Picturing Deflation: Velocity of Money Slows

A: Where did the money go? The fed is trying to stop a deflationary spiral, but still there are those out there that dismiss we are experiencing deflation. Which begs the questions, WHAT IS DEFLATION? Saying it is the opposite of inflation doesn't really help us because there are different definitions for inflation. I used to view inflation as a general increase in prices and the cost of living. I was wrong. Sure, that is one form of inflation, but it is not the type of inflation that the fed worries about that ultimately would lead to aggressive rate hikes to fight it. Rather, the form of inflation the fed worries about is an expansion of the money supply & credit; that may trickle through to wages. Acknowledging this, we can now come to a simple definition for deflation: a contraction in the money supply & credit, and a correlating drop in the velocity of money. Lets discuss.

What is the velocity of money and why do we care? Well, it kinda means something if we are trying to gauge the strength of an economy. I like the way Brian Bloom describes the Velocity of Money:

This is best understood by thinking about the concept of the Economic Multiplier Effect. Essentially, if I earn $100 and I save (say) $4.50 then I will spend the other $95.50. The person who receives the $95.50 will spend some and save some. In this way, a $100 injected into the economy by the Central Bank grows to become a multiple of the original $100.

So, a $100 that I earn today, will be spent by me to buy earrings for my wife so she doesn't leave me. Then, the store clerk will take that $100, and pay her energy bill. Then, Con Ed will take that $100, and put it towards the salary for one of their employees, and so on and so on. The point is that the same $100 gets circulated throughout the economy. The higher the velocity of money, the stronger the economy as the same fixed unit of money freely flows throughout the system. Think of an economy where a $100 earned, doesn't get spent and therefore doesn't flow back into the economy; clearly that is not a sign of a strong economy right? Well, that is where deflation kicks in. In times of hyperinflation, the velocity of money should surge. In times of deflation, the velocity of money slows. So lets look into this.

If you recall my 'Fisher's Debt-Deflation Theory' discussion, Stage 8 included the "Slower Velocity of Money". You calculate the velocity of money by dividing the total GDP (a measure of the nations output) by the money supply. As I discussed last week, the adjusted monetary base is surging as the fed tries to inflate their way out of this mess. Before we take a look at the charts, we need to understand one thing:

The increase or decrease in the velocity of money has a multiplier effect because this new money OR saved money will either create more new money or contract the multiplier effect. Slowing velocity leads to a negative multiplier effect while rising velocity leads to a positive multiplier effect.

I can't seem to find a chart on the Velocity of Money, but I do see this chart from the St. Louis fed showing us the M1 Multiplier Effect, which shows the effect of money velocity as I just stated above:

Quite a sharp decline in the multiplier effect! This is the result of a slowdown in the velocity of money, consistent with Stage 8 of Fisher's Debt-Deflation theory. As time goes on, it is becoming more clear that we are indeed in a period of debt deflation.

Which leads to where did the money go? Is it in mattresses? Is it being spent? Is it in bank deposits, yet not being lent? Tom Evslin chimes in about 'The Physics of Money' over at Seeking Alpha:

The faster we spend, the more money there is available in the economy. Money we put in our mattresses might as well not exist as far as the economy is concerned even though it may be very important to us. Money we put in the bank is USUALLY as good as spent economically because it gets lent to someone else who spends it. But these aren't usual times; if the bank doesn't relend the money, it might as well be in a mattress.

Banks aren't lending like they used to; we aren't spending like we used to. The velocity of our money supply has slowed to a crawl; that's how we moved from inflation to deflation; the money stopped going around. Inflation isn't a concern because deflation is the problem. Governments want prices to stop falling so they're working to cheapen their currencies – backwards of what we're used to since inflation is what we usually worry about.

These are unprecedented times and the first time I am experiencing a cycle of debt-deflation in the real world. The fed is conducting massive lending facilities, aggressively cutting funds rate, bailing out insolvent banks/insurance companies, and applying measures not used since the Great Depression. To me, this is an amazing learning experience not to be missed, and I want to see not only the effects of what they are doing on the money supply, etc., but what the end result winds up being so I can position myself appropriately. I will be watching the M1 Money Multiplier and the Adjusted Monetary Base weekly as this story continues to play out.

Thoughts?

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The Buyer - Seller Disconnect

A: Okay, for readers of this site for the past few years the current environment in Manhattan real estate is no surprise. I've downplayed the weaker dollar / foreign demand trade that so many brokers used as a reason this market will forever flourish, I've discussed the decline in buyer confidence since AUG 2007, I tried to explain the severity of the credit crisis since the beginning, and I explained why 2009's bonus season was the one to worry about + discussing how the wall street business model was 'game over'. If you missed these, go back and read the discussions and put yourself back into time & place. We are at now now, the downturn has started, and the market is fairly illiquid at the moment as an end result to everything just mentioned. The reason lies in a lack of buyer confidence which leads to a disconnect between buyers & sellers.

So, why is the market illiquid? Two main reasons:

a) sellers are anchored to peak pricing; yet to realize the significant decline in buyer confidence OR that their property is likely worth 15-20% below peak levels

b) buyer confidence has not only declined, but has been shattered; as prices fall and fundamentals deteriorate, more buyers have rushed to the sidelines rather than jump into the market to take advantage of deals. The sideline money theory (the argument, mostly by brokers, that there will be a floor on prices because buyers will flock to pick up deals from the sidelines on even the most minuscule of price adjustments) was proven wrong once again

...the disconnect is making the market illiquid. Lets discuss each.

SELLERS: Some of you guys really have to sell your property! I sure hope that you did not decide to work with the broker that promised you an unrealistically high price simply on the premise that the way they do business is so far superior to every other broker out there. If you did fall for this broker trick, you probably find yourself behind-the-curve, watching the market deteriorate in front of you, playing catchup with your asking price to try and re-stimulate traffic. If you have to sell, stop anchoring your price expectations to peak levels and comparable units that sold when buyer confidence was significantly higher. If you do anchor your property near peak levels and find traffic very slow, your only shot is to hope that a greater fool will show up at the next open house, and offer a bid near ask. This is quickly becoming wishful thinking that will put you even further behind-the-curve. If you have to sell, adjust your price accordingly to more in line with where deals are actually happening at right now; and trust me, they are few and far between!

If you don't have to sell quickly, yet you would like to sell, you have some decisions to make. Seller psychology goes something like this:

SELLER SAYS: Well, if I don't price my property near the top sale in my building 10 months ago, I will never know if I can get a better price! So, I'd rather at least try and test the market first, and then I'll lower my price late if I get no bites.

That's fine, its your place and you can do whatever you want! But the problem with this sell-side philosophy is when the seller gets a realistic bid in the first 1-2 months, as they are priced near peak levels! When this occurs, the seller usually gets greedy, either doesn't respond to the realistic bid or only responds with a modest counter offer. If the deal doesn't happen, they often find themselves regretting it later on. It wasn't the buyer that was unrealistic, it was the seller! So, my advice to sellers in this category, is strongly consider a low ball bid you may get if you are currently testing the market; it may be the best bid you get!!

BUYERS: Oh, the buyers. Oh how they have waited for this. In my 4 years of real estate, so many buyers watched the market rise 10%, then 20%, then 30%, then 40% since 2004's transaction levels. Towards the end of the boom (I would put the peak at contracts/deals signed in early-mid 2007), buyers found themselves wondering 'when will it end'? It's funny how psychology works. Buyers who did not pull the trigger yet, get MORE INTERESTED when the media reports rising prices and LESS INTERESTED when media reports pressure on prices. Isn't that amazing? Not really, it's human nature. Buyers like to think they are putting money to work in an environment where their newest asset is appreciating. Nobody likes a depreciating asset. But if you buy when the market is pressured, the price you are likely to pay should be more attractive then if you bought at the height of the boom with prices rising. Don't people want a better deal? Yes, they do but buy side psychology is too ingrained on the direction of the asset as opposed to the price of the asset!

This is the reason why even with the market down 18-20% or so from peak levels, as I believe deals are happening at now, the market is still illiquid! If anything, buyers who have been waiting patiently, are now rushing to the sidelines to wait even more for a better deal as the direction of the asset's trend becomes more clear. This phenomenon is why sales volume will be very poor for the next few quarters here in Manhattan; with the root causes of this lying in deteriorating macro fundamentals (job losses, nationwide recession, negative wealth effect, etc.) and a severe credit crisis. Hence the disconnect reveals itself.

The distance between buyers and sellers right now are contributing to this illiquid market and the cycle feeds on itself. I wouldn't be surprised to see sales volume down 40-50% in the 4th quarter. Some brokers find themselves in awe, or shock to see that even with massive reductions their property is still not getting many bids. Other brokers are still up to their old tricks, promising the world to sellers trying to get as many listings as possible. For me, I think its all about the buyers; always have! Until buyer confidence returns, this market will be illiquid and that means those sellers that are forced to sell, are revealed. The knee jerk correction from peak levels is in process and its time to see who is overexposed. Adapt accordingly or risk finding yourself in a fierce sell side competition with other sellers who have to sell too, at a time when strong, quality bids are more of a rarity.

They say the deal happens when there is a 'meeting of the minds'. Well, in this market, it's the seller's mind that has to be more proactive to make the connection!

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Fed BB: Co-ops/Condos Down 15-20% Since Mid Summer

A: Quite interesting to see this right after a discussion on how illiquid this market is right now. The Federal Reserve Beige Book was released today and there is an interesting tidbit on NYC real estate, confirming the real time discussions on UrbanDigs.com over the past several months. Lets keep on keeping it real at UD!

From the Federal Reserve 2nd District - NEW YORK:

Construction and Real Estate

Housing markets in the District have deteriorated further since the last report. A major residential appraisal firm reports substantial deterioration in New York City's housing market over the past two months: prices of Manhattan co-ops and condos are reported to have fallen by 15 to 20 percent since mid-summer, though it is hard to get a clear handle on prices due to thin volume--much of the recent activity is reportedly from desperate sellers. Transaction activity has dropped off noticeably, and there has been a large increase in the number of listings. Some buyers that had signed contracts for units under construction earlier this year are having trouble getting financing at the contract price now that market values have dropped. Many of those having difficulty selling their apartments are putting them up for rent, boosting the number of rental listings substantially--particularly in doorman buildings. Average asking rents are reported to be down 1 to 4 percent from a year earlier.

"Thin Volume"? Sound like something you read here on UrbanDigs.com recently? Thats because you did! The major appraiser was Jonathan Miller's firm Miller Samuel. Jonathan blogs over at the Matrix.

Earlier Today ---> The Buyer Seller Disconnect

"The distance between buyers and sellers right now are contributing to this illiquid market and the cycle feeds on itself. I wouldn't be surprised to see sales volume down 40-50% in the 4th quarter. The knee jerk correction from peak levels is in process and its time to see who is overexposed."

NOV 20th ---> Adjustment Phase Will Reveal Skinny Dippers

"With the market highly illiquid right now as buyers back off, sellers that were overexposed, over-leveraged, lost their job, bought on the currency trade with expectations to flip at a profit, or just scared about the future, aggressive price reductions are the only way to move property."

NOV 14th ---> Manhattan Inventory Passes 9,000

"As sales volume slows and inventory rises, it represents a shift in psychology amongst both buyers & sellers. The Manhattan real estate marketplace right now is noticeably more illiquid today than normal for this time of year."

NOV 8th ---> A Downturn Begins

"If I had to estimate where we are right now, I think we had the quick adjustment of 12%-18% from peak levels already, with pockets of distress doing deals at lower levels or wherever a serious bid that can get financing comes in at. We are at now now and I will tell you that the price that deals are happening at in ALL neighborhoods in Manhattan are down right now from peak levels!"

OCT 16th ---> Yale Club Highlights

"Sellers are anchoring to peak 2007 types of prices of $1,400 per square foot. They have not yet faced the reality that to move their properties they will have to compete with other listings and offer buyers a margin of safety. I think forces are conspiring for a significant break in prices, it hasn't happened yet, but buyers are going to be in charge soon."

JULY 7th ---> Low Ball Bids & Cold Feet

"That is how I would describe today's Manhattan real estate marketplace. Today's Manhattan real estate market is one of caution and proper pricing. On the streets, brokers are learning very quickly these days that the used car salesman approach to selling properties doesn't really work anymore; and in fact, only makes the agent using the tactic look like an idiot and way behind the curve. I am finding buyer's to be very savvy these days, very cognizant of what is going on around them, even if they do not fully understand the depth or severity of credit deflation that is currently occurring. It all adds up to the same thing, continued decline in buyer confidence. This results in cautious bidding."

Keeping it real folks!! That's what you get here and what I will continue to do. You want to stay ahead, keep it here!

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NYC Commercial Meltdown - Listen to the Message for Residential

According to a recent New York Times article, as we have been expecting, New York City's office market has hit the skids, big time. In my mind, the message here with regard to residential real estate is very noteworthy. Eventually in a poor demand environment prices will fall, despite a previously tight supply environment and positive long-term outlook. The New York City commercial market is sending a strong signal not just about the New York residential condominium market, but even the multi-family rental market.

Way back in January of 2008, I penned a piece Commercial Real Estate - The Next Train Wreck? In that piece I touched on the Three Cardinal Sins of Real Estate 1) Overpaying, 2) Over-Leveraging 3) Over-Building. In my opinion at the time, it was obvious that many had broken the first two rules, but that in some markets, particularly New York, the third rule had not been totally violated.

In June I did a follow-up piece on the commercial market and focused on the NYC Office Market. I noted:

"The Manhattan office market is and has been for several years, purely a demand-driven market, supply just isn't a big factor. Further, I will aver that as a result of the tight supply situation, which, under normal circumstances looked likely to persist for at least a couple more years, few employers in New York want to risk running out of space and/or having to find new space at substantially higher rents. For these reasons it is particularly notable that the commercial market in New York is softening fast. It argues that space reductions are being made despite the fact that space might be quite tight in the next upturn, indicating that those cutting back expect their employment levels in Manhattan to remain lower for several years to come."

I also included some interesting figures to back this up, saying:

"According to Scott Latham, Executive Vice President of Cushman & Wakefield, as quoted earlier this year on The Stoler Report, during the 1960s, 1970s and 1980s builders delivered an average of 56.5 million square feet of new commercial office space per decade, plus or minus. In the 1990s and 2000s 15.5 million feet of new space was delivered while 25 million feet of commercial space was converted to other uses. The city has been experiencing demand growth of about 3.5 million square feet per year typically.

The Manhattan office market constitutes an estimated 350 million square feet of space. So the typical annual addition of space recently has been 1% of the total. As you can tell, it would take several years of space additions with no increase in demand to cause vacancy rates to move up 3 percentage points. Another way to look at it is that as the economy recovered from 9/11, between 2004 to 2006 vacancy rates fell from 10.9% to 5% and 30 million square feet of space was absorbed. Voila! demand-driven market."

So now some figures from Colliers AB as reported in the New York Times. There is nearly 16 million square feet of office space in 68 office buildings as large blocks listed today. This is a doubling of large office blocks, which had previously been incredibly tight, due to the very reasonable growth of new supply (which always has lots of contiguous space). The large block space that is avialable constitutes about 5% of the total NYC office market in and of itself. Importantly, at least 16 large office blocks are being marketed for sublease, up from 3 last year. Let's focus on this last point for a minute. In many cases when commercial real estate owners lose tenants, if they are at all optimistic about the long term, particularly in a great market like New York City, they decide, that if they can afford to, they will let the space stay empty for a while, rather than entering into long-term leases at low prices. In fact, Michael Calacino, the president of brokerage firm Studley, is quoted in the New York Times article as saying "A lot of landlords are still in denial." However, sublettors can't play that game. If you are on the hook for real estate you can no longer afford, you hit bids. The old Wall Street maxim "Your first loss is your best loss" comes into play. In fact, according to Studley, as a result of aggressive sublet deals, actual rents on deals that have been signed in the last quarter fell by as much as 20-30%. Now most people in commercial real estate know this phenomenon of sublets by heart. But it is instructive to think about indirect price transmission mechanisms like this that come into play in downturns across various asset classes. Let's take another example. I had a client in Florida that was a very successful, family-run real estate operation. They were looking for broken deals to buy cheap and finish rehabbing. I spoke with several large banks I knew had portfolios of loans in the markets my client was interested in. I had a discussion with the chief lending officer of National City Bank one day and he told me that they had learned from the early 90s not to blow out real estate at 30 cents on the dollar BLAH BLAH BLAH. You know, National City never did blow out their impaired assets. They are gone now and management is likely being blown out instead, having been acquired by PNC as a result of pressure from regulators. My bet, is that they will now finally start selling problem assets at whatever price it takes to clear them out. On the other hand, maybe PNC can afford to hold out for higher prices. Maybe it will be another bank that sets the new low price floor because the FDIC liquidates them directly. My point is there is no way to stop the price adjustment; eventually someone will have to sell and it will only take one transaction to establish a new, lower price plane. This is what we are seeing in the commercial market with sublets.

Let's talk about another market that people still believe is somewhat impervious to the pain we are seeing in commercial. As Urban Digs readers know, I love the New York City multi-family rental market as an asset class longer term, but I think people overpaid for properties and over-levered them. You can read about it in my September 2008 piece NY City Rental Property-As Good As T-Bills - NOT! This is another market that is in no way over-supplied, but I am convinced will see pressure on rents due to demand issues. But wait, you say, if people become afraid to buy condos, won't they continue to rent and won't that boost the rental market. Here's the rub - some more non-obvious transmission mechanisms for lower prices are at work. As noted in another recent piece, Toll Bros. is doing rent to own in one of its buildings and they are competing with sublet listings by current owners. Separately, young people are increasingly sharing apartments. According to New York Habitats roomate share accommodations are up nearly 50% from 2006 through the first half of 2008. According to an article in the Queens Gazette, the New York Foundation for Senior Citizens' Home Sharing program has received the largest increase in home sharing applicants at any time since it started 27 years ago.

Tishman, who bought Peter Cooper Village and Stuyvesant Town to take these apartment complexes upscale, is reportedly packing the place with college students who will each pay a premium amount to jam into apartments together. Why are they doing this? They need to support the huge leverage they put on the project. What do you think converting these apartments to dorms will do to rents longer term? Won't the huge absorption of college students into these gigantic apartment complexes hurt rents at the other East Village buildings that used to serve as accommodations for students.

The cat is now very much out of the bag with regard to over-levered multi-family housing and the attempts to get rent-regulated apartments to turn over to free market rates (Schumer Seeks protection for Apartment Buildings Facing Default). Not only will officials be watching the landlords closely, but tenants are starting to realize that they are in no position to try and push rents up on the apartments that have been deregulated.

Now I don't have to tell you that with mergers, acquisitions and liquidations of financial firms still ongoing, pressure on office property rents will continue to increase. I think you may see now how even the heretofore bullet proof multi-family rental market which dominates New York City residential space (about 70% renters and 30% owners), could see rents and/or occupancy pinched. I hope, therefore, that the point is not lost on you that despite the tight supply of owner-occupied residential space, a large percentage of existing owner-occupied buildings being co-ops where owners are traditionally less leveraged and carrying strong cash reserves, demand still rules. Transmission mechanisms we may not even be able to visualize now will pressure prices down, and weak-handed owners, no matter how small the number, will ultimately set pricing when the merde hits the oscillating respirateur. Which should be happening right about now.

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Housing Supply Fix? Grant Investors A Tax Exemption Benefit

A: I'm just a guy thinking out loud here about an alternative to help the housing supply problem in this country, instead of meddling with rates! Breaking news on WSJ.com states, "Treasury Considers Plan to Stem Home-Price Decline; Rates Could Be as Low as 4.5% for Newly Issued Loans". Instead of rate meddling, why not tweak the capital gains tax benefit for investors and make it similar to the tax exemption that is offered to primary residents who live in their homes for a period of 2/5 years? Let me explain.

First, the rate meddling news from WSJ.com:

The Treasury Department is considering a plan to revitalize the U.S. housing market by reducing mortgage rates for new loans, according to people familiar with the matter. The plan, which is in the development stages, would use mortgage giants Fannie Mae and Freddie Mac to bring loan rates down as low as 4.5%, a full percentage point lower than the prevailing rates for 30-year fixed mortgages.

Under the plan, Treasury would buy securities underpinning loans guaranteed by the two mortgage giants, which are temporarily under the control of the government, as well as those guaranteed by the Federal Housing Administration.

Sweet, more tinkering and more loan purchases by our government to get rates even lower than they are right now, to convince people to buy homes while the rate is low enough! Oh yea, this can't fail and I'm sure the rate meddling or loan purchases by the government has no side effects!

Instead, how about this:

GRANT THE PRIMARY TAX CAPITAL GAINS EXEMPTION BENEFIT TO INVESTORS AND CHANGE THE QUALIFICATION TERMS SO THAT THE PROPERTY PURCHASED BY THE INVESTOR MUST BE HELD FOR A MINIMUM PERIOD OF 5 YEARS

Lets look at how the tax code is right now for both primary residents and investors. Please note I am NOT an accountant or tax attorney or anything; I'm just a guy talking out loud here and wondering if this idea is more or less feasible than meddling with rates and having our gov't purchase more loans from the lovely and very honest people at Fannie Mae & Freddi Mac.

Primary Residence Tax Benefit: Homeowners who use their property as their primary residence may be exempt from paying capital gains taxes on any gain realized from the property as long as the meet the following criteria:

Owned the home for at least 2 years out of a 5 year period (the ownership test), and

Lived in the home as your main home for at least 2 years out of a 5 year period (the use test)

There are limits to the exemption:

a) up to $250,000 - for a single
b) up to $500,000 - for married couple

Investor 1031 Exchange Tax Benefit: Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.

This is how it is now!

What I am suggesting is to TWEAK THE INVESTOR TAX BENEFIT so that it mirrors the primary residence tax EXEMPTION, but there needs to be a control since the investor won't have plans to use the property as their primary residence. So, the control needs to have two purposes:

1) allow the investor to use the property for investment purposes
2) restrict the property from re-entering the housing supply for a period of 5 years

There is a HUGE difference between tax exemption and tax deferment!

TAX EXEMPTION - A tax exemption is an exemption from all or certain taxes of a state or nation in which part of the taxes that would normally be collected from an individual or an organization are instead foregone.

TAX DEFERRED - Deferred tax is an accounting concept, meaning a future tax liability or asset, resulting from temporary differences between book (accounting) value of assets and liabilities and their tax value, or timing differences between the recognition of gains and losses in financial statements and their recognition in a tax computation. Ultimately, the taxes will have to be paid at a future date.

By leveling the playing field between primary residents and investors, there is a great incentive on top of already distressed housing prices nationwide (where many houses/condos can actually be rented out for a profit) for qualified investors to buy housing supply and be incentivized at the end of the transaction. Chances are high that even after the 5 year period, the investor will choose to keep the performing asset on their books!

Lending standards have tightened enough on their own to prevent this from spiraling out of control in terms of unqualified investors buying housing stock in response to this tax code benefit. And best of all, it is an alternative to the government meddling with rates and/or buying up loans directly from the GSE's. The government should not be interfering too much with rates for fear of ultimate side effects and convincing people to buy a home strictly because rates came to down to 4.5%! Too many people may buy for all the wrong reasons! Instead, investors will buy for the right reasons, and it could help our housing supply problem and help to stabilize the market with limited unintended consequences.

What do you guys think? Be harsh, this is just an idea? Is this a good one, or is it flawed?

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Treasuries Get Silly Sparking Bubble Talk

A: The 30YR Treasury Yield fell about 113 basis points in the last 4 weeks alone. The move, highly similar to the silly parabolic move that ends up characterizing the final phase of a bubble, was sparked by 'Bernanke talk' that the fed may wind up purchasing longer term treasuries. I've discussed this treasury bubble talk a few times here on UrbanDigs, as I always like to look ahead - even if that means way ahead. But don't forget the words I associate with any treasury bubble; 'endgame', 'multi-year train of thought', '5th or 6th chapter to this slowdown', and 'final stages of secular bull market in treasuries'! Lets discuss.

Please note that when I discuss something that I see as likely down the road, that doesn't mean you go and put a trade on immediately; this site is an open forum not investment advice on equities! But I often discuss trading markets outside of Manhattan real estate, so content here will be mixed. As a trader that likes to find good entry points, sometimes timing is wrong and you have to make the decision to bail and start over. The short the long end of the curve trade is just that, I was very wrong on timing, and I hit my stop losses on TBT/PST about 12 trading days ago, and been watching since. The final stage of any bubble is the 'silliness' stage when the asset takes off, so to speak, just as the bubble talk gets going. The dot com's did it, housing did it, oil and other commodities did it, and now treasuries seem to be doing it. But the end result is usually the same.

Think back to oil for a moment. When crude passed through $100/barrel, the bubble talk already started. Those shorting oil at that phase had the right idea but the wrong timing and likely couldn't bear to watch the price of oil spike quickly from $100 to $145 from May to July. That 45% rise in two months time was the silliness that topped off the bubble in oil, before the burst sent the commodity plunging. From a trading perspective, identifying the bubble is one thing, putting on a huge position immediately is another. Most bubbles get a bit parabolic in the final stage, and oil was no different.

Back to treasuries. Here is what I said about the timing of any treasury bubble:

"Stages of Slowdown & End Game" (Oct 28th) - STAGE 10 (Yet To Come, End Game) - Treasury Market?: massive treasury issuance to fund bailouts, nearing the end of rate cut cycle which is yet to come (I'll bet on 75-100 more bps of easing), stabilizing economic data which is far off, unwinding or slowing of treasury purchases by foreigners, rolling over of treasuries, selling of widely owned treasuries for this slowdown, and most of the damage done to equities already may all contribute to the selling of treasuries. The treasury market is arguably at the tail end of a 20 year secular bull market. What will treasury buyers demand in yields 12-24 months from now? Will treasuries still be in huge demand, as they are today, right in the center of the crisis? The end game may bring with it the end to the secular bull market in treasuries and higher yields; especially in the longer end of the curve!

NOTE: 'what will treasury buyers demand in yields 12-24 months from now?'...not today, not a month from now, in 1-2 years! That is what I mean by talking about the bubbly market that has not reached its peak yet.

"A 'New Age' Slowdown Could Pop Treasury Bubble" (Oct 14th) - . If the long end of the curve does pop, and treasury yields spike down the road, think about how that will affect borrowing costs for businesses and lending rates for homebuyers/consumers. This may be a side effect of the massive medicine we took to combat this new age slowdown, is a multi-year train of thought and yes, it is worth discussing on a real estate blog. It could be the 5th or 6th chapter of the nationwide housing slowdown as affordability restricts with higher borrowing costs. Time will tell.

NOTE: 'is a multi-year train of thought and yes, it is worth discussing on a real estate blog. It could be the 5th or 6th chapter of the nationwide housing slowdown'...a multi-year train of thought meaning something to consider for the next few years, not now!

Sure, I had a position in TBT/PST because there were a number of occasions where yields were moving opposite of equities (rising when stocks got murdered), and some treasury auctions went badly. I thought the market may have been signaling something. I was wrong, the position went against me, and I ultimately hit it out at a loss. Fine, happens all the time. As a trader you can have the best trade ideas imaginable, and yet the position will go against you. Shorting oil at $115, in theory was a great trade. But if you couldn't take the ride up to $145, and hit it out at $130 for a loss, it turned out in hindsight that your idea was right but your timing a bit off. Live to trade another day; minimize your losses, maximize your gains.

With the big move in treasuries over the past few weeks, Merrill's David Rosenberg discusses "Treasuries In Bubble Phase, Merrill’s Rosenberg Says":

Demand for Treasuries has reached the ‘bubble” phase seen among technology stocks in 2000 and real estate six years later, according to David Rosenberg, chief North American economist at Merrill Lynch & Co.

Even though Treasuries have entered “overvalued territory,” yields may fall further and remain near record lows as the Federal Reserve, households and institutional investors increase purchases as the economy worsens, Rosenberg wrote.

Bubbly phase, meaning the silliness likely started and it will probably last longer than you think! My concern is not for today, its not for next month, and its not even for next quarter. It is for endgame, which to me is the period of time AFTER this credit crisis where some of the problems resulting from the measures taken to stem the crisis start to appear. If there is anything I learned from trading, its that bubbles tend to pop fast & furious; like oil did. If there is a bubble in treasuries, and if it does deflate later on (who knows what may spark it), rates can certainly rise very fast in a short period of time if their is a mad rush for the exits. I think this is something to worry about mid/late 2009 and 2010 as part of endgame. I wonder how beaten down the economy is at that time and if higher treasury yields equate to higher borrowing costs across the board. It may be an unintended consequence of a bubbly market, as the fed monetizes the debt by purchasing longer term treasuries; perhaps because this is the last of the ammunition left in the feds arsenal. This will make all those printed dollars that were dropped from the helicopter, actually hit the ground and enter the system. This could mark the top of the dollar deflation run.

In this piece, "Fixing the Monetary Unfixable", Nicholas Jones discusses:

"I've been saying for some time now in B&B that when the Federal Reserve and U.S. Treasury begin to monetize the debt we will know the bond bubble is near its bursting point.

First of all, monetizing debt is when the U.S. Treasury creates the government bonds and the Fed simply prints money to buy them. The destruction of the domestic currency that ensues is obvious, and in this case would be astronomical considering the amount of debt that would need to be monetized in order to sustain the U.S.' massive budget deficit.

With all of the recent bailouts, and more to come, the government has gone further into the red than it ever has (understatement). It is going to have to finance a massive amount of new debt as well as roll over old debt. Obviously the government would like to finance that debt at the lowest possible rate of interest; enter Federal Reserve stage to add artificial demand to these markets resulting in lower interest rates."

Well, right now demand for US Treasuries is no problem at all! The question is whether it is maintained at these levels. Time will tell, and I still think this is going to be one of a few chapters of the endgame story.

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Chasing A Moving Target

A: A post for the sellers out there after getting some calls recently about this topic. If I had one piece of advice to Manhattan sellers, especially those who own properties that have few special resale features to offer (amazing park or river views, large outdoor space, fireplace, roof rights, amazing location, etc..), it would be to fight denial, resist the urge to anchor to peak prices, and to price your property aggressively at the outset. The hope is to be ahead-of-the-curve and to sell the property before you are forced to chase a moving target. The target of course are the buyers and the bid they may be willing to submit for your property.

When I say 'chasing a moving target', I refer to any property that has reduced their asking price 3,4, or even 5 times over the course of the listing in the desperate hopes to find out where "market value" is. This type of seller is chasing a moving target, a target of buyers that seem to be running away ahead of them; finding themselves behind the curve chasing the market as it falls. As the buyers run away due to declining confidence and deteriorating economic fundamentals, the seller's are chasing them down with the hopes of catching up. The result tends to be counterproductive because it ultimately can lead to fierce sell side competition and even a further depression of buy side confidence.

Let's say you are a buyer and you find an apartment that meets your needs. Now lets say that this property's asking price was reduced from $2,000,000 to $1,950,000, to $1,900,000, to $1,825,000, and is now asking $1,795,000; from original asking price to current asking price. As a savvy buyer in a market that is clearly pressured, with inventory clearly rising, with sales volume clearly way down, what are you going to be thinking about a potential bid?

Chances are you will say to yourself something like this..."well, the seller is obviously eager to sell because they keep reducing the asking price, so why not bid lower and see what type of response I get". This is the kind of psychology that occurs out in the field. Denying this exists, well, is to deny that psychology plays a role in the buyers mind during the buying process.

This buy side psychology is everywhere right now! Arguing this is to be an eternal optimist, and to see the silver lining in every situation; which is fine, but it may get you into trouble if you strategize a property sale in this manner. I'm not saying deals are not happening, they are, but deals that are happening are from buyers that are bidding cautiously! Even the Fed's beige book quoted Jonathan Miller's appraisal firm as telling us this:

"A major residential appraisal firm reports substantial deterioration in New York City's housing market over the past two months: prices of Manhattan co-ops and condos are reported to have fallen by 15 to 20 percent since mid-summer, though it is hard to get a clear handle on prices due to thin volume--much of the recent activity is reportedly from desperate sellers."

This is where deals are happening at, due to the illiquid nature of the marketplace right now! Sellers should learn from this real time information and price accordingly; but most are not. Most sellers are still anchored to previous sales in their buildings, even though the time & place of those sales were in an environment much less pressured than today. As far as I'm concerned, if you are going to use a comparable sale from 8-12 months ago, might as well plan on selling for 20% or so below that figure; calculating in a premium/discount for what floor you are on, light/view differences, layout differences, and renovation differences.

There is a reason sales volume will be down significantly for the months of OCT-DEC 2008, and the reason is a disconnect between buyers & sellers. So, who's right? The buyers of course! The buyers are ALWAYS RIGHT! Umm, correct me if I am wrong, but that apartment you are trying to sell is ONLY worth as much as a buyer is willing & able to pay for it! Nothing more, nothing less. Just because your broker can't believe a buyer is not biting at a certain price, just because a seller can't believe no bids came in after a reduction or two, is proof that the market has changed and that the target is moving!

As publisher of UrbanDigs.com for the past 3 years, I am outrageously lucky to have such a great readership, and active forum for people to openly discuss their thoughts on any topic of the day. But one side effect is that sellers call me for help after they mistakenly fell for the oldest trick in the book; signing on with a broker that excels at the sales pitch, promises an unrealistic price for their property, and sells themselves as an expert on their building with plenty of buyers waiting already in the wings. Of course, the high price puts the seller behind the curve and forces them to ultimately chase the moving target; and there never really were any serious buyers to begin with! So, these sellers call me because they want to know what price their property should be listed at given the real time conditions of the marketplace. I can't help these people because they are signed to listing agreements with their broker, and it would be unethical of me to interfere and give advice to somebody else's client.

I don't care who you use to sell your property, but you need to be smart and acknowledge the world we are in RIGHT NOW! The world 6 months ago doesn't matter anymore. If you decide to price high because a broker promises that their business will get you that number, don't expect a quick sale! In fact, expect a long time on market with plenty of price reductions to re-stimulate traffic to your listing as time goes on.

The reasons why I think the next 2-3 quarters in Manhattan will continue to be pressured are as follows:

1) JOBS - when the forced marriages of the credit crisis close, the re-organization, costs cuts, and job cuts will be announced. I believe Merrill alone is expected to announce up to 30,000 job cuts when their deal with Bank of America closes next quarter. Merrill will not be the only financial institution to announce layoffs.

As it gets going in the financial sector, the slowdown will ultimately seap into the real economy here in NYC. The result will be layoffs at consumer driven business during the course of 2009. Its a very sad chapter of this crisis. To think that Manhattan real estate has seen the worst of the declines, as we enter a period of heavy job losses, is quite silly. Unfortunately, we must assume that X percentage of these jobs lost are from those that own a home here in Manhattan. Lets keep it real here as always, 2009 is likely to be the dark year for Manhattan's economy and it is certainly rational to expect this fundamental to continue to pressure the sell side of our real estate market.

2) APPRAISALS - NEGATIVE TIME VALUE - something that very few are discussing. Let us wake up the reality that the market has eroded and that the significant erosion in prices has not yet filtered through to closed sales. In comes 'negative time value' from the appraisal side. Now, when you do comps analysis on that property you are considering bidding for, you have to review comps from the past 6-8 months, which means the deal was signed into contract between 8-11 months ago or so. It's only when the deal closes that the purchase price is recorded as a matter of public record; and then used as a comp. Think about what will happen when NOV & DEC sales get recorded in JAN & FEB of next year! These fresh comps, that reflect the erosion I have been describing recently, will set the new hallmark for analysis!

Jonathan Miller adds:

"Conditions this fall have been characterized by low sales activity and price erosion. We have been making negative time adjustments on most of our appraisals during this period to reflect the change in value between the date the “comp” sold and current value. Not one lender has expressed concern and in fact, continue to remind their approved appraisers to reflect current market conditions in their reports. The rapid change in this underwriting orientation is personally shocking to me since underwriting has been detached from reality for so long. In my view, restoring trust in the lending process begins with having correct valuations as a benchmark for informed lending decisions."

When these deals close, and are entered into the system as comps, it will set the new level for future analysis. The question then becomes, how much longer will the appraisers price in 'negative time value' into their #s?

3) MEDIA - I am telling you that the market is illiquid, sales volume down significantly, and that deals being done today are in the 15-25% down from peak range. It is likely that these contracts that are signed today, will close in the next 1-3 months. With that said, it appears Q1 of 2009, released April of 2009, could be an ugly report. If it is, and reflects what real time information I am discussing here, then the media is going to go overboard with it.

The effects on buy side confidence and psychology from the media's take on the Manhattan market at that time, is likely to further dampen demand at a time when many sellers will probably have a time pressure to move the property. Time will tell if the media enhances this slowdown cycle.

4) POCKETS OF DISTRESS - feeds from #1. It is likely we see more pockets of distress as long as this market REMAINS ILLIQUID! That is the key phrase, illiquid! If this market remains illiquid, and there are few bids being submitted, trust me, you will eventually see those sellers that absolutely must move property. This may lead to some fierce sell side competition IF the market remains illiquid for a significant portion of 2009. I generally ask myself, what fundamentals will improve over the next few quarters that will lead to a wave of buyers entering this market with strong bids, adding liquidity to the market? I have trouble rationalizing an answer to this question right now.

Sellers, price ahead of the curve for any hope of avoiding chasing a moving target!

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Madoff Scam: "He’s a person of integrity..."

A: Waking up this morning here to plenty of news; Senate votes down auto bailout as Harry Reid states "No more talks on auto bailout..." & Bernard Madoff admits to employees of running a $50Bln Ponzi Scheme, using new principal from new investors to pay out returns to existing investors. The shame of wall street continues and the lack of trust, confidence, and transparency is certainty going to be very difficult to reclaim down the road. Absolutely amazing. When the tide goes out and the money stops flowing, the scams are ultimately revealed.

The Madoff 'lie' is going to directly impact other hedge funds with investments held there. Its another sore on the toe for an industry already reeling with losses; expect 2009 to see many Manhattan based hedge funds close their doors. A report by Morgan Stanley expects assets under management at hedge funds to shrink to $900Bln by the end of 2009, down about 50% from peak levels earlier in the year (source).

Bloomberg's "Madoff ‘Big Lie’ Hits Fairfield Sentry, Kingate Funds" discusses:

Hedge funds, already heading for their worst year on record, may lose at least $10 billion from investing with a New York firm that founder Bernard L. Madoff called "a giant Ponzi scheme."

Investors, ranging from hedge funds that depend on outside managers to wealthy individuals, entrusted their money with the 70-year-old Madoff, who told employees before his arrest yesterday that his firm was "one big lie" and may have cost clients as much as $50 billion. His confession comes with hedge fund assets poised to fall as low as $1.1 trillion by Jan. 1 from $1.9 trillion in June, reflecting market losses and customer redemptions, analysts at Morgan Stanley estimate.

"If the losses were $50 billion or even half that amount, it would be the biggest Ponzi scheme in history," said Mark Schonfeld, the former head of the U.S. Securities and Exchange Commission’s New York office, who is now a partner at Gibson Dunn & Crutcher LLP.

As this news breaks, Madoff's defense lawyer states, "...Bernard Madoff is a longstanding leader in the financial services industry,we will fight to get through this unfortunate set of events. He’s a person of integrity.". Yea right. Person of integrity my ass! The guy just admitted to the biggest ponzi scam in US history, and yet he is still a person of integrity. If it smells like shit, and it looks like shit, then it's probably shit! This is shit and I'm getting more and more ashamed at wall street, the markets that I grew up admiring and loving, as these scams reveal themselves.

This whole mess is a complete farce and blame lies everywhere:

a) wall street innovation that failed the test
b) flawed ratings models and turning a blind eye
c) ignored warnings on use of leverage
d) deregulation and allowing leverage to get to 30:1 or even 40:1
e) subsidizing rates/affordability and promoting a housing bubble
f) 'everybody should own a home' policies enabling GSEs to take on leverage up to 120:1 and buy up bad loans as the secondary market froze over
g) fee based securitization model that rewarded quantity over quality
i) exotic loan products designed to make higher purchase prices more affordable for the short term
j) loan fraud on behalf of both lenders and consumers; deceptive loan tactics
k) bloated appraisals to get the # where it needed to be so the deal would go through
l) clueless NAR statements on the state of the housing market and Brokerage Agencies pushing sales and higher purchase prices to take advantage of vested interest via commissions collected at closings
m) lack of oversight from SEC on ratings agencies wrapping subprime junk as AAA structured investment products
n) cashing out of equity and use of home as ATM for consumption, pinning more into debt as housing market collapsed; many homes now have negative equity
o) fractional reserve banking system; encouraged to take on risk to get bigger returns

the list can go on and on....It is a sad day for America. As a debtor nation, a nation of non savers, a nation of 'buy now/worry later', we enter this dark period with consumer balance sheets in deep need of repair.

The other sobering piece of news today is that the Senate voted down the auto bailout bill that would have provided a 'bridge loan to nowhere' and kept the Big 3 automakers alive for a bit longer; until they needed more funds that is. The business model of the Big 3 is inefficient and not successful, period. Letting the companies fail, go into bankruptcy, and be restructured will do the dirty work that needs to be done for a more successful and efficient model later on. But the side effects of a credit event will hurt, many jobs will unfortunately be lost, and the supply chain shock will hurt not only the US, but global economies as well. Pain today and tomorrow, for a brighter future.

Bankruptcy now looms for GM, F & Chrysler unless the gov't comes out with a new way to get funds to keep these troubled businesses alive for a bit longer. While I was against any bailout for these guys, I honestly thought the gov't would not allow them to fail because of the jobs involved. At least the system of checks & balances is working, Mish will be very proud today; but it wont be because of the pain associated with these firms failing. It will be because these companies should not exist in their current form, or be bailed out to maintain their current form. Perhaps a restructuring was shown to be impossible in the time period allotted by the bailout terms. Who knows. With Obama (for a bailout) taking office next month, it will be interesting to see if he pulls something out. Bloomberg discusses one reason why the talks may have stalled:

Connecticut Democrat Christopher Dodd, who helped lead the negotiations, said the final unresolved issue in the Senate talks was a Republican demand that unionized autoworkers accept a reduction in wages next year, rather than later, to match wages of U.S. workers at foreign-owned companies, such as Toyota Motor Corp.

The Senate failure came when a bid to cut off debate on the bill the House passed Dec. 10 fell short of the required 60 votes. The vote on ending the debate was 52 in favor, 35 against. Earlier last night, negotiations on an alternate bailout plan failed. A plan offered by Tennessee Republican Senator Bob Corker, which served as a basis for a possible compromise yesterday, would have required automakers to offer bondholders 30 cents on the dollar. Automakers would also have had to convince the United Auto Workers to take half of the $23 billion it’s owed for health care as GM stock instead, and eliminate a program in which UAW workers are paid not to work if there are no tasks for them.

It seems both the Unions and the Bondholders were unwilling to take haircuts. So be it. You play tough, you got to be prepared to have your bluff called. The Senate called the bluff and voted it down.

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You Want To See What An 'Illiquid Market' Produces?

A: It brings out those that must sell! Here is a good example of actions that will be taken in an illiquid marketplace, to move property. Recall my piece on Thursday, 'Chasing A Moving Target', where I stated..."Think about what will happen when NOV & DEC sales get recorded in JAN & FEB of next year! These fresh comps, that reflect the erosion I have been describing recently, will set the new hallmark for analysis!". This market is certainly interesting!

UPDATE: This seems to be an error with the wrong price, floorplan, and description. The floorplan is a CONV2/1BTH and smaller than 1,200 sft. The description states 2BR/2BTH, 1,200 sft, $2,000/Maint, and a price tage of $595,000, yet the internal system shows the price as $1MIL. I would expect this to be corrected in a day or two.

240 E 55th St; APT 14C2

PRICE: $595,000 (reduced $405,000 on re-listing Dec 12th)
SIZE: 1,200 SFT - 2BR/2BTH
MAINT/RE TAX: $2,000/Mth
ON MARKET SINCE: 10/25/2008

Now, I would expect tons of calls on this property and since its a sponsor sale, those considering only condos may at least take a peak considering there is no board approval, up to 90% financing, and immediate sublet allowed. Monthlies are high, but I think the price discounts this. I would not be surprised to see a bidding war for this property by next week; as all it takes is two qualified and interested buyers.

The property is asking $495/sft at the current asking price assuming 1,200 sft is accurate for the total size. Looking at the last few sales in this building which closed in AUG & SEPT (before the Lehman collapse as the contracts for these sales were likely signed around JUNE/JULY timeframe), I get a trading value of aprox $767/sft (9F) & $728/sft (2G).. for a studio units and low floor 1BR unit.

Using the average of these last two sales, $748/sft, I'm curious to see what the above unit would be valued at:

$748 x 1,200 = $897,600

This is the rough valuation based on the market when the last two comps went into contract. Forget for a moment premium being on a higher floor and for being a 2BR/2BTH, renovations, etc.. Assuming the market dropped 20% from June, and using the above figure as a rough valuation based on the last two sales, I get a current aprox market valuation of about $718,000 for 14C2. The current asking price is $123,000 below that! This is a very quick comps analysis and I haven't seen any of the units. Normally I would have to calculate in discount/premium for higher floor, light/view, and renovations to past comps to get a more accurate #, but for sake of this discussion, it's safe to say that the current asking price is still a great deal.

In an illiquid market, with no bids, we find out who must sell and things like this pop up! This is where deals are found, and it doesn't even matter if we are down 15%, 20%, or even 25% because if you have to sell, you have to sell! Now, as long as this market remains illiquid and deals are happening at discounted levels, the next 2-3 months will reveal how weak the current market really is. This is when comps will be exposed and a new benchmark set to conduct future bidding strategies too. This is when things get interesting!

Will future buyers set the trends of bidding below these distressed sales when the comps become public record? How will co-op boards deal with quickly deteriorating prices and distress sales? How will it affect future actives? How will it affect future appraisals? How will it affect future buyer confidence? As with most slowdown cycles, there is an adverse feedback loop that feeds the process. I don't see this slowdown being any different.

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CDS Money 'Waiting Around' For Auto Rescue Closure?

A: For anyone late to the credit crisis party, or I should say funeral, credit default swaps (CDS) have played a large role in the shadow banking system taking this crisis from bad to worse! When Bear Stearns was rescued via a fed sponsored merger to JP Morgan, CDS counterparty risk played a large role in not allowing Bear to fail. When AIG, a large issuer of credit default swaps on the other side of the trade, got into trouble the gov't had to step in and rescue that company from failure. Allowing AIG to fail would have hit the global CDS market likely leading to a large disruption or even systemic failure of the worldwide financial system. Now, it seems the CDS nuclear war games are playing a role again; this time in the auto rescue talks. One additional reason (besides deteriorating fundamentals and credit quality) why banks aren't lending? It could easily be they are waiting to see how the auto game plays out and how many billions they may or may not have to pay out should a credit event occur.

Back in March, Bear Stearns was rescued from failure and a credit event did not occur. As a result, tens of billions that would have been paid out by CDS issuers were saved at the expense of CDS purchasers of credit protection. Contraryinvestor.com explained the market movements the week after the Bear-JPM deal was announced, as those CDS holders of protection went from being largely in-the-money on the Friday before the announcement, to big time out-of-the-money when the markets re-opened the following Monday (via, 'Derivatives Tail Wagging The Financial Market Dog'):

"Now put yourself in the position of a meaningfully levered hedge fund who had purchased CDS contracts against Bear credit vehicles. You had levered up against what was continually becoming very profitable CDS positions or credits as Bear was heading nose first into the tarmac. Who knows, you might have even increased the position prior to the weekend based on info your fellow good buddy hedgies were feeding you about Bear's imminent demise. When those long CDS contracts against Bear credits/positions went to zero virtually the Monday after the JPM acquisition announcement, all you were left with was massively deflated CDS asset values relative to the prior Friday and still in place leverage. So what do you do when you get up in the morning on Monday after the Bear acquisition announcement (assuming you slept Sunday night, that is)? You start delevering. You start unwinding in place inflation themed trade positions to raise liquidity. You sell what assets you can (gold, oil, commod's, etc.) and get less short those sectors you have heavily shorted (financials, brokers, consumer, etc.) to raise liquidity and decrease total leverage against a now immediately diminished asset base."

Fast forward to today and the ongoing talks that TARP may be used to keep the Big 3 autos alive until the next administration takes office. The TARP, originally designed for distressed asset purchases, has only been used so for to fortify the banks balance sheets (by injection of capital directly into the banks) in an environment where capital raising from the private sector & share dilution is almost impossible. Should a credit event occur for the Big 3, there will be payouts by the firms that issued CDS against a GM/F default. Below is the gross notional value of GM's & F's CDS contracts, net notional, and contracts outstanding as provided by DTCC:

The payout is not as big as you would think because of daily mark-to-market collateral posting of CDS contracts, via Reuters:

If payments on GM's swaps are triggered, they are unlikely to have systemic consequences as most of the losses have already been taken as the securities weakened.

"CDS contracts require daily posting of mark-to-market collateral posting," Taksler said. "Given that auto company bonds already trade in the $20s, the additional collateral posting prompted by a potential bankruptcy should be fairly small."

By contrast, if GM looks like it will avoid bankruptcy, CDS on the company could rally significantly, leading to the need for large adjustments in the value of the contracts by buyers of protection, he added.

Okay, so it won't cause any systemic problems if these guys fail; but what does it mean for the big banks lending capacity?

Masacchio, over at Oxdown Gazette, has a very interesting piece titled, "Paying off on Credit Default Swaps is So Important", that is a worthy read:

The current gross notional amount of credit default swaps with GM as the reference entity is $44bn*. This is down from $65bn just three weeks ago. The net notional amount is $3.4bn, up bit since then. According to the DTTC, the notional amount is the maximum amount of money that will change hands on the occurrence of an event of default, after netting and application of collateral.

This implies that a large additional amount of collateral has been posted. That money is gone from the banking and investment sector, and isn’t available to be loaned out or otherwise put to good use. It is merely sitting in vaults, waiting around to see what happens to GM.

Meanwhile, the price of GM CDSs has gone way up. The rapid increase in the price of GM CDSs this year, coupled with the decrease in notional amount outstanding, implies that sellers of protection have been buying up protection in the over-the-counter market, presumably to set off against their sales of protection. The AIGs and Citigroups of the world are the sellers of protection, and they’re busy sending money to the buyers of protection, both directly through purchases of gambling CDSs and indirectly through posting collateral for their sins. And we all know where that money is coming from: Henry Paulson and Ben Bernanke. If the bailout comes, and the bankruptcy doesn’t, the prices of GM CDSs will fall quickly. The recent purchasers will be hurt, and maybe that will include AIG and Citi.

This shadow question can’t be ignored. It infects every aspect of the whole bailout situation. Take Citigroup, with its $3tn plus in credit default swaps. Taxpayers are pouring money and guarantees into their treasury. Are they pouring money onto hedge funds and other buyers of protection, trying to prop up their swaps, or solving their exposure to GM and the other failing entities?

One thing is for sure, the CDS market is proving to play a big role in this credit crisis. It is no longer as simple as, "...do we save the autos for fear of losing American jobs?". No! Part of the formula for whether an entity lives or dies is now a function of things like counterparty risk and systemic attachment to the financial system. Its the sad reality of the complex system of finance that we designed, marveled at, few profited greatly from, powered the housing boom, and ultimately helped to cause the current crisis.

As this system unwinds, the complexities are revealed and the truth is that firms like AIG, Citi, Bear were deemed to connected to fail while firms like Lehman were not. Now, I'm no expert on the OTC CDS market, trading CDS, or even contractual terms that kick in on a credit event; but I do know that this market is tied to the current crisis and the counterparty risk and potential damage done by a triggered credit event is something discussed in any bailout/rescue talks. Has to be. We must be asking the right questions here.

Oh what a tangled web we weave!

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Trading Down: It's Cool to Be Frugal

It's hip to be cheap! I know, I have a vice-like grip on the obvious. But the trading down trend that is being reported in the media may be more than just a knee-jerk reaction to the economic slowdown. This time "cheap chic" may not be fad but a long-term shift in attitude. So let's explore the "new frugality" and its implications for the economy, markets and even New York's Real Estate market.

In case any of our readers recently woke up from a coma, let's review some recent news from the world over. First and foremost, according to CNN, the Federal Reserve's flow of funds report released today showed consumer debt fell at an annualized $30 billion rate in the third quarter. This is the first time this data series has shown a decline since data started being reported in 1952. The CNN article notes that according to the report, U.S. households have lost $2.8 trillion in wealth during the quarter, an 18% rate of decline, which has only been eclipsed once in the past 56 years. So how's that for a cold shower? It's no surprise people snapped their pocketbooks shut. The question is: Does the trading down behavior we are seeing along with the spending pullback just represent a reaction to the market crash or a long-term change in behavior? Let's check out how people have reacted globally.

According to CBS Marketwatch, David Dillon, CEO of the U.S. grocery store chain Kroger, told investors "We're seeing particularly strong growth in our private selections and value tiers" on their recent conference call. Apparently they are doing brisk sales in BEER and other items they sell under private label brands. In fact, the firm found that 14% of its customers traded down to its corporate brand items for the quarter ended Nov 8, according to data collected from its shopper cards. The grocery is also targeting restaurant sales by enticing consumers with more ready-to-eat meals. In addition, they are using their private label brands like a cudgel to beat down prices proposed by their branded product suppliers. This is not solely a U.S. phenomenon, as reported by Talking Retail a UK-based grocery industry report, which has recently had articles on Tesco's new Discounter Range of products and the fall-off in holiday food spending plans. Of course, if solid food is too expensive there is always soup, sales of which are apparently benefiting from the belt-tightening trend.

With sales of even necessities being crimped and showing consumers trading down, it should not be surprising that non-durable goods purchases would likewise be impacted. In Australia "Trading down on handbags" was discussed by high-end retailer Oroton, with regard to their recent results.

Is it surprising to anyone, then, that of the Dow 30 stocks only Wal-Mart and McDonalds are up year-to-year? These purveyors of life's necessities in cheap bulk form are flourishing as consumers cut back. But is this just a diet fad the consumer is on, or does the trend have legs?

My personal feeling is that a lot of the froth in consumption over the last few years was driven by newly rich folks overseas, financial intermediaries/traders/bankers/brokers whose businesses boomed with globalization and the commodity boom and perhaps, most importantly in the U.S., aspirational consumers. The intercontinental super consumers were generally from resource-rich countries like Russia, Brazil, and the Mid-East, or low cost labor rich countries like China. Another source of added consumption in the U.S. was definitely from the aspirational consumer. Many in the U.S. were not really wealthy, but tried to live like they were or thought they were going to be rich from their real estate investments. The other big contingent of aspirational consumers were the newly upper-middle-class folks in emerging countries who for the first time in history actually had a wide variety of internationally made branded/luxury goods available to them - and lots of savings to spend on them.

A recent Investor's Business Daily (IBD) article entitled After Buying Like Truly Wealthy, Aspirational Rich Curb Spending. In the article Howard Davidowitz, chairman of an eponymous retail consulting firm, says "A lot of it relates to a depression in financial services. Additionally, that aspirational customer who shops at Coach (COH), making $100,000, who wants to live like he makes half a million, is completely underwater because of debts."

Interestingly, the aspirational consumer appears to be getting hit hardest. Maritz Research did a recent poll which showed that those in the $75,000 to $100,000 a year income brackets planned to spend 41% less this holiday season than last. In contrast, last year they had planned to spend more on average than those with household incomes of $100,000 or more. The over $100,000 annual income set plan to cut back by only 26%, while the less-than- $75,000 crowd planned to trim just 14%.

According to Hana Ben-Shabat a retail analyst with A.T. Kearney, who was quoted in the IBD article, "Over the last decade global sales among luxury-goods retailers have grown more than 10% a year, vs. 2% for chains generally. Much of this growth came from middle market consumers trading up to luxury."

Now if, as I suspect, the aspirational consumer doesn't just have to cut back this Christmas, but has to semi permanently downshift his/her aspirations to adjust to an economy that just isn't going to offer the same upward mobility for several years, it could have a significant lasting impact.

According to the US Census, the cohort of those earning $75,000 to $99,999 constitutes an estimated 12.1% of the population. The next higher bracket of those earning $100,000 to $149,000 constitutes another 11.4% of the population, for a total of 23.5% of all households captured in these two groups. My guess is that a lot of the aspirational consumers, investors, and real estate owners are ensconced in these two groups. That's a substantial part of the population that has been hit by imploding markets and collapsing availability of debt.

The chart to the left, from Business Week, just confirms what many of us have suspected for a while. Now completely tapped out the American consumer has had to start saving. My bet is that the latest uptick is the start of a new uptrend that will continue for quite a while. Why? there's no one left to float our current bills and future obligations any longer.

I know this is a lot of speculation on my part, but "cheap chic" may be here to stay for a while. In the future I'll be reporting once in a while about how durable the trading down, de-leveraging and otherwise lowering of expectations trends appear to be.

Now I would aver that to be in New York City, you might make $200,000 per year and still be an aspirational consumer, if you live in a free market apartment or are/plan to be a real estate owner. Couple that with the decimation on Wall Street and we could be looking at a serious reduction in buyers for "luxury" apartments. Those multi-media rooms, health spas and private roof decks may seem a whole lot less necessary in the current environment.

From the Blogosphere:

MISH: The Future is Frugality

Wal-Mart's Scott Says Shoppers Changing Behavior on Job Worries

Shopper are Returning To Frugal Times in Wake of Financial Crisis

Material Consumption Gives Way to Frugality

Frugality: What a Novel Idea

New Frugality Emerges

When the Eonomy Goes Bust, Memebership-based Retailers Boom

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Fed Day: Expect A Cut, But I Say Save The Bullets!

A: No shock here folks, the markets are expecting between 50 & 75 bps of easing to the funds rate and likely discount rate as well. If you ask me what I think the fed will do, I would say cut 1/2 point. If you ask me what I think the fed should do, I think they should only cut 1/4 point, and leave some room later on for a 50 or even 75 bps cut if things get real hairy! With quantitative easing (read Jeff's piece on September 5th, "The Path of Deleveraging: Quantitative Ease Please!") upon us and ahead of us, this rate cut is more for 'cushioning the blow' that the macro economy is about to bring. The statement also should show an increase in deterioration of economic indicators, with the bias towards economic growth leaving inflation risks aside.

The report and decision is out at the traditional 2:15PM time. With equity prices down some 45% or so from peak levels hit mid 2007, one can argue that stocks have 'priced in' a very severe recession already. S&P earnings expectations for 2009 had been cut a few times already and its pretty clear that nobody really knows how bad the hit to corporate profits is going to be; only that it will be bad! In my view, its the dragging out of declining profits and lagging earnings warnings that is the big threat to stocks over the next few quarters.

We have a 16 month credit crisis going on, and one could argue that the duration of very challenging conditions for corporations even after the credit markets normalize could last at least another 12-16 months. The damage was done and we are entering the period of damage assessment. Ugh, macro economic data (gdp, unemployment, manufacturing, etc..) for 2009 is going to be really ugly and after the first wave of it, we will start to look for things like 'the Second derivative', or a slowing of the rate of change in the deterioration. How high will unemployment hit? How fast did GDP contract? How many quarters did GDP contract? Etc..

The fed knows this and massive fiscal and monetary stimulus has been applied already to cushion the blow to the real economy as we assess damage from the 16-mth credit tsunami. The NBER already declared the recession to have started in DEC 2007, so I want to know, are we approaching mid way through, or are we past mid way through?

Anyway, it seems clear the fed is about to embark (if they haven't already) on a path of quantitative easing with the FFR so low already. For those that don't know, this basically means the fed will be printing money & increasing the money supply, likely by purchasing longer term treasury bonds from primary dealers and injecting the cash directly into the system. In fact, it seems to already be happening. This was the medicine Japan used in the '90s to fight deflation once they used up the 'bullets' of rate cuts. With our funds rate at 1%, I wonder if the fed really wants to bring that rate to 0%. I know Ben wants to inflate, and inflate he will try to do, but the effects of rate cuts on lending rates have not been having the desired effect. So to me, this rate cut is more for a 'bigger cushion' to the economic blow that is upon us. Also, the stock markets are pricing in 1/2 point cut and I doubt the fed wants to disrupt the markets right now; this is how it has become.

Since the mid '90s, I've been watching these rate decisions and the impact on the tradable markets very closely. With volatility comes trading profit potential, so as a trader, I want to play it. Its a nice side effect to have seen how markets react when they don't get what they want!

Anyway, Ben is a scholar, not a trader, and so is the rest of the fed board of governors. They will cut today, but I think it should be only a 1/4 point. If quantitative easing is the path they are on, and they know this better than we do, why waste another bullet if we don't need to? Cutting 1/4 or cutting 1/2 at this stage won't worsen the economy, so its a matter of how much additional cushion towards the present downturn they want to apply; rate cuts take 8-2 months to funnel through the economic system. Lets not forget, there is a big cushion already in place via massive easing for the past 15 months; the oomph of which still lie ahead of us.

So, save the 1/4 point for when we might need it more. This seems to be the worst crisis in the past 70 years or so, and stocks have got hit hard. However, as a trader, I can tell you that we only had 1 limit down day so far pre-open! It would be narrow sighted of me to predict no more catastrophic opens ahead of us, especially in the near term. With "Made - off's" scam revealed, how many more cockroaches may be lying underneath? What major company will issue a big profit warning? What major company may declare bankruptcy? What major fraud may pop up here or abroad; hmm that rhymes? What major bank may have to be rescued or nationalized? What may the next spark be?

Who knows. But to say this threat is beyond us, at this point in time, is silly. So, save your bullets for when we may need it most. We can always use them! But when they are gone, we can't and the markets may go through a rough phase where a 1/2 point surprise rate cut both achieves the added cushion to economic growth + calming the markets as they react to an event.

PHOTO SOURCE: Marketblog.com

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Landleases: When The 'Worst Case' Scenario Happens

Picture this: you know that the land rent for your doorman co-op building will increase in 2009 but you don't know by how much. You know you bought your apartment for below the market value of comparable apartments in the neighborhood because of the uncertainty of being in a land-lease building. Since the land-lease has another 50 years, you're not that concerned about it and felt like the discount was priced in.

You go to a shareholder meeting about 18 months before the land rent is going to be renegotiated with the leaseholder and the "worst case scenario" presented is that the land rent will go up by 150%. The land rent of $500,000/year is 25% of your maintenance. So your understanding after the meeting is that the "worst case scenario" is that your maintenance could go up by 50%. It's a bummer, but only 2 or 3 people who attended the meeting put their apartments on the market because the outlook doesn't seem that bad.

Fast forward 18 months. You receive a notice that the land rent is going up to $2,500,000. Your maintenance is going to double! The entire building is in shock. Based on the research you did on land-lease buildings before buying the apartment, this kind of land rent increase is unprecedented for a land-lease building in Manhattan.

Property values in the building plummet:

Straight studios that once sold for ~$350K are now asking:
$290K

Alcove studios that were once selling for ~$400K are now asking:
$239K
$325K

Junior 4s that were once selling for $675K are now asking:
$555K

The only thing that the shareholders can do is to negotiate with the leaseholder to buy the land. Your maintenance will still be very high, but at least then you wont have to worry about the land rent increasing every 10 years or the landlease expiring (which has never happened in NYC to my knowledge). And at least the interest on the underlying mortgage will be tax deductible whereas I'm 99% sure that land rent paid to a private owner is not tax deductible.

What could have been done to prepare for this? Every few years, the board could have increased the maintenance to build up a reserve fund over time to buy the land when the 25 year fixed land rent period was up. Instead of planning for the renegotiation of the land rent, the board chose to keep the maintenance as low as possible for as long as possible.

What could be done now to lower the maintenance & increase property values? Allow everything: pied-a-terre and co-purchases are already allowed, and the building only requires 15% down. After two years you can sublet your apartment for two years - change the policy to allow unlimited subletting. Allow investors to purchase in the building. The pet policy is that only pets under 40 lbs are allowed - start allowing pets of all sizes. Right now there is a full time doorman - cut the doorman back to part time or eliminate the doorman entirely. Increase the supers salary and ask him to take packages and dry cleaning. Un-landscape the roof deck so it doesn't need as much maintenance. Find or create room in the basement to rent out storage. Sell the commercial space. There are still rent stabilized tenants in the building. Try to get anyone who doesn't meet the rent stabilization laws out of the building so the building can benefit from the flip tax when those apartments turn over in the future. Put a cell tower on the roof deck to generate monthly income.

NOTE: A land-lease owned by a private owner is very different from a land-lease owned by the City of New York. So if you live in Battery Park City and are reading this, please don't freak out!

To be continued...

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RE Transaction Revenue Down 61% - Hits MTA Funds

A: The decline in real estate transaction produced tax revenue has hit the MTA's kitty and is playing a role in today's decision to hike rates. Between the loss of collected tax revenue from Wall Street & real estate transactions, the city will be forced to either cutback on services or hike other rates to fill the void; or combination of both. Today's news confirms the illiquid nature of this market, and likely shows the buyer strike starting at or around the September time frame. Markets and investor psychology is funny like that, sometimes the writing is on the wall but until that spark comes, you won't see any drastic change. It seems rational to now declare that the fall of Lehman Brothers & rescue of AIG were the sparks that really started the buyer strike here in Manhattan.

If collected real estate transaction taxes are down 61%, or down $63,000,000.00 from $103M to $37M compared to the same period from last year (collected mid month), that pretty much reflects the contracts signed activity from SEP & OCT (given 2-3 months closing time from contracts signed), and any delayed closings from new development purchases. This is why I can say that the 'buyer strike', or 'illiquid market', or whatever you want to call it likely was sparked at this time; coincidentally the time when Lehman declared bankruptcy and AIG was rescued by the government. To me, these credit crisis events was the spark that lit the illiquid fire.

The NY Times reports, "M.T.A. Approves Cuts but Seeks Help":

The authority said this week that an important source of revenue — taxes on real estate transactions — was running well below recent forecasts, which had already been revised downward several times to account for the economic downturn.

Those real estate and mortgage taxes brought in $37 million this month (the proceeds are received by mid-month), compared with $103 million in the same period last year, Gary J. Dellaverson, the authority’s chief financial officer, said at a meeting of the board’s finance committee on Monday.

“This is a really sobering number,” Mr. Dellaverson said. “This does show how frightening this economy can be in terms of our sensitive taxes.”

He said the authority had tried to be very conservative in predicting real estate transaction tax receipts as the economy worsened, basing its forecasts on projections made by the city.

He said that projections of December’s tax receipts had repeatedly been reduced as the year progressed, falling to $88 million from $99 million before finally being revised down again only a month ago, to $64 million. But the reality was even worse, missing the mark by $27 million.

This just shows how the slowdown trickles into the main economy and ultimately leads to decisions that are very tough to make, yet necessary. Between wall street revenue taxes and real estate transaction taxes collected, we are in for at least a year of collections being sharply down from past years. Lets hope the powers that be can manage this budget problem effectively and minimize the damage.

Gov. Patterson's proposed 'doomsday budget' includes higher taxes on a host of products/services as well as 'deep cuts' in spending. According to Newsday.com's "Bloomberg says Paterson's NYC budget cuts unfair":

Mayor Michael Bloomberg said yesterday he understood Gov. David A. Paterson's task of closing a $15.4-billion deficit, but called it unfair for Albany to cut the city proportionally "more ... than anyplace else."

The cut in state aid would amount to harsher budget cuts for the city already suffering a worsening fiscal crisis.

In response to a projected $4 billion deficit through 2010, Bloomberg in November proposed tax hikes, cancellation of the incoming police cadet class of 1,000 officers and shrinking the city's workforce by 3,000 people. Last week, Bloomberg last week asked city agencies to find $1.4 billion in cuts for 2010.

This is the dark period after any severe economic crisis. There is no reason to avoid acknowledging it, and nothing wrong with discussing it. We have to go through this to come out the other end, so lets be prepared for changes we may face, adapt accordingly, and hopefully these guys know what they are doing!

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Are You Half Full or Half Empty?

A: Which are you? If you are half full, you are choosing to look at the fact that the fed took on a ZIRP policy for rates, threw in the kitchen sink, and that the treasury just bailed out the automakers with a $13.4Bln bridge loan. The half full mentality will say that this is all good stuff, it prevented a disaster, and that inflation will succeed in killing off deflation so buy stocks, buy real estate, and buy commodities. If you are half empty you look at the fact that things are so bad, that the fed had to take on a ZIRP policy, that the treasury felt forced to rescue the auto's for fear of collateral damage that bankruptcy would bring, and the more important news that S&P lowered its credit ratings on 11 US & European banks and on GE & GE Capital ratings to negative. For the half full folks, enjoy the champagne, but for me, it's way too early to celebrate.

At 2:14PM on Tuesday, one minute before the fed announced their decision on rates, the DOW was trading at 8,672. Then the following occurred:

1) Fed abandoned rate cuts and instead chose to announce that the fed funds target rate will be in a range from 0% to 0.25%. The reason was that the effective funds rate was already close to 0%, via massive liquidity injections, and a rate cut would be more psychological than real. So, they acknowledged this and chose to just take on a zero-interest-rate-policy, or ZIRP.

2) Fed hinted at the next steps of quantitative easing to combat the credit crisis, which in essence, is the fed printing money. By purchasing longer term treasuries and large amounts of mortgage backed securities, the fed can control rates more effectively. As they buy, the newly minted dolla