Reggie Middleton is an entrepreneurial investor who guides a small team of independent analysts, engineers & developers to usher in the era of peer-to-peer capital markets.
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reggie@veritaseum.com
BoomBustBlogger and Director of Research at Paisley Financial, Mario Ricchio, writes on the abject futility of QE during a balance sheet recession. That is where I, and he, believe the US and Japan are right now. See my video take on this from a real estate perspective here. You can download Mr. Ricchio's report via this link, but in the mean time I would like to highlight some of the not so common sense remarks that I came across in such.
The report relies heavily on the conceptual framework of a U.S economy in a balance sheet recession. Our main thesis rests on the belief that until U.S households repair their balance sheets and generate real income growth, they are in no position to drive a self-sustaining economic recovery. Monetary policy (including quantitative easing (QE)) produces limited results in generating real economic growth--- since the demand for credit and the lack of qualified borrowers remain the issue not the supply of funds. Instead, expansive fiscal policy, through increased government budget deficits, exists as the primary lever to raise economic activity, transfer real financial assets to the private sector, and ease the pain of the deleveraging cycle.
When the U.S housing bubble burst, the effects reached far beyond the decline in home prices and in construction-related employment. The nature of the economic landscape changed. As home values began their descent in 2006 against a backdrop of record mortgage debt, household net worth plunged primarily through a loss of home equity (see exhibit 1). Consumer attitudes shifted from conspicuous consumption to frugality. After several decades of leveraging up the balance sheet and living beyond their means, households started the process of deleveraging characterized by: debt minimization and reduction, increased personal savings, and lower consumption (see exhibit 2). The balance sheet recession commenced and how we look at the economic cycle must change.
THE PRECURSOR TO A BALANCE SHEET RECESSION
A debt-financed asset bubble precedes a balance sheet recession. Consequently, we begin by paraphrasing the thoughts of legendary hedge fund manager, Ray Dalio, on the cycle leading up to the collapse. A healthy economic expansion starts with a private sector (corporate or household) agent holding minimal debt. The private sector begins to see income rise at the pace of GDP. At this stage of the economic expansion, the majority of aggregate demand comes from cash-based income.
For example, let’s assume the private sector spends $1,000 of cash income (which contributes to the economy); now someone else has $1,000 of income. As the economy expands, the private sector feels more optimistic and decides to leverage up the balance sheet by going to the bank and borrowing $100 per year against $1,000 of income....
FEATURES OF A BALANCE SHEET RECESSION
DEBT MINIMIZATION
Since asset prices decline (eg. house prices) well below the value of corresponding liabilities (eg. mortgages), balance sheets become impaired (eg. negative equity or negative net worth). In order to repair balance sheets, the private sector moves away from profit maximization to debt minimization2. The deleveraging cycle ends up reducing funding needs. Unfortunately, with no borrowers, the economy loses aggregate demand equivalent to the sum of un-borrowed savings and debt repayment3 . Even in a zero interest rate environment, the private sector refrains from taking on added liabilities (see exhibit 3). This outcome renders monetary policy ineffective by creating a liquidity trap.
On this very salient point, I must chime in with my own analysis and opinion...
September 1st, 2007: The very first post on BoomBustBlog tells the whole story for the next 6 years!
Thoughts on the US Publicly Traded Homebuilders - BoomBustBlog
I noticed that many pundits are focusing on single family residential market, most likely because it is in the news so often. It is bad, very bad. I am an ex-residential real estate investor who sold off in 2005 due to fundamentals that were totally out of whack. It appears that many do not see how precarious the commercial sector has become, with many deals being done at 2-5% cap rates (net profit yields) in Manhattan and many major metro areas, which is absolutely ridiculous considering the risk and illiquidity of these deals. The compensation for these deals are coming no where near justifying the risk. I am sure the excessive liquidity coupled with significant demand caused the cap rate compression, but the buyers fell for it assuming liquidity and demand would continue for some time. Well, corporate liquidity has just dried up, and many are stuck holding the bag with buildings that are yielding as low as half that of treasuries, yet easily quadrupling the risk. Some are even selling at lower cap rates in successful flips (reference the Blackstone purchase of Sam Zell's portfolio, which was totally overpriced, yet Blackstone managed to flip much of the portfolio over to speculators, some of which actually flipped it over to someone else at a profit – ALL in a period of a few months). This has now become nigh in impossible, but in an attempt to raise the cap rates, commercial rents have skyrocketed to all time highs in the major metro areas, causing significant pressure on corporate profits (I have inside knowledge of this affecting MAJOR public and private firms who are looking to expand and are getting squeezed).
And now, on to small residential (single family and 1-4 family residential)…
For those who really have a life and do not have the time to read building company annual reports, here is a bullet list of tidbits that all will find interesting, particularly in light of today's mortgage environment (pardon if their is info that you are already privy to, this is a comprehensive summary, but I am sure everybody is to find something that is of illuminating):...
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Reggie's grassroots analysis:
The S&P index severely understates the glut in housing and the downward pressure on pricing. It uses the repeat sales methodology which only includes houses have that have been sold at least twice, which excludes all new construction. So the homebuilder’s product which is being slashed in price with butcher knives and cleavers don’t even show up in the index, and these homes must be slashed enough to sell in a slow market that no longer has cheap credit, has much competition in excess supply, and no longer has the phantom appraisal pricing which helped sustain the bubble in the first place (more on this later).
The index also fails to include anything but single family detached and semi-detached housing, so coops and condos aren’t included in the mix. This means that areas like Manhattan and Brooklyn, South Miami and Las Vegas, DC and Cally are severely under counted. The mere act of excluding condos (the worst victim of boom time speculation) instantaneously makes things look a lot better than they are.
Also excluded are properties who experienced larger than median jumps in pricing, which where considered to be investor properties (benefiting from significant renovation in anticipation of resale). Investor properties constitute a very significant amount of the current prime and sub-prime defaults now.
Mentioned earlier was the push from appraisers eager to win new business. In the residential investment game, you (as in bank, mortgage banker, mortgage broker, real estate broker, investor, seller, and everyone in between) push the appraiser to come in with the highest value possible to allow you to a.) get the biggest loan possible, b.) obtain the most preferential pricing/terms (lower LTV) possible, c.) get as much from the sale as possible, or d.) all of the above. In the comparable valuation game, you pick comparables and adjust them for particulars to come up with a valuation. Once that inflated value is actually recorded in the city register, it's inflated value is used to further hyper-inflate other deals, and the upward spiral continues. The appraiser, in the boom times, picked the highest prices (which were inflated) to get a highest price (which itself was inflated) that is added into the records to make (guess what???) higher prices. Throw the petrochemical fuel of very cheap money and easy credit NINJA loans and it is easy to see how this housing boom was more than a boom, it was a speculative explosion in real asset prices that usually average 1%-3% a year in appreciation doing about 12%-100% in many places.
The caveat is, this works both ways. When the appraisers get busted for being too aggressive (and threatened with litigation and discipline - if you read the articles, they have been passing the buck saying they were pressured into inflating numbers) they start getting overly conservative and do the opposite. The banks also stop looking the other way since they may actually have to use their own money to fund/keep these loans instead of the OPM method of MBS/CDO fame. So now, the guys are looking for the lowest average prices in an attempt to be conservative, and the process reverses itself.
Now, we haven't even gotten to the commercial sector yet, where the real money is thrown around. Speculation and credit underwriting lite is coming home to roost in a sector near you.
October 2007
Straight Talk From the Homebuilder CFO: The Coming Land Recession, Pt IThursday, October 11th, 2007
December 2007
Do you remember when I said Commercial Real Estate was sure to fall?Thursday, December 20th, 2007 by Reggie Middleton
My first post on my blog in September warned about the coming drop in real estate prices. I revisited the topic a couple of weeks ago, as I prepared the research of a short position in the sector. Well, we are almost done with the research and the position and I will release a summary of the research and the performance (expected and actual) of the position after Christmas.
Check this out from January 2008
The Commercial Real Estate Crash Cometh, and I know ... - BoomBustBlog
A couple of weeks ago I informed BoomBustBlog.com readers that I was working on a big project concerning commercial real estate short candidates. I stated last year that I was sure CRE was headed down, hard. Well, I am now ready to start releasing the results of my research over the next week or so. Unfortunately, the market has moved against the subject of my research fiercely as I was completing it, but it appears to be far from over. Who is the subject of that research, you ask? General Growth Properties (GGP). I have actually seen this company pop up in the media and a few discussion groups from time to time, but they have no idea what the management of this company has been up to. First, a little background on how I got here. Those who are not versed in commercial real estate valuation are urged to read my quick and dirty primer on CRE valuation .
I told members of my analytical team to screen the commercial real estate trust, service, and development sector for the usual suspects, starting with the the guys that purchased Sam Zell’s flipped properties from Blackstone. I made some of the companies available via blog post and download: 
Commercial Real Estate Cos. (43 kB). Forest City Enterprise Peer Comparison (198.98 kB), Vonardo Realty Trust (146.49 kB). After and exhaustive screen and resultant short list, we chose GGP. I then instructed the team to canvass local and national brokers (4), databases (5) and data aggregators (several) to get the most precise localized rental and expenses figures possible. This data, as well as purchase dates, prices, management actions, capital improvements, etc. were used to plug into models such as this 33 page illustrative example, 
GGPs Woodlands Village (612.34 kB), to ascertain the true value of GGP’s portfolio. We also measured and valued their development operations, joint ventures, CMBS financing, off balance sheet vehicles and master planned communities. Sum total, I now have roughly 2 gigabytes of “REAL” valuation data on my servers covering 260 properties owned or partly owned by GGP. A this point, I may know more about their operations than they do.
What is more telling is the window of understanding this opens into the commercial real estate space in the US. It is my opinion that most are extremely over-optimistic regarding the prospects for this space.
And here we are Now, in 2011...
The “American Realist” Says: Past as Prologue – Re-blown Bubble to Pop Before the Previous Bubble Finishes Popping!!!! Wednesday, May 18th, 2011
In the post that followed said appearance, Reggie Middleton ON CNBC’s Fast Money Discussing Hopium in Real Estate, I ran down what I perceived to be the major risks of real estate in the states today, and that is a departure from the fundamentals and bleak macro outlook. During the Q&A at Roubini's crib, where I was actually guilty of accusing Nouriel of being too optimistic (I know, that's probably a first - but if anyone were to do such it would probably end up being me), participants were suggesting in a rather optimistic fashion that if a hard landing or recessionary environment were to come it would presage a time to buy assets at value prices. Of course, that is assuming those assets that you got very cheap didn't then proceed to get much cheaper. Nouriel replied exactly as I would have (and have in the past, particularly during my Keynote at the ING Valuation Conference in Amsterdam), and that was that it simply cannot taken as a given that assets prices will cyclically snap back in a year or even two. Now, I do have an investment strategy that I plan to pursue in regards to real estate, but it is quite different from what I see being bandied about today and over the last 8 years or so. To wit (as excerpted from the link directly above):
... It is the reporting company’s responsibility to report, not to obfuscate. The big problem with this “hide the market marks” thing is that markets tend to revert to mean. Unless said market values fundamentally catch up with said market prices, you will get a snapback. That is what is happening in residential real estate now. That is what happened in Japan over the last 21 years!!! That’s right, it wasn’t a lost decade in Japan, it was a lost 2.1 decades!
This has been the first balance sheet recession that the US has ever had, but there is precedence to follow. Japan had a balance sheet recession following their gigantic real asset bust. They made a slew of fiscal and policy errors, which essentially prolonged their real asset recession (now officially a depression) for T-W-E-N-T-Y O-N-E long years! For those that may have a problem reading that, it is 21 long years.What did the Japanese do wrong?
- They refused to mark assets to market
- They attempted to prop up zombie banks
- They failed to promptly clean up NPAs in the banking system
- They looked the other way in regards to real estate value shenanigans
