Zero Interest Rates, But Where's the Inflation

Currently deflation is winning the first couple of rounds in the inflation/deflation debate raging among economists, analysts, and investors. CPI/PPI remains subdued. GDP growth is sluggish as evidenced by this morning's GDP report, which showed a slow down in second quarter growth to a 2.4% annualized rate. Wage price inflation? Forget about it. You have to have a job first before you demand higher wages. Commodities surging? Yeah, cocoa prices hit all time highs, mostly due to some jokers at a commodities hedge fund who are clearly trying to build the world's largest chocolate bar, because why else would you take delivery of the biggest amount of physical cocoa in 14 years? But the price of gold hasn't really kept up with the gold bug crowd's expectations. Even hedge fund manager John Paulson has suffered losses in his funds, and he had managed to expertly time every hairpin turn in the market for some time.

So the Fed is keeping interest rates at zero, and anyone who's had any economics classes knows that exceedingly friendly monetary stimulus coupled with exceedingly friendly fiscal stimulus should cause runaway inflation. Except that hasn't happened yet. Instead prices for everything have either taken a breather from heading lower (i.e. housing,) or are still actively going lower (i.e. your favorite retailers are having a sale.)

The only thing staging a monster rally is financial assets. The stock market ripped, and is currently taking a reflective pause to decide if it can defy all the recent rotten economic news to rip ever higher. Heck even the Fed's portfolio of Maiden Lane securities is staging a big comeback. Paper profits on "formerly" toxic securities! But the real out-performer is the bond market. Interest rates on treasuries are at record lows. This was the busiest July on record for sales by junk issuers. Financial firms are jumping on the bandwagon, feverishly issuing debt at record low rates before the window of opportunity closes. According to the FT:

Wall Street executives say recent debt issues were triggered by “reverse inquiries” – informal approaches by fundmanagers seeking to raise their exposure to a sector they had largely avoided since the crisis.

Fund managers have so much cash with nowhere good to go with it, so they're begging financial firms to issue debt. Why financial firms? Because they are too big to fail. So you get slightly higher rates than treasuries, with the US government's stamp of approval on it. What is too much money chasing too few goods? I think that's called inflation.

Seems like the "reverse inquiry" situation was exactly what was going on in the mid-00's, when Wall Street needed subprime product to continue to feed the CDO machine. All the demand for subprime mortgages perpetuated the frenzy in housing. Again CPI/PPI was subdued and interest rates were low because there was no "inflation," just a massive financial bubble in the making. Will the story end the same way this time?

Madoff Trustee Goes After the Goods

Irving Picard, the hard working court-appointed trustee tasked with recovering assets for Bernie Madoff's victims, said in an interview that he might sue around half the estimated 2,000 individual investors who unwittingly made money investing in the ponzi scheme. Although Mr. Picard sent hundreds of letters last year to investors who withdrew money from their Madoff accounts before the fraud was exposed asking them to settle the matter amicably, few of them have chosen to do so. Now it's time to pay the piper. While it seems entirely reasonable (not to mention lawful) for Mr. Picard to go after those who accidentally profited from the scheme, it's not as easy to stomach when you are, say, an 87 year-old retiree who plowed all of her life savings, including the life insurance proceeds from her husband's passing, into what she thought was a safe investment.

Meanwhile, Mr. Picard accused one of the largest feeder funds, Fairfield Greenwich Group, of having "actual and constructive knowledge" of the ponzi scheme. Not sure why this took two years to figure out. When you get paid hundreds of millions in fees to perform due diligence for investors, and yet you are incapable of making a phone call to a single counterparty to make sure the firm is actually trading with somebody else. Or perhaps confirming that the auditing firm has the 20 partners it claims to have and isn't just one dude in an office in Florida. Or actually doing something, anything other than counting and spending all those fat fees on houses and cars and boats and PR agents to brag about all your houses and cars and boats in Vanity Fair, then you probably are more than just a lousy money manager. You are probably complicit in the scheme. But in either case, you need to give the money back so that those 87 year-old retirees can have something to split between them.

Earnings and Headlines 7/21/2010

• Morgan Stanley had a great quarter! Seriously! I know, I can't believe it either (see yesterday's highly inaccurate prediction below.) The investment bank roared back into the big leagues with a second quarter profit of $1.96 billion, up from $149 million a year earlier. $514 million of that was related to the sale of its retail asset-management arm, but earnings on a continuing basis were still better than expected. Results in its new and improved asset management unit were boosted by the purchase of Smith Barney from Citi. CFO Ruth Porat stated that although the banking industry will undergo a period of intense scrutiny, the firm was not a target of a major investigation. So things are looking up including the stock price, which is up 8%. Now go sell your real estate arm while you have the chance.
• BlackRock also had strong results, posting a near doubling in quarterly profit to $432 million. The surge in profits was attributed to the purchase of BGI last year. Seems like the thing to do to boost profits is go out and buy a money manager.
• Wells Fargo posted a profit of $2.88 billion, higher than last year's $2.58 billion but on slightly lower revenues. Results were better than expected and the stock is up 5%.
• The WSJ's quarterly housing report is out and shows a deteriorating housing market. It's nothing you didn't already know; pending sales down sharply after expiration of tax credit, new housing construction down, inventories up across the board. etc etc. But it has a nice city by city chart that makes you say things like "Wow, I'm glad I don't live in Detroit."
• MBA purchase applications are actually up slightly, which may have something to do with mortgage interest rates being at their lowest levels in the history of the universe.

Morgan Stanley, Lehman, and Real Estate Investing

The day before Morgan Stanley is set to report earnings, the WSJ runs a story about the investment bank's attempts to deal with the $46 billion disaster that is MSREF, its commercial property investment funds. MSREF never met a commercial real estate investment it didn't love during the boom and is now stuck with a host of turkeys in every corner of the world. What now? Should it sell the pile of ailing (yet diversified!) real estate investments? After all, both Citi and Bank of America have sold off significant real-estate investment fund businesses in the past month, to Apollo and Blackrock respectively. Also, ING is looking to do the same and MS really does just like to do what everyone else is doing, just later, and less profitably. Should it hold on and hope for the best? After all, the fund still earns management fees even when it does stuff like lose 75% of its investors' money. Maybe leak a story to the press, see if anyone out there has any better ideas?

Here's an idea: Maybe Lehman can buy it? After all, Lehman's bankruptcy has done nothing to slow down the frantic pace of activity at the real estate arm of the now-defunct investment bank. The WSJ reports that Lehman just took over Innkeepers, a REIT that owns more than 70 hotels. Well, this was less of a traditional takeover and more of a "you're wearing it" type of deal, as the hotel operator filed for bankruptcy and Lehman was its largest creditor. Lehman's debt in Innkeepers stems from its participation in the 2007 $1.5 billion buyout performed by none other than Apollo Investment, a subsidiary of the same folks that just bought Citi's real estate portfolio (see above.) Buy low AND high. I think that's called dollar cost averaging.

What should Morgan Stanley do? Tomorrow's earnings announcement will offer some clues as to whether the firm can finally return to its former glory as a premier investment bank, rather than a GS also-ran. If so, maybe MS has a shot at reaping a solid price for its ailing commercial real estate investment funds based on the prestige factor associated with its name. Because it's not going to get top dollar based on the fund's performance.

I'm predicting a lousy quarter for MS. They might even lose money. Why? Because all its competitors have had a lousy quarter and MS does exactly the same thing, except usually worse, even though the market seems to grant them some sort of a premium. How much longer can the premium prevail? Tune in tomorrow.

Goldman Sachs' Earnings Miss Estimates

With the $550 million settlement with the SEC behind it, Goldman Sachs can get back to doing what it does best: trading, advising, and then trading ahead of its advice. The problem is, even if you are the best at front-running, picking-off, and lobbying, there's not much you can do about lackluster markets.

Earnings for the investment banking giant were pretty weak, $0.78 a share to be exact, which was a far cry from the $4.93 a share GS earned in last year's second quarter or the $5.59 per share it earned in the first quarter of 2010. Even when adjusting for the impact of the UK payroll tax and the SEC settlement, earnings of $2.75 per share are pretty paltry, yet somehow the stock is only down around 3% on the news pre-market. Given the size of the miss, I would've expected a bigger hit. Maybe investors were prepared by the lousy investment banking results out of the big banks. Or maybe nobody's awake yet.

Goldman Settles, Now What?

Goldman Sachs settled its dispute with the SEC over whether it misled investors in some CDO deals for $550 million. Apparently, if you tell one client to buy a security while simultaneously telling another that it's worthless, it'll cost you $550 million. Goldman should've known better. I mean, after the internet bust, it cost Henry Blodget $25 million just for telling investors to buy a stock while secretly believing deep down inside that it was worthless. He didn't even tell anyone to short the stocks he was recommending, he just kind of had a bad feeling and sent one internal email to a colleague. $550 million is a nice round number. It's a big enough penalty to make you think that the bank definitely did something very wrong and is contrite. The investment bank went so far as to admit that it made a "mistake." On the other hand, the penalty amounts to about one week's worth of trading revenues. That's right. One week. So yeah, they're kind of sorry, but considering how much money the bank made during the credit boom, and then how much money it extracted from the government afterwards, this penalty amounts to peanuts.

Everybody knows that investment banks need to continually create complex products out of thin air that nobody really understands and then market them as the opportunity of a lifetime. That is where the real juice lies. Nobody gets rich trading transparent products like stocks anymore. Turns out, much of the time "complex" actually means worthless. If this weren't the case, investment bankers wouldn't be so rich, and they wouldn't have to pay so many gosh darn fees to various regulatory agencies every few years. We wouldn't have bankrupt municipalities done in by interest rate swaps, or pension funds that can't seem to meet their obligations because they bought some SIVs that were AAA rated for about a minute, or foreign banks that are pissed off at us because they just discovered they are exposed to a bunch of defaulting US subprime borrowers, or mutual funds that don't understand why their largest holding turned out to be a ponzi scheme masquerading as an oil and gas company. Or investors who don't understand why that internet stock never had an 8,000% annual growth rate. Or rich people who can't figure out why the hedge fund that their advisor told them was a guaranteed money maker, with a strategy that was "too complicated to explain," was a ponzi scheme masquerading as a...ponzi scheme.

In any event, with this round of regulatory action pretty much behind them, it's time to move on to a better question: How are investment banks going to screw their customers out of money next? So far, earnings out of the big banks have been decent due mostly to reduced charges taken on the main-street banking side. Investment banking revenues are down significantly. Goldman tends to outperform the other banks in trading, but without a large lending arm to lean on, odds are that earnings might disappoint. Time to get the quants cranking on some new products.

FDIC Giving Distressed Real Estate Away and Other Distressing News

The FDIC conducted the second bulk sale of its sizable commercial real estate portfolio, which it inherited from all of the bankrupt banks deemed too small to survive. As a taxpayer, you'll be happy to hear it went off without the hitch and we get to keep much of the upside to boot! Wouldn't want to miss out on any of the upside, considering all the downside that's been shoveled down our throats in the past few years. Colony Capital and a minority owned investment firm named Cogsville LLC are proud owners of $1.85 billion (notional) in distressed assets. The investors paid 59 cents on the dollar, or $445 million for a 40% equity stake, with the FDIC retaining 60%, and (this is my favorite part) they get a seven-year, zero-interest loan, to reduce the upfront cash to $218 million. Let me repeat my favorite part: seven-year, zero-interest financing. I know I've been grousing for awhile now how all that zero interest financing is only benefitting the banks and they aren't passing the savings on to consumers and small businesses. Turns out I was wrong. All that zero percent money is helping large private equity funds goose their returns too!

Let's see, how else are we boosting the economy? Oh, according to the latest Fed lending survey, hedge funds, in addition to private equity funds, are getting better terms from their lenders. Consumers? Not so much. Dealers reported that funding markets for key consumer loans remained under stress, with a quarter of dealers reporting that liquidity and functioning of the consumer loan market had deteriorated in recent months. So what to do if you are a small business or consumer that needs a loan and you can't get one because your bank is too busy offering good deals to hedge funds? Quit complaining and start your own fund! Better yet, find the nearest woman or minority, call them CEO, and give the FDIC to call. You'll get all sorts of zero-percent financing, provided you take a few Las Vegas condos off their hands.

Living the High Life as Renters in Miami

Bloomberg's story on the condo-turned-rental scene in downtown Miami makes me wish I were a recent college graduate with an accounting degree. Who cares about the financial meltdown when you are having this much fun? If you can fast forward through the crazy amount of real estate development of the mid-oughts, when developers neglected to give each other a call or count the cranes already littering the skyline and deduce that maybe the city didn't need ANOTHER luxury condo development in downtown Miami, things haven't turned out too bad. Oh wait, you also have to fast forward through the real estate bust, when a bunch of empty and half-built buildings sat among the chirping crickets, awaiting a buyer for all the excess units. Then forget about the part where a bunch of buildings were handed over to the lenders, prices were slashed, bulk sales occurred, and large losses were booked. Finally we come to present day in downtown Miami, where are bunch of 24 year-old accountants are renting luxury condos with wraparound decks, rooftop pools and spas, and going out every night to the restaurants and bars that have popped up to satisfy the partying needs of a its new tenants.

See? It all worked out after all. Developers didn't really misjudge demand, they just mispriced it. There are plenty of people that want to live in luxury high-rises in the middle of the action in exciting downtown locations. It's just that most of them are accountants in their 20's, who noted that it was far cheaper to rent a unit from a bankrupt developer for $900 a month than pay $500,000 for it. I know accountants get a bad rap, but for once they actually did the math right.

The biggest problem now? Older residents (probably owners who are bitter about paying too much for their unit) are complaining about "crowds by the pool, loud music, and women taking their tops off" in one particular development that has been overrun by recent University of Miami graduates who are renting. Jorge Perez, President of The Related Group in Miami which was forced to hand back two of the three Icon Towers it built said it the best: “Over the long run, what we did in building those buildings, was it wrong?” Perez said. “I wish there wasn’t the suffering on a personal basis, on a banking basis and individual basis. But have we made Miami a much better city? Absolutely, yes.”

Retail Sales and Consumer Credit

Yesterday's reports from the world of the retailing were, by most accounts, underwhelming. Thomson Reuters index of 28 retailers showed sales at stores open at least a year rose only 3.1% in June. While far better than the 4.9% drop reported in the same month last year, it's not the snap back that most were expecting just a few short months ago when many retailers placed their orders. What does this mean? Excess inventory for the stores and hopefully big sales coming up for the consumer. Woo Hoo!!

Lackluster retail sales are logical given the continuing shrinking in consumer credit. It seems that the American consumer is still hungover from its credit card binge of the mid-oughts and is attempting to cut back. The Federal Reserve's report on consumer credit yesterday showed a contraction in credit at an annual rate of 4.5% in May, with revolving credit down a whopping 10.5%. Total consumer credit currently stands at $2.4 trillion, down from roughly $2.6 trillion at its peak and up from $2 trillion in at the end of 2003, when the US was climbing out of the last recession. So credit contracted by $200 billion and our entire financial system nearly collapsed. During most economic recoveries, credit is expanding. Yet most consumers just can't do it anymore. They have to cut back because they just can't borrow anymore due to economic hardship or just plain common sense. It's hard to expand when you're really supposed to be contracting. Which is why you can't solve a problem of too much debt by offering more credit. But don't worry, the Fed's just gonna keep on trying.

Commercial Real Estate Update

The WSJ property report has some informatively juicy nuggets about the state of the commercial real estate market. In short, things are looking up but it's still a grind getting deals done. Case in point: Dividend Capital Total Realty Trust's $1.4 billion purchase of 32 properties from iStar Financial. On the bright side, it was the biggest commercial real estate transaction since August 2008! Of course, the buyer had to pony up 37% in equity and agree to a $443 million loan that had limited recourse to its operating partnership. Oh and the seller had to provide $100 million in mezz financing too. And Google, Amazon.com, and FedEx were some of the tenants. Still, the largest commercial real estate transaction since August 2008! According to the WSJ, five commercial real estate portfolio sales valued at more than $1 billion have been completed in the US since 2007. Back in 2007, when commercial real estate hot potato was the fun fad, 20 such deals were closed. So the sludge-like recovery is moving forward, yet at a more reasoned and sobering pace.

Moving on to the condo market, the WSJ reports that some adventurous folk are snapping up condos in bulk at reduced prices in some of the hardest hit markets, like Florida. Florida, if you'll recall is merely one of the places where condo developers went a little cuckoo with the building and decided it was a great idea to build around 300 years of luxury inventory. Some of those folks have gone bankrupt, while others are just puking units to stay in business. In any event, buyers are scooping up boatloads (cause its Florida) of condos at "fire sale" prices and hope to sell them for higher prices. The classic quote comes courtesy of a property broker that is currently marketing units: "Bulk sales in general can depreciate value of an asset and it does trickle down and affect other properties." Right. Cause it's the bulk sale that "depreciates" the asset, and not the fact that there are like 5,000 similar units on the market at prices where nothing is selling. Buyers who had the misfortune of purchasing before the market collapsed are torn between hating the fact that the value of their condo has just officially been cut in half and liking the fact that somebody actually bought all the units that were for sale in the building.

Meanwhile, builders such as Toll Brothers, whose overpriced units on a Singer Island development don't look so hot compared to the prices of a bulk sale that just took place in a competing property offer up these optimistic words of wisdom: "Anything that gets the inventory down is a good thing." True enough. But if the bulk buyer just plans to turn around and flip the properties for a higher price (which is true in most cases,) how exactly does that solve the inventory problem?

Joseph Cassano is Really a Hero

The man responsible for blowing up AIG, nay our entire financial system, has finally slithered out from his hole to say his piece to Congress. A reasonable person might expect a tone of contrition from the tool who bankrupted the world's largest insurance company in a matter of years because he loved subprime so much he couldn't stop selling insurance way too cheaply on it. Maybe something like: "Props to you guys and all your constituents for all the dough. We did a few trades that didn't really work out, so, it's awesome that the government could be a backstop for us. I mean, we could've just gone bankrupt and that would've sucked." Or even "Wow, I feel so bad about causing all this trouble that I'm gonna write a $300 million check, equal to all the pay I collected on profits I never made." But then apparently none of you people know Joseph Cassano. Widely reported to be an arrogant jerk BEFORE the crisis, it turns out that the implosion of AIG has only strengthened his self love. The following are the highlights from the WSJ's account of Mr. Cassano's testimony:

• Joseph Cassano, who led the division of American International Group Inc. responsible for the mortgage trades that proved the insurer's downfall, on Wednesday staunchly defended his actions, maintaining he made "prudent" decisions and that American taxpayers would have been better off had he stayed on.
• AIG's problems, he said, were brought on by a liquidity crisis when credit markets seized up— and weren't a result of lax underwriting practices or defaults among mortgage assets his unit had insured.
• "I think I would have negotiated a much better deal for the taxpayer than what the taxpayer got"
• Mr. Cassano said things might have turned out differently, had he not been asked to leave AIG.
• Mr. Cassano did not hesitate to parcel blame and responsibility elsewhere. He said he still disagrees with the decision by AIG's outside auditors, PricewaterhouseCoopers, to disallow an accounting adjustment that made his unit's reported losses from derivatives look smaller. "I still believe now that it was a wholly appropriate adjustment," his testimony said. The accounting firm declined to comment, saying it does not comment on client matters.

He didn't cause any of these problems. But still, he would've handled the clean-up way better from all those problems he never caused to begin with. The market was wrong, the auditors were wrong, the government was wrong, Goldman Sachs was wrong. All those margin calls? Meaningless! My marks were right. I'm never wrong about anything! EVER! Somebody should give me a cape. Oh, and build a statue of me too. Several statues. Like that guy who used to run Uzbekistan. No wait, maybe its Turkmenistan? One of the Stans. Anyway, you know what I mean. I'm a friggin hero!