) collected by the roving eye of an intellectual crow.  Yet step back from the dots and you may see a pattern, and patterns are what make ecosystems out of the rhythms of life. 

Fascinating … and logical

That’s what calendar increments like decades are for – to let us take stock.

I opened the new decade by looking back at the old one, with the longest and most substantive post I’ve ever written, seven parts on the decade’s biggest invisible stories:

All of them are important, and if there is only one post of mine you read in its entirety, it should be that one, but as I despair of receiving the undivided attention of our ADD/ Twitter generation, I will succumb to market forces and provide sound bites, starting with Part 1, the perpetual-motion credo:

By no stretch of the imagination was Mr. Raines unusual in the Aughties – nearly every financial wizard, on or off Wall Street, was similarly enraptured with the wealth machine that was the decade’s global capital markets.  It was all driven by the belief that risk could be quantitatively controlled by hedging strategies – a deeply seductive belief.

Tell me again how default risks are not correlated

For that, one needed an unwitting wizard.  Cometh the willful disbelief, cometh the formula.  As I wrote [Posted March, 2009]:

The E = mc² of financial engineering

Guaranteed perpetual motion!

Suppose I offered you a free lunch?  Would you take it?

Between Li’s formula and Raines’s willingness to believe it and massively bet on it with the country’s money for his stockholders’ and his own profits, we were ready an asset boom.  That was amplified by two other forces documented in Part 2, yield starvation and dematerialization of global capital:

When I was a kid, financial capital was represented tangible: gold, silver, currency.  Bonds were bearer bonds, stock certificates.  Actual pieces of paper (that’s not an oxymoron) with embossing, stamping, engraving, or certification of authenticity.  Possession of the scrip was critical to proving no-questions asked credit.

Money, though an intangible concept, through 1999 had a tangible expression.

During the Nineties, many indicia of status dematerialized.  Airplane tickets went electronic (when was the last time you saw a paper one?); so did driver’s licenses.

My identity is an illusion, as is everything else here

Most significant in this dematerialization was that of capital.  From having once had a tangible existence, by the time the Aughties opened, capital was evidenced by matching sets of numbers contained in bank and financial institution computers, making a mockery of the old how-to-steal-a-million caper movie that was a screen staple when we were growing up.

From this vision of money …

… to this, art replacing cash

Now there was plenty of financial-asset demand globally, and the potential for an expanded supply domestically.  To that tinder we needed wizards to strike matches, with they did, as documented in Part 3, tangles in the financial web, with FIN 46 (shielding companies from the dreaded ‘consolidation’) and allowing the explosion in Credit Default Swaps:

Along with thousands of others, I can testify how much accounting brainpower was consumed defining the maximum perimeter of entities in which the Parent had a big economic stake without the dreaded FIN 46 consolidation.  This still goes on today, consolidation being the Thing To Avoid At All Costs.

Simple, isn’t it?  Vinot Kothari’s FIN 46 flow chart

As you can imagine, this led to contortions by which entities sought to avoid having to consolidate.

A total of 470 participants from the US and Europe participated in the survey. Most also felt that the market will adapt itself with new structures which simply cosmetically re-engineer SPEs to fall out of the definitions of the Interpretation.

That was the invisible story.  FIN 46, which sought to make things more transparent, in fact made them more opaque.  While investors basked in the illusion of transparent consolidation, in reality they were absorbing ever more risk.

Our structures have a firm foundation

By mid-decade the economy was humming merrily away, and it seemed the party would never end, but as covered in Part 4, the 2006 crest, two things should have tipped us off: FAS 157 was issued, and Angelo Mozilo began cashing out:

During 2006 Angelo Mozilo, Countrywide’s founder, CEO, and largest stockholder, began selling his positions; in fact, Mr. Mozilo “modified the executive sales plan in late 2006 to accelerate his stock sales. Critics say he sped up them up because he was aware of problems at Countrywide.”

Problems?  What problems?

By mid-2007, Mr. Mozilo was coming under fire, although at the time the smoldering appeared merely fumes and not a conflagration.

[Snip]

Regarding his stock sales, I thought Mr. Mozilo’s explanation credible, said so at the time.  Later I came to feel a complete chump for having done so.  But here’s the invisible story – as far as I know, despite the stock price sliding, there was no more detailed investigation into Countrywide’s business model and finances, if only to rebut the presumption that Mr. Mozilo was cashing out while the cashing was good:

[In 2009] the SEC released emails in which Mozilo referred to certain mortgage products as “poison” and “toxic” at the same time Countrywide was making riskier and riskier moves with its lending operations.

Don’t paste this label on the product, okay?

At the time, Mr. Mozilo’s actions were scrutinized; FAS 157 was overlooked.  That opened the window for the last mover (Fannie Mae) before the world inverted.  As covered in Part 5, the wrong zags, the capping folly was that, as Angelo Mozilo was beetling out of subprime, Fannie Mae (under Daniel Mudd, Raines’s Mister-Clean successor)  was gobbling it up:

Moreover, shifting to riskier securities – moving up the risk curve – meant that the companies could increase their profits by increasing the risk to us taxpayers.  That’s what they did – just at the moment that many (like Angelo Mozilo) were dramatically reducing their exposure to subprime lending, the GSEs increased theirs. 

Where Angelos fear to tread …

[Snip]

Mr. Mozilo, who was closest to the action, was cashing out of Countrywide and cashing Countrywide out of these loans.  Fannie Mae and Freddie Mac, who were further from the risks and from the touch on assets necessary to evaluate and manage those risks, were aggressively buying them from aggressively selling Mr. Mozilo.

Somebody had to be wrong.

They couldn’t all have been right at the same time: Johnson, Raines, and Mozilo

By 2007, we were looking unhappily at a risk curve hit by a seismic shock, with sudden paper writedowns of virtually every financial situation in the world.  That led to the first of many responses.  As described in Part 6, rule changes with the game in progress, to the volatile mix we added new uncertainty:

2007: Repeal of the uptick rule

During the summer of 2007, as the credit crunch deepened and the decline in asset values started to accelerate, the SEC inexplicably did the equivalent of severing the runaway automobile’s brakes [Posted December, 2008]:

Who repealed the uptick rule?!?!?

[Snip]

Aftermath.  Realizable values of structured assets collapsed to fire-sale prices.  Those discounts became the bludgeons of FAS-157-driven writedowns.  One by one Wall Street’s financial pillars – Bear Stearns, Lehman Brothers, AIG, and Fannie Mae – suffered bear raids.  Billions of capital disappeared even as some capital migrated to the raiders.  Finally, in April, 2009, the SEC restored the uptick rule.

Finally, in Part 7, effects not yet visible, I listed the two big invisible stories of 2009 whose importance wouldn’t surface until this year.  One of them (Chairman Bernanke’s reappointment) proved a bit more contentious than I expected – although really, they never laid a glove on him – and the other, although small at the time, is like that first corn kernel to pop in the pan:

2009: California’s shameless IOU issuance

In July, the state of California did an extraordinary thing: it repudiated its debts.

Why pay debts when you can print money?  A California IOU

Instead of paying its bills with cash, the state printed paper, backed by nothing, and ordered people to accept it.

If you or I did that, we would be summarily hauled into court and our property potentially seized. 

Oh, wait – it was the court itself that was welshing.

To be sure, the state dressed up this reneging on its debts with flowery language:

[Snip]

We are living in interesting times.  The decade upcoming promises to be no less interesting.

Does this mean danger/ opportunity?  

With the Chinese holding $800 billion of our paper, we’re about to find out.

With that as the forest, let’s plunge into the trees:

Enlightenment’s in there

[Continued tomorrow in Part 2.]

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[Expanded greatly from State of the Market 23, available in the Recent issues section of the CAS Financial Web site.]

[Continued from yesterday's Part 2 and the preceding Part 1.]

What’s bad for production is good for affordability – isn’t it?

C. Housing and affordable housing, excess housing, enough affordability?

Housing both drives the economy (via construction and refinancing, both of which circulate money rapidly) and is driven by it: housing demand is elastic, and when people lose their jobs or see their income fall, they spend less on housing.

With a weak domestic economy, we’ll be seeing plenty of middle-class affordability, due to the overhanging supply (unsold homes) and latent supply (people living in houses they’d rather sell if they could).

Problem is, the home can’t move but the people can

13.  Total US households will be level, not increasing

Because housing demand is elastic, total households rise and fall with economic circumstances – a weak economy means fewer new households (and fewer babies) and can even lead to household contraction. 

Although in a normal year we are likely to produce 300,000 new households in America, continuing weakness in the economy (see State of the Market 20) will mean that in 2010 the aggregate US national households will hold level or possibly keep shrinking – at least until we stop shedding jobs, that is. 

The pain will not be evenly felt.  Job contraction, household contraction, and housing price declines all reinforce each other, so the very places where the recession will linger the longest are also those with the weakest housing markets. 

At this point, foreclosures are being propelled by joblessness, which is sending millions of previously credit-worthy people with ordinary mortgages into delinquency.

States facing structural budget deficits without significant new immigration are going to have to cut and cut, then cut again, if only to slow the rate at which their sovereign insolvency becomes manifest. 

Add to that America’s natural demographic movement – toward coastlines and sunshine, and we can confidently expect the 2010 census to show Congressional seats being lost in the Midwest and plains states, and being gained in the southwest. 

The 2004 presidential election: see the pattern?

14.  Average national home prices will rise, but weakly

Fewer new households formed means more empty houses on the market, which of course means continuing softness in single-family home prices – in those parts of the country with a supply overhang.  (As we said yesterday, in 2010 the recession’s going to be even more severely regional.)  While home prices may be done falling (except in places with deep structural economic problems), they’re unlikely to rise much either. 

Continuing softness in home prices will create opportunities to convert the properties – either unsold condominiums or hermit-crab homes – into workforce housing or other forms of long-term affordability.  It’s critical that we as a nation grab those opportunities when we can, so as not to miss again the opportunities missed in the S&L bailout twenty years ago.

The big bank that went bust: Lincoln Savings and Loan

15.  Rent increases will be held back by the shadow rental market

A large supply of lower-priced affordable single-family homes held by eager sellers/ landlords will create a shadow market in rentals.  There are also worries about re-defaults of post-modified home mortgages further slowing down the economy, an additional further complicating factor out of which it is hard to see good news.  As the New York Times put it in a New Year’s Day article:

The Obama administration’s $75 billion program to protect homeowners from foreclosure has been widely pronounced a disappointment, and some economists and real estate experts now contend it has done more harm than good.

How many of them are actually helped?

Critics increasingly argue that the program, Making Home Affordable, has raised false hopes among people who simply cannot afford their homes.

As a result, desperate homeowners have sent payments to banks in often-futile efforts to keep their homes, which some see as wasting dollars they could have saved in preparation for moving to cheaper rental residences. Some borrowers have seen their credit tarnished while falsely assuming that loan modifications involved no negative reports to credit agencies.

Some experts argue the program has impeded economic recovery by delaying a wrenching yet cleansing process through which borrowers give up unaffordable homes and banks fully reckon with their disastrous bets on real estate, enabling money to flow more freely through the financial system.

That and the contraction in total households mean downward pressure on rents (bad for multifamily prices). 

Enough with the stimulus, okay?

16.  2010 production will be nearly at a standstill

There’s one unquestionable bright spot: recessions stop production in its tracks. 

No more spec-built homes, okay?

New production of both single-family and multifamily housing is at its lowest level in well more than a decade, perhaps 125,000 new starts in 2010.  That’s less than 40% of a normal year’s new household formation, and there’s no reason to think that 2011 will see that much of a jump in production.  In other words, 2012 and beyond will see significant rises in property values, for those of us still around to see them.

17.  LIHTC pricing will stabilize at 75¢ or so

In terms of affordable housing, during 2008 and 2009 the LIHTC delivery chain broke and only partially self-repaired.  We end 2009 with the slow-arriving relief for the production pipeline – the TCAP soft loans and the LIHTC Exchange – finally reaching the properties for which it was intended.

Oh my paws and whiskers, where is the money?

Now the questions are when will tax credit prices stabilize, and at what levels?

For nearly eighteen months, supply of new LIHTC so far outstripped suddenly-shrunken demand that not only did prices fall precipitously, for some properties and some locations the market entirely disappeared – no bid at any price.  Adding to that downward pricing pressure, for most of 2009 rumors abounded (among those who hadn’t signed non-disclosure agreements, anyhow) that the GSEs might be reselling large blocks of existing LIHTC.

Because I know, I’m not telling

In November, seemingly out of nowhere, the Wall Street Journal broke the long-rumored story with a headline seemingly calculated to kill the deal:

Buffett Joins Goldman in Bid for Fannie Mae Tax Credits

Definitely the headline you don’t want in the midst of a populist anti-financier fervor:

Buffet?  Goldman?  Fannie Mae?  String ‘em up!

Sure enough, Treasury hastily and emphatically nixed that transaction.  Now, with the resale market seemingly having settled down, during 2010 aggregate national demand (new equity bid) will roughly match aggregate supply (new LIHTC offered for sale).  Prices will space out broadly, ranging from highs nearing 90¢ for well-located CRA primary areas (e.g. New York City, San Francisco city), falling off to 65¢ for tertiary markets outside principal financial centers. 

Unfortunately, the national market is not homogenous, and as the four-tier stratification we outlined in State of the Market 22: Close Like a Barbarian becomes manifest, the states with demand shortfalls will grow increasingly agitated. 

I’m getting rather agitated

For LIHTC, the real threat isn’t short-term, but longer-term.

18.  LIHTC will lose market share to newer tax credits

Like the crocodile and the cycad, the Low Income Housing Tax Credit is an anachronistic holdover; approaching its quarter century, in terms of investor user-friendliness it has long since superseded by other better-adapted creatures, yet flourishing nonetheless.

For millennia I’ve had to put up with hearing about superior lizards that’ll supplant me

New entrants like New Market Tax Credits and energy tax credits (wind and solar), designed and enacted after the LIHTC and taking advantages of lessons learned in LIHTC syndication, are faster pay-in, last administratively complex, and more readily comprehensible asset classes.  While energy credits they do not provide the CRA benefits that are the LIHTC’s special feature, with financial institutions’ vastly shrunken CRA appetite, that commodity has lost most of its value. 

Reviving the LIHTC market will be driven not by CRA motivations but by yield considerations, and in this LIHTC advocates will have to be very careful what they wish for.  In their efforts to educate corporate investors and persuade them to become new entrants, they will have to thread a needle: motivate CFOs to embrace tax credits as an investment concept, then prevent them from having their heads turned by newer models.

Which vehicle looks sexier to you?

As a result, though 2010 LIHTC volume will be stable, the LIHTC will be losing market share to the newcomers.  That will erode its Congressional support, partly if prices hovering in the 75¢ range give uninformed critics an easy argument that the LIHTC is inefficient.

When 2009 opened, I thought there was a risk LIHTC would be zero-funded in favor of a full-blown Exchange – which would be bad for affordable housing, as the LIHTC is a uniquely successful affordable housing resource because it is a different kind of money with unique benefits that cannot be replicated by appropriated programs.  Now I’m worried again – not about 2010, when I believe there will be cumulative legislative fatigue – but in 2011, when there will be a new Congress, possibly under Republican control.  If the LIHTC’s equity-raising still looks anemic, calls for its replacement by pure grants will grow.

19. Consolidation will squeeze out 15-20% of sponsors

By the time the year is over, 15-20% of the pipeline properties that received 2008 and 2009 LIHTC allocations will have somehow dried up and disappeared.  Already 10-20% of affordable housing sponsors are dormant if not moribund.  As 2010 wears on, more of these will surface – and many of them will be non-profits.

Though it pains me to tell my friends this, the shakeout is long overdue.  We have too many too-small sponsors; we need more scalable Production MEEs.  We also need comprehensively to rethink the distribution of Production MEEs around the country, and how we can use legislative motivation and resource incentives to drive portfolio rationalization: capable Production MEEs spaced continuously across the national landscape, each one successfully owning a geographically logical and localized portfolio of properties.

Cover the landscape, and make best use of the resources

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[Expanded greatly from State of the Market 23, available in the Recent issues section of the CAS Financial Web site.]

[Continued from yesterday's Part 1.]

Yesterday’s potful of predictions focused on macroeconomic policy: Bernanke’s reappointment, rising US interest rates, lingering recession, surprisingly strong dollar, risks of sovereign bankruptcy, and capital markets around the world.

I predict you’ll believe my predictions

The year will be similarly eventful in our domestic capital markets

B. US capital markets: as the tall timber regrows, smaller timber falls

2009 was the year of TARP; 2010 will be the year post-TARP.

Defining the way forward

7. All the big TARP banks will recover

In 2008, seven big institutions took TARP: Merrill Lynch ($10b, subsequently bought by Bank of America), Goldman Sachs ($10b), Morgan Stanley ($10b), Bank of America ($15b plus Merrill), JPMorgan Chase ($25b), Wells Fargo ($25b), and Citi ($45b). 

The original September 2008 figures; Citi subsequently needed more

By year-end, all seven had repaid, motivated in part by the desire to escape the government’s restrictions on compensation.  [The New York Times has an interesting and lengthy Steven Brill article on the machinations of compensation-setting between the master and the TARP; I may yet post on it. – Ed.]

By now the TARP-recipient banks have been so pounded by regulators, Chief Risk Officers, new zealous auditors, and stock market analysts, that it’s hard to believe any more bad news could still be hidden within them.

All the bad news that’s fit to print

As we’ve seen in other posts, banks now are enjoying very nice spreads between their lending rates and the Fed’s artificially low funding rates.  As those healthy spreads continue in 2010, the major post-TARP banks ought to continue making money.  Further, if they can achieve recoveries on post-writedown assets greater than the new book value, they’ll have write ups to reverse some of their previous writedowns. 

No, the banking problems lie elsewhere, one level lower in the ecosystemic canopy.

8. In 2010, many regional banks will fail

In 2009, the major banks went through the wringer.  In 2010, it will be the turn of regional banks.

The canopy layer has already been TARPed; the regional banks are the understory

During 2009, regional and smaller banks were largely untouched by TARP.  Now they are facing their own waves of maturity defaults, covenant defaults, and payment defaults.  Extend-and-pretend is finally running out of time.

As shown in this MSNBC graphic [Interesting article as well – Ed.], the looming pain is regionally concentrated:

During 2010, there will be rolling smolder sales – not precisely fire sales, but a continuing outflow of income-producing real estate available, some of it being absorbed by private equity and the numerous distress funds jostling for institutional dollars.  For the selling institutions, fig leaves will be preferred, a portion of the sale dressed up in a slow-realization financial instrument for a portion of the price, but not so much as to bring into question the sale’s validity for FIN 46 (see The decade’s biggest invisible stories, Part 3). 

Failure of regional banks will mean a more regionalized recession, especially if bank failure is coupled with state or local insolvency (see Item 5 of yesterday’s post).

9. TALF will be revived

“Look, TALF is only mostly dead!”

Before TARP, Treasury initially proposed a financed-asset pool structure known as TALF – the Term Asset-backed securities Loan Facility – as a means of enabling banks and the government to auction your headaches, with the Fed providing most of the financing and the buyer taking most of the risk (as well as capturing most of the upside).

When first introduced (September, 2008), I thought TALF a good structure; when it was suddenly overtaken by TARP (”paying your rescuer“), I concurred in the move, because TALF requires a semi-orderly market and enough time for the buyers to evaluate the asset pools carefully, and in October 2008 the global financial markets were so close to hysteria there was no time for anything other than mad experimentation.

Things are different now.  TARP was about stabilizing banks, not resolving assets.  TALF is about resolving assets by shifting the risk/ control profile from a bank (or worse, the government) to private entrepreneurs who are expert in these asset classes [You shamelessly shilling? – Ed.].

And we’ll put our money where our mouth is

It’s already clear that FDIC and Treasury will have a busy 2010 taking over or brokering shotgun marriages of failing local and regional banks.  Out of that will emerge large portfolios of complex assets that will need individualized asset restructuring.  TALF and its offshoot PPIP (the Public-Private Investment Program) will be revived and deployed in moving these assets into the hands of people who can resolve them.

10. The GSEs will be frozen in time

Sixteen months ago – how time flies – Treasury seized control of Fannie Mae and Freddie Mac, placing both of them into conservatorship, a thing I thought impossible right up until the moment it happened.  (See The decade’s biggest invisible stories, Part 6.)

My shareholders won’t be happy about this

Since then the GSEs’ role and importance has only grown, to the point where it is equally unthinkable that we would remove their direct Federal underpinning any time soon.

Eventually each GSE will be bifurcated into a ‘good bank’ and a ‘bad bank,’ in a classic recapitalization strategy used for over five hundred years (Italy’s Monte dei Paschi di Siena).  Like a financial appendix, the bad bank becomes the repository for all the unresolved, hard-to-value, or questionable assets, leaving the good bank free to be privatized by having Federal support withdrawn.

However, separating into a good bank versus a bad bank should only occur when the problems’ full extent is known and the public markets will readily accept the newly independent good bank.  With the GSEs holding securities originated by all and sundry, it’ll be another year or two before those portfolios can be considered even minimally seasoned. 

In short, throughout 2010 the GSEs will remain in limbo, and as long as they are able to keep buying loans and providing liquidity, treasury motto will be it ain’t more broke, don’t fix it.

Safe as houses

11. The risk curve will widen and stay wide

Right now, global capital is scared.  Scared of lingering recession.  Scared of monetary policy.  Scared of sovereign insolvency.  Scared of the unknown future. 

I’ve got reason for being scared

When capital is scared, it ventures only a short ways from safety, which means safe nations, safe security types, safe asset classes, safe maturities – and always with a line of retreat, meaning a liquidity option.  Flight to higher-credit assets requires collateral, not counterparties, in view of the market’s loss of faith in ratings agencies and guarantors.  Every asset class will stratify, and for real estate assets, the stratification will occur by location, property quality, debt service coverage, sponsor.  Safer will be overly rewarded and riskier will be overly punished.  The gap between creditworthy haves and creditless have-nots will become more palpable and more painful.

The result is a steep yield curve and a steep risk curve.  You want to borrow money for a long period, secured by a repositioning asset, and with anything less than sterling credit?  Be prepared to pay up for it.

Is that loan proposal a joke?

It will be Ben Bernanke’s job to keep the yield curve smooth and relatively flat.  If he succeeds in calming investors’ fears about runaway inflation – for instance, by methodically raising interest rates to discourage deficit spending but not so much as to retard the recovery – then capital providers will be willing to put money out for longer maturities.

12. Financial and real estate service-sector consolidation will continue

All this financial pressure – and in particular, the widening risk curve – will continue the trend toward consolidation in both the financial sector and in real estate services.

The impetus for financial-sector consolidation is self-evident: the FDIC doesn’t want to own banks, nor does it want customers to be deprived of service.  So it will broker acquisitions, the larger and better-capitalized banks (like those that have recently repaid their TARP; see yesterday’s post) taking over the smaller bank’s balance sheet (both liabilities in terms of deposits and assets in terms of loans receivable), financed by loss-sharing arrangements from the FDIC or Fed.

Ecosystemically, this consolidation is probably a good thing.  In finance, the dematerialization of capital (see The decade’s biggest invisible stories, Part 2) has created a decades-long wind blowing banks toward greater scale (measured in money and customers) and greater electronic reach.  Banks were small and distributed throughout communities only when money was tangible (meaning it had to be stored in vaults) and lending was local (because credit information and capital could not flow vast distances).  Make the credit decision numerical and you make it electronic – which allows you to shrink your deposit-taking infrastructure to an ATM and a Web site, and redeploy the money saved into ever-more-sophisticated software and data management systems.

When you click the keys, where does your money go?

Similar pressures are acting, albeit with different consequences, in real estate service businesses.  In the thirty-plus years I’ve been in this business, not only has its pace steadily quickened, the overall sector professionalism has risen as well. Increasing specialization and sophistication mean that businesses now need bigger platforms to deliver market-leading results, and once they have those bigger platforms, they can span larger asset portfolios.  The truly national property management company is within sight.

Meanwhile, real estate service businesses will face fee pressure from their customers.  So they’ll continue to consolidate, with the more capable significantly increasing their market share.  Survival traits will be scale, service quality, systems and information technology, and people.  Businesses that impose hard ceilings on compensation will experience adverse selection of their people: the best will leave or be de-motivated and the organization’s quality premium will diminish.

So much for my motivation!

[Concluded tomorrow in Part 3.]

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