Monday, May 30, 2011

Turning Point Approaching Part II

Before reading this post please familiarize yourself with the thesis discussed in Turning Point Approaching Part I.

As we approach the June 13, 2011 phase transition date extreme conditions surrounding the US federal debt financing markets remain the most obvious peril.  This market has so much pressure built into it that contagion is very likely to begin here.

Discussions centered around this topic have elicited feedback that its dynamic nature is not well understood.  When this is the case a comparison to something more familiar can be helpful.  We will attempt to convey an objective snapshot of this market by comparing it as closely as possible to a condominium complex.

The Villas at Maiden Lane
In 1968 a group of local developers built a block constructed 150 unit apartment complex which they profitably owned and managed for 39 years.  In 2007 a group of hedge fund financed former bankers bought their cash cow and proceeded to turn it into 150 condominium units managed by a board of directors elected by unit owners but controlled by and indebted to their hedge fund.  While elected by the unit owners the board serves at the behest of the property management company.  The perception of the management company is one of fierce independence but clauses buried deep in the condo documents prevent them from being fired and place them under the control of the financing hedge fund.

The board has taxing authority and determines the monthly fees needed from each unit to cover the operating budget.  When operating costs surpass the revenue received from fees the local bank (an operating company of the hedge fund) steps in and covers the shortfall creating a liability for the complex.  This prevents interruption of basic services.  In 2007 the fees were set at $300/mo and at full capacity this would generate $540,000/yr.  The initial operating budget was $650,000/yr but fees would be raised once all units were occupied and values increased.  Units were sold for an average price of $175,000 each and were projected to reach a value of $200,000-250,000 depending on location in the complex.  The $300/mo fees were a small price to pay for the opportunity to become a homeowner.

Sales of units at Maiden Lane start strong giving owners a sense of greed and euphoria.  Some owners opt to purchase a second unit for rental income.  By the end of 2007 though sales are slowing, possibly a temporary correction before picking back up.  2008 is a slow grind as sales begin to really slow down.  The operating budget grows slightly as the pool is not compliant with ADA (American's With Disabilities)  standards requiring a $75,000 upgrade to provide additional handrails along with two chair lifts making the pool and diving platform accessible to all.  Along with general increases in service fees the operating budget is now $750,000 for the complex.  This works out to $417/mo for each unit but the current board was elected on a promise not to increase fees.  They were able to charge owners renting units a fee but this only amounted to an average of $15/mo if spread over the year.  The board also faced its first issue with non-payment of dues.  Six unit owners had stopped paying dues and this was seen as temporary.  Surely they would come to their senses or foolishly sell their unit to a smarter investor.  This created an additional $21,600 shortfall.  At this point the complex has a total liability of $314,600 including a $110,000 deficit from 2007 and $204,600 for 2008.  Since things will get better soon, the bank has stepped in and provided a three year loan at 3.5%.  Next year the complex will incur $9,438 in interest expenses.

Competition for board positions is fierce and a new group is elected for 2009.  The management company encourages the board to be in closer dialog with the bank as they offer an expert opinion on how to get things back on track.  The one thing the board can not do is raise fees as they just campaigned on the issue.  The bank proposes upgrades for the complex and offers a new three year loan to finance the project.  The board sees that they will get credit for doing this work while not raising fees and buys into the plan.  The bank sets everything up and the board is so elated they pay little attention to the details of the plan.  Work is to include the following:
  • Lead paint abatement in window sashes
  • Hinge replacement on interior doors
  • Low impact recycled tire mulch in landscape areas
  • Solar pool heating system
  • Solar lighting in common areas
  • Carbon reduction system in areas with vehicle traffic
  • New recycled tire low impact sidewalks throughout the complex
These upgrades are significant and the bank's consultant assures the board that they will draw new owners to the complex over the next few years.  They assure the board that this is not only the smart way to survive the market downturn but actually be stronger on the other side.  The same 3.5% interest rate is offered on another three year loan so the actual cost to the association will only be $1,458/mo!  The board goes ahead with the project.  Little attention is paid to the fact that they monthly payment covers only the interest on the $500,000 bill incurred making these improvements.

At the beginning of 2010 the association has a total liability of $1,064,600 but no one really notices as the interest expense is only $3,105/mo.  In addition to the capital improvements and the $314,600 carried into 2009 failure to pay dues, interest expenses and increased operating costs created another large shortfall.  Sales are not picking up and recent comparables show that units are only worth between $130,000-$150,000 each.  The new improvements create new maintenance expenses and combined with the interest expenses and increasingly slow payment of dues a $350,000 deficit is incurred.  The bank offers another three year loan but reminds the complex that next year they will have to begin paying off or refinancing the first tranches of debt.  The total liability now stands at $1,414,600 or $9,430/unit.

As 2011 begins unit sales have for the most part stopped.  New buyers are wary of the complex's debt burden.  Even with some units priced just over $100,000 the $3,600 in annual fees seems unreasonable and with the mounting foreclosures banks are reluctant to finance new buyers.  The complex is now incurring a deficit of $35,000/mo as revenues have declined significantly and operating costs have not only remained high but continued to climb.  The annual board meeting in December is held at the bank's office.  The board expects another three year loan at 3.5% and promises to cap spending and freeze the debt load at the current $1,834,600.  The bank informs them that they can only offer a rate of 9% on the 2008 loan of $314,600 which now needs to be refinanced.  Interest payments alone on that will be $28,314.  The situation is not manageable and clearly the $500,000 loan for improvements will be up for renewal soon bringing another blow to the budget.  

Conclusion:

The board was spending other peoples money as they made decisions on behalf of the complex.  Their judgement was clouded by easy access to financing.  They made expensive improvements that did little to make the complex more desirable.  Without realizing it they were destroying their own tax base.  Each time the debt was increased the risk grew because there was no understanding that if their rate rose at all it could sink the entire complex.  

In this case study the following were represented:
  • Condo owners (tax paying citizens)
  • Condo renters (citizens receiving benefits but not paying taxes)
  • Board of directors (Taxing authority i.e. legislative/executive branches combined)
  • Property management company (The federal reserve)
  • Local bank (Primary dealers of the fed)


The United States currently has over $14,000,000,000,000 in actual debt (this does not include an estimated $80,000,000,000,000 in known liabilities).  According to information available, in 2010 the country took in $2,381,000,000,000 and spent $3,552,000,000,000.  To simplify this, they spent roughly $1.4918 for every $1.00 received in revenue.  The debt incurred, over $1.1trillion, along with the existing debt is being financed at the lowest interest rates in recorded history.  If rates were to rise even slightly the deficit expands rapidly.  Who will finance this increasing debt?

What makes the situation even more similar to the case study is that the federal reserve (a private institution) has been purchasing debt issues by the treasury to finance the currency spending binge.  This private entity has been given the authority to create currency on behalf of the nation and uses this currency to enable the overspending.

At some point the treasury bond market will have a meeting just like the one at the end of 2011 when the bank informed the condo association board that if they wanted more credit it would cost more.  When that happens a contagion will immediately break lose.  The tax base in the US has been damaged badly by private institutions.  The citizens have been taught not to think for themselves and consequently have no concept of the peril they face.

As we cross the phase transition on June 13, 2011 as new cycle will emerge.  We will enter a 4.3 year period where public debts will be seen for what they are, unplayable piles of paper.  There will be a scramble for real assets.  This will not happen in one day but slowly over time.  The first increases in rates will be seen as a false buying opportunity.  Objective investors will trade against this profiting from the demise of paper.  What is most saddening is that after being burned by stocks and real estate blind citizens who have rushed to the safety of bonds and fixed interest rate instruments will experience a total wipe-out.