European Banking
I like Forbes magazine, and while I’ve only met Steve Forbes once, he’s seems to be a terrifically engaging fellow. That having been said, while he and I are probably not very far apart in our core political thinking, I DO disagree with him on many key points (gold standard being the top of the list). However, he wrote an excellent op-ed piece back in December about Angela Merkel and the actions/inactions which permeate European decision-making today. Recent events, particularly in Greece, suggest that Ms. Merkel may have read Mr. Forbes and followed suit. Nonetheless, I think some of Forbes conclusions may be ill-founded. (For a full copy of his article, click here.)
Forbes draws an analogy between the European actions of this past Fall with the draconian anti-inflation actions of the last days of the Weimar Republic during the great depression. Students of history may recall that those actions led to the fall of the German republic and the rise of Hitler. Forbes suggests that Merkel is frightened of the inflationary impacts of European central banks buying up Italian and Spanish bonds (thus pumping lots of Euros into the economy).
Forbes points out that banking is very different in Europe than in the U.S. He does not explicitly note — but seems to assume his readers would know — that Europe doesn’t have a system analogous to our Federal Reserve, but rather the major money-center banks serve that same purpose. (In practice, the European banks are joined at the hip with U.S. banks, and thus have an implicit liquidity guarantee from the U.S. Fed.) Forbes notes that liquidity is already strained in Europe, with U.S. money market funds having already withdrawn about $1 Trillion. In addition, European businesses look more to banks than bonds for raising long-term capital. In the U.S., industrial bank loans to nonfinancial corporations totals about $1.1 Trillion, while in Europe the corresponding number is about $6.4 Trillion. Contrast this with the bond market — in the U.S., corporate bonded debt is $4.8 Trillion, but only $1.2 Trillion in Europe. European banks are also the primary buyers of European government debt, while in the U.S. the banks are only one set of many sets of buyers.
I think where Forbes misses the point in his criticism is his failure to recognize that liquidity for this bond-buying spree would come not from a central source such as a Federal Reserve system but rather from German taxpayers. The Germans have bent over backwards already to bear the financial brunt of this crisis, mainly because they are apoplectic at the idea of the collapse of the Euro.
Forbes is also implicitly paying some homage to the Hamiltonian idea that a centralized, Federal Europe (which does not yet exist) could buy up bonds from member countries and issue a new “Euro Bond” which would take its place. The first U.S. Treasury Secretary came up with this idea for two reasons — first, the individual states were heavily in debt to pay for the Revolution, and second it would create a much stronger central government, which would issue a uniform currency and raise money through Federal taxes.
However, Europe of 2012 isn’t nearly as well organized as the U.S. of 1790 (amazing, but true). Plus, even if Angela and Nick (remember — Sarkozy gets a vote, too!) could wave Harry Potter’s wand and create a unified Federal Europe, the burden would still be borne disproportionately. Northern European countries (and even Northern Italy, which is more like Germany than pundits recognize) are quite healthy with the status quo. The peripheral countries (the “PIIGS” for short) are the principle problem right now. Back in the 1790’s, the debts of the various states were actually fairly well-distributed. (And yes, the irony of using Harry Potter as an example — a British wizard who still uses the Pound rather than the Euro — was on purpose.)
So, Forbes gets it half right. The model we now see in Greece may be the answer — a compromise on the bonds, with fiscal restraints borne by the countries that are in trouble. Will Europe ever see a Federal system with the same sort of fiscal and monetary controls we have here in the U.S.? Probably not for a long time. In the meantime, Angela has to play the cards she’s dealt, not the ones Forbes would like to imagine she has.
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Conerly’s Businomics Newsletter
I’ve mentioned before that one of my favorite economic writers, particularly for the Pacific Northwest, is Dr. Bill Conerly out of Lake Oswego, Oregon. Even though Greenfield’s practice is national, we have to maintain a bit of a Northwest focus to our work. Dr. Conerly helps us with the underlying economics driving the economy of this salmon habitat in which I live.
Dr. Conerly’s “charts” are wonderfully informal and informative at the same time. In the ‘old days’ he would simply hand-write his thoughts on the charts then fax them to his subscribers (remember “faxing”?). Today, of course, it’s all digitized and stored on his web site, with an emailed link. Nonetheless, the succinct hand-written notes are still there, and the brevity is welcomed. (I could learn from that.)
Rather than reproduce the charts here, I’ll simply give you a link (here) and you can go view them yourself. If you’d like to contact Dr. Conerly — he’s a great speaker and consultant on economic issues — then the e-mail address is bill@conerlyconsulting.com. A quick synopsis may whet your appetite:
- Business equipment orders are still not back to the pre-2008 peak.
- Consumer sentiment is up, but not back to 2007 levels
- A January, 2012, Wall Street Journal survey pegged the risk of recession at 19%
- Private non-residential construction has “turned the corner”, but is still significantly lower than 2007-2009 levels.
- Unemployment: great headlines, but we’re a very long way from feeling good.
- Mortgage rates are at all-time lows, but only if you have great credit.
- Stock market: lots of up-side if Europe manages to muddle through
- Oregon and Washington bankruptcy filings on the way down, but still over double the 2007 rates
- Boeing orders may be tapering off, but still significantly exceed deliveries — no need to cut output
- Wheat prices (an important economic component in our area) are downturning, due to the global slowdown.
Well, folks, that’s about it — great reading from a great analyst.
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A truly dumb idea
First, there is virtually NO chance that this idea will come to pass, thank goodness.
SOME pundits propose shutting down the Federal Reserve. I’m serious. Presidential candidate Ron Paul considers it a central tenet of his philosophy. He would put us back on a gold standard, which would mean that the government could only issue paper dollars if they were backed by gold holdings (i.e. — Ft. Knox), and would stand ready to buy gold at a stated price. One assumes that gold coins would also circulate, although at today’s rates, the smallest gold coin available today (1/10 oz) would be worth about $150. Hardly the sort of thing you’d use in a vending machine.
From an economists perspective, it’s impossible to imagine a 21st century nation — particularly one with the most complex economy in the world — to exist without a central bank. In the first decade of the 20th century, the U.S. suffered a tremendous depression, much of which was driven by bank liquidity problems (and thus bank failures). To address this, the U.S. Government established not one central bank but in fact a network of regional central banks, all of which would coordinate their activities via a central Federal Reserve Board. Members of the Federal Reserve Board are appointed by the President and confirmed by the Senate for 14-year terms, a period of time selected to make sure that no ONE political party or political philosophy would dominate. The members of this board, along with a rotating subset of the Presidents of the regional banks, form what is called the Federal Open Market Committee (FOMC).
The FED really only has two tools at its disposal. Taken together, these tools are called “monetary policy”. It can set the “Fed Funds Rate” which is the rate at which member banks can borrow money for short periods of time. Since member banks borrow (and pay back) constantly, this is an extraordinarily important base-line for interest rates. A rise in this rate would stimulate a rise in overall rates throughout the economy. Currently, this rate is about a half percent — nearly inconsequential. Clearly, the FED wants to keep rates low to stimulate the economy. A hint of inflation in the market would probably stimulate a rise in rates, to slow the economy down a bit and thus negatively impact inflation. The FED can also buy and sell government bonds, and in fact can force member banks to buy and sell bonds. Buying bonds from the banks puts money into the economy that these banks can lend. Recently, the FED has been buying long-term bonds and selling short-term, to “twist” the yield curve.
The Government also influences the economy through “fiscal” policy, exerted through the Treasury Department. Keynesians would hold that the government can stimulate the economy via deficit spending. In the current economic crisis, the Fiscal and Monetary roles heavily intersected, particularly in the TARP funding under President Bush, and continued under President Obama, which used the full faith and credit of the Treasury to prop up our failing banking system. The FED was an active participant in that process, and indeed (as shown in the movie), Fed Chair Bernake really sold this process to Congress. As expensive as it was, and despite the political ramifications, it is beyond belief that any thinking person would have allowed our banking system to collapse. A few banks dying was inevitable (e.g. — Lehman Brothers), but the entire system collapsing would have put the U.S. in an intractably difficult position, probably carrying the entire world’s economy with it.
As pointed out in a CNBC report by Mark Koba this morning (click here for a link), its noted that a gold standard would both put limits on growth as well as impose short-run volatility. The American economy would, at least for short periods, be held hostage to the whims of gold traders. Further, production of gold in the world is probably insufficient to sustain reasonable levels of growth.
In addition, removing a relatively independent FED from the scene would leave the Treasury Secretary in an intractably politicized position. The U.S. has had 75 Treasury Secretaries over the past 225 years, from Alexander Hamilton to Tim Geitner. (Also 6 “acting” secretaries who were never confirmed by the Senate.) Many — if not most — have been contentiously fought over. (The first Treasury Secretary, Hamilton, was shot in a duel. The second was run out of office after being accused of setting fire to the State Department building.) Given the current contentiousness that permeates Capitol Hill, the notion of subjecting the American economy to the vagaries of Congress every 3 years sounds like something out of a third-world country, much less the most important economy in the world.
Fortunately, this proposal hasn’t a ghost of a chance. Nonetheless, the inanity of it begs our attention.
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Marcus & Millichap’s Apartment Report
Of the major commercial real estate brokerage firms, Marcus and Millichap seem to consistently do the best job of thoughtful and insightful research. We track their work regularly here at Greenfield. Their 2012 Apartment Report just hit our desks, and it follows our expectations of excellent work on their part.
courtesy Marcus & Millichap
The apartment sector is rebounding nicely, but because of the intersection of favorable demographics and unfavorable economics. It’s driven by pent-up demand among “prime renters” (young adults who want to “unbundle” from parents and roommates) who would potentially have become homeowners a few years ago. Development had been stagnant for a few years, leaving the market with a potential shortage in supply. Developers, lenders, and investors had a brief pause late last year, but M&M expects to see steady additions to supply over the next three years.
courtesy Marcus & Millichap
As a result of all of this, vacancy rates are trending downward, and are expected to hit 5% this year (down from a peak of about 8% in 2009). This has the effect of driving up rents to historically high levels, even after a net decline from 2008 to 2009. With all this, apartment transactions are back up to pre-2009 levels, while the average price per unit is now topping $90,000 (up nearly to the peak of 2006) and cap rates are down in the 6.5% range (still off the trough of about 5.5% seen in the 2006-2006 period).
- courtesy Marcus & Millichap
The surprising upshot of all of this is that apartment cap rates are still at record high spreads over the 10-year Treasury long-term average. Market participants got nervous back in the 2006 period, when the spread had shrunk to 90 basis points (from a more “normal” rage of 380 to 430 basis points experienced since the S&L crisis 15 years earlier). Today, the spread is at 460 basis points, reflecting a bit of continued risk-aversion on the part of market participants, along with historic low rates on treasuries.
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Yet another comment about today’s economic news
It’s hard NOT to be pleased at today’s economic news. The unemployment rate is down, total employment is up (the two numbers don’t ALWAYS move in sync, due to the growth in the potential workforce), the stock market is up, the dollar is up versus the Euro, Yen, and Pound (not always a good thing), and bond yields are up (reflecting a potential demand for borrowing — a very “old school” view of stocks versus bonds). Intriguingly, oil is up but only by $0.59 a barrel as of this writing (12:35am EST on Friday the 3rd) — one would normally expect that great economic news would spur a run on oil.
Which may, in fact, reflect the continued anxiety in the marketplace. Recessions rarely happen in a straight line (see my post a few weeks ago on the relationship between the yield curve and the onset of a recession — click here for a shortcut). Real estate continues to be in disarray, and the banking sector is still in rehab, with the continued concern of a relapse if the Euro crisis doesn’t solve itself.
Ben Bernake’s testimony before the House Budget Committee this week was painful to watch — members of Congress would prefer to listen to themselves rather than the Chair of the Fed, and it was clear that members of that august committee had only a cursory understanding of what the FED actually DOES. Nonetheless, a piece of Bernake’s testimony had the tone of Armageddon. He noted that we’re on our way to addressing the CURRENT problems — the huge deficit overhang, the Euro crisis, etc. Congress still has ample work to do in those areas, but we are at least confronting the issues. The larger problem, in his mind, is what start happening in about 10 years or so when the demographic overhang starts hitting. The rapid shrinkage in the number of people PAYING into social security and medicare versus the number of people COLLECTING these transfer payments will be substantial, and this doesn’t even begin to address the productivity problems associated with a society in which a substantial number of people are retired and not contributing to the nation’s output.
Sigh…. at least it looks great today, right?
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Proposals for fixing housing
John K. McIlwain is the Senior Resident Fellow/J. Ronald Terwilliger Chair for Housing at the Urban Land Institute (ULI) in Washington, D.C. I don’t necessarily agree with everything he says, but he stimulates some interesting thinking in a piece this week titled “Fixing the Housing Markets: Three Proposals“. (click on the title to link to the article itself.)
In summary, he proposes:
1. Renting federally held REO
2. Creating a mortgage interest credit
3. Divide mortgages for underwater homeowners into a “paying” first and a “delayed” second.
He admits that in the current political climate, none of the above stands a ghost of a chance (nor would any other solution, good or bad), but even though I might disagree with some of what he says, I’m a firm believer in the old In Search of Excellence adage: ready, shoot, aim. Really excellent organizations (and government entities — which are rarely even CLOSE to achieving excellence) have a proclivity for doing SOMETHING. The Marine Corps calls it the “70% solution”, which dictates that you attack as soon as you think you have 70% of the information needed for success. Why not 100%? Because fate favors the side with the initiative and momentum, that’s why.
So, please indulge me for a moment to comment on McIlwain’s proposals, but DON’T take my criticism as an indication that I wouldn’t vote in favor of doing exactly what he proposes, because in the current climate, a half-good idea is probably better than no idea at all.
1. Rent federally held REO — Well, even McIlwain admits (or at least implies) that the government is a terrible landlord, so he would propose turning this over to the private sector via pools of “privatized” REOs. What he’s essentially saying is to sell these REO’s (currently about 250,000, and expected to grow to a million) to investors with the caveats that they be held off the market as rentals for a period of time, AND that there be adequate maintenance to keep them from turning into slums.
My ONE disagreement with this is that less government involvement is usually better than MORE. Plenty of investors stand ready to buy REOs right now, and the resale market is sufficiently poor that these investors recognize they have to be in it for the long haul. Local planning ordinances are usually adequate vis-a-vis slum prevention IF they are enforced properly (as is not always the case). There is no reason to believe that additional Federal caveats would improve the situation. In short, this is actually being accomplished already, and deserves facilitation by the government, not regulation.
2. Mortgage interest credit — McIlwain notes, and we concur, that the current mortgage interest deduction benefits taxpayers earning over $100,000, but hardly those earning less. He suggests replacing this with a flat 15% tax credit, which would have the double-barrelled effect of raising the effective tax rate on those earning over the 15% marginal break-point, but directly benefitting dollar-for-dollar those below that break point. It’s an intriguing idea, but would require the Realtors’ and Mortgage Bankers’ buy-in. In today’s troubled market, it’s difficult to see how they would agree to anything that tinkers with the status quo.
3. Divide mortgages for underwater homeowners into a “paying” first and a “delayed” second. As much as I like this one on the surface, it ONLY works for homeowners who plan to stay in their houses until prices rise (on average) about 20%. We don’t see that happening for quite a few years, so this essentially just kicks the can down the road a bit. Even that, though, is an improvement over the status quo, and keeps homeowners in their homes for the time being. The real problem, of course, is how to deal with the “delayed” paper on banks books.
In short, McIlwain’s proposals at least stimulate some conversation about solutions for the terrific vacant REO problem. One big issue is lack of credit for suitable property managers — banks are loathe to loan on “second” homes today, and investment property (REOs turned into rental homes) is a troublesome loan to get. I would propose that the agencies/banks holding paper on vacant homes simply privatize it immediately — if a bank holds a $100,000 loan on a vacant house, then a reasonably creditworthy investor who is willing to start amortizing that loan should be able to walk in, pick up the keys, and walk out the door. Sure, this would violate all sorts of down-payment caveats in place right now, but it would get interest payments moving again, provide much-needed rental housing, and get some local entrepreneurs busy managing otherwise dead assets.
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S&P Case Shiller Index
There are two important house price indices in the U.S. — the Federal Housing Finance Authority index (which can be localized down to the SMSA level) and the S&P Case Shiller Index. The latter actually pre-dates the former, and was the source of data for co-founder Robert Shiller (yes, the Nobel Laureate) making his “housing bubble” cries in the wilderness a half-decade ago. If for no other reason, we pay homage to this report, which hit our desks this morning. Additionally, the FHFA index and the C-S index measure house prices somewhat differently, so at a localized level the two indices may say somewhat different things. Here at Greenfield, we often have to cobble together an index for a market that is smaller than an SMSA. Using these two indices in tandem, a researcher is able to discern more subtle issues in a local market. Hence, keeping up with house prices really requires both rather than one or the other.
Bottom line? For the most recent analysis period (October-November, 2011), both their 10-city and 20-city composites showed price declines of 1.3%, and for the second consecutive month, 19 of the 20 cities tracked showed declines. Further, the 10-city and 20-city indices showed annual returns of negative 3.6% and negative 3.7% respectively. Worst city? Atlanta, with a negative 11.8% annual return. The only two cities with positive annual returns were Detroit (+3.8%) and Washington, DC (+0.5%).
Our own research here at Greenfield suggests that the current “bottom fishing” on house prices will probably sustain until there is some equilibrium in the home ownership rates. One might argue that the stagnation in house prices is indelibly linked to over-supply (the “shadow” inventory in the U.S. equals about a year and a half of sales) and the lack of demand (which is tied to the unemployment rate). Nonetheless, thirty years ago, when interest rates were double what they are today, and the unemployment rate in the U.S. was about the same, home prices were strong and stable.
Why is today different? Three things — first, the home price bubble was caused by the home ownership rate bubble. Until home ownership rates get back to a sustainable level, home prices won’t start behaving. (What is behaving, you might ask? Historically, before the bubble, home prices track very nicely against household income, which means they’re a great inflation hedge.) Second, the recent collapse in home prices has taken the bloom off the rose, so to speak, as American households have lost faith in the “home” as a store-house of value. Finally, the low-down-payment loan was one of the most notable victims of the housing collapse (unfairly, we might add). As such, “starter” home sales are moribund (just look at new home sales for the clue to this one) and if “starter” homes can’t be sold, then “move up” homes can’t be bought.
I hate to be the bearer of bad tidings on a cold, winter day. (Irony — the northwestern U.S., where I live, is the ONLY part of the country not facing unseasonably warm weather this winter.) Unfortunately, housing is just going to limp along for a while.
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Global R.E. Perspective
The Royal Institution of Chartered Surveyors (RICS, for short), with over 100,000 members throughout the world, is the largest real estate organization of its type. Their quarterly Global Property Survey gives a great snap-shot into the world-wide investment market. (Full disclosure — I’m a Fellow of the RICS Faculty of Valuation, and a contributor to this survey.)
The headline really captures the big picture — Weaker economic picture takes its toll on real estate sentiment. Not every region feels the same pain — Canada, Brazil, Russia, China, and others continue to buck the trend and record positive net balance readings. Nonetheless, in some of the most economically significant regions, at least from an investment perspective, expectations continue to be weak. Obvious problem areas are the troubled spots in the Euro zone, but negative expectations are also reported in the U.S., India, Singapore, the U.K., Scandinavia, and Switzerland (among others). However, despite a weak real estate market, investment demand is expected to grow in the U.S. and even in the Republic of Ireland, which is one of the Euro trouble-spots. China, despite value-growth expectations, is among the weakest regions of those expecting positive investment growth, behind South Africa in total investment expectations.
One of the more telling studies compares expectations of demand for commercial space and expectations of available space. Among major markets, only Canada, Poland, Russia, and Hong Kong expect meaningful decreases in supply coupled with increases in demand. Not unexpectedly, most of the trouble-spots reflect increases in supply significantly outstripping increases in demand, with the most notable gaps expected in the UAE, the Euro trouble spots (plus, interestingly, the Netherlands, France, Scandinavia, and Switzerland), India, and the U.K. Expectations for the U.S., China, Brazil, Hungary, Japan, and Thailand all appear healthy, with increases in demand expected to exceed increases in supply.
The survey is available on the RICS website, which you can access by clicking here.
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The death of defined benefit plans
Actually, this is old news. It’s fairly well accepted now that, at least here in the U.S. and in the U.K., the only jobs with defined benefit retirement plans (or nearly so) are in the public sector — government employees, military, and the like. There are a few union-specified plans still out there, but given the dearth of union-members outside government service, these are waning away, as well.
For the uninitiated, employer-funded retirement plans basically fall into two categories (separate and apart from individual retirement plans, or IRAs): defined benefit and defined contribution. In the former (DB), the employment agreement includes a provision that after a certain date (say, 30 years of employment), the employee may retire with a lifetime of pay equal to some percentage of, say, the last year’s salary, or the average of the last five years, or something like that. In a defined contribution (DC) plan, the company agrees to make annual contributions toward a retirement plan via some formula, and upon retirement, the employee will receive whatever is there. The 401-K is the most popular type of DC plan here in the U.S.
This topic came to my attention due to an article in Institutional Investor a few days ago titled “Shell Is Last FTSE 100 Company to Close DB Plan.” We have to remind ourselves that Shell isn’t an American company, but rather a decidedly European one, (“Royal Dutch Shell”), headquartered in The Hague but registered in London with 101,000 employees world-wide. This is confusing sometimes, because Shell-US has a headquarters in Houston and employs 22,000 here in America.
But, back to the subject at hand. Shell just announced that it will accept no further new members into its DB plan, becoming the last FTSE company to do so. Thus, in the U.K. at least, the DB plans are no more.
The economic implications of this are fascinating, and can only be viewed in longer-term perspectives. Post WW-II saw the emergence of a wide-spread middle-class in the developed world, and much of this was linked to job-loyalty. Much of that job-loyalty stemmed from the idea that if a person worked for a particular firm for an entire career, that person would be “set for life”. Of course, stock market hems-and-haws coupled with rapidly changing demographics and mergers/dissolutions of old, well-established names cast significant doubt on the ability of most of these 30-year horizons to actually come to fruition. Nonetheless, that was part of the American (and elsewhere) post WW-II middle-class dream.
With the dissolution of DB plans, everyone is more-or-less on his or her own. A well-managed and well-funded 401-K, coupled with a near-religious funding of an IRA can do pretty much the same thing as a DB plan, although it requires a substantial degree of discipline, financial acumen, and planning on the individual’s part. Sadly, we have to remember that exactly half the people in any society are below average. Hence, cradle-to-grave self discipline, while it sounds like fun in a Ron Paul speech, none-the-less has serious societal implications when put to the test.
I’m on the Board of one of those “dissolved” DB plans that isn’t taking any more new members. Actuarily, it’s a royal pain in the neck. No “new” money is coming in for new employees, but the old employee’s aren’t fully funded yet and the stock market sufferings, coupled with demographic shifts, has turned all of us on the board into actuaries cum soothsayers. Fortunately, the sponsor organization has the resources to fix any unfunded problems, but I’m sure there are plenty of other DB plans out there with funding issues. Indeed, plenty has been written in recent months about very real shortfalls in public (state and municipal) DB plans.
As our population gets older, this shift from DB to DC plans will get more interesting. Recall that the Chinese have a curse, “May you live in interesting times.”
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Korpacz Survey
The quarterly PriceWaterhouse Cooper’s real estate survey is now known as the PWC Real Estate Investor Survey. However, those of us who have used and trusted it for so many years will always think of it as the Korpacz Survey, named after its founder Peter Korpacz, MAI, and former active member of the Real Estate Counseling Group of America. The latest issue (4th Quarter, 2012) just hit my desk, and as always, it’s a great snap-shot into the current thinking of real estate investors in the U.S.
The headline pretty much says it all, “Buying beyond core remains tricky.” The principle problem is the protracted recovery. Investors are still attracted to core assets for the yield, but are skittish on anything not bought for income. Particularly favored are community shopping centers with grocery anchors, apartments, offices in tech centers, and port-oriented industrial.
However, a growing number of investors are looking at secondary markets, but expecting returns that are a “multiple of core deals.” Part of the challenge here is bank underwriting standards, which can really hinge on the finer points of a deal.
Among investment sub-sectors, cap rates have declined across the board this past quarter, with the exception of warehouse (+4) and flex/R&D (+3). The most notable decline was in the net lease sub-sector (-54 points). Apartments continue to “lead” with the lowest overall cap rate of 5.8% (down another 18 basis points from the previous survey).
Not withstanding my comments about the the survey’s founder, Susan Smith, the Director of Real Estate Business Advisory Services at PwC, does a great job putting this survey together every quarter. The quality and quantity of information continues to grow, and its usefulness to real estate decision makers cannot be over-stressed. For more information, or to subscribe to the survey, visit pwc.com.
From a small northwestern observatory... 