“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.

“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.

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.

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

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).

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?

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.

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.

1. Federal Deposit Insurance Corp.: The agency that insures deposits at the nation’s banks would operate auctions of troubled mortgage loans and then provide financing to the winning bidders. The FDIC would also share the risks if the mortgages fell further in value.
2. Term Asset-Backed Securities Loan Facility: A Federal Reserve-operated loan facility will receive $200 billion from the government’s $700 billion bailout program. That money will enable the Fed to support as much as $1 trillion in loans to investors who want to buy securities backed by various types of consumer loans in an effort to make auto loans, credit card debt and student loans more available. The TALF will be expanded to allow the Fed to provide loans to investors buying securities backed by residential and commercial mortgages.
3. Public-Private Investment Funds: The Treasury would launch these partnerships between the government and the private sector, with the government matching dollar-for-dollar money put up by private investors to buy toxic assets.

Unfortunately, it is unclear that this plan has any hope of success.  Specifically, the “Public-Private Investment Funds” (PPIF) concept that is intended to remove toxic asset from banks balance sheets seem fraught with problems.

PRICING - Let’s take a look at this specific component of the plan from a real estate practitioners perspective.  To begin with I, and most other real estate professionals, are bombarded daily with a  barrage of emails announcing new “distressed asset” funds that have been created.  I wish I had been keeping track since 2007, but I know that the total is well into the billions of dollars that have been raised.  These funds are specifically targeting the very same distressed assets that the PPIF program is targeting.  What is noticeably absent, however, are the emails that announce that any deals have actually been completed.

From my own experience trying to buy troubled assets, and those of the fund managers I have spoken with, I can tell you that capital is not the problem.  The problem, I have found, is that the banks are not willing to let the assets go at a price that makes the risk worthwhile to an investor.  Most of these assets are REO for a reason, and that reason has to be addressed before the asset will be successful.  If these were such great and performing assets the bank wouldn’t own them – they would still be in investors hands.  So, the PPIF has to address what price these assets will be purchased for.  

Today, without the government plan, if banks were willing to sell for a “market” price, which adequately prices the risk involved, there is a ready and willing pool of investors.  Tomorrow, with the government plan, the banks will still need to be willing to sell at a market price, even if the investors are getting a loan from the government.  That market value will most likely be less than where the bank has the asset on the books.  Until they actually sell, they can keep the assets on their books at a higher value (although still written down significantly).  Once the asset is actually sold, the market value is the market value and the “pain” is realized.  I know on all of the projects I have looked at, the value I underwrote to was +/- 70% of the “written down” bank book value.  This discrepancy could mean much more future pain for the banking system.

Low Leverage Amounts - As I read the announcement, the PPIF program will basically amount to 50% leverage.  It is unclear whether the government piece will be a loan, in which case any additional debt would be classified as a second mortgage.  If it is a loan, will the government subordinate their position to a traditional lender?  The other option would be that the government piece would be equity and the public-private partnership could then go put additional debt on the assets.  That would obviously be the better scenario.  Even in today’s difficult market, experienced real estate operators can get much better than 50% financing.  However, they wouldn’t be able to even come close to the low interest rate the government would (most likely) offer.  Does that low rate offset the low leverage ratio?  I doubt it.  Equity is always the most expensive piece of the capital stack.  Add more equity to a deal and the required rate of return goes up dramatically.

I recently had the opportunity to hear the Honorable John E. Sununu (Member of the Troubled Asset Relief Program Oversight Board) speak on the TARP program.  He indicated that the Public-Private program was going to take the form of a 90% government loan, matched with 10% investor equity.  Somewhere between last weeks speech and today’s roll-out, the plan changed.  However, given that the previous discussions had centered around a “loan” program, my guess is that today’s PPIF program will be a loan as well.

Lack of Trust - The lack of trust in the government is a big issue, and is one that John E. Sununu brought up as a reason for a lack of participation in TARP.  Our government has already shown a willingness and ability to re-trade the terms of the agreement under which banks accepted Stimulus Funds.  Under TARP they went back and placed tighter restrictions on executive compensation, dividend policies, acquisition programs, and share repurchase programs.  More recently, Congress voted to tax bonuses at a 90% level for those companies that accepted bailout funds.  All of these meaningfully influence the way the private sector operates their businesses.  And, they were all implemented after the initial agreement.  Anyone in real estate knows that the key to any partnership arrangement is trust.  If you don’t trust your partner, you are in for a miserable journey.  The fear is that the government isn’t a trustworthy partner.  The fear is that the government will, after the fact, impose significant limitations on how we operate our businesses.

Overall, I think this program has some very significant flaws.  Maybe it buys the administration a few points on the Dow today, but I doubt even that.  I think that the real estate professional has other, less restrictive, sources of capital available to them.  And that is assuming you can get a bank to agree to a market price.  In this economy, I’m not sure they are there yet and I don’t see anything in this program that will help incentivize them to sell at market.  

The banks are like the neighbor who wants to sell their house for $X when the market keeps telling them it’s worth $Y.  Yet, they just won’t sell.  As long as grandma keeps bailing them out and paying their mortgage, there’s no real incentive for them to let it go at a market price.  Until there is an incentive, all of the other neighbors point to that one house and say, “he’s selling his for $X, mine must be worth $X too”.  The buyers just roll their eyes and go find another neighborhood.

So, why does this economy need some inflation (some being the key word).  Our economy is driven by consumer spending.  We earn income and then we spend it at an alarming rate.  However, during this recession, consumer spending has all but dried up.  This is partially due to the freezing of the credit markets, but also due in large part to consumer expectations and confidence.  Americans are “on the sidelines” waiting to see what happens before they get back into the spending frenzy.  Why buy today when it will be on sale tomorrow?  What inflation does is add a little urgency to the equation.

If consumers anticipate that things may be more expensive if they wait, they will act sooner.  In the real estate world, investors have been sitting idle because they feel that prices are declining.  If they wait until next week/month/quarter they can get the same property for less.  A healthy dose of inflation should help them realize that prices might not fall forever.

Maintaining a healthy level of inflation (over deflation or stag-flation) will do wonders to get our economy back on track.  Even the expectation of impending inflation should be very helpful.  If anyone needs confirmation of this, take a look at Japan in the mid-1990’s (or call me and I’ll walk you through the interaction).