Steve Croft of “60 Minutes” reports on the looming financial crisis and what the states are planning to do about it.

You’ll begin to hear more and more about this in the mainstream media.  This has the potential to be the next housing crisis and the source of a second dip of a double dip recession.

- Brad

First, let me say that I am a big believer in Austrian economic theory.  I’ve read Ludwig von Mises and actually enjoyed it and I have a copy of Rothbard’s Man, Economy and State on my desk.  Until recently, if you tried to talk to a non-economist about Austrian economic theory you’d get that look that a dog makes when they hear a high pitched sound.  Think “Nipper” the RCA records dog and you’ll get the picture.  However, the world might be ready to accept Austrian Economic Theory into mainstream culture.  As a recent article on CNBC.Com pointed out, “not since the New Deal has Austrian economics enjoyed the political popularity that it does now”.

CNBC goes on to provide a sanitized explanation of the Austrian Economic theory of business cycles:

1) In a market economy, lower interest rates are a sign that more wealth is available in society for new business projects. Either society is more wealthy—and therefore saving more without lowering spending—or its members are saving more—delaying current consumption in favor of future consumption, and incidentally providing loanable funds for projects that will be sold for future consumption.

2) In either case, the low interest rates are a sign of additional savings—and therefore a sign that more money will be available for future consumption. Businessmen respond to this by starting or expanding business lines aimed at future consumption—that is, projects that take time and larger amounts of money to complete.

3) Many of the projects seem profitable only because low interest rates make them cheap to fund and the assumption of future consumer spending out of increased savings promises demand for their products. For businesses, this is a kind of paradise: they get to borrow cheaply and sell to wealthier people in the future.

4) Low interest rate-fueled business expansion spreads through the economy. The cost of labor and materials goes up, which provides people with more money to spend or save. Retail businesses expand as well as the higher-order long-term manufacturing, investment and research & design projects. This creates what looks like a benign cycle: expansion fueling expansion.

5) When the low interest rates are caused by central bank intervention, however, this paradise turns out to be an illusion. The wealth that would have led to future spending does not actually exist—because the low interest rates aren’t caused by an increase in the amount of savings. Because we already know the interest rates weren’t caused an increase in the savings rates, it’s fair to assume that the additional wealth created during the boom mostly went to spending rather than increased savings. (Indeed, savings might actually have decreased as people anticipating future wealth rationally spend more now because they perceive less need for savings to finance future spending.)

6) As it is revealed that savings-fueled demand is lower than expected, many of the projects go bust. Investments in them need to be liquidated, some at a total loss. The investments in those long term projects now look like irresponsible speculation on an assumption of future growth. The Austrians call them “malinvestments.”

7) The liquidation of those malinvestments means the loss of value in the resources those investments would have used, including the loss of jobs in those businesses. This spreads the “bust” from the original speculative areas to cover the economy—in a reverse of the boom cycle.

A side note here: It’s sometimes asked why a consumer boom doesn’t follow a long-term project bust. After all, if the problem was an assumption by businesses of increased savings, shouldn’t learning the reality that people weren’t saving cause the retail sector to boom? Unfortunately, this doesn’t happen. In fact, the reverse is usually the case. The reason is straight-forward: the mistake wasn’t underestimating spending, it was overestimating savings. What’s more, the liquidation of malinvestments causes unemployment, often triggering consumers to start saving more and spending less.

9) The economy develops what looks like an output gap. It is producing far less than it once did and employment is at a far lower level. This is mainly because part of the old output was geared toward future consumption that is now understood to be impossible. The output gap is just a shadow of the old, unsustainable boom.

I’d encourage you to follow the link and read the article.  It does a pretty good job of summarizing some of the basics of Austrian theory.  It’s not perfect, but its a pretty good introduction.  If it seems logical, head over to Amazon and pick up a copy of “The Theory of Money and Credit” by Ludwig von Mises – Link.  You’ll be glad you did and you’ll have a renewed clarity on the recent boom-bust cycle we are experiencing.

Citing an excessive amount of existing debt, Fitch Ratings cut the rating for the State of Connecticut’s $956 million bond issuance.  Already the state with the highest level of tax supported debt, Connecticut is issuing these bonds to close a nearly billion dollar budget gap.  Last year the state borrowed over $947 million to cover a  similar budget gap rather than cut spending.  Fitch, apparently, had seen enough and reduced the States rating one level to AA.

“The downgrade reflects the state’s reduced financial flexibility, illustrated by its reliance on sizable debt issuances during the current biennium to close operating gaps in the context of already high liabilities,” Fitch said.

While Connecticut does have the largest amount of outstanding tax supported debt of any of the 50 states at over $13.7 billion, it also boasts being the wealthiest of the 50 states with a per capita personal income of $54,397 in 2009.  I believe much of Fitch’s concern is due to how the state is using the funds it borrows.  Spending for long term capital improvements that benefit Connecticut citizens is one thing.  At least then you have a hard asset to show for it.  What Connecticut is doing, borrowing to finance a budget deficit, is akin to running up your credit card debt to finance a lavish lifestyle.  Frankly, it is unsustainable.

One has to wonder if this is the first of many such downgrades to come as we witness the consequences internationally (Think PIIGS – Portugal, Ireland, Italy, Greece and Spain) of excessive borrowing to support an unsustainable spending pace.

Yesterday, the Motley Fool website ran an interesting article by Nick Kapur titled “Why do we still listen to the ratings agencies“.  The general premise of the article is that the ratings agencies are either unable or unwilling to provide an accurate assessment of a company’s financial strength.  The author goes on to contemplate what role the ratings agencies played in the recent financial meltdown and how much responsibility we should assign them.

“The line here between ignorance and dutiful compliance is thin and not meaningful. Though many have alleged that the ratings agencies were on the take outright, it doesn’t really matter if they were or weren’t. Essentially, the ratings agencies were either crooked or they were stupid. Either way, they’re guilty.”

The article raises an interesting question of what role should a Moody’s or S&P rating play in an investors analysis?  Should they still be trusted, or have they lost all investor confidence?  Finally, is there an opportunity for a new player to emerge as a truly unbiased opinion, and what would that new player have to do to earn the respect of the investing community?

I believe there is an opportunity, but the road to respect will be a long one.  Thorough, independent analysis will always be worth much more than a 3rd party report from a vendor whose motivations may be cloudy at best.

It seems like the worst may yet be over.  The Congressional Oversight Panel recently released its February Oversight Report entitled, “Commercial Real Estate Losses and the Risk to Financial Stability”.  You can read the full report HERE.  While the initial wave of destabilization came from the larger institutions (think AIG, Lehman Brothers, Etc.), this looming round could come from the nations’ small to mid-sized banks.

The report estimates that in the next 4 years over $1.4 trillion (with a “T”) of commercial loans will come due and need to be retired or refinanced.  In one half of those cases, the value of the underlying asset is now worth less than the amount owed on the loan.  They are “underwater” and they are a problem.  Losses to the lending institutions could total over $300 billion.  That’s not the amount that will default.  That’s the loss realized after foreclosing on the property, finding a buyer and selling it for whatever can be achieved.

But wait, we ran the Stress Test and our banks have the capital reserves to weather this storm.  Unfortunately, the Stress Test only looked through 2010.  The vast majority of these loans will become a problem for the banks in 2011-2014.  Plus, the Stress Test was only run on the larger banks.  The small and mid-sized banks were never subjected to the Stress Test.

On the plus side, there has been an insane amount of equity raised to acquire these troubled assets.  Once the banks have foreclosed on the assets and they are brought to market, there should be a willing pool of buyers.  The question then becomes, will there be so many buyers that the value get bid up to a point where the “distressed buyers” are no longer interested.  My best guess is that you see an initial round of sales at very attractive pricing.  As buyers flock to this sector, the demand and valuations will go up and the transaction volume will go down.

Econstories.tv has posted a very entertaining video comparing the economic theories of John Maynard Keynes and the free market theorist Friedrick von Hayak.  It’s a little long at over 7 minutes, but well worth investing the time.

So, who do you side with?  Keynes or Hayak?

I was stuck by this question last month as I watched the Tour de France bicycle race.  Of course, I was cheering for Lance, hoping for a big comeback.  But, I also wanted to cheer for the “American” team.  It dawned on me that there was no truly American team.  Team Garmin Slipstream had the American sponsor, but most of its riders we foreign.  Team Astana had a Spanish sponsor, but a fair number of American riders.  Even Lance lives a fair amount of the year outside of the US.  In the end, I had to settle for nearly-American teams, but it got me thinking…

Today I read another article about a “Buy America” clause being added to a House spending bill that precluded any of the $33b of appropriated funds from being used to purchase cars other than those made by GM, Ford or Chrysler.  Yes, those three are American registered companies.  However, Mercedes, Toyota and many other have plants located in the US that employ thousand of Americans.  A portion of a dollar spent on a Toyota will work its way back to the American workforce.  BMW does a great job of keeping the South Carolina economy humming with their Greenville plant.  Conversely, many of the Ford vehicles are assembled in Mexico or Canada and employ their nationals.

So, what is the tipping point where a company becomes American?  For cars, I’d assume the profit margin to be in the 6-10% range.  That means that 90-94% goes to someone other than the manufacturer.  I know the dealers take 10-20% of the sales price, and we’ll assume they are “American” whether the car is a Honda, Ford or Fiat.  The remaining percentages goes to the raw goods and labor to assemble the car.  In some cases, that’s Americans and it some cases it’s not.  Conceivably, you could buy an American car and have 70% of the money go outside the US.

In this global, flat economy trade-restrictive “Buy American” clauses don’t make much sense.  They do, however, make politicians feel proud enough to wear their American flag lapel pins… (which was most likely made in China).

Round 1 consisted of the US and China each attaching “Buy Domestic” requirements to their stimulus packages and both screaming that they were unfair.  Today, in Round 2, the International Trade Commission ruled that China had been unfairly dumping tires in the US.  The tidal wave of low cost Chinese tires had disrupted the US tire market and forced tire plant closings by Goodyear, Continental Tire, and Bridgestone/Firestone.  However, none of these companies were the complainant.  The group that was crying foul was the United Steelworker union.

As a consumer, I like having the Chinese tires as an option.  Even if I don’t buy their tires, the low cost option makes the higher quality tires become more price competitive.  That’s a good thing for me.  I can then take the money I saved and buy more groceries, or maybe a movie night for the family.  Either way, my disposable income works its way into the US monetary system.  You’d be hard pressed to make a case that a low cost (as long as it is safe) option is a bad thing for the consumer.

This begs the question of who is harmed then.  Clearly, the Steelworkers feel that they have been harmed.  However, last I checked this was somewhat of a free market economy.  If they can make a tire that performs as well and is cost competitive, then what is the problem?  I guess the problem is that they can’t compete.  That is a problem – on many levels.

I can remember paying $750 for a DVD player.  Not a really nice one, mind you.  This was when they first came out and it was an average player.  Today, thanks to low cost producers, you can get a DVD player for about $35 – maybe less if you look hard enough.  Is that bad for the economy?

If that title doesn’t scare you then you might need to check your pulse…  Reuters ran an article this morning talking about how the US Federal Reserve couldn’t understand why the yield curve reached its steepest level in history last week.  Some of the theories it puts forth include, “the economy is recovering so well so there is less need for secure government backed investments”, “China may be repositioning its portfolio of treasuries”, and “the US economy is worsening and there might be a collapse of the US dollar”.  Some of these theories are in diametric opposition to each other, providing further indication that the Federal Reserve really isn’t sure of much.

I know I only have a college degree in economics, but let me give this a try…  We know the US Government is going to have to issue roughly $2 trillion of Treasuries to fund next year’s deficit.  That will push the Supply curve for treasuries out to the right.  We also know that the US economy continues to struggle, signs of improvement are few and far between and there is a very real prospect of inflation on the horizon.  That will shift the Demand curve in to the left.  What you are left with is reduced quantity demanded for Treasuries and a reduced price for Treasuries.  A general believe that this economic condition won’t last forever, and some change will be coming amplifies the effect the further out the yield curve you go.  A lower price means a higher yield and, voila, your yield curve is steepening.  I know this is a gross oversimplification of the Treasury market, but it at least gets you heading in the right direction.

According to a recent Bloomberg article, the renowned investor George Soros feels that commercial real estate has an additional 30% decline left in its pricing.  If he is correct, that would mean an upcoming strain on the US banking system on an unbelievable scale.  Commercial prices have already fallen +/- 30% from their 2007 highs.  An additional 30% would be devastating.  Soros also commented on the current Administrations monetary policy, fearing that we are setting ourselves up for a period of significant inflation.

It all puts the real estate investor in a tough predicament.  The impending inflation would drive you towards buying now and locking in your capital costs.  However, with the specter of additional pricing declines on the horizon, investors are reluctant to buy now for fear of overpaying.  So, again, the real estate market remains locked in indecision. 

Here in Richmond, the situation is very similar.  Richmond BizSense ran an article this week talking about the lack of sales activity in this market.  In addition to quoting some fantastic market experts (including your truly), the article does a very good job of laying out the situation that faces both buyers and sellers in today’s market.  No doubt, it’s a tough one.  The companies that can be flexible and creative will do much better than those that can’t.