Tuesday, 15 February 2011 17:15

The Coming Interest Rate Volatility, Sovereign Contagion, Geo-political Unrest & Double-Dip Recessions: Here's The Answer To Valuing Global Real Estate Through This Mess

In reviewing today's headlines, we come across the reliably unreliable Eurozone statistician and forecasting figure failure, again: Euro Zone Economic Growth Below Forecasts:

The euro zone economy grew at the same quarterly rate in the fourth quarter as in the third, data showed on Tuesday, defying expectations of an acceleration.

The European Union's statistics office Eurostat said gross domestic product in the 16 countries using the euro at the time grew 0.3 percent in the October-December period, the same as in the third quarter.

Year-on-year, the expansion was 2.0 percent in the fourth quarter, compared to 1.9 percent in the third quarter.

Economists polled by Reuters had on average expected increases of 0.4 percent quarter-on-quarter and of 2.1 percent year-on-year.

Of course, it is that expected (yet not actually achieved) growth that was supposed to fund the deficits in many of the PIIGS group austerity plans. Export was a major component of this, but if the Eurozone is growing slower than anticipated (big surprise) and the EU members rely primarily on trade with each other, then who will buy all of the stuff to allow these states to pull each other out of the hole. The kicker is that the individual countries' forecasts are considerably more optimistic than the economists' forecasts, which in and of themselves were simply too optimistic. This has been a pattern since the markets collapsed three years ago. Referencing "Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!" you can see where this is a pattern in country after indebted country in Europe - both in and out of the Eurozone - Greece, Spain, Italy, Portugal, even the UK. To wit...

What about the UK?

I'm glad you asked. We just finished our UK analysis (subscribers, see UK Public Finances March 2010 UK Public Finances March 2010 2010-03-24 09:32:01 617.23 Kb), and the Greek theme has continued into the land of the Brits.


It's even worse when the more feeble economies that don't have their own printing presses get caught in the disinformation (subscribers, reference File Icon Greece Public Finances Projections):




Speaking of the UK, one can expect rates to be raised any minute now. I guess all of the Bernanke-ish QE cum ZIRP is starting to face reality. From CNBC - UK Inflation Surges to 4%, Highest Since Nov. 2008:

The Office for National Statistics said that the rate of consumer price inflation rose to 4.0 percent in January, in line with economists' forecasts, from 3.7 percent in December.

The rise, which was driven by higher oil prices and increased indirect taxation, means inflation has been at least a percentage point above the BoE's 2 percent target for more than a year.

BoE Governor Mervyn King will have to publish a letter to finance minister George Osborne later on Tuesday explaining why inflation remains so high.

Oh, that should be rich!

Previously King has blamed above-target inflation on a succession of one-off factors, including rises in value-added tax, the depreciation of sterling and spikes in commodity prices.

How sure is he that these are one-off factors? The Sterling is not going to depreciate any further? Britain will not hit the VAT bin for revenues again? And here's the kicker, commodity prices will spike no more because Ben Bernanke has finished his exportation of input price, food and commodity price inflation to the rest of the world. Yep, all one-off occurrences.

Economists expect the BoE to raise interest rates from their record low of 0.5 percent later this year, and investors are betting a rise will come by May... On the month, CPI rose by 0.1 percent, the first time it has risen between December and January on record. CPI typically falls in January due to post-Christmas discounting. The retail price inflation gauge, which includes more housing costs and is the benchmark for many wage deals rose to 5.1 percent, its highest since May 2010.

Oh, there's more:

As I have alluded to for some time, you cannot raise taxes and cut spending amid a glut in debt and general global slowdown and expect to grow your way out of the hole. This is common sense, reference Data suggests Portugal headed back into recession:

Feb 14 (Reuters) - Portugal's economy shrank 0.3 percent in the last quarter of 2010, reversing a third-quarter expansion and reinforcing market expectations of a new recession this year as public sector cutbacks eat into consumer demand. The decline matched forecasts from a Reuters economist survey, though Monday's data also showed growth of 1.4 percent across the whole of 2010, beating the government's own prediction of 1.3 percent mainly thanks to a rise in exports. Portugal's economy contracted 2.5 percent in 2009 and analysts say it must break a cycle of chronically poor growth and recession if it is to dig itself out of a debt crisis that has made it the next candidate for an EU bailout. With the government seeking to calm creditors by raising taxes and cutting public sector wages to reduce the fiscal deficit to 4.6 percent of GDP this year from around 7 percent in 2011, it is difficult to see where an acceleration will come from in the short-term. Poor growth in turn makes it harder to meet fiscal targets.

The odds are greater in favor of a Portugal restructuring than they are against one. I can say this because I had my team take the time to pour through the math, all of the math. All viewers should reference Portugal’s Debt Ridden Finances: An Analysis of Haircuts, Restructuring and Strategy – Professional Analysis wherein you can find a complete workup of the Portuguese situation and complete scenario analysis of haircuts, how much, how they should be structured, and nominal and NPV losses to debt holders. This is the type of stuff that simply cannot be found anywhere else on the web. I have made available for free to exemplify the quality of work that we do here.

It doesn't take a genius to determine that Europe is going to see some interest rate volatility in the near to medium term and the risk of contagion is great.

foreign claims of PIIGS

This economic and financial contagion, combined with the upcoming interest rate volatility (when rates are set at zero, what direction do you expect them to go in the face of market turmoil?), will wreak havoc on the anemic real estate markets both in Europe and the US.

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Amsterdam’s VPRO Backlight and Reggie Middleton on brutal honesty, destructive derivatives and the “overbanked” status of many European sovereign nations. Start at 7:35 in the video. The essence of Realpolitik is espoused at 11:00 in the video. Basically, "If you're pessimistic or optimistic, you'll probably end up being broke very soon!".

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Finally, a SOLUTION, at least for those interest in real asset classes!

We have come up with a solution to the pricing and valuation of said real estate assets, taking into consideration the nuances, inputs and risks coming from so many different geo-political, macro-economic and financial directions. It entails taking the talents of objective observation and rigorous, multi-discipline analysis and broaching the problem from the most realistic perspective possible. For those that have just started following me, this methodology has created an outstanding track record of calling nearly every single aspect of the 2008 market crash, including real estate markets, specific REIT bankruptcies (GGP), bank collapses (ex. Bear Stearns), etc. months in advance of their actual occurrence (see the complete list and links to substantiation at the bottom of this post).

To begin with, we have isolated risks of contagion and place probabilities on them...

... and taken cross asset and geographic correlations into consideration.

As you can see above, correlation across geo-political boundaries and asset classes abound. So, where does this leave us in terms of our proprietary contagion model.

What we set out to do was to adjust the pathways of apparent pure financial contagion with several, real world factors.


In order to derive more meaningful conclusions about the risk emanating from the cross border exposures, it is essential to closely scrutinise the geographical break down of the total exposure as well as the level of risk surrounding each component. We have therefore developed a foreign claims model which aims to quantify the amount of imported financial risk for major developed countries including major European countries, US, Japan and Australia.

I.        Summary of the methodology

  • We have followed a bottom-up approach wherein we have first identified the countries/ regions with high financial risk either owing to rising sovereign risk (ballooning government debt and fiscal deficit) or structural issues including asset bubble collapse, declining GDP, rising unemployment, current account deficits, etc. For the purpose of our analysis, we have selected PIIGS, CEE, Middle East (UAE and Kuwait), China and closely related countries (Korea and Malaysia), US and UK as the trigger points of the financial risk dissemination across the analysed developed countries.
  • In order to quantify the financial risk emanating in the selected regions (trigger points), we looked into the probability of the risk event happening due to three factors - a) government default b) private sector default c) social unrest. The probabilities for each factor were arrived on the basis of a number of variables determining the relative weakness of the country. The aggregate risk event probability for each country (trigger point) is the average of the risk event probability due to the three factors.
  • Foreign claims of the developed countries against the trigger point countries were taken as the exposure which will result in transfer of financial risk. The exposures of each developed country were expressed as % of its respective GDP in order to build a relative scale for inter-country comparison.
  • Risk event probability of the trigger point countries was multiplied with the respective exposure of the developed countries to arrive at the total financial risk imported by each developed country.

II.         Detailed description of methodology

Amid the global slowdown and the financial crisis of an unprecedented scale, some countries stand out to be more vulnerable and have been more severely hit than the others. We identified some of these problematic countries/ regions to be the trigger points which are capable of spreading financial risk to other countries. For the purpose of our analysis, we have selected PIIGS (Portugal, Ireland, Italy, Greece, Spain) , Central and eastern Europe (Czech Republic, Hungary, Poland, Slovakia, Estonia, Latvia, Lithuania, Bulgaria, Romania, Croatia, Serbia, Turkey, Ukraine, Russia) , Middle East (UAE and Kuwait), China and closely related countries (Korea and Malaysia), US and UK as the trigger points.

Further, the economic and financial issues surrounding each of the hard-hit countries tend to vary. The problems for the countries in Central and Eastern Europe were primarily driven by huge foreign imbalances (very high foreign private borrowing and high current account deficits) and high export orientation. The crisis in Greece was triggered by huge government debt and rising fiscal deficit. Structural issues resulting from bursting of asset bubble and rising unemployment have been the major areas of concerns for Spain and Ireland which are also witnessing rapid increase in government debt and fiscal deficits. Italy, on the other hand, has one of the largest government debt as % of GDP which is feeding the increased sovereign risk perception for the country. UAE is teetering under the sharp correction in highly leveraged real estate sector while China runs under the risk of collapse of huge asset price bubble developed over the last few years. US and UK – the two super-powers are also striving with the asset price declines and rising unemployment while the bail-out of the financial sector and huge fiscal stimulus is fuelling the rapid increase in government debt and fiscal deficits.

The income decline, job cuts and mounting debt burdens have also led to social unrest and political instability in some of these countries. Since there is a wide spectrum of issues and some issues impact a country more than the other, we evaluated the country’s relative standing vis-à-vis other countries on the following three risk factors.

  • Government default – Variables considered include government debt as % of GDP and fiscal deficit as % of GDP in 2010.
  • Private sector default – Variables considered include asset price decline (house price decline over last two years), unemployment ( unemployment rate in 2010e), decline in income levels ( real GDP growth and inflation rate in 2009 and 2010e) and foreign imbalances (foreign debt as % of GDP and current account balance in 2009 and 2010e)
  • Social unrest - Variables considered include general strikes, demonstrations, protests, unemployment, government policies, and political instability.

The methodology for computing the risk event probability on account of each of the three factors is discussed below

We then took this analysis and used it to build contingent pricing mechanisms into cap rate and economic capital analysis, complete with mechanisms for factoring the contingent risks of over supply.

One can consider this a derivative whose goal is to achieve clarity and pricing transparency, which is ironic since much of the Street uses derivative products to create opacity in pricing - which oft brings wider profit margins. This is heady stuff for the traditionally staid real estate industry, but we are in heady times.  The result is a pricing and valuation mechanisms that takes into account the major risks to the global real estate markets today -

  1. economic/financial contagion
  2. interest rate volatility
  3. geo-political risks
  4. excess supply due to overbuilding
  5. weak macro factors
  6. and of course, that oft-forgotten aspect - the core fundamentals.

I will be revealing more on this pricing of hard to value assets in a time of potential turmoil as the keynote speaker for approximately 200 institutional CRE investors at the ING Commercial Real Estate Conference in Amsterdam on April 8th. See www.seminar.ingref.com (or click below to expand). Feel free to contact me if you are interested in attending. I will personally work with institutional subscribers to develop customized pricing/valuation mechanisms for their real asset investments.

For those who have not followed me throughout the Asset Securitization and Pan-European Sovereign Debt Crisis, I have a relatively respectable record for calling the reality of the situation, including but not limited to….

  1. The housing market crash in September of 2007: Correction, and further thoughts on the topic and How Far Will US Home Prices Drop?
  2. Home builders falling and their grossly misleading use of off balance sheet structures to conceal excessive debt in November of 2007 (not a single sell side analyst that we know of made mention of this very material point in the industry): Lennar, Voodoo Accounting & Other Things of Mystery and Myth!
  3. The collapse of Bear Stearns in January 2008 (2 months before Bear Stearns fell, while trading in the $100s and still had buy ratings and investment grade AA or better from the ratings agencies): Is this the Breaking of the Bear? | After the collapse, a prudent bullish call as well… Joe Lewis on the Bear Stearns buyout Monday, March 17th, 2008: “The problem with the deal is that it is too low, and too favorable for Morgan. It is literally guaranteed to drive angst from the other side. Whenever you do a deal, you always make sure the other side gets to walk away with something.  If you don’t you always risk the deal falling though unnecessarily. $2 is a slap in the face to employees who have lost a life savings and have the power to block the deal. At the very least, by the building at market price and get the company for free!” | BSC calls are almost free and the JP Morgan Deal is not signed in stone Monday, March 17th, 2008 | This is going to be an exciting, and scary morning Monday, March 17th, 2008 | As I anticipated, Bear Stearns is not a done deal Tuesday, March 18th, 2008 [Bear Stearns stock goes from $1 and change to $10, front month calls literally explode from pennies to several dollars]

  4. The warning of Lehman Brothers before anyone had a clue!!! (February through May 2008): Is Lehman really a lemming in disguise? Thursday, February 21st, 2008 | Web chatter on Lehman Brothers Sunday, March 16th, 2008 (It would appear that Lehman’s hedges are paying off for them. The have the most CMBS and RMBS as a percent of tangible equity on the street following BSC. The question is, “Can they monetize those hedges?”. I’m curious to see how the options on Lehman will be priced tomorrow. I really don’t have enough. Goes to show you how stingy I am. I bought them before Lehman was on anybody’s radar and I was still to cheap to gorge. Now, all of the alarms have sounded and I’ll have to pay up to participate or go in short. There is too much attention focused on Lehman right now. ) | I just got this email on Lehman from my clearing desk Monday, March 17th, 2008 by Reggie Middleton | Lehman stock, rumors and anti-rumors that support the rumors Friday, March 28th, 2008 | May 2008
  5. The fall of commercial real estate in general (September of 2007) and the collapse of General Growth Properties [nation's 2nd largest mall owner] in particular (November 2007): BoomBustBlog.com’s answer to GGP’s latest press release and Another GGP update coming… (among over 700 pages of analysis, review the January 2008 archives or search for “GGP” for more research).
  6. The collapse of state and municipal finances, with California in particular (May 2008): Municipal bond market and the securitization crisis – part 2
  7. The collapse of the regional banks (32 of them, actually) in May 2008: As I see it, these 32 banks and thrifts are in deep doo-doo! as well as the fall of Countrywide and Washington Mutual
  8. The collapse of the monoline insurers, Ambac and MBIA in late 2007 & 2008: A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton, Welcome to the World of Dr. FrankenFinance! and Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion
  9. The overvaluation of Goldman Sachs from June 2008 to present): “Can You Believe There Are Still Analysts Arguing How Undervalued Goldman Sachs Is? Those July 150 Puts Say Otherwise, Let’s Take a Look”, “When the Patina Fades… The Rise and Fall of Goldman Sachs???“and Reggie Middleton vs Goldman Sachs, Round 2)
  10. The ENTIRE Pan-European Sovereign Debt Crisis (potentially soon to be the Global Sovereign Debt Crisis) starting in January of 2009 and explicit detail as of January 2010: The Pan-European Sovereign Debt Crisis
  11. Ireland austerity and the disguised sink hole of debt and non-performing assets that is the Irish banking system: I Suggest Those That Dislike Hearing “I Told You So” Divest from Western and Southern European Debt, It’ll Get Worse Before It Get’s Better!
  12. The mobile computing paradigm shift, May 2010: »

Last modified on Thursday, 17 February 2011 02:11