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Harry Newton's In Search of The Perfect Investment Technology Investor. Harry Newton

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9:00 AM EST, Friday, April 3, 2009.
Stockmarkets continue to rise. I now believe the present 20% recovery so far has legs. Latest "legs-adder" has been this week's loosening of the mark-to-market rule, which now gives financials the freedom to report ebullient (though fake) results. And it's impressive that G20 leaders quickly agreed on stimulus programs and said they'd dump $1.1 trillion into the IMF.

The big market gains have been among financials. Compare their recent prices to their one-year lows:

The biggest gloom is rising unemployment and the devastation it is doing to the commercial real estate (CRE) industry. But there is clearly money around and being "put to work" (to use a ghastly expression). Rising housing sales and full restaurants attest to that.

Today's column is long. For that I apologize. I wanted to include three articles -- one wonderfully optimistic, two ultra-gloomy. First, the positive one. From this weekend's Economist:

The economy
A faint sound of applause
Some signs suggest that the recession is lifting, but the path to recovery is fraught with danger

THE current recession has broken many of the rules of business cycles, but not this one: when something gets cheap enough, buyers emerge.

America’s housing bubble seems mostly deflated. According to the S&P/Case-Shiller 20-city index, house prices through January were down 29% from their all-time peak. Relative to incomes, houses are now 10% undervalued, and relative to rents they are fairly valued, thinks Paul Dales of Capital Economics, a consultancy.

This is luring buyers back. House sales rose unexpectedly in February. The National Association of Realtors estimates that up to 45% of existing homes sold were “distressed” properties—those in, or close to, foreclosure. In Nevada, which with California, Florida and Arizona was the epicentre of the boom and bust, fourth-quarter sales were more than double their level a year earlier. Keith Kelley, a Las Vegas estate agent, has an investor interested in offering about $80,000 for a foreclosed, four-unit apartment building which, fully let, could bring in over $25,000 a year in gross rent. He has two buyers interested in paying $220,000 for a five-bedroom house that sold in 2004 for more than triple that. Their monthly mortgage payment would be about half the rent on a similar property. Even so, he says, “I still talk to buyers waiting to see when we get to the bottom.” Indeed, homes may be fairly valued now but could get dirt cheap if, as commonly happens, prices overshoot.

The stabilising of the housing market is one of several tantalising glimmers that the end of the recession may be in sight. In March factory purchasing managers were their least gloomy about new orders since last August. Vehicle sales rose 8% in March from February. New claims for unemployment insurance have stopped rising. Gross domestic product, which shrank at a 6.3% annual rate in the fourth quarter, probably shrank at a similar rate in the first, but the composition of the drop was more encouraging; it was driven not by the collapse in consumer spending, but by sinking output as businesses sought to bring inventories into line with lower sales. Second-quarter growth “has a good chance of being positive”, according to Ian Morris and Ryan Wang, economists at HSBC, though “the risks…are still huge.”

What has brought this turnabout? In part, the normal corrective powers of the economy. Larry Summers, Barack Obama’s main economic adviser, has noted that current annualised vehicle sales of about 9m are well below the 14m necessary for replacement and rising population, while annualised housing starts are about a quarter of the rate needed to support the forming of new households.

The improvement is also the expected response to monetary and fiscal stimulus, both of which have been exceptionally aggressive. The Federal Reserve, having lowered short-term interest rates in effect to zero, has intervened in bond markets to push down long-term mortgage rates as well. On April 1st paycheques were due to begin reflecting the tax cuts in Barack Obama’s $787 billion fiscal stimulus.

As investors have shifted their economic outlook from catastrophic to merely grim, the stockmarket has shot higher, by 19% on April 1st from its 12-year low on March 9th. Like houses, stocks look cheap. Strategists at Deutsche Bank estimate that investors can expect to earn an additional seven percentage points over the long run from holding stocks instead of Treasury bonds, the highest such “equity risk premium” in at least 25 years. Mr. Summers says it may be “the sale of the century”.

Yet even if the bottom in economic activity is in sight, a robust recovery almost certainly is not. Housing usually leads the way out of recession as falling interest rates unleash pent-up demand. But easy credit in earlier years has turned many renters into homeowners already. At the end of last year 67.5% of households owned their home, down from a peak of 69% in 2006 but still well above the 64% that prevailed from 1965 to 1997. Moreover, many prospective buyers cannot take advantage of low mortgage rates because higher down-payments are now required.

The tonic of lower interest rates has been dulled by the dysfunctional financial system. That is why credit markets have not reflected the optimism of stocks and are forcing corporations to pay punitive yields on the bonds they issue (see chart).

Consumer spending may also be depressed for some years to come by the record 18% collapse in household net worth over the course of last year, a drop of $11 trillion. That is a chief reason why the OECD on March 31st released an exceptionally gloomy prognosis, predicting that the American economy would shrink by 4% this year and not grow at all next year. Deflation, it said, “may become a threat”.

The greatest risk of renewed recession or stagnation comes from the banking system. As long as home prices keep falling and unemployment keeps rising, banks’ bad loans will keep mounting. Huge questions hang over the Treasury’s plan to remove those loans, and many economists think it must commit more public capital than the already authorised $700 billion in TARP money. Perversely, a continued stockmarket rally could undermine the chances of more aid, lulling some in Washington to believe enough has been done.

Tim Geithner, the treasury secretary, understands that. “The big mistake governments make in recessions”, he said on March 29th, “is…they see that first glimmer of light, and the impetus to policy fades.” Yet he hurt his own case the same day by saying that more TARP money is not needed for now because some banks will repay the government capital they have previously received. That is bad news, not good news: banks are lining up to repay the money to free themselves from political interference, even though the loss of capital will constrain their lending. That increases the odds of a multi-year, Japanese-style credit crunch.

Even if the administration wants the money, Congress at present is in no mood to grant it. The Senate and House budget resolutions were silent on the administration’s request for $750 billion in extra funds (with a budgeted cost of $250 billion). The administration is wisely waiting for tempers to cool before asking for the money.

The second article is from today's Wall Street Journal.

U.S. Office Vacancies Hit 15.2% -- and Rising
Companies, struggling to cut costs, dumped a near-record 25 million square feet of office space in the first quarter, driving vacancy up and rents down, according to data to be released today by Reis Inc.

Businesses that needed to lease space took advantage of the market weakness to extract concessions from landlords. But the trends exacerbated financial woes for owners, especially those who owe more on their mortgages than their properties' current value.

The office vacancy rate nationwide rose to 15.2% from 14.5% in the previous quarter, and likely will surpass 19.3% over the next year, according to Reis, a New York firm that tracks commercial property. That would put the vacancy rate above the level during the real-estate bust of the early 1990s, the worst on record.

Effective rents, which include free rent and other landlord concessions, fell 2% in the first quarter to a national average of $24.16, the largest drop since the first quarter of 2002, according to Reis. Sublet space, on average, is going for between 10% and 15% less than what landlords are charging.

The weakening commercial real-estate market is posing yet another threat to the ailing economy because it is causing the value of buildings to plummet, often to less than the amount of their mortgages. In one closely watched transaction earlier this week, the marquee John Hancock Tower in Boston was valued at $660.6 million in a foreclosure auction, less than half of its $1.3 billion price in 2006. Washington policy makers are scrambling to extend bailout programs to help shore up commercial real estate.

Until now, many have expected commercial real estate to fare better than the housing market, thanks to the lack of rampant overbuilding in the recent cycle. But supply is being dumped on the market instead from layoffs. With as many as 1.5 million jobs expected to be cut this year, more than 50 million square feet of office space is expected to be emptied out for the full year, projects Reis.

"We're only at the beginning of a hurricane that may continue for at least the next 18 to 24 months," said Reis research director Victor Calanog.

The third article is from Q1 Publishing.

The Soft Panic of 2009 Has Just Begun
By Andrew Mickey,Chief Investment Strategist

Boston’s Clarendon Street sits on one of city’s most iconic buildings. It’s also the symbol of what could kick off what I call the “Soft Panic of 2009.”

Locals know it simply as “The Hancock.” The 60-story frame wrapped in reflective blue glass makes it look like the tallest mirror in the world. I’m sure it was an impressive sight when it was built in the 70’s. It still is.

The I.M. Pei designed building stood as a symbol of financial strength and ingenuity. Now, it’s looking a whole lot different.

And for those of us looking into this situation now we will be protected. And for more aggressive folks, we’ll actually be able to profit from it all. Here’s how.

A Sign of the Times

The Hancock Tower was purchased by Broadway Partners in 2006. It cost $1.3 billion. The vacancy rate was a mere 5%. Broadway looked like they had another big winner on their hands.

Broadway Partners was one of the rock stars of the real estate boom. The New York real estate firm snapped up $15 billion worth of real estate between 2000 and 2007. The firm stuck to red hot real estate markets in places like Boston, New York City, Washington D.C., and Florida. The strategy paid off too. Broadway earned an average 35% annualized return from leveraged real estate deals.

A lot has changed since then. The boom has turned to bust. In less than three years The Hancock Tower has turned from an iconic asset to a top-heavy liability. Now, Broadway had to sell out.

Earlier this week, Broadway defaulted on the Hancock Tower payments. The building had to be auctioned off. In a two minute auction (using the term “auction” loosely - there was only one bid) the Hancock sold for a $20.1 million and the assumption of $640.5 million in debt. That works out to a total price of about $660 million. That’s almost half of the $1.3 billion paid for the building back in 2006. More importantly, it shows just how far commercial real estate (CRE) values have fallen.

The thing is, CRE problems won’t be one for Manhattan real estate players. Not at all. This is a sign of things to come in the CRE market. And when we look at who owns most of the CRE debt, it’s easy to see it will affect a lot more people.

I’d go as far to say, the CRE crash could be even more disastrous than the housing bubble. The costs will run into the hundreds of billions of dollars. Here’s why.

The “Sweetest” Piece of the Pie

For long time readers of our Free e-Letter, the Prosperity Dispatch, the problems of CRE shouldn’t be much of a surprise. We’ve been expecting this for a while. Back in Kicking Off the Panic of 2009, we warned of the vicious cycle about to hit CRE:

As unemployment rises, consumers spend less, retail sales fall some more, more shops close down and walk away from their leases, and overleveraged mall owners collect less revenue eventually defaulting on their loans and forcing the banks to take the losses. Throughout it all, unemployment rises even more from the retail stores closing up, manufacturers cutting back production because the retail outlets buy less from them, banks cut back staff, and start the cycle all over again.

Falling CRE values are a problem, but it’s not the big problem. The big problem is the debt.

As we’ve seen time and time again, markets do work – when they’re allowed to. The Hancock Tower is the perfect example. The owners were forced to liquidate. They lost all of their equity. The property and all the liens against it (primarily the $640 million mortgage) were sold to a new owner.

If the new owners can run the building efficiently enough to make payments, their equity will build. If not, the lenders will be forced to take the building, sell it, and write off the loan.

Markets work. And they will continue to do one-time deals like this. However, if there is a widespread downturn in CRE prices, most CRE transactions won’t go this smoothly. Sellers will outnumber buyers. And we’ve seen how prices can fall very quickly when that happens. At that time, the lenders (and those who bought the securitized loans) will be on the hook for falling prices. From here, there is no place to go but down. 

Unemployment Soars, CRE Crashes

When you think about it, you can practically see the next big round of bailouts headed for CRE. Another vicious cycle has begun. And it all stems from rising unemployment.

It’s no secret unemployment is on the climb. At the end of February, the official unemployment rate in the U.S. was 8.1%. The next unemployment report is due out tomorrow. The consensus estimates forecast another 650,000 jobs lost and the unemployment rate to climb to 8.5%.

The march to double digit unemployment we predicted last year is continuing. It’s only a matter of time until we see the real consequences of 10%+ unemployment. One of the hardest hit sectors will be CRE.

During a recession, especially a bad one, commercial rents fall fast. As jobs are lost, offices shut down, and the office property market reaches significant points of overcapacity. Inevitably, the cost of leasing an office falls. Since CRE prices are based on rental prices, CRE prices fall just as fast.

The decline stems from the vicious cycle which was started a year and a half ago.

Trickling Down Economics

It’s the same vicious cycle we’ve been over before. Businesses cut back on spending, investing, and hiring. Unemployed people, or those who just fear they will be unemployed, cut spending. This, in turn, reduces revenues and the downward cycle continues.

This is nothing new. We see it every day. The key here is the cycle takes a long while to hit CRE.

The delay comes from many factors. For instance, businesses don’t renew leases every month. They don’t close up shop quickly. They try to survive until the last dollar is spent. This results in a long delay. Considering the recession began in November 2007, right about now is the time when it starts to hit CRE.

New York is the “canary in the coal mine” when it comes to CRE. A year ago, vacancy rates in the Big Apple were between 7% and 8%. The rate climbed to 10.9% at the end of 2008. Now, just three months later, the vacancies are up to 12%. And they’re still going to go.

Climbing vacancy rates have pushed the cost of renting way down. The lease rate on a square foot of office space went from $74.49 to $65.18 in just the past three months. That’s a 12.5% decline in just three months. Keep in mind; this is in New York City where some of the world’s most valuable CRE is. We can only imagine what is going on across the country.

CRE has its own vicious cycle. Unemployment increases, demand for office space decreases, rents fall, and then commercial property prices fall. CRE prices have already fallen and the next leg down could make the subprime crisis look like a cakewalk.

The Biggest Shoe of them All

The difference between the impact of the housing bubble bursting and the CRE bubble is critical to understand. The majority of residential loans were originated by banks or other lenders, packaged together (securitized), and then sold off to investors.

These mortgage-backed securities paid anywhere from 6% to 10% (depending on which tranche you bought). Investors were happy to have them. They were especially happy to buy them if they were buying insurance against a default from AIG – but that’s a topic for another day.

CRE is a whole different matter. Many of the CRE loans paid higher rates of interest. More importantly, they were backed by renters with businesses which generated revenue and profits. In other words, CRE loans were made to people who could pay them unlike a lot of the residential loans. So the banks didn’t sell them off to others. They kept them on their books.

These loans meant more interest income which would allow them to pay a higher interest rate to attract more cash from depositors and still make strong profits. Meanwhile, they could sell the garbage residential loans to someone else.

That’s why the CRE downturn will create even bigger problems…have a great impact on balance sheets…and end up in even bigger bailouts.

Of course, we went over how bad commercial real estate declines would be for regional banks months ago. At the time Wall Street was still riding high on hopes the new administration would provide a plan quickly.

The big problem though is not that banks kept the CRE loans on their books. The Fed, Treasury, and FDIC are making progress. They’re getting bad residential and credit card loans off banks’ books. CRE loans are a different story. That will change.

A Bigger Shoe to Drop

We’re not the only ones hot on the trail of commercial real estate though. A lot of people have spotted this storm on the horizon. But only a few have boarded up their windows and moved to higher ground.

Billionaire hedge fund investor George Soros sees it coming. He says, “CRE has not yet fallen in value. It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent.”

The impact on the value of real estate loans is starting to appear as well.

The Wall Street Journal claims “Commercial Property Faces Crisis.” The financial news service reports:

  • The U.S. banking sector could suffer as much as $250 billion in commercial real-estate losses in this downturn. More than 700 banks could fail as a result of their exposure to CRE.

  • In 1993, less than 2% of the nation's banks and savings institutions had commercial real-estate exposure. In 2008 that had risen to about 12% or about 800 financial institutions.

  • CRE in the U.S. is worth $6.5 trillion and financed by about $3.1 trillion in debt.

  • Deutsche Bank predicts about two-thirds of the $154.5 billion of securitized commercial mortgages coming due between now and 2012 likely won't qualify for refinancing.

  • Matthew Anderson, partner at Foresight Analytics, expects nearly 50% about $524.5 billion of whole commercial mortgages held by U.S. banks and thrifts are expected to come due between this year and 2012 as they exceed 90% of the property's value because, today, lenders generally won't loan over 65% of a commercial property's value.

A CRE crash would require an additional $250 billion (or more) bailout from the government. That’s another big number that Congress is going to have to muster up the political will to pass. Or the Fed will just cover it. Either way, it’s an ugly scenario shaping up. And one industry (insurance companies) will likely pay a big price.

Pockets of Weakness

Over the past few years, insurance companies bet big on CRE loans. It makes perfect sense from their perspective.

Insurance companies have the same motivation as banks do to seek out a higher return. They get a great return on the capital they are responsible for managing. They can charge lower premiums to attract more business. And they can still maintain healthy profits. It’s great – until real estate prices start to fall and the CRE loans are at risk.

The downturn has already taken a toll on most life insurance stocks. As you can see in the chart below, the decline of shares of major life insurers range from 63% to 91%:

Life Insurance Stocks: Tough Road Ahead


Decline From

52-Week High

Hartford Financial Services (HIG) 


Lincoln Financial (LNC) 


Prudential (PRU) 


MetLife (MET) 




Sun Life (SLF) 


I think this is just the start of it though. Housing has got the headlines, but it’s CRE that can do just as much damage – if not more.

You see, there were never any runs on banks over the past few months. The public had confidence in the FDIC. So there was never any need to run and withdraw all your money – which you can’t really do anyway without a week’s notice. Insurance companies are a completely different matter.

There is no government backstop guaranteeing your life insurance. Maybe the AIG deal is an example of what will come, but you can bet there won’t be much public support for it. AIG, an insurance company, has done everything so poorly the public might just not be willing to allow Congress to foot the bill for the CRE downturn. That’s the real risk here. If there’s a bailout – ok. Insurance stocks will be worth a tiny fraction of what they are worth today (I don’t think they can’t fall another 70, 80, or 90%).

Insurance firms have already started preparing. Earlier this week Principal Financial Group (NYSE:PFG) announced it was going to do everything necessary to cut expenses. It stopped hiring. It slashed pay across the board up to 10%. It also cut back employee vacation time. These are not actions taken by a company expecting the good times to return during the anticipated recovery in the “second half of 2009.”

Irrational Crisis and Rational Opportunity

In the end (yes the end is near – this was a bit long, but it’s not a simple topic and the risks posed warrant the time), the CRE debt issues are a ticking time bomb. With unemployment on the rise, vacancy rates rising, rents dropping, and CRE loans on the brink of default, this is shaping up to be a big problem.

The deal to unload the iconic Hancock Tower is just a sign of what’s to come. There are buyers now. But when liquidations increase, you’ll see prices fall much faster than the three year near-50% decline in the price of the Hancock Tower.

More importantly, spotting problems like this early enough allows us to make the moves necessary to protect ourselves from the very real risks posed to the major insurance companies. You don’t have to short commercial real estate REITs or insurance stocks to take advantage here.

By focusing on the reality of what’s on the horizon, we have the chance to adjust our plans accordingly. We’ll have the chance to prepare psychologically, get prepared for some more bad news, and we’ll be able to make the right moves when this does become a problem.

And it is that, getting prepared to act rationally when others will be surprised and act irrationally, that will allow us to turn this potential crisis into a genuine opportunity.

Picturing the Recession.
This is really interesting. New York Times readers are sending in their photos and captions from around the world. How do you see the recession playing out in your community? What signs of hardship or resilience stand out? How are you or your family personally affected? There are five categories -- business, family, home, sacrifice, transportation and work. To see the photos along with their stories, click here.

The most tasteless, but wonderful video. If you don't like four-letter words, don't watch it. The video tells the story of the failed marriage via a horse race. Use Windows Media Player or equivalent to play it. Click here.

Ridding your PC of the Conficker virus. Four percent of PCs have it. For how to get rid of it, click here.

Senior driving -- Part 1
A senior citizen was driving down the freeway, his car phone rang. Answering, he heard his wife's voice urgently warning him, 'Herman, I just heard on the news that there's a car going the wrong way on Interstate 77. Please be careful!'

'Hell,' said Herman, 'It's not just one car. It's hundreds of them!'

Senior driving -- Part 2
Two elderly women were out driving in a large car - both could barely see over the dashboard. As they were cruising along, they came to an intersection.. The stoplight was red, but they just went on through. The woman in the passenger seat thought to herself 'I must be losing it. I could have sworn we just went through a red light.' After a few more minutes, they came to another intersection and the light was red again.

Again, they went right through. The woman in the passenger seat was almost sure that the light had been red but was really concerned that she was losing it She was getting nervous at the next intersection, sure enough, the light was red and they went on through. So, she turned to the other woman and said, 'Mildred, did you know that we just ran through three red lights in a row? You could have killed us both!'

Mildred turned to her and said, 'Oh! Am I driving?'

Tennis this weekend.

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.