by Gary North
by Gary North
George Soros recently made two predictions. First, commercial real estate will decline by 30% in the United States. "It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent." Second, when banks finally begin to lend, the swollen monetary base will lead to serious price inflation. He called this "an explosion of inflation."
These two predictions seem to be in opposition to each other. A fall of 30% in commercial real estate would surely place downward price pressure on the American economy. Local banks are more heavily invested in commercial real estate than residential. Fannie Mae and Freddie Mac created the housing boom. The government and the Federal Reserve System are trying to bring the boom back to life by buying the debt of these two agencies, using FED fiat money. Mortgage rates are now under 5%. Still, the residential real estate market continues to fall.
COMMERCIAL REAL ESTATE
Commercial real estate's future value is ultimately a function of the net revenues it can generate. The economy continues to remain in recession. The expectation of national unemployment in the 9% range is now conventional. As consumers shift spending from discretionary to non-discretionary goods and services, existing businesses that cater to discretionary spending will come under intense pressure. Some are going to go out of business. They will cancel their leases.
I had a taste of this recently. My wife and I went to lunch downtown in our little community. It is the county seat. The county has recently opened a large, modern facility several miles from the town square. The old buildings are still occupied by the county, but not with the same high concentration of employees.
We headed for a great little Mexican restaurant. It was gone. Next door, a 2,700 square foot facility was empty. Another empty office was three doors down. There used to be a sandwich shop down the street. Gone.
This has happened in less than two months. Businesses that were doing fine are gone forever. The owners should have seen this coming, but owners are optimistic. They think, "It won't happen to me." But it does.
Every owner should have gone shopping for a new location as soon as the county announced the new building. I assume that was at least five years ago. Maybe it was more. Those store fronts should be occupied today by businesses that are not dependent on walk-in traffic from county employees. The rent should have fallen as soon as the leases ran out in the year that the new facility was approved. But this is never how it works. The existing renters did not perceive that their business plans were doomed. They pretended that the flow of customers would not change, despite the fact that the customers would no longer be within walking distance.
On the door of the sandwich shop was a forlorn note announcing the closing and thanking the customers for their loyalty. Loyalty? When? For how long? What percentage of customers? Most of the ex-customers will never read that sign. They won't go downtown again. If they do, they will not stay long enough to buy a sandwich.
Now the owners of all that space are facing a disaster. We are in a recession. Banks will not lend to small start-up businesses. The landlords had bet their future on rental income from small businesses that catered to the county's employees. Now they must find completely different types of renters. The rental space is no longer prime. They should have canceled leases, year by year, on every business that was county employee—dependent. The recession would have hit, but they would now have a cushion. They have no cushion.
People see things coming. They ought to understand that new market conditions will force major plan revisions. Bankruptcy is one of those plan revisions. But people assume that whatever trends are good will continue, while trends that are negative will evaporate. Their optimism leads them into business. Then it leads them out.
It takes a systematic act of will to follow the implications of an irreversible trend. The trend of traffic was obvious, given the new county building, but existing renters refused to extrapolate the trend. They did not devote time and effort to overcoming this trend by starting over elsewhere, while they still had working capital. Instead, they just sat.
What is true of a business owner is also true for most employees and most investors.
THE REAL ESTATE FALL-OUT
How many investors had heard of subprime mortgages in 2005? Of those who did, how many of them knew of the packaging of these mortgages? How many knew that the credit-rating services were rating as AAA packages that are today being sold at 30 cents on the dollar? How many knew that these packages were being bought by hedge finds with borrowed money at leverage of 30-to-1? On and on it went.
The fall-out was not perceived by regulatory agencies, the entire investment banking industry, commercial banks, Federal Reserve economists, and European bankers who decided that 30-to-1 was too conservative.
We are now in a recession the likes of which nobody has ever seen. The fall-out continues to fall out. Investors think that the problem is solved. Then two more appear.
Soros' words ought to be accurate: "It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know. . . ." They are not accurate. The phrase, "so we know," is wrong. "We" do not know.
The typical bankers who lent 60% of their depositors' money to commercial real estate projects are in the same situation as the landlords of the now-empty space in my town square were two years ago. They did nothing to protect themselves when they might have been able to. They sat, just as their lease-holders sat. They all knew that the courthouse was going to be run at quarter staff. But they did not perceive that the departure of the employees would bankrupt business after business.
Local bankers are sitting there, hoping for the best. They are not in emergency mode, preparing for the departure of their tenants. Their tenants will be forced by market conditions to close their doors.
The market is relentless. It will have its way. The reality of falling traffic and lower purchases will make itself felt, as surely as it made itself felt last Christmas. The discounting began as soon as the shopping season did. Yet hope remained. The press kept saying that things were slow, but that business owners hoped for a buying spree in the final days. It never materialized. It was wishful thinking.
Consider this fall-out. Banks will find that borrowers cease paying. Developers are going under now. Abandoned, 70% completed strip malls testify to the spreading crisis. Empty large anchor stores no longer provide the overflow foot traffic for the shops that once profited from the anchor business, which now has departed. Properties like this line every main drag in the country. Has the local Circuit City building been rented to a new customer in your town? It hasn't in mine.
This is truly a case of falling dominoes. At this point, there is nothing that the borrowers can do, other than to hope, pray, and delay. The banks that lent to them must cut back on new loans, either now or when the defaults force the change.
Companies with good credit and years of reliable repayment now face the prospect of their banks calling the loans. The banks will refuse to roll over these loans. They will have no choice. Their capital will be gone. It is gone now, but they have not yet written down the losses. They will not be able to delay much longer unless the Financial Accounting Standards Board revises FAS 157 in the next week (which it may do).
Because the initial phase of this recession has been related closely to residential real estate, which was marketed nationally by Freddie and Fannie, most local businessmen have not faced the problem of collapsed bank capital. Their lenders have continued to roll over their lines of credit. This is about to end.
I remember the situation in Texas in 1985, when oil fell and the real estate bubble collapsed. Good businesses that had long worked with a local bank found that the local bank had been absorbed by a distant national bank. The local staff had either departed or had handcuffs put on them by a national committee that knew nothing of local conditions. Businesses that had depended on a long tradition of borrowing and repaying found that they were facing bankruptcy.
A line of credit today is considered a permanent operating condition. Businesses no more plan to pay off these loans than the U.S. Treasury expects to pay off its lines of credit. The name of the game in both markets is rollover. The Treasury can play this game because it has China and the Federal Reserve to keep the money flowing. A local business does not.
Soros makes a public statement about 30% losses in commercial real estate, and it does not get top billing. It is just more noise. Soros is very rich. He made his money in leveraged currency futures markets, the toughest market there is. If he says there will be a 30% decline, plan for this.
But how can you? If you run a business, you can pay your bank to sign an agreement to supply credit. That is worth the money, I think. It will give you a source of capital, if your accounts receivable really do become accounts paid. Your customers are using you as their line of credit. You will find it difficult to speed up collections. You will find it impossible to get them to pay cash up front.
Your employer may need a different client base, but it cannot get it in a recessionary economy. The competition for such clients is fierce.
Soros also predicted explosive price inflation. He has looked at the monetary base of the Federal Reserve. What else could he conclude? When banks pull their excess reserves out of Federal Reserve accounts that pay 0% to .25%, and they start lending — to anyone, on any terms — the fractional reserve process will begin.
Soros knows currencies better than any other public figure. He has become rich from his ability to predict and even trigger major currency devaluations. Central bankers insist that everything is fine; Soros takes a position on the other side of the trade; and the central bank capitulates. It hands him a billion or more dollars' worth of profits. He goes on to bigger fish to fry.
He could have said this: "It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, that prices in dollars will rise at east [xx] percent." He didn't.
The public does not perceive any of this. It has no idea what the monetary base is, or what this has to do with M1. People just struggle to stay ahead of the recession's fall-out. They have so little money to spend that is not committed to paying monthly bills that changes in their plans are marginal. They cannot fund major changes.
We do not see panic yet. We see hope that the Obama Administration's weekly new policies will work. If the earlier ones had any chance of working, why are new ones announced each week?
Investors want to believe that the Federal Reserve and the Treasury can extricate the economy from the broad disaster that Federal Reserve policy and Treasury policy created under Greenspan. They expect the Treasury's revolving door of experts from the Council on Foreign Relations to get it right this time. They take the official assurances at face value. There is no FAS 157 governing official pronouncements from Geithner or Summers or Bernanke. There is nothing that compels pundits to write down their statements at face value to something markedly less. There is no mark-to-market accounting for political pronouncements.
Soros says we will experience falling commercial property prices and rising general prices. If he believes this, then he has to be making an assumption: the present bailout plans of both the Treasury and the Federal Reserve will not reach the local banks and the local real estate markets. He is saying that Wall Street and Main Street are not in synch. Main street is where consumers meet sellers and work out deals. He is saying that Main Street's businesses will not be able to avoid consumers that refuse to buy.
Main Street today is where businesses that boomed under Greenspan now operate. That world is gone. Consumers will still spend money, but they will not spend it on the same products as before. Main Street's businesses that rely on discretionary spending to keep their doors open will not be able to survive.
Soros is saying what Ludwig von Mises and Austrian School economists have been saying for over nine decades. The issue is relative prices. The general price level can rise, but specific consumers, businesses, and sectors will not benefit. In short, the economy is not like the ebb and flow of the tides. All ships don't rise and fall together.
Donald Trump did fine when the Federal Reserve's real estate bubble was expanding. Investors thought he would make all those Atlantic City casinos keep them rich. They were wrong. Three of the casinos filed for Chapter 11 protection in February. The problems? Leverage. Recession. A change in taste by gamblers who were discretionary gamblers. They stopped gambling.
People who make money under one set of conditions lose money when these conditions change. Soros is predicting two seemingly rival sets of conditions: falling commercial real estate and rising prices. Those who are heavily invested in commercial real estate will take a hit before mass inflation arrives.
The recovery phase will bring monetary inflation: the multiplication of the monetary base. That will do the renters of busted businesses no good. It may bail out owners of these properties if they can keep the banks from foreclosing. It's a race against time.
The world needs capital, not more digits. The Treasury and the Federal Reserve can rearrange digits and interest rates. Investors and borrowers will follow the money. The planners can lure investors and consumers into one or another market by means of the flow of borrowed and newly created digits. But by undermining the information sent by prices, the digit-masters lure investors and buyers into debt traps. As surely as Donald Trump and his investors failed to adopt an exit strategy to deal with Bernanke's tight money policies, 2006—2007, so will investors and borrowers fail to adopt a survival strategy for the next wave of price inflation.
The destruction of capital through bad investing is the legacy of tax policies, monetary policies, and subsidy policies of government and its ally, the central bank. All over the world, this unholy alliance has destroyed capital. There is no good reason, in theory or practice, that indicates that these digit masters will get it right this time.
Donald Trump is smart. His bondholders are smart. Central bankers are smart. But they are not smarter that the assembled knowledge of a free market that is not being distorted by bureaucratic monetary policy. If the government would pay the salaries of every Federal Reserve employee, sending them all home and freezing current assets forever, the economy would become productive after a sharp, fearsome depression. That is not going to happen. The digital deception will go on.
Don't be deceived. The system is rigged against you.
March 28, 2009
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