New Onion

Looks like the Gazette is picking up on what some of us have been predicting… in 2007 I was bullish on the construction industry because I thought that increases in employment would continue and demand for housing would rise to a corresponding degree. The combination of term limits, tighter financing, and global recession has taken us toward the scenario that became more clear in mid 2008.

Overbuilding of commercial buildings is the culprit this time.

In July 2008 I wrote:

The next casualty if real estate goes will be the construction boom. Prices of construction have already risen substantially in dollar terms If the public’s ability to buy falls then builders will not be able to sell quickly, returns to speculative builders will fall, and some may lose money and those most dependent on leverage will fail while most slow down the pace of building. Then the workers building them may then be unemployed – the failure of education and lure of the drug industry have sent a large number of young Bermudians into the combination of drug dealing and construction work. They are going to be pissed off and the effects on Bermuda will be quite painful.

Denis over at 21square.com has also written about this.

Odds of a large hotel project are very low, although there may be a lot of cleanup work done at Morgan’s Point I think we can be sure that the ultimate beneficiaries will be the usual Friends and Family Plan members. At the same time, the overspending by government during the boom times and deficit spending to fund current expenditure has left the government unable to prudently pursue large capital projects now in a time of cheaper construction.

For the record – the real slowdown is just beginning.

From the New York Times:

Some suggest that the banks, spooked by enormous losses, have replaced a disastrously indiscriminate willingness to hand out money with an equally arbitrary aversion to lend — even on industries that continue to grow.

Some have suggested that Ewart Brown is a remarkable alchemist for his ability to make a Platinum era in tourism (he picked occupancy numbers from the week of the Newport Bermuda Race) from tourism numbers that most would consider to be more Talc than anything. I expect that if Brown continues to work his magic in tourism and if the US slowdown becomes a truly widespread credit bust then we could soon be in the “Peat” period of tourism. The only thing that will prevent that is if the government decides to use the taxpayers to subsidize large capital investments in tourism for the benefit of private developers… like the Southlands/Morgan’s Point giveaway and the Club Med giveaway. Either way, the people of Bermuda get screwed.

An interesting article in the paper today: Car sales concerns.

With car sales dropping 24 percent in May alone, dealerships said it was hard not to notice a lack of customers.

This is not only an indication of economic weakness, but it’s also going to show up somewhere else where it hurts. The government takes a large tax on every car sold. Fewer sales means less tax revenue.

Since our government has presided over massive increase in spending which have not been fatal thanks to almost matching gains in tax revenue, we can expect nothing good from the combination of poor financial control, economic slowdown, and a Finance Minister who would have been fired if she was a company CFO.

Edit: Changed the link from a duplicate of the car sales story to Bob Richards’ response to the audit.

Disclaimer: The following is speculative. I have no non-public information on current banking conditions whatsoever and am very likely wrong, or at least I hope the worst does not come true.

The Royal Gazette picked up a real estate story… just in time for me to finish another – somewhat speculative piece about real estate markets of the future.

The value of a bond is dependent on the amount of the regular interest (coupon) payments and the prevailing interest rates. When interest rates rise the interest payment amount of a bond stay the same, but it’s possible to get new bonds that make a higher interest payment, so the value of the old bond falls.

So for real estate: if interest rates rise, the amount that can be borrowed falls for any given payment amount.

The more that debt is used as a tool to buy property, the more that property will behave like a bond, rising as interest rates fall and falling as they rise. With increasing use of 100% financing and other “innovative” financing methods this part of what happened in the United States. Incidentally, this is why we should be very wary of any government initiative that simply serves to increase the amount of debt that consumers are able to take on to buy a property, such as giving away down payments. They tend to raise house prices in the short run, but if house prices fall and someone has borrowed all the money to buy it then the lender has immediately lost money. If the lender is the government then it’s the taxpayer who is in trouble – which in the USA is exactly what will happen as the US government is ultimately backing much of the mortgage industry.

What I missed is that the lender’s use of Mark to market accounting adds another dimension to the dynamic. And was the driver of the first waves of the credit crisis. Banks are highly leveraged – they often have leverage of on the order of 15:1, which is to say they have large amounts of assets and debt that are based on a fairly small amount of equity. When the value of their assets falls they then have to reduce their lending or raise capital to return their leverage (which they call “reserve ratio”) to more normal levels. As the credit crisis continues it is now appearing quite likely that some major financial players will (or already have) reached the point where their liabilities (debts) exceed the values of their assets, making them effectively insolvent. The US Federal government is then going to start to take these risks onto its balance sheet – as has begun with Fannie Mae and Freddie Mac, both of which would otherwise be sliding into bankruptcy, and if the Fed is not able to stem the decline in confidence those two will in all likelihood be joined by a variety of other financial institutions.

Bloomberg link.

U.S. banks can lend $12 for every dollar raised through the securities, so $100 million of the preferred shares may become as much as $1.2 billion in credit, based on Basel I banking rules.

When prices fall, the bank’s risk of loss in a foreclosure increases. Under the old paradigm with a 20% down payment on a house, it’s rare for banks to take a bath and the bankers are far less sensitive to downturns in the real estate market. This has previously been especially true, where large down payments and substantial discounts on valuing rental income have kept Bermuda banks safe from market declines. However, with first time buyers in Bermuda now being offered the ability to borrow more than 100% provided they live in a property for period, the banks have essentially made an economic loss the instant they write these mortgages (they have origination expenses). Accounting rules determine if banks need to show a loss on their income statement/balance sheets, and so the dynamic in Bermuda may be different if the banks don’t need to start taking huge write downs when prices do start do decline.

The problem is that the sale price of real estate is dependent on the bank’s ability to lend.

*cue ominous music*

Once a bank starts to lose money as house prices decline and credit starts to be constrained then they can’t lend as much so house prices decline and credit becomes more constrained so the banks can’t lend as much so house prices decline… and so on. A vicious cycle. The newest and most greatest loan/value ratio mortgages lose money first – and as prices decline successively older vintage mortgage holders find themselves underwater.

That’s essentially what has been happening in the USA. As house prices have declined mortgage rates have gone up, reflecting the unavailability of credit, which has effectively increased the cost of ownership.

In the US (and to a vastly lesser degree in Bermuda) bankers have decided to abandon risk controls because they have been in an almost generation long bull market for real estate that began with the taming of inflation in the early 1980s and which last had a major shakeup almost 20 years ago. The world has changed and there’s a very real risk that the USA will face massive financial stress as layers of debt unravel, what began with sub-prime mortgages issued by 22 year old Las Vegas mortgage officers has now spread because the growth of the US economy has for most of the past 6-8 years been dependent upon debt creation. The crisis has the potential to be truly crippling for America as the US Federal Government is in terrible financial shape after years of neo-Keynsian policy under Regan and Bush II and may be unable to produce a policy response to restore confidence, which in a worst case scenario will result in a truly spectacular recession and possibly a depression.

In theory, we in Bermuda should have been taking note and creating a sovereign wealth fund during the boom times instead of abandoning financial control in the government and spending hundreds of millions of dollars on farcical projects, and we DEFINITELY should not be spending like drunken sailors now.

Some time ago Bank of Bermuda head Phil Butterfield remarked in his sweeping style that “We have never lost money on Bermuda mortgages.” Sorry Phil, you have lost money on mortgages before and you’re about to again. However, the margins are so large on Bermuda mortgages that we probably don’t have to fear the kind of financial mass destruction that is happening in the United States (all bets are off for Bermuda banking if some major insurers go bankrupt, the government starts talking about exchange control, and a hotel or two closes at the same time).

Developing a price index for Bermuda real estate is far more difficult than in the United States because every home is a custom home. In the USA you will have quite literally identical houses being built all over the country so they’re really a commodity and easy to index. A Vexed says:

The article claims that the average cost of a single family home is now just under a million. Meanwhile a January 2007 article from the same agency put the price at 1.325 million. That implies the average sales price of Bermuda real estate has dropped by more than 25% in one year.

Before we get hysterical, we need to remember that because properties in Bermuda are all different, the median transaction price is not necessarily the same as the price change any given property from year to year. We can infer changes in the market’s demands, but because houses are not commodities, a decrease in year over year median price does not imply a falling market, and could instead reflect a smaller number of high-end transactions, or a larger number of low-end transactions.

A more careful and subjective analysis of comparative properties is needed to arrive at the actual year over year decline in what a property sold for last year compared to what it would sell for today. I believe that at present we can have some faith in the agency’s estimate of a flat market with longer time on market, from which we can infer that if time on market does not stabilise or fall then prices will decline and may have already, sales price data lags as properties that come on the market today will not sell for months.

Next up… lending.

It’s late, I’m tired, but two things happened today.

1. A realtor said that now is the time to buy (Bermuda Sun)
2. An analyst exposed that a bank faces writedowns from credit losses (Royal Gazette)

Oh. No.

I thought that the American “experts” suggesting a buying opportunity a year ago were dead wrong. While the focus of her words are on the residential owner-occupier who faces different constraints (a very long time horizon, the opportunity cost of renting vs. owning) The question is still: Is Bermuda headed the same place as the United States, Spain, the UK, and a number of other countries?

In the Bermuda Sun:

Market conditions for home buyers are the best they’ve been for 15 years, Bermuda’s largest realtor said this week.

The days of properties getting snapped up as soon as they come on the market are over – nowadays houses and condos may have to sit for months before a buyer comes along.

I disagree, and suspect that the piper is just showing up. Because of the use of financial leverage, real estate prices are downward sticky and so we see time on the market rise before price declines begin.

Here’s an article from February 6, 2007 – A few months before US real estate prices began to fall dramatically.

As markets have “normalized” around the country properties are staying on the market longer before selling. In many areas a perfectly good listing may take sixty to ninety days to sell, sometimes longer. This raises considerations that are new to many agents, and that haven’t been at issue for some time.

The author had no clue what was about to hit the US real estate industry. I remember walking into a KB Homes showroom in April 2007 when I was on holiday in the USA and the salesman was convinced that the market had already turned around… when in fact the pain was just about to begin.

Personally I have become more bearish on Bermuda than I was back in September as credit writedowns have spread beyond just sub-prime housing, and more bearish in general than I was in July 2007.

If this article about Bank of Butterfield in today’s business section is true then Bermuda will just be entering the process of feeling the sustained effects from massive credit losses occurring elsewhere.

Butterfield Bank is expected to make significant markdowns in its “held to maturity” portfolio by the end of this year due to a widening in credit spreads and the further deterioration of the US housing market, according to a new equity research report released by LOM.

If the Bank faces losses then turn this will impair the bank’s balance sheet. In turn this affects their ability of the banks to lend. And in turn they will either need to raise capital, raise mortgage rates, and curtail lending. I must disclaimer that I have no knowledge whatsoever of Bank of Butterfield’s operations and have not even done the due diligence of looking at their annual report and financial statements.

Foreign global banks have generally been able to raise capital from sovereign wealth funds and other sources, but since then have faced further losses and will this time around be unable to raise additional capital as investors become wary of throwing good money after bad. Combine with oil price increases and the stage is set for a multiple year period of pain in global finance, the effects of which could easily be felt in each and every one of our pockets (note, all bets are off if oil suddenly falls to $40 per barrel, but bet on a depression if Bush tries to invade Iran to send oil to $250).

Although local banks end up being more sensible than some of their American counterparts because they hold loans on their own books, Bank of Bermuda (HSBC) have bought into Bermuda American style financial innovation which has allowed for higher leverage and exposed the Bank’s balance sheets to much higher risk of loss. This is fine during rising markets, but comes back to bite them during a bear market. For example, by offering what is in effect an option on Bermuda real estate with their No money down, interest only mortgages. You pay the difference between the interest and rental payment and if at the end of the three years the house is worth more then you sell it at a profit. If not then you mail the Bank the keys. All you risk are your credit ratings (no, it’s not actually that simple, but close enough).

It’s worth noting that the intrinsic value of Bermuda real estate is driven substantially by the effects of immigration and local wages, which thus far have also suffered as the same credit crunch affecting banks has also affected insurance companies and will probably affect bonuses and pay in those companies as well.

The next casualty if real estate goes will be the construction boom. Prices of construction have already risen substantially in dollar terms If the public’s ability to buy falls then builders will not be able to sell quickly, returns to speculative builders will fall, and some may lose money and those most dependent on leverage will fail while most slow down the pace of building. Then the workers building them may then be unemployed – the failure of education and lure of the drug industry have sent a large number of young Bermudians into the combination of drug dealing and construction work. They are going to be pissed off and the effects on Bermuda will be quite painful.

As Alan Card said “He was underwater and he had his arms wrapped round the fish and the fish was pushing him under… (and) I knew there was no good going to come out of it.“

If you saw someone sitting in a hotel bar reading a finance textbook and laughing that was me.

Why?

Because I was revising the principles of capital budgeting and putting it in the context of the Bermuda government’s decision making.

Capital Budgeting Process in the Bermuda government
1. Generate Investment Ideas (How can we funnel ourselves lots of money but make it look like it’s not stealing?)
2. Analyzing individual proposals (How much can we funnel to ourselves?)
3. Planning and capital budgeting (How can we do this so that nobody notices, or if it has to be public how can we make it look not completely crooked?)
4. Monitoring & Post Auditing (Let’s keep Larry too busy with other things.)

*facepalm*

Fun times ahead for many of us as people like George Soros calling for a major recession.

Last time (post-tech bubble) was from equity excess… this time it’s debt and a major breakdown both in the financial responsibility of the US government and the debt originators in the United States.

Let’s just hope the Bermuda banks have been more sensible (and by and large I suspect so).

Things are finally going to start getting really exciting in debt markets – by which I mean that the average joe in the United States and other countries is likely to be seriously affected by a global loss of liquidity and a widening spreads as the losses from making loans to people who could only afford them in an up market begins to result in reduced lending by banks.

I have a strong suspicion that we are going to see a global slowdown over the next few years as a consequence of a contraction of credit as the effects of the misalignment of financial incentives that began in 2001 with a bunch of 22 year old Las Vegas mortgage brokers (who I used to drink with) throwing away risk controls during a bull market, which in a competitive oligopoly and a sustained bull market in real estate caused by low US interest rates caused by the American government’s inability to manage its taxation and borrowing in turn caused all the competing firms to drop their own risk controls in order to survive. I wrote about this a while ago.

The other reason that this real estate recession will be far worse than previous ones is that previously institutions kept mortgage debt on their own books, which gave them incentives to restructure loans rather than force mass foreclosures. It’s much better for a bank to lose 10% of the value lent by restructuring rather than the 30-50% they’re looking at losing in some markets thanks to foreclosures. This time around many of the mortgages are owned in separate structured investment entities that are not structured to allow for any decision maker to be able to restructure the underlying loans in the portfolio, leaving foreclosure as the only option…

But I have a sneaking suspicion that in 3-5 years buying property in the USA is going to be a great investment.

One of the big issues with the disaster that will be our construction industry and cement supply is that on a very basic level the politicians trying to shut it down or introduce competition don’t know very basic economic concepts - through no fault of their own. They, and others I have spoken to have taken the general economic statement “All else being equal, more competition leads to lower prices and higher consumer surplus” and have decided to get back at the landed white family that currently operates a business with no local competition.

There are two problems with this.

1. Bermuda Cement is currently selling cement at below what they could charge. They are NOT maximizing profit as a monopoly would were there one cement plant that was not faced with foreign competition.
What’s the evidence for this? In general in a market, a monopolist would (theoretically) be able to increase price until the point that another entrant would find it profitable to enter the market. The Royal Gazette article gives us a clue as to how expensive cement would be in order to justify building another cement plant – namely, on the order of double what they are today (ignoring the significant economies of scale that make cement in Bermuda a natural monopoly). The reason for this is that the required profit to justify spending the $12-$15 million necessary to build a new cement plant would be well over a million dollars a year – and that’s just capitalizing the physical plant over 30 years. To make that payment would, according to Jim Butterfield require doubling cement prices – which are currently around $10 per bag retail. So essentially, it would likely take somewhat more than double the current price to justify two cement plants (when you figure the additional overhead/land combined with the capitalization of the plant required).

Who would lose? – pretty much everyone.
Bermuda Cement – not greedy experienced operators lose their business.
Bermuda public – Pay double for cement what they used to, results in more expensive housing with no increase incentive to supply.
Bermuda construction firms – who cease to operate during the supply stoppages
Bermuda taxpayer – who would ultimately pay more for capital projects at WEDCO to replace the silos.

Who wins?
Minister Burgess’ ego.
The construction firm who gets the contract to build new silos (sound familiar?)
The consortium of rich businesspeople who get the new lease on new silos.

Which side are you on?

The basic principle here is social cost.

2. The fundamental principal of expropriating from old land-owners ignores that in a modern financial system the only barriers to entry into the wealthy classes are (a) ability to learn skills, and (b) knowledge of what’s possible and how to progress. In a modern system everyone has (or should have) access to the educational basics (university, CFA, CMA, or similar self-study), the capital (banks will loan, BSBDC will underwrite small loans, etc.), access to any social circle one wants, etc. So if one is serious about taking the future of business from the old guard then one can, and should wrench it from their hands the good old fashioned way – by beating them at their own game… and not by vindictive silly action against a natural monopoly.

2a) is of course the question: Who will be running the plant now? If it’s the usual suspects then that’s a huge scandal and is abject corruption.