January 19, 2024
By Steve Blumenthal
“I think $700 billion could default… The lenders are going to have to do things with them. They’re going to be selling. It’s going to be a generational change in real estate coming, end of 2024 and all of 2025. We will be talking about real estate being just a massive change, $700 billion to $1 trillion in defaults coming.”
– Howard Lutnick, CEO Cantor Fitzgerald
I remember the call from Mark Finn in 2007. “Do we have any subprime mortgage exposure?” he asked.
Mark is Vantage Consulting Group, Inc.’s Chairman and CEO. His investment experience is envious. Mark was the lead investor in a fund of hedge funds that my firm managed.
“I don’t think we do,” I answered.
“Find out!” Mark bellowed.
I immediately huddled with our portfolio team. We called the 20 or so fund managers, and I reported back. “No exposure,” I told him. But I didn’t understand the urgency. “Mark, what is going on?”
Parading through Mark’s office were the guys on the other side of the trade, betting on the collapse. If you watched the movie The Big Short, you know what I’m talking about. Here’s the Wikipedia synopsis:
“In 2005, eccentric hedge fund manager Michael Burry discovered that the United States housing market, based on high-risk subprime loans, [was] extremely unstable. Anticipating the market’s collapse in the second quarter of 2007, as interest rates would rise from adjustable-rate mortgages, he proposes to create a credit default swap market, allowing him to bet against, or short, market-based mortgage-backed securities, for profit.”
Mortgage-backed securities tied to U.S. real estate—as well as an expansive web of derivatives tied to those mortgage-backed securities—collapsed in value. Banks had considerable exposure, and financial institutions all over the globe suffered severe damage, including Lehman Brothers, which notably collapsed in September of 2008.
“How big is the problem?” I asked Mark that first day he called. At the time, he suspected the damages might fall in the vicinity of $400 billion. As we know now, the Great Financial Crisis turned out to be far bigger than he or I imagined. The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. It was among the five worst financial crises the world had experienced and led to a loss of more than $2 trillion from the global economy. U.S. households lost $11 trillion. Wikipedia
Mark wasn’t the only one ringing the alarm bells in 2007. After my call with him, I began writing about it. “Steve, you’re so bearish,” people told me. But, like Mark, I thought the problem was going to be in the $400 billion range. Turns out I wasn’t bearish enough.
Because of Mark’s warning and what we learned thereafter, we sent redemption paperwork to every one of the 20 hedge funds in our fund of funds. We had a tight window and were able to exit almost all of them by the end of 2007.
Regrettably, what we didn’t do was short the subprime mortgage market like hedge fund managers Michael Burry and John Paulson. Paulson and his firm made an estimated $2.5 billion during the crisis—first on his big subprime short and then on subsequent recovery investing in Bank of America, Goldman Sachs, Citigroup, and JPMorgan Chase.
Warren Buffett, for his part, had a sizable portion of his portfolio in cash at the depth of the crisis. Here’s how Ryan Fuhrmann characterized Buffett’s crisis wins in Investopedia in 2022:
“His buys included the purchase of $5 billion in perpetual preferred shares in Goldman Sachs that paid him a 10% interest rate and also included warrants to buy additional Goldman shares. Goldman also had the option to repurchase the securities at a 10% premium, which it recently announced it would do. He did the same with General Electric, buying $3 billion in perpetual preferred stock with a 10% interest rate and redeemable in three years at a 10% premium. He also purchased billions in convertible preferred in Swiss Re and Dow Chemical, all of which required liquidity to get them through the tumultuous credit crisis. As a result, he has made billions and helped steer these and other American firms through an extremely difficult period.”
Liquidity, in his case, was a good position to be in. Makes you wonder why he’s sitting on a record amount of cash today… The discipline of inaction in the absence of a good opportunity – aggressive action when one is identified.
When you have created great wealth, you wake up daily thinking about what could blow it up. No one can know for sure what’s going to happen and when. Even with warning signs, the timing of big events is, as it was prior to the last crisis, difficult to predict.
The Merciless Mathematics of Loss
It’s not -20% one should worry about; that is relatively easy to recover from. What’s needed is a 25% subsequent return—painful but not impaired. But -50% requires a 100% subsequent return; -75%, a subsequent 300% return; and -80% requires 400%. Sadly, I don’t think most investors understand how the math works.
It looks like this:
The Next Big Short?
We can measure the magnitude of risk within a system. We can understand how economic systems function. We can know at any given time the cost of money – the level of interest rates (that’s where the Fed and risk markets come in). And we can measure the size and various sources of debt. That’s all information we can use to help us try to assess the degree of risk within the system.
Given the size acceleration of U.S. government debt, which I write about often, I believe we’re nearing an end game that will force us to restructure the debt and entitlement systems—both examples of leverage. History tells us the potential range of impact such a restructuring would have on the economy and systems. Leverage works well until it becomes too big. Then, it breaks. And when it breaks, as it did in 2008, liquidity dries up, which is the message in Li Lu’s quote, the discipline of inaction in the absence of a good opportunity—aggressive action when one is identified.
Think of our economic system like a car. Liquidity is akin to motor oil. Just as a car engine won’t work without oil, our economic system won’t work without liquidity. For a better understanding, take 30 minutes to watch Ray Dalio’s animated video, “How the Economic System Works.” It’s basic, easy to understand, and important. (Please share it with your children.)
I love Stan Druckenmiller’s candid, common-sense way of talking about things. Here’s an excerpt (hat tip Firstlinks) from a talk he gave in May 2023 at the Sohn Investment Conference, where he discussed the actions of the Fed over the last few years:
“As I just described, now we have a big hike in interest rates. It’s hard to look at that constellation of factors, know that we’ve only had a few soft landings since 1950 and all of them were preceded by what I would call proactive rather than reactive Fed policy, and believe we’re going to have a soft landing. One never knows. But if you’re just looking at the odds, they’re very tough. In terms of the timing, I have much less certainty on that than I do on whether we’re going to have a hard landing or a soft landing.
“The timing is difficult, but I will say, in our shop we tend to use anecdotal information a lot. It’s somewhat mixed. Housing, which has tended to lead historically, is actually fairly robust. Travel and restaurants and stuff like that are fairly robust. But trucking, which has been a guiding light for my firm in terms of economic forecasting with a six-to-eight-month lead time, is extremely weak. We’re hearing bad anecdotes from retail. The banking problem we always knew.
“Given what I’ve already described, there were going to be bodies out there. When you have free money, people do stupid things. When you have free money for 11 years, people do really stupid things. So, the stuff under the hood is starting to emerge—obviously, the regional banks recently, [and] we had Bed Bath & Beyond. But I would assume there’s a lot more bodies coming. The median regional bank has 43% of their loans in commercial real estate—about 40% of that in office. We’ve had this huge change in lifestyle due to COVID. Number one, the great resignation, and number two, people aren’t going to the office. So, we have actually a higher vacancy rate than we had in 2008.
“I put all that together, and I look also at the inverted yield curve. The timing is sort of third, probably fourth, quarter of this year [or] first quarter of 2024. I wouldn’t be surprised if the bean counters a year from now—as they tend to do backward-looking—that things started (to go bad) sometime in the second quarter.”
No one in 2007 and 2008 believed housing could collapse. This time, I believe the next “Big Short” will be in the commercial real estate space before we reach the restructuring of government debts and entitlements. To explain my thinking further, the next few editions of this newsletter will discuss the current state of commercial real estate, as spurred by my good friend and real estate developer Jim T. He sees the pretend and extend game the banks are playing—they’ve stopped lending—and he and others are having difficulty finding funding. There is no way to be 100% certain about my predictions, but probabilities are high enough to warrant putting the commercial real estate issue On Your Radar if it’s not there already.
Jim sent me an email early this week suggesting I watch last Sunday’s 60 Minutes episode on CBS about commercial real estate loans. “Steve, this is what I’ve been trying to alert everyone about. They are spot on in the segment, but there’s much more to the story. This will have a much bigger impact than you’re being told.”
I watched the segment and then spent an hour talking with Jim. Following that call, I reached out to a large real estate investor based in Dallas. Then, out of the blue, I received a call from—lo and behold—one of Mark Finn’s Venture Capital partners based in NYC. “Did you see the article in the NY Post with Cantor Fitzgerald’s CEO, Howard Lutnick, talking about commercial real estate?”
Here’s what Lutnick said:
“I think what’s going to happen is loan sales, which no one talks about, are going to become a huge business. Because when mortgages on commercial buildings come to a trillion, coming due in the next two and a half years at these high rates, you’re not going to get proceeds. Meaning, when you have a $120 million loan on a building and somebody says, ‘I’ll give you $90 million at a much higher rate,’ you throw the keys back to the lenders… Real estate equity rates are going to be in trouble.”
You may say, “I’m not invested in commercial office buildings; how does this affect me?” I’m saying it will because it will impact the economic system’s liquidity, impair banks, drive interest rates on loans higher and lending conditions tighter, and create less access to capital. And all this waterfalls down to you, me, and everyone.
Grab that coffee and find your favorite chair. I know, I know—more uplifting news from Steve. I work with investors with significant wealth and seek to protect their wealth. As an investment manager, I wake up every day thinking about minimizing loss. Simply take in the data, don’t stress, and be aware. It’s all about risk management, asset positioning, and—if I’m right—the opportunities that present in periods of market dislocation.
For a deeper dive into the crisis, I will speak with friends in the CMBS (commercial mortgage-backed securities) and derivative spaces, both on the sell-and-buy side and various hedge fund managers: Who is positioning for the next big short, and how are they playing it? How might the authorities respond? Do we get a second BTFP (Bank Term Funding Program)? This one to allow banks to put their commercial real estate loans to the Fed at par? I hope not!
Today’s problem is big; perhaps we’ve learned a few things from The Great Financial Crisis. We’ve seen the Fed and legislators do some unimaginable things. My best guess is we don’t see a system-wide meltdown. Individual problems here and there. Some big, some small. There will be more than a few banks, and asset holders taken to the woodshed. How this can be good for the economy is clear enough to me. Recession, yes. Soft landing, no.
On My Radar:
- 60-Minutes – Commercial Real Estate
- Random Tweet’s
- Personal Note: Snow Today, Tampa Next Week
- Trade Signals: Weekly Update, January 17, 2024
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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60-Minutes On CRE – Commercial Real Estate
Hybrid work leaves offices empty and building owners reeling:
Following are several summary bullet points followed by a link to the story.
- $1.2 trillion in commercial real estate loans expire in the next two years. Interest rates have risen.
- Peek inside all the vertical real estate in NYC, and there’s a fundamental question. Where is everyone?
- More than 95 million square feet of New York office space is currently unoccupied. That’s the equivalent of 30 Empire State Buildings,
- 61 Broadway near Wall Street. Half the building lies empty.
- In this post-COVID world there is the changing nature of how people work and live. We’re not going back to where we were, said the owner of 61 Broadway. It’s a different world, and it’s going to be turbulent.
- Fridays are dead Mondays are not much busier as tenants shrink their office footprint office landlords are confronting the fact that some of their buildings have become obsolete.
- The CEO said we invest a lot of equity. If it works, we make a lot of money. If it doesn’t work, the lender can take over the building. You have to face reality, and reality is coming your way.
- The reality is the price of office buildings is tanking as much as 40%.
- Since the pandemic uptown and Columbia Business School Professor Stijn Van Nieuwerburgh, a professor of real estate, has modeled out the impact of hybrid work on pricing and calls it a train wreck in slow motion.
- And this is just the beginning. The reason it is just the beginning is that there are a lot of office tenants who have not had to make an active space decision yet. Do I want to renew this space? Do I want to vacate? Maybe I’ve signed a new lease for half as much space. This is what tenants have been doing for the last three years. So when you take all of those current and future declines of cash flows into account, we end up with about a 40% reduction in the value of these offices.
Professor Stijn Van Nieuwerburgh has been meeting with captains of industry in the Federal Reserve on this very point.
- Commercial real estate is a huge part of the book of business of your typical bank. And I’m talking mostly about these smaller and medium sized maybe regional banks. They have a lot of exposure, which is their bread-and-butter activity. About 30% of all their loans are commercial real estate loans. And here we are sort of seeing weakness in office. That is something that we have never seen before. And banks need to come to grips with that. I think we’re at the beginning of a crisis.
- There’s a potential crisis here in December 2024.
- Nationwide office loan delinquency rates are 6%, almost four times what they were a year ago.
- But banks have been reluctant to write down those losses.
- There’s this buildup of bad debt in the system, but it’s not being dealt with just yet.
- And that’s largely because the banks have been kicking the can down the road as best they can, trying to push this off as far as they can.
- What does that mean? It means that banks are entering into extensions on a lot of their bad loans, which essentially change their classification. From a non performing loan alone that’s in distress to a performing loan a healthy loan, even though they haven’t received a pay down on the loan.
- And the collateral value on that loan continues to drop, extend-and-pretend… that’s right.
- It works really well when interest rates are low because the banks can keep the status quo going.
- But once rates are high, it doesn’t really work anymore.
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
Personal Note: Snow Today, Tampa Next Week
“Falling snow brings peace like no other I’ve ever known.”
– Katrina Mayer
“Winter, through your horary frost, I travel on, longing to be lost.”
– Angie Weiland-Crosby
It’s snowing today. White, beautiful, and peaceful.
I wrote from home this morning and drove to the office around noon. Along the way, I saw a few kids with sleds hiking up a hill, smiling ear to ear. I bet you remember walking in their footsteps. Time with your friends and the thrill of riding down the hill. What fun.
I’m finishing up today’s post sitting on my office couch (my second favorite chair). The floor-to-ceiling windows give the office a bit of a fishbowl feel, and on snowy days like today, it’s wonderful. The slow, steady falling of snow warms the soul. Here’s a look (pardon the sneaker):
I see much of the country has frigid cold weather right now. The weather channel says to “brace for one more arctic blast this weekend, with much of the country east of the Rocky Mountains experiencing bitterly cold temperatures. However, a notable pattern change will follow, welcoming warmer weather.” I do know my friends in Colorado and Utah are skiing in deep, fresh powder. “More speed, more air!” And remember mom’s golden rule, “Do on to others as you wish they would do to you.” Which all skiers know means, “No friends on a powder day!” But do buy the first round when the day is done.
I hope that there is warm weather in Tampa, Florida, next Wednesday and Thursday.
I fly down for a dinner meeting on Tuesday, followed by a full day of presentations on Wednesday. Yes, golf is in the picture on Thursday morning at Old Memorial. It’s a wonderful course. I’ve got my clubs packed.
For those not flying to Florida, stay warm and act like a kid again! Sled on!
Trade Signals: Weekly Update – January 10, 2024
“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”
– Charlie Munger
Notable this week:
The big surprise for me and others in 2023 was the liquidity the Fed and the Treasury injected into the system after the SVB banking crisis last spring. Capital raced out of bank accounts to other larger (perceived to be safer banks) and into money market funds via brokerage accounts, mutual funds, and ETFs.
The massive amount of capital running from those 0% interest-paying bank accounts into the much higher-paying money market funds left the money market funds needing more Treasury bills to buy. The Treasury created new Treasury bills, and money exited the reverse repo market to lock in higher yields Janet Yellen was issuing via new T-bills. Effectively injected the idle cash into the financial system—a back door stealth QE.
The remaining liquidity will likely be gone by the end of March or early April 2024. Some think sooner. This liquidity helped support risk assets and the economy in 2023. We are looking for a peak in the markets by quarter end tied to the end of the liquidity injection. While the Fed raised interest rates to tighten financial conditions, they back-doored liquidity into the system, muting the impact. I missed this.
Bullish conditions remain regarding most equity market indicators you’ll find below.
What didn’t miss this move was the weekly MACD trend indicator for the S&P 500 Index. I’m closely monitoring all trend indicators, primarily the weekly MACD. Here’s a quick look: Green arrows are bullish intermediate-term trend signals, and red arrows are bearish.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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