The Return of Reasonable Returns

"There's so much money around!"

Every investor circa 2004 - ?????

Every day we read about new funds being raised to invest in distressed this or distressed that. The airwaves have replaced get rich with no money down real estate investing commercials with get rich with foreclosure and short sale investing commercials. My contrary nature tells me that all this bottom fishing is a sure sign that we are nowhere near the bottom. An Op Ed piece in Monday's Wall Street Journal by Ethan Penner called "How Low Interest Rates Contributed to the Credit Crisis" really gave me a framework for how to think about why my gut feeling actually makes sense in the real world.

Penner was a pioneer of the CMBS market, who watched an empire at Nomura go down the tubes in the 1998 CMBS debacle, and not only does he know from whence he speaks, but he has learned the hard lessons of investing through assets cycles. You can find a copy of the piece here. In it, Penner explains in very clear and concise language how investors struggling to obtain high returns in a low return world (when the Fed lowered Fed funds to 1% following the DotCom/Y2K/911 experience), ended up going off the deep end chasing private equity, leveraged debt hedge funds and all manner of other risque investments. He notes that "It can be argued that it was the low interest-rate environment that actually fueled the huge boom in the hedge-fund and private-equity world that we've witnessed in the past decade. A major flaw in all this was that targeted returns became disconnected from the risk-free U.S. Treasury yield benchmark, to which all investments are implicitly pegged." He goes on to opine that "The system became burdened with the need to produce high returns, with many investors chasing that magic 20%, in spite of the fact that yield targets had little to do with the realities of the low-rate environment."

Along the way to trying to achieve 20% returns, so many basic tenets of investing were violated it is simply amazing. Let's touch on a couple of them. The first is the one Penner focuses on:

Don't stretch for yield (or returns) - i.e., when assets generate a high return it is because they are high risk, regardless of their packaging, and while they may look cheap they are cheap for a reason, so be sure that the risk of failure is very low (even Graham & Dodd, who loved cheap, harped on this latter point).

Match maturities, don't use short-term debt to finance long-term assets. The values of long-term debt securities tend to move around a lot more than shorter-term ones. Don't leave yourself open to having to refinance short-term debt during a downturn in the value of your long-term asset. SIVs were a great example of this, as were auction rate securities and the funding of certain mortgage REITs and even Bear Stearns.

Don't leverage assets with highly volatile cash flows. Perhaps the best example of this was the leveraged buyout of Freescale Semiconductor. The semiconductor business is inherently cyclical due to the large capital investments needed to build plants and the long lead times. This also results in the companies having high operating leverage. It doesn't cost much to make one more chip and this generates a lot of incremental profit. It also really hurts profits and debt service ability if you have to make fewer chips. Why would anyone buy a company like this and load it up with debt?......a big smoking crater is the likely result.

Don't leverage illiquid assets. This is a tricky one. Lots of hybrid securities, CDOs and other funky debt products looked very liquid while markets were functioning well, but liquidity went to zero as soon as people figured out they were much less safe that previously thought. The takeaway here is that the more complex the security (and harder to value without market comparables), the more likely it is that the instrument will turn wickedly illiquid if something changes the outlook for its structure or the underlying asset it is based on.

Don't leverage assets particularly using short-term money on an investment with an initial negative equity carry. This one is too complex to explain in this post, but it's about to crush the commercial real estate market. More in another post.

Of course, violation of these basic tenets is a part of all financial cycles and this is the same as it ever was, but of course the players have to keep coming up with increasingly sophisticated ways to delude themselves. This of course makes the unraveling all the more painful....it's not just a case of bidding tech stocks up to the moon and then having them collapse. As Penner notes, "Ultimately as is always the case, there comes a time when someone rears his or her head and questions the sanity of a deal and by implication, the entire market. At that moment, when everyone is fully invested and market participants have become most complacent about risk-management concerns, everything turns and the party ends abruptly. And thus begins the reversing of the leverage-driven run-up in assets values, with valuations ultimately returning to a level that is sensible and not predicated upon either excessive leverage or pro forma assumptions that everything will work out just perfectly."

For my part I would add that the most ironical thing about financial markets is that just as these kinds of re-pricing begin to happen, for some reason the world usually goes through a wrenching change, which not only adds to the aversion to leverage, but also makes the assumptions that investors are willing to plug into pro formas become much more pessimistic as opposed to just correcting from rosy to rational. Maybe it's George Soros' concept of the Alchemy of Finance,where financiers actually change the outcomes in the real world due to their monkeying in financial markets - it actually looks like this time around it really has been financial players who caused the mess. Or maybe it's just that the problems that are building in the world are what stops the financial freight train's run just as the populous at large starts to understand them. Regardless, Penner's concept that asset prices have to fall to the point where investors are offered a reasonable return versus risk free rates sans any hocus pocus or use of outrageous amounts of leverage is spot on. But as he notes, this higher return spread versus the risk free rate may involve a higher risk free rate (in today's case he thinks this may be driven by inflation). I would add to this that the rate of return must also be calculated off of a more problematic fundamental, regulatory and tax outlook.

I doubt that those stepping in to buy distressed assets now have fully embraced the potential economic changes and likely regulatory and tax changes that may stretch out the time horizons on their investments so far that the annualized returns won't really be worth the risks they are taking. Maybe they do understand and they will keep their powder dry until price levels really do represent strong rates of future return, factoring in the realities of the changing world. With all the volume of home purchasing being ascribed to foreclosure buyers, I have trouble believing that returns in this market will be compelling for a long time to come.

From the Blogosphere

The Political Psychology of Debt - Getting Rich on Foreclosures

Real Estate Tips for the Intrepid Bargain Hunter

Discover the Hidden Fortunes in Foreclosures with Web 2.0 Marketing System

Investors Betting on Distressed Funds

Distressed Funds See Third Staright Quarter of Growth

Private Equity Funds Focus on Distressed Debt

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