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The Daily Reckoning Thursday, February 11, 2010 Markets dally while the next real estate tsunami gathers energy, The real cost of Greek ruins...from a different perspective, Plus, Bill Bonner on human nature and the snow blowers in DC... Eric Fry, reporting from the Golden State with the tarnished finances... Let’s begin today’s edition with a riddle: What location in the world is famous for its sun-drenched beaches, azure seas, arid Mediterranean climate, rugged coastlines, olive trees, earthquakes, smoggy cities, hedonistic mythology, dismal government finances and well-preserved antiquities? That’s right, California. If you answered “Greece”, you did not read the riddle carefully. The antiquities of Newport Beach are far better preserved than anything you could find in Athens. Furthermore, Greece’s government finances are not merely “dismal,” they are horrific. California is facing a budget deficit this year of about $40 billion, which is roughly equivalent to 2% of the state’s $2 trillion economy (GSP). That’s dismal. But over on the Mediterranean, Greece’s budget deficit is on track to hit $50 billion, which is a very big number for an economy that is one fifth the size of California’s. In fact, that’s a horrific number. What’s more, Greece’s accumulated debt totals $443 billion – a whopping 113% of GDP. Neither California nor Greece can print their own currencies, of course. So both of these borrowers must rely on traditional remedies, like cost-cutting and bailouts...or just bailouts. This is where the chart below comes into play. It tracks the pricing of credit default swaps (CDS) on 5-year bonds from California and Greece. [Simply stated, a CDS is an insurance policy against default. The higher the CDS price, the higher the cost of the insurance. At the moment, the price of a 5- year Greek CDS is about 375 basis points, meaning it would cost about $375,000 to ensure $10 million worth of Greek government bonds for five years]. For most of the last 15 months, CDS investors have been assigning a higher probability to a California default than to a Greek default. About a month ago, however, investors changed their minds...but not by much. At yesterday’s quotes of 375 bps for the Greek CDS and 325 bps for the California one, the pricing differential between the two is little more than a rounding error. So what do these CDS prices imply? Are the finances of California and Greece merely the twin sons of different mothers? Probably not. The sky-high prices of California CDS may have more do with the state’s sky-high profile than its large deficits. According to yesterday’s CDS prices, for example, California (and Greece) were both riskier credits than El Salvador, Bulgaria, Lebanon or Kazakhstan. Heck, they were riskier than New Jersey. Greece might belong in this company. California probably does not. Net-net, the surprising similarity between California and Greek CDS prices probably says more about their respective prospects of a bailout than about their underlying finances. California’s finances are poor, but so far the federal government has refrained from offering assistance. Greece’s finances are abysmal, but the nations at the core of the European Union are rushing to help. So what’s all the fuss about? Why would France, for example, worry about saving Greece? The answer may be that France doesn’t care about Greece at all. But France does care about France. As it turns out, French banks are sitting on $75 billion worth of loans to Greece. Even more troubling, French banks are sitting on another $775 billion worth of loans to the other “Club O’ Med” countries (Portugal, Spain, Ireland, and Italy) that reside on the fringes of EU viability. Therefore, as London’s Daily Telegraph observes, “Germany [and France] face a Hobson’s Choice: if loan guarantees for Greece turn into a slippery slope towards implicit support for the whole of the ‘Club O’ Med’ (Portugal, Spain, Ireland, and Italy), EU creditors could be tainted by contingent liabilities worth trillions. Yet failure to reach a deal risks a sovereign version of the Lehman crisis.” No wonder then that Germany and France are diving into the water to rescue the drowning Greeks. But did you ever see how a drowning man treats a lifeguard? The lifeguard dives into the water and speeds toward the drowning man. Once the lifeguard arrives, however, the drowning man, in an effort to keep his own head above water, grabs hold of the lifeguard and plunges him under the water. The lifeguards in Europe may be slipping under the waves already. During the brief period of time that the French and Germans have contemplated a Greek rescue package, the perceived risk of a French government default has more than doubled, according to CDS pricing. At the same time, 10-year French and German bond yields have both jumped about 15 basis points. Your California editor has no idea how the Greek crisis will unfold. Nor does he have any idea how his beloved state will make it from paycheck to paycheck, or what lifeline Governor Schwarzenegger will attempt to latch to the state’s budget. But your editor suspects that every lifeline in the water – whether it is latched to California or Greece or AIG or Portugal or Goldman Sachs – is secured on the other end by a tragically flawed economic theory and/or a printing press. So if you are a nimble investor, go ahead and try to trade off the bailout headlines. But if you aren’t, buy a little gold. And whatever you do, avoid long-term government bonds – our Daily Reckoning short- sale of the decade! The Daily Reckoning PRESENTS: For most people, “less bad” somehow equals “good.” Be it in test scores, economic data or slightly better than failed marriages...anything superior to total catastrophe is considered by many a triumph. That’s how most people interpret the abysmal housing data, too. It’s “less bad” than in 2007...so it must be good, right? Wrong. In today’s issue, guest essayist, David Galland, gets the inside scoop on how “less bad” in the real estate sector is quickly becoming “more bad...much more bad.” Enjoy... An Insider’s View of the Real Estate Train Wreck By David Galland, The Casey Report The first time I spoke with real estate entrepreneur Andy Miller was in late 2007, when I asked him to serve on the faculty of a Casey Research Summit. And there was no one in the nation I wanted more than Andy to address the critical topic of real estate. My interest in Andy was due to the fact that he has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects – such as shopping centers, apartment communities, office buildings, and warehouses – from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming. Back in 2007, however, what most intrigued me about Andy was that he had been almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people who think they know what’s going on, and those who actually know – Andy very much belongs in the latter category. In fact, he initially refused to speak at our event, only agreeing very reluctantly after I had hounded him for several months. The reason for his refusal, I later found out, was that he had spoken at several industry events before the real estate collapse and had been all but booed off the stage for his dire outlook. So far, Andy’s real estate forecasts continue to come true. As you’ll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation’s biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate. GALLAND: No one has been more right on the housing market in recent years. So, what’s coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well? MILLER: I don’t think so. For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the US were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA. If it’s true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn’t help a homeowner whose property is worth less than the mortgage. So when the supply of government- facilitated loans dries up, it’s going to put the home market in a very, very bad place. Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper. The public doesn’t have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It’s huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can’t get people to focus on it, and it’s very esoteric, it’s very hard to understand. But it’s not something the bond market won’t notice. The government can’t keep doing what it has been doing to support mortgage lending without pushing interest rates way up. Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that’s exactly where they’re headed. So anyone who’s comforted by current statistics on single- family homes should look beyond the data and into the dynamics of the market. What they’ll find is very alarming. GALLAND: On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money. MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the US Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that it was going to remove all the caps on the agencies. GALLAND: So what about commercial real estate? MILLER: When I saw what was happening in the housing market, I liquidated all my multi-family apartments, shopping centers, and office buildings. I liquidated all my loan portfolios, and I’m happy I did. It occurred to me in 2005 and 2006 that the commercial world had to follow suit. Why? Because it’s a normal progression. Obviously, when single-family homes decline in value, multi-family apartments decline in value. And when consumers hit the wall with spending and debt, that’s going to have an impact on retailers that pay for commercial space. Furthermore, the financing for retail properties had gotten ludicrous. The conduits were making loans that they advertised as 80% of property value when they originated them, but in reality the loan-to-value ratios were well over 100%. And I say that to you with absolute, categorical certainty, because I was a seller and nobody knew the value of the properties that I was selling better than I did. I had operated some of them for 20 years, so I knew exactly what they were bringing in. I knew what the operating expenses were, and I knew what the cap rates were. And, you know, the underwriting on the loan side and the purchasing side of these assets was completely insane. It was ludicrous. It did not reflect at all what the conduits thought they were doing. They were valuing the properties way too aggressively. I became very bearish about the commercial business starting in late ‘05. GALLAND: Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash? MILLER: I think the first thing that changed was that people learned that prices don’t go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don’t think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate. But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in Fantasyland for 10 years. And that was the first change – a mental adjustment from Alice in Wonderland to reality. Today it’s clear that commercial properties are not performing and that values have gone down, although I’ve got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is. To be continued... David Galland, for The Daily Reckoning --------------------------------------------------------------- And now to Bill who has today’s reckoning from Bethesda, Maryland... Not much action in the financial markets yesterday. The Dow fell 20 points...completely inconclusive. We don’t know whether the final stage has begun or not. We think it has...but we’re not sure. The big action was in the bond market, where the US government tied its all-time record by borrowing $25 billion worth of 10-year notes. All in all, the sale went well...but yields rose slightly...to 3.69%. At some point, bond yields will rise decisively to the upside. But whether that has begun or not...we don’t know yet. Ben Bernanke says he will raise the discount rate “before long.” The inflation numbers are coming in higher than expected. At some point, Mr. Bernanke will have to raise rates to stop inflation. But we suspect that that will not happen any time soon. We have a depression to live through first. But we strongly suspect that Mr. Bernanke has no idea what he is doing. In short, we don’t know what will happen or when it will happen. But we’re pretty sure that Mr. Bernanke understands even less than we do. (For reasons we elaborate below...) Still, we’re counting on him to guide us. We just watch what he does...and listen to what he says...and head in the opposite direction! In the meantime, we are snowed in tight...at least three feet of snow is outside our door. Washington went from panic to desperation yesterday. The snow came down lightly...but then the wind whipped it up. Local officials ceased road clearing operations when it became ‘too dangerous’ for them to operate. They couldn’t see where they were going or what they were doing. Local motorists were told to get off the road. This seemed unnecessary, from our point of view, since it was impossible to get on the road...or even to tell where the road was. Still, we were warned to stay off so that emergency vehicles could get by. Wind gusts up to 60 mph were reported. Power went out for thousands of homes. Then, the power company stopped trying to fix the downed wires. They judged it too dangerous to continue working. Then, the police too, announced that they could not respond to calls. They might as well have sent out an invitation to criminals: Rob a liquor store; please. Fortunately, the miscreants were holed up too. Nobody wanted to go out. And those that did risked their lives...at least, that was how the authorities made it sound: “If your car is stuck, remain in your vehicle. Do not attempt to walk to safety. You may become disoriented by the white-out conditions.” They were afraid you would fall into a snow bank. Then, when the giant snow-blower came through, your frozen body might damage the machine. And so the nation’s capital and surrounding suburbs went quiet. No one moved. No one went to work...because there was no work to go to. No one went shopping because there were no shops open. Schools were closed. Edward – who escaped to a friend’s house before the snow began – has the whole week off. This winter is setting records in the Mid-Atlantic region. Fine by us. Our juice works. We have a gas fire in the living room. And we stocked up a supply of wine that would last us through the apocalypse, if necessary. We are comfortably snowed in. Warm. Well-fed. Even content. Our refuge yesterday was marred only by one thing – our own thoughts. “What about the poor people in hospitals and old-age homes?” asked our mother...88 years old. “People can’t get in to work. Who looks after them?” “Well, it’s probably time for a little culling,” we joked. “Nature has to assert herself from time to time.” Of course, mankind is always trying to get the upper hand against nature. In matters to do with science and technology, he has clearly succeeded. His efforts, compounded over generations, make it possible for your editor to enjoy one of the fiercest blizzards to hit this part of the world in 100 years. He is able to watch the snow through his double-paned, insulated glass windows...while drinking a glass of wine that came all the way from South America. He is able to check the financial news from all over the world on his laptop computer...and then pass on his own opinions and thoughts to hundreds of thousands of readers all over the planet. To nature, man is master. But to human nature he is still a slave. Ah...dear reader...that is the kind of thought you get in a blizzard... A thought worth having but one that, on a normal day, would have driven by like a Post Office van. But yesterday, it was stuck in a drift...right in front of the house, impossible to ignore. Yes, dear reader...man makes progress in things he can touch and feel...twist and hammer. He can fashion himself a warm house...and a truck to deliver the newspaper. But there are many things he can’t get a grip on. Even in the 21st century, despite all the study of domestic relations, he gets along with his spouse no better than Henry VIII got along with his...and he fares no better with his children than Jacob did with his boys. But wait... You’re probably thinking that this snow is causing your editor to go a little stir-crazy...right? He has a case of cabin fever, maybe...he’s getting pretty far afield from his Daily Reckoning subject matter, right? Well, you are wrong. We’ll explain why...below... And more thoughts along the same line... One thing that man cannot get a grip on is central banking. Or, more broadly, economics. Wait a minute. If he can send a man to the moon he can certainly make some progress in economics, right? Wrong again! Economics is not a hard science. It’s a human science. Like psychology or history...it’s an observational science. A decent historian observes what happens and does his best to tell the story faithfully. He is a fool if he thinks he can control it or make it turn out differently. An honest psychologist, also, can sometimes help people understand what they are doing. At the margin, he can even change human behavior – perhaps. But he cannot really change the way people think or feel. Because he cannot change human nature. Likewise, an economist with a residual trace of dignity and integrity admits that he is only half-capable of describing how people get along in their economic undertakings. At best, he has a dim, vague idea of what is going on. He may even be able to give some good Dutch-uncle advice from time to time. ‘Don’t spend more than you earn,’ he might tell his nephew. Or, ‘a penny saved is a penny earned.’ Or, ‘don’t put all your eggs into one basket.’ That kind of thing. At the margin, this advice might even be helpful. But never in his wildest delusions does he imagine that he can improve or control an entire economy. In a theoretical sense, this would mean improving human nature...and he knows this is impossible. Human nature expresses itself in an infinite variety of ways. One man wants to work hard. One wants to spend every penny. One likes gaudy automobiles. Another is afraid it will be a cold winter...he spends all his money stocking up on food and firewood. Who’s right? They all are expressing their own fears, desires, and ideas – through the markets and the economy. Any action an economist takes to improve things necessarily means bending these people away from what THEY want towards what HE thinks they should have. And since prosperity makes no sense outside of the voluntary choices of the people themselves, the meddling economist inevitably makes them poorer. Because his interference shifts time and resources away from what people really want. The economist is human too. As such, he is prone to human error...and a prisoner of human nature. What do all these people in Washington do? Well, we got a copy of the free local paper – The Politico. Want to get a job in the capitol? Just look in the paper. There are dozens of jobs on offer. “Energy Analyst,” says one. They ask for a “proven analyst,” whatever that is. Another ‘trade group’ advertises for a “Director, Policy and Research...to guide its policy/research initiatives...” Still another wants a “Vice President for Government Affairs.” What is that? “Lobby experience” required, it explains. How about this: “Legislative Assistant.” Senator Bob Corker is looking for someone to handle “energy and natural resources” issues for him. What kind of government is this, dear reader? The people’s elected representative knows nothing; so he hires a policy wonk. Gosh...there a dozens of jobs on offer. And none of them seem to require any real skill...except a talent for BS: Congressional Relations...Federal Relations...Director of Public Policy...Government Affairs Director... If none of these people ever came to work again, would the Republic be worse off? Regards, Bill Bonner, for The Daily Reckoning --------------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com   The Daily Reckoning - Special Reports: Gold: The Truth About Gold Fiat Currency: Using the Past to See into the Future "THE GREAT AMERICAN RECOVERY RP-OFF" Brace yourself for what's about to go down as the BIGGEST FINANCIAL SWINDLE in world history