Tuesday, January 4, 2011

Where the Real Deals Will Be

Today, let’s put the conclusions of my first two blog posts of this year together. The second blog post discussed “Four ‘Uncomfortable’ Situations to Watch in Early 2011,’ (http://seekingalpha.com/article/244531-four-uncomfortable-situations-to-watch-in-early-2011). The basic point of this post is that there are four areas of the economy that bear watching because the situations that exist within these sectors are extremely fragile and could result in some kind of collapse in the future.

In my first blog of the year, “Economic Policy in the Decade of the Twenty-Tens: More of the Same” (http://seekingalpha.com/article/244325-economic-policy-in-the-decade-of-the-twenty-tens-more-of-the-same), I argued that the federal government will continue to follow the same economic policy philosophy that it has followed for the previous fifty years. I have called this a policy of “credit inflation.” The focus of this policy is to keep unemployment as low as possible for as long as possible over time. The consequence of this policy has been the massive growth of debt over this fifty-year period and the financial innovation that has accompanied the growth.

A consequence of the first situation is that there may be a substantial amount of distressed assets around that can be purchased very, very cheaply.

The consequence of the second situation is that the federal government will do all it can to keep the first situation from spiraling downward.

The opportunity? There will be a lot of assets available for sale at very cheap prices.

The means? There will be a lot of government money around that can be obtained very cheaply to acquire these assets!

We already see that the latter situation already exists. Yesterday I quoted Gillian Tett of the Financial Times reflecting on the easy monetary and fiscal policies of the last two years and the peace they have brought the financial markets: “While a sense of peace might have returned to parts of the financial system in the past two years, this has only been achieved by virtue of government aid - and rock-bottom interest rates.”

Will this continue?

Ben Bernanke, at the Fed, has begun the program of acquiring $900 billion in U. S. Treasury bonds to provide more liquidity to the financial system and keep long-term interest rates from rising. This is just a part of what I call the policy of “credit inflation.” The United States government is not going to let this recovery collapse if it can avoid it. Therefore, Bubble Ben will continue to throw more-and-more spaghetti against the wall (http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing).

But, that will not be all if further problems are recorded in the four problem areas I mentioned in yesterday’s post. The areas I focused on yesterday were the sovereign debt problem in Europe, the fragility of state and local finances in the United States, problem loans in the commercial real estate area, and the solvency of many of the 7,800 or so commercial banks in the United States banking system that make up about one-third of all the banking assets in the country.

In terms of the sovereign debt problem in Europe, the European Central Bank (ECB) is already committed to buy billions of Euros worth of sovereign debt of European Union countries in order to stem the financial crisis on the continent. Also, we know from the statistics related to the financial meltdown of 2008 and 2009 that the United States central bank, the Federal Reserve System, has really become the central banker to the world.

Will these institutions, as well as the European Union, itself, not try to put a floor to the prices of sovereign debt?

And, what about the fiscal dilemma facing state and local governments in the United States?
The ground is already shifting. State governments are starting to write laws that will lessen the power of government labor unions…even in New York and New Jersey and other states that have been pro-labor for years. Furthermore, do you really think state governments and the federal government are going to let local governments just fail? Do you really think that the federal government is going to let state governments fail? (See “When States Default: 2011, Meet 1841,” http://professional.wsj.com/article/SB10001424052748704835504576060193029215716.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.)

And, what about a collapse in the commercial real estate market? The reason that loans in this area have been buoyed up for so long is to buy time for the FDIC in dealing with smaller commercial banks who have a disproportionate amounts of these loans on their balance sheets.
Many of these banks are going to need to be closed in one way or another (3,000 as Elizabeth Warren warned) and the FDIC just cannot handle more than three to four closing a week at the present time. As this process continues, the Federal Reserve and the federal government cannot remove the liquidity now in the system and threaten higher interest rates and foreclosures on these distressed properties.

The bottom line is that a lot of “stuff” is going may be coming on the market in the next twelve months or so and the prices of these assets are going to be very attractive.

The downside risk?

The federal government is going to try and take away as much of this risk as possible. The “Greenspan Put” has now become the “Bernanke Put.”

The federal government will do all it can to maintain or improve the employment situation and it will do all it can to bailout sectors of the economy experiencing significant financial difficulties in order to prevent a double dip in the economy.

Thus, opportunities to purchase distressed assets may be plentiful in such a scenario. And, just remember, large banks and large corporations have billions and billions of dollars of cash on hand to purchase these assets. This is true for the United States, http://dealbook.nytimes.com/2011/01/03/confident-deal-makers-pulled-out-checkbooks-in-2010/?ref=business, and for Europe http://professional.wsj.com/article/SB10001424052748704111504576059450313071700.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj. And, if they don’t have the cash on hand, they can just borrow it for next to nothing.

Wealthy individuals and developers are also moving in this area. The amount of activity picking up provides vivid support for the fact that distressed properties are already being scooped up, cheaply. It is likely, especially in real estate development to see a lot of distressed buying over the next year, but this will be "big bank" business because "smaller banks" don't usually do this kind of business and those that got into this kind of business have been burned, badly. Also, it will be business coming from hedge funds and private equity funds.

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