A Muddy Road Ahead

We are going to have a recession! I can say that with almost absolute certainty. The open questions are timing, severity, duration and strength of recovery. I can’t accurately answer any of those questions and neither can anybody else. Economists have repeatedly and spectacularly failed to accurately predict the onset and severity of recessions. I believe the reason is that there is a major emotional/irrational component that is impossible to quantify.

The economic facts are straightforward. A one word description is mis-allocation. Some assets get wildly overpriced. Some sector of the economy fails to adapt to changing circumstances. The lure of goosing profits with leverage becomes irresistible — the higher the leverage, the greater the profit. A series of defaults reveals structural weakness in a sector of the economy. Before the fall, some contrarian investors are selling off or shorting. Other investors notice. A tipping point is reached, which creates a cascade. The exits are then jammed and free fall ensues.

Once the recession is in full swing, a vicious cycle sets in. Banks call loans. Individuals and organizations hoard cash. Decision making becomes paralyzed. Tax receipts plummet. Both government and the private sector lay off employees. Consumption contracts. Marginal players are forced into the cruel arms of the bankruptcy courts.

At some point, asset prices reach truly attractive levels. Those with access to cash start buying. Some companies have survived the shakeout and prospered. Optimism sets in.

At every stage of this process, there is a major emotional component. Investors pile into faddish investments because we are herd animals, with an almost limitless capacity to rationalize. Greed blinds us. We are obsessed with peer group approval. Getting outside the herd is a scary act. When the rush to the exits begins, we are paralyzed with fear. It takes awhile for the greed bug to overwhelm the fear demon. The relatively new field of behavioral economics is attempting to quantify our emotional responses, but I am not sure it will ever be totally successful, because the acts of measuring and reporting will probably alter behavior.

For example, not every default creates panic. During the last recession, several medium size government bodies defaulted. The Muni market jittered, but did not panic. Then Detroit went broke — a fairly big deal. Still no big Muni sell-off. Today, we have Puerto Rico, a $73 billion default with a big haircut in the offing. Muni yields haven’t budged. I think the reason for the calm response is that there was a lot of notice. Holders of Detroit and Puerto Rico paper started selling before the default, at progressively steeper discounts. Those holding the paper at the time of the default had a basis of 10 or 20 cents on the dollar, maybe less. At lease some of them made money.

I believe we are at risk of a significant downturn in the not-too-distant future. Virtually every advanced economy is packing too much debt. Excessive leverage can turn a small problem into a big one in a hurry, when the debt won’t roll over. In addition, we are facing a demographic tsunami. The last of the baby boom generation goes onto Medicare in 2029. We have saved no money to pay the demographic bill. Meaning that governments will have to go even more deeply into debt and/or raise taxes significantly to service the promises of the welfare state. Either course stunts economic growth.

I’ll give you a real estate example of the rollover problem. Let us say you own a commercial property with a net annual income of $100,000 from a creditworthy tenant on a long lease. In today’s market, that would be valued at a 5 cap or better. That means you could sell it for $2,000,000 ($100k is 5% of $2 mil). Many lenders would be happy to give you a loan of 75% of value or $1,500,000. Great stuff! You get $1.5 mil tax free. At a 4% rate, you still have $40,000/year in cash flow after servicing an interest-only loan. Five years pass and it is time to roll the loan. We are in a downturn and your bank is under pressure to strengthen its balance sheet. The appraiser is pushed to be conservative, and says your asset would trade at a 7 cap, yielding (in round numbers) a value of $1,500,000. Your 75% loan will now be $1,125,000. Your choice is to send the bank $375,000 or the keys. Your new interest payment on the lower loan amount with probably be higher than on the old loan, because the interest rate will be higher, and a paydown of principal component will have been added. That assumes that your tenant has not gone broke or negotiated a rent reduction. Multiply that scenario thousands of times and you can see how an economy is going to spiral downward.

The higher the leverage; the greater the problem. In 2008, the big Wall Street shops that went down were levered 30 or 40 to 1. They had borrowed short and lent long. When the market stopped rolling their loans because of a perceived loss of value in their assets, they had to fire sale assets to repay loans. A stampede ensued.

My prediction is that, sometime soon, a default or series of defaults will push the system toward a tipping point. The excessive level of leverage we currently have will provide the momentum that pushes us past the tipping point. My recommendation is that you lower your own leverage and keep some dry powder. In the immortal words of the country song: “Detour! There’s a muddy road ahead. I should have read that Detour sign.”