Sunday, 14 June 2009 00:00

Reggie Middleton's Take on Investing for Inflation, pt. 4

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One of my blog subscribers asked me, "So does this (inflation correlated returns - see Reggie's take on investing for inflation parts 1, 2 and 3 for the background to this article) alter your thesis on your commercial real estate companies that you have been bearish on?"

Not as of now. Currently, I see us as in a highly deflationary period, with real asset values dropping through the floor. Commercial, retail and residential properties are still apparently in a free fall, cushioned somewhat by massive global stimulus which has taken some effect. It appears as if small private company EBITDA is on the rise which is massively bullish. If taken in a vacuum then this is a telling sign, unfortunately we don't live in a vacuum.

For one EBITDA is an investment banker's concoction to allow them to ignore


a dearth of real profits in order to get clients to focus on pure operating profits.  If a banker can show EBITDA going up, then he can charge more for the deal. Unsuspecting clients have gone for this in the past, totally ignoring the fact that in some situations you can pack leverage and gearing into a company and drive EBITDA through the roof while at the same time driving the company into the ground. We will probably see a lot of examples of this as those leverage loans start to cause marginal companies to collapse, en masse. Hey, the deals looked good 4 years ago, with strong EBITDA, after all it is Earnings Before Interest, Taxes, Depreciation and Amortization - or to put it in laymen's terms, the money I make without paying out too much of the money that I owe!

If we were to switch to a highly inflationary period then I may have to revisit the thesis on commercial real estate, but as I said in the first paragraph, we are not there now. If I had to take a wild guess on where we would end up mid-term, I would gander a stagflationary environment. I haven't researched these assets in a stagflation environment in detail, but I do know as an ex-landlord that it is difficult to raise rents on tenants that are not working or whose businesses are floundering.

I can see significant progress from the government and the Fed's massive actions fiscal and monetary actions, but the problem is that it is very short term and transitory in nature, and more importantly they addressed the symptoms of the situation and not the root problem. Remember, the subprime loans started imploding when we had historically low interest rates, historically low unemployment, and economy that was humming along using 9 cylinders of an 8 cylinder engine. If these poorly underwritten and overleveraged assets can cause such destruction and mayhem in such a (apparently, and superficially) strong economic environment, what do you think happens when their cousins (resetting and recasting Alt-A, credit cards, leveraged loans, machinery leases, commercial  and CRE loans) start to rollover in the next two years in the weakest economic environment since the Great Depression? After all, the media seriously erred in calling this a subprime crisis in 2007. It as an asset securitization crisis, borne from poorly underwritten loans through the OPM analysis method (don't worry about repayment, we're lending Other People's Money).

Even if the government is able to get us back to the level that we were at in 2005 (which ain't gonna happen, for we are all deleveraging now), we are most likely going to have the same shock as that brought upon us by the subprime impetus, simply along a more diverse line of asset categories. This could have been avoided by addressing these poorly underwritten assets in the first place, but in order to do that, you will definitely have to declare some darling brand name companies and institutions insolvent, and it appears some just don't have the guts to do it. To a certain extent, the market did it for us and if you are fundamentally inclined, and objective, it was not very hard at all to see coming:

As you can see, I named the failure of all of these institutions months in advance. It was not a crystal ball, it was not luck, and it was not divine intelligence. It was an objective, educated and independent glance at their balance sheet in the, then, current macroeconomic environment. Despite a quarter that went against me (nobody's perfect), I still feel I have a firm grasp of what is going on and I must say that the root cause of many of these failures are still there. There surviving brethren have survived on global governmental life support, but the disease is still in the body .  

A perfect example of this is the banking system. A framework was created to mark the poorly underwritten assets to market and create a funding mechanism to allow for the purchase of these bad assets from the banks, probably rending them insolvent in the process (actually, to be more accurate, declaring them insolvent because if you're insolvent, then you're insolvent) - and lay a groundwork of government and taxpayer capital to fill in the holes and gaps left from the universal "marking to market". This plan had its weaknesses and its problems, but it was the best thing thus far.

 Instead, the government, the banks and the popular media seem to have worked together in a massive propaganda program to raise the outlook on said institutions, coordinate in masking their problems (by weakening GAAP reporting requirement through FASB (banks no longer have to tell the truth, and most retail and institutional investors have a memory of about a single fiscal quarter), and replacing the government preferred equity investments that were (prudently, it appears) forced upon them with private investor's (and not necessarily the brightest one's) capital. Now, tell me, doesn't this basically leave us where we started from, sans having banks at about 3x the valuation they were at last quarter?

The only difference is that private money has taken the place of government money, roughly dollar for dollar, in terms of propping up banks who:

  • Are the ones who's management teams dug the hole for themselves in the first place
  • Said they didn't need capital, then started taking massive unrealized and realized capital losses
  • Main profit engines, asset securitization, practically no longer exists
  • Despite the fact that they profess they didn't need extra capital, cannot even repay some of the government loans, and this is with the assistance of private capital flooding in.

The last point is quite telling. During this most recent bank rally (which I saw coming almost to the day it happened, but significantly underestimated its breadth and depth), I observed:

The CEO of Bank of America wondering why investors were bidding up his stock past $13 per share when he announced he was pricing a secondary offering at $12 (what!!!)

The CEOs of most industrial entities are telling us that they don't see the optimism that the investment markets are seeing. What??? The company operators don't see it and they are in the front lines, while the guys that sit in front of computers screens looking at stocks are able to see it infinitely more clearly?

The CEO Wells Fargo calling the stress tests asinine, and stating that in way, form or fashion does his company need the "excess" capital offered by the government. Okay, but when it is time to pay that capital back, they can't afford to do it. What gives??? It appears as if you needed it to me. As a matter of fact, of all of the big banks, nearly none of them could afford to repay the government's money immediately if called upon (that's right, even if the government didn't impose the ability to raise private capital in its stead) because all of these banks were taking advantage of trillions of other government s subsidies that literally dwarfed the few dozen billion that were the TARP funds injected into banks. What were to happen if the government snatched back ALL of the guarantees, expedited bank charters, liquidity programs, subpar collateral acceptance programs, and the alphabet soup that was the Treasury's assistance plan? To state that the banking system is healthy because progress is seen after $12 trillion dollars or so of assistance is a farce, at best. Is the banking product over the last year $12 trillion itself? The US and UK government's have essentially purchased their respective banking systems and some are trying to call the episode of collapse to be over and behind us. What happens when we attempt to allow capitalism to take over again?

Well, I digress into a spiraling rant, so back to the point. Until the poorly underwritten loans are fully marked to market and or removed from the bank's balance sheet, we will continue to have a significant overhang of low productivity - ala Japan in the 1980's. Remember, and for those who didn't know, there is only one single banking name that survived that period intact (out of nearly all of the major banks), and that is despite the massive amount of government effort to prop up the nation's banks. This lesson needs to be learned instead of the error being repeated. It took a decade for it to happen, but nearly all of the banks eventually failed due to a lack of flushing out the system. The US system has not been flushed, it has been partially packed with taxpayer capital, which has in turned been partially repacked with private investor capital, but the bad stuff is exactly where it was when all of this began, and the underlying fundamentals that are causing these assets to devalue is actually getting much worse, much faster.

So, do I see inflation occurring without economic stagnation? Not in the near to medium term. Will it occur as stagflation? That will be the only way it occurs unless the banking problem is rectified, in my so humble and (un)academic opinion. How does this effect CRE? I will entertain this discussion in the private forums for subscribers.  What I will say out here on the open blog, is that since many CRE and residential companies have significantly overpaid for properties over the last 7 or so years, if the prudent investor can cherry pick from these assets at fire sale prices you will be very, very well positioned to weather the storms ahead, come inflation, stagflation or deflation. Gone are the days of instant capital appreciation investing - BoomBustBloggers should now be heralding and embracing the old school, cash flow is KING!

The Asset Securitization Crisis Analysis road-map to date:

  1.   Intro: The great housing bull run - creation of asset bubble, Declining lending standards, lax underwriting activities increased the bubble - A comparison with the same during the S&L crisis
  2.   Securitization - dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble - declining home prices and rising foreclosure
  3.   Counterparty risk analyses - counter-party failure will open up another Pandora's box (must read for anyone who is not a CDS specialist)
  4.   The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue 
  5.    Municipal bond market and the securitization crisis - part I
  6.    Municipal bond market and the securitization crisis - part 2 (should be read by whoever is not a muni expert - this newsbyte may be worth reading as well)
  7.    An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
  8.    Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
  9.   More on the banking backdrop, we've never had so many loans!
  10.   As I see it, these 32 banks and thrifts are in deep doo-doo!
  11.   A little more on HELOCs, 2nd lien loans and rose colored glasses
  12.   Will Countywide cause the next shoe to drop?
  13.   Capital, Leverage and Loss in the Banking System
  14.   Doo-Doo bank drill down, part 1 - Wells Fargo
  15.   Doo-Doo Bank 32 drill down: Part 2 - Popular
  16.    Doo-Doo Bank 32 drill down: Part 3 - SunTrust Bank
  17.   The Anatomy of a Sick Bank!
  18.   Doo Doo Bank 32 Drill Down 1.5: Wells Fargo Bank
  19.   GE: The Uber Bank???
  20.   Sun Trust Forensic Analysis
  21.   Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street
  22.   Goldman Sachs Forensic Analysis
  23.   American Express: When the best of the best start with the shenanigans, what does that mean for the rest..
  24.   Part one of three of my opinion of HSBC and the macro factors affecting it
  25.   The Big Bank Bust
  26. Continued Deterioration in Global Lending, Government Intervention in Free Markets
  27. The Butterfly is released!
  28. Global Recession - an economic reality
  29. The banking backdrop for 2009

And in ending, an interesting article to read in your spare time:

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Reggie Middleton

Resident Contrarian Badass at BoomBustBlog (you can call me Editor-in-Chief)...

Disruptor-in-Chief at, where we're ushering the P2P Economy.