On HCLP and Secondary Offerings In General

Following the glory of obscene growth potential yesterday – in the form of long term supply agreement amendments being announced – HCLP followed up by declaring a secondary offering. After hours and to the open, the price was off 5%.

I cannot in good conscience sit by and allow this to pass unaddressed. For you see, many of you have a very cliche, knee jerk opinion of companies raising money, which I have commented on before now.

Why is this? What is it about secondary offerings that you hate so much?

Myth One: They’re Dilutive

There is a major opinion in markets, unquestionably, that secondary share offerings inherently ruin the performance for existing shareholders.

The logic goes something like this – ahem – “ABC makes $100,000 per quarter, with 1 million shares outstanding, and I earn $0.10 a share. If they issue another 100,000 shares then I only make $0.091!”

Let’s just quickly break down this scenario and why it’s wrong.

First off, if a company sells shares, they take money onto their balance sheet. Especially right now, where new shares are routinely sold at prices FAR beyond their worth, the new cash on the balance sheet more than overcompensates for the loss of earnings, at least in the short term. If my company is selling stock at 20-30X earnings, it’s sort of a buffer to that dilution fear, isn’t it? Actually, lots of secondary offerings immediately make money for existing shareholders.

I only clearly lose if management is somehow selling stock for less than it’s worth; in which case they will most likely be sued up a tree. If they’re selling it at par, for fair value, then by definition it’s a wash (fair value including some form of discount for future earnings potential).

And then there’s the biggest question: what is management planning on doing with the money? Are they squirreling it away in non-marketable warehouses they plan on building, perhaps somewhere in Antartica? Or are they, like most businesses, trying to grow? And what is the potential of that growth? If opportunities that attract that new money have higher earnings per share than existing net operations, then all prior shares in existence will have benefited from the new equity.

Claim: whether or not a secondary offering is dilutive depends very much on what management is going to do with the money.

Myth Two: Debt Is Always A More Effective Way To Finance A Company

There’s another specious tidbit circling business community colleges. “So you have an opportunity to pursue; equity or bonds? Well offering bonds to finance the job will always have a bigger payoff for shareholders.”

Again, I find this claim to be wanting. The argument is weak from the onset. But please first note what I am not about to argue. I am not arguing that this claim is always false. But it is clearly also not always true.

If I raise money on a project, at best existing shareholders will be able to make a return above both the principle of the notes and the interest you owe on the bonds.

How is this that different from raising new money?

To start, the principle of the bond corresponds to the price per share of the equity raise. Turning these two objects over, we can see that, at least in our present environment, new shares being sold for more than they’re worth, from one perspective secondary offerings have a superior element to them for existing shareholders – existing shareholders can actually make money off the transaction (see above).

If my company issues debt, how have I benefited besides through “future possible earnings”? I cannot make money on the transaction. By nature of issuing a bond, every cent will need to be repaid (or else carry severe implications for myself as a shareholder). I personally have not directly benefited.

If my company issues stock at a big mark up – like they can right now – as a shareholder I have probably made money. New shares in a healthy market add more to the balance sheet than the new money receives in return.

After turning over the principle/equity issue, now let’s look at the dilution. Well, surely dilution corresponds to the interest on the bonds, does it not?

Where do you suppose interest gets paid? From the Ether? It comes directly from existing operations. If you’re lucky, the new/expanded business venture management is pursuing earns enough to offset both the principle of the bond and the interest and you, as a shareholder, make money on top. Otherwise, it’s a drag on earnings and…you guessed it – dilutive.

Now it could be parsed over here that debt’s return is finitely, contractually limited, so if a company raises debt to finance a project and that project has a fat payoff, then equity will always get more than in the alternative world where the project was financed through a secondary.

While this is technically true when peered at through the very narrow lens of a profitable, big payoff growth story, it overlooks two important points of view. The first is that 1) the game changes completely if a project does not make money, in which case the equity raise if vastly superior to the debt issuance (since the new equity will have diluted the loss for existing shareholders) whereas the debt, being a higher claim than stock, will compound the losses. The second being 2) a company can always just raise debt after a secondary (or vise versa) – and frequently many of the impacts of either a secondary or a debt issuance can be reversed or even transformed in the other direction (market prices permitting).

Claim: whether or not debt is superior to secondary offerings depends very much on a case by case basis for a company. Current debt levels, the possible payoff of the business growth, downside risks, interest rates, and market premiums for secondary must all be carefully considered. This business rule of thumb is overly simplistic.

Beware Billionaires Pushing Leverage

I couldn’t just let this stand unchallenged. Sometimes debt is the answer, but other times it’s best to just issue some more equity. It isn’t fair to turn the choice into a bumper sticker that management has to adamantly follow.

And so often, raising debt is exactly the wrong answer.

Some of the biggest pushers of corporate debt are so often big activist shareholders with goals ill-aligned with the regular mom and pop retirement accounts; people looking for a quick buck and possessing dubious intentions. Guys like Dan Gilbert in Detroit who are just too happy to fuck over an entire company of hardworking employee shareholders in a start up tech advertising company, then leave them holding nothing (and subsequently being supported by Michigan’s Supreme Court…cough cough). (For the record, that had nothing to do with debt, I just felt like spelling out what a piece of shit Dan Gilbert is).

It’s a long standing favorite of activist shareholders to take a big position in a lackluster company with low leverage, then pressure them to take on as much debt as possible, fling it around on the balance sheet to beat some poorly defined analyst metrics and make an illusion of growth, spice it up into a popular position, then unload the company for a fast gain on multiples expansion.

The only way it gets better for the hedge fund guys is if they can pay out as much of that leverage to themselves, either in special dividends, or – better – by bullying management into buying their private assets at a premium (you don’t have to share with anyone else that way).

At the end of the road, you have a lackluster and profitable company transformed into a glitzy and unprofitable one. That isn’t growing a business; it’s liquidating one.

It’s all fun and glam right now, with interest rates so low. However, as debt needs to get turned over next decade, we’ll get to see who was actually working for their company versus who was trying to rob it.

It All Comes Down To Trust And Timing

Do you trust your management, or don’t you? Secondary offerings and debt issuance can both go bad if the mood is right. What is the money being used for and what are the risks?

Is the company pulling a lot of strange moves on their filings? Are the cash flows pages telling the story of a company that isn’t actually taking in more cash, despite a great “growth” story? Are classes of shares being thrown around like a bowl of alphabet soup?

And what are prospects of the business looking like? Is demand for products growing? Does the company have more business than they can possibly service? At the end of the day, this is likely to be the biggest factor in the success or failure of any business. Debt versus secondary offering will probably play a backseat, if management is working as a proper fiduciary in a hot business cycle.

Update: I purchased more shares of HCLP for $62.47

First The Good News, Then The Bad

Most of my portfolio is now solidly shrugging off Yellen’s slip of the tongue. Our good bankster friends over at JPMorgan said it best – Yellen is fresh and inexperienced, and she still needs to learn how to speak without actually saying anything.

It will come. It will come.

Despite my state of shock at watching Yellen crack the market like an egg yesterday, I didn’t react. I want to watch a few more days before I make a move, even if they should lose me money. With a +14% year going, I have buffer room.

Now, the good word here is that CCJ and BAS are both moving higher. I suspect HCLP will join in soon as well (that position can be rewarded a little breather, it’s come a long way). The energy themes are solid and intact.

The bad side of the coin is that fear/reality of higher interest rates is going to just ravish the REIT and associated housing space. Check out VNQ over a five day period, and you can almost sink the cracking point up with Yellen’s comments. My current position AEC is breaking down again this morning, and an old position MAA is following.

This has to be treaded carefully. If you’re juggling garbage like NLY, I’d say you’re one four day panic away from another round of 30% losses.

I’ve said well before today, back when I never imagined Yellen would spook interest rates higher, that I was interested in rebuying MAA. This is sort of a blessing in that regards. I’d venture a guess that long term damage to multifamily REITs from higher interest rates will hover somewhere between “negligible” and “not damaging, actually positive”.

But well before that point, there will probably be a lot of indiscriminate selling from emotionally driven fund managers. The climax of that, if it should materialize, is the buying opportunity.

Between then and now, it’s important to keep a wary eye on reform efforts to Fannie and Freddie. There’s been some “bipartisan chatter”. Mortgage origination is >70% dominated by the government backed mortgage giants, and the entire housing market is totally dependent on them. A poorly thought out reform effort could rain chaos. But there’s no sense even having a discussion about that just yet. First things first, interest rates.

Soon Government Will Be Incentivized To Have Higher Interest Rates

For the moment, the Fed remains leading the charge to hold interest rates low, based on what I would say is a faulty premise that the US economy just needs more expensive homes and homeowner tax income to get out of the hole it finds itself in.

The primary advantages of low interest rates are:
1) Cheap borrowing/refinancing, taking pressure off consumers
2) Allegedly easier to acquire homes, raising tax receipts (except for banking restrictions on lending)
3) Increased home sales enable retirees to downsize without collapsing pricing/bankrupting themselves
4) Support prices of goods and services, avoiding debt spiral

Each of these virtues, however, comes at the assumption that the consumer had the leeway to borrow more, and would take the pause to put themselves on solid footing, paying down debt and restructuring. Cheap credit was (and is always) supposed to be a momentary stepping stone to a better tomorrow.

In reality, it always becomes a game a chicken.

Consumers haven’t repaired their savings accounts at all. Debt levels should be something like three quarters of what they are – we’ve had near zero interest rates for five years and banks have so many programs running to help consumers pay off loans, it’s ridiculous. But it hasn’t happened. Consumer finances remain horrible, the money has largely been spent in ways that haven’t strategically benefited the recipients, and the low interest rates have seeded a newer, more dangerous problem.

The nation’s retirement system is on the rocks.

Looking at the state of public pensions and private 401k’s, the baby boomer’s retirement is in peril. Misallocations into housing and malinvestment have taken their toll. This isn’t exactly breaking news.

However, heretofore the assumption has been that the Fed’s knee jerk reaction to keep rates low was the only pathway and that there would be no push to counter this until unemployment levels and economic prosperity returned.

I would suggest that within the next few years, as baby boomer retirement heats up and the ability to create a virtuous cycle built on higher home prices and cheap credit slips away, the pressure on the Fed to maintain low rates will actually begin to cave to a growing murmur from the crowd demanding higher rates to maintain retirement obligations.

While this move will be a death knell for economic growth, from the point of view of aging boomers (the reigning political powerhouse and largest voting segment) economic growth would be a hollow victory as their own retirement obligations come under pressure and we increasingly see benefit cuts, such as are being witnessed in Detroit or California. Maintaining the status quo at the expense of economic growth puts them ahead, as they have a larger share of current goods and services, whereas permitting growth would ultimately lead them personally to greater poverty.

High interest rates takes pressure off of pension systems, and enables savings accounts to grow rapidly (such as those of boomers who have taken the final steps of downsizing homesteads and transferred much of their wealth into fixed income investments). It also improves quality of life for those savers by putting pressure on pricing.

Within three to five years, I expect interest rates get pushed up above 6% annually, for the purpose of refinancing retirement accounts for the benefit of boomers, at the expense of the rest of the country (planet?). When this occurs, I don’t think it will be because the Fed has lost control of the bond market. I actually believe it will be done intentionally, driven from political expediency.

Select Multifamily REITs Benefit From Higher Interest Rates

I’ve been sleeping on several issues that impact my two multifamily companies (AEC and CLP).

These issues are the effects of higher interest rates as they determine mortgages, the subsequent demand for rental units, and the ability of the space to borrow money to finance growth.

It’s a pernicious structuring, for sure. No easy answers here; as the effects seem to run counter to one another and can vary immensely depending on who you are and what your positioning is.

However, my general feel for the situation is this:

For the moment, financing for multifamily/REITs is generally secure. Conservatives are salivating to dismantle Fannie and Freddie, and the public probably concurs with those sentiments, but that would strike at the heart of liberal incentives. So any attempt to reform those institutions will probably be shut down or deflected.

However, this financing is set to get more expensive, if bonds keep rising. If you’re a company saddled with debt, this could cause all sorts of trouble. I remember back when I was first perusing through the space for purchases, I saw a lot of multifamily REITs that were knee deep in loans with bad cash flow and not enough on the books. If financing for apartment construction goes up and you’re holding the wrong companies, growth will go out the window and these badly situated players turn into takeover targets for the best of breed.

Meanwhile, there will most likely be shown to have been a small upsurge in housing purchases this last month. Players on the sidelines who became fretful that the window of opportunity was permanently closing likely rushed out to lock in a house purchase. After that surge though, the path to homeownership is getting harder, not easier, with the treasury selloff. This should solidify the 95% occupancy rates these companies have been experiencing, and get any apartment communities they construct filled.

I like AEC and CLP because they have had a vigilance about paying off debt, improving credit ratings, reinvesting into the business, and controlling operations. Their cash positions are well padded, and if push came to shove, they could quickly turn their cash flows on the liabilities, locking the companies down. I’m not worried about either of these two companies getting swept away from higher rates.

AEC just finished their second equity offering, and CLP is busy merging with MAA to make one of the largest multifamily REITs in the country.

Thus, until I see contradictions to these beliefs, I’m inclined to feel that both AEC and CLP will benefit on net from raising interest rates, even though it may momentarily hamper their growth. They are in superior positions relative competitors thanks to smart management decisions. And I am holding firm here.

The Bond Story No One Is Talking About

Greece’s 10 year has soothed down tremendously, now trading inside of 10% yield, just above 8%. It was above 30% just this time last year.

It appears that a Greek default has been taken off the table. If anyone actually made a pile of money on that move (as opposed to averaging down or getting back to even) well then, I congratulate you. I certainly wasn’t going to touch it.

So what happens now?

Well, 8% is still very expensive. Greece has a host of problems mostly stemming from economic contraction and, I suppose if you really believe they even tried to implement any, austerity. And I believe the europroblem demands further attention and, most importantly, central bank intervention. If the EU ultimately holds it together, or if they decide to part ways, the euro will need to be accommodating in either case.

Now I think it was a year ago, I ran into a piece that was analyzing the behavior of countries who had debt market problems – I can’t quite remember who was the author.

But the gist of the material was that countries actually don’t tend to default on their obligations in the middle of the crisis. They wait until they have things under control and are in a more stable position. And that’s when they look at their books and realize how well they’d be doing if they didn’t have to be making payments.

It’s when the country is in a good place that they actually hit the switch.

The study looked at places like Russia and Argentina and the defaults they underwent; which were largely unexpected.

Another paper I was able to track down comes from Stanford University, authored by Mr. Tomz and Mr. Wright. The good folks at Stanford found that countries do default more during the middle of crisis, but that the correlations was remarkably weak: http://www.stanford.edu/~tomz/pubs/TW2007.pdf

In any sense, the development in the Greek bond market is a remarkable turnaround. I am not convinced that we’ve seen the last of the consequences to come from the last twenty years. And I would not be surprised if, at some undisclosed time in the future, the market was ear holed by a surprise default from at least one of these countries.

But at present the Greek turnaround is incredible to watch. One can only marvel at it all.

Danger Passing For Now, Or So It Seems

I have to hand it to the EU countries. We are now years into this crisis, and still they manage to keep their bonds funded. Spanish bonds are easing back down from the 5% mark that had me on my toes. It would appear that the flare up has been contained…for now.

But that’s not the name of this game. They can save themselves as many times as they like. It would be better to ask, “what are the odds they save themselves every time one of these crises kicks up.” Much like a kid juggling eggs in his mom’s kitchen, the prudent bet is that he drops them. The moments leading up to the inevitable wrath bearing down on him are of entertainment value only.

Gasoline prices are imploding. That is merely a factual statement. I can’t decide what to think about it yet. Lower gasoline prices are inherently good for the consumer, it is true. But following the economic reports we’ve been receiving, and right out of Christmas and the optimistic projection parties that come with that time of year, and I’m not entirely sure of the thing being good.

My preference remains withdrawn defensiveness. Lots of cash, hand picked hedges. And only names of quality that I don’t mind being left holding without a bid.

On HCLP and Secondary Offerings In General

Following the glory of obscene growth potential yesterday – in the form of long term supply agreement amendments being announced – HCLP followed up by declaring a secondary offering. After hours and to the open, the price was off 5%.

I cannot in good conscience sit by and allow this to pass unaddressed. For you see, many of you have a very cliche, knee jerk opinion of companies raising money, which I have commented on before now.

Why is this? What is it about secondary offerings that you hate so much?

Myth One: They’re Dilutive

There is a major opinion in markets, unquestionably, that secondary share offerings inherently ruin the performance for existing shareholders.

The logic goes something like this – ahem – “ABC makes $100,000 per quarter, with 1 million shares outstanding, and I earn $0.10 a share. If they issue another 100,000 shares then I only make $0.091!”

Let’s just quickly break down this scenario and why it’s wrong.

First off, if a company sells shares, they take money onto their balance sheet. Especially right now, where new shares are routinely sold at prices FAR beyond their worth, the new cash on the balance sheet more than overcompensates for the loss of earnings, at least in the short term. If my company is selling stock at 20-30X earnings, it’s sort of a buffer to that dilution fear, isn’t it? Actually, lots of secondary offerings immediately make money for existing shareholders.

I only clearly lose if management is somehow selling stock for less than it’s worth; in which case they will most likely be sued up a tree. If they’re selling it at par, for fair value, then by definition it’s a wash (fair value including some form of discount for future earnings potential).

And then there’s the biggest question: what is management planning on doing with the money? Are they squirreling it away in non-marketable warehouses they plan on building, perhaps somewhere in Antartica? Or are they, like most businesses, trying to grow? And what is the potential of that growth? If opportunities that attract that new money have higher earnings per share than existing net operations, then all prior shares in existence will have benefited from the new equity.

Claim: whether or not a secondary offering is dilutive depends very much on what management is going to do with the money.

Myth Two: Debt Is Always A More Effective Way To Finance A Company

There’s another specious tidbit circling business community colleges. “So you have an opportunity to pursue; equity or bonds? Well offering bonds to finance the job will always have a bigger payoff for shareholders.”

Again, I find this claim to be wanting. The argument is weak from the onset. But please first note what I am not about to argue. I am not arguing that this claim is always false. But it is clearly also not always true.

If I raise money on a project, at best existing shareholders will be able to make a return above both the principle of the notes and the interest you owe on the bonds.

How is this that different from raising new money?

To start, the principle of the bond corresponds to the price per share of the equity raise. Turning these two objects over, we can see that, at least in our present environment, new shares being sold for more than they’re worth, from one perspective secondary offerings have a superior element to them for existing shareholders – existing shareholders can actually make money off the transaction (see above).

If my company issues debt, how have I benefited besides through “future possible earnings”? I cannot make money on the transaction. By nature of issuing a bond, every cent will need to be repaid (or else carry severe implications for myself as a shareholder). I personally have not directly benefited.

If my company issues stock at a big mark up – like they can right now – as a shareholder I have probably made money. New shares in a healthy market add more to the balance sheet than the new money receives in return.

After turning over the principle/equity issue, now let’s look at the dilution. Well, surely dilution corresponds to the interest on the bonds, does it not?

Where do you suppose interest gets paid? From the Ether? It comes directly from existing operations. If you’re lucky, the new/expanded business venture management is pursuing earns enough to offset both the principle of the bond and the interest and you, as a shareholder, make money on top. Otherwise, it’s a drag on earnings and…you guessed it – dilutive.

Now it could be parsed over here that debt’s return is finitely, contractually limited, so if a company raises debt to finance a project and that project has a fat payoff, then equity will always get more than in the alternative world where the project was financed through a secondary.

While this is technically true when peered at through the very narrow lens of a profitable, big payoff growth story, it overlooks two important points of view. The first is that 1) the game changes completely if a project does not make money, in which case the equity raise if vastly superior to the debt issuance (since the new equity will have diluted the loss for existing shareholders) whereas the debt, being a higher claim than stock, will compound the losses. The second being 2) a company can always just raise debt after a secondary (or vise versa) – and frequently many of the impacts of either a secondary or a debt issuance can be reversed or even transformed in the other direction (market prices permitting).

Claim: whether or not debt is superior to secondary offerings depends very much on a case by case basis for a company. Current debt levels, the possible payoff of the business growth, downside risks, interest rates, and market premiums for secondary must all be carefully considered. This business rule of thumb is overly simplistic.

Beware Billionaires Pushing Leverage

I couldn’t just let this stand unchallenged. Sometimes debt is the answer, but other times it’s best to just issue some more equity. It isn’t fair to turn the choice into a bumper sticker that management has to adamantly follow.

And so often, raising debt is exactly the wrong answer.

Some of the biggest pushers of corporate debt are so often big activist shareholders with goals ill-aligned with the regular mom and pop retirement accounts; people looking for a quick buck and possessing dubious intentions. Guys like Dan Gilbert in Detroit who are just too happy to fuck over an entire company of hardworking employee shareholders in a start up tech advertising company, then leave them holding nothing (and subsequently being supported by Michigan’s Supreme Court…cough cough). (For the record, that had nothing to do with debt, I just felt like spelling out what a piece of shit Dan Gilbert is).

It’s a long standing favorite of activist shareholders to take a big position in a lackluster company with low leverage, then pressure them to take on as much debt as possible, fling it around on the balance sheet to beat some poorly defined analyst metrics and make an illusion of growth, spice it up into a popular position, then unload the company for a fast gain on multiples expansion.

The only way it gets better for the hedge fund guys is if they can pay out as much of that leverage to themselves, either in special dividends, or – better – by bullying management into buying their private assets at a premium (you don’t have to share with anyone else that way).

At the end of the road, you have a lackluster and profitable company transformed into a glitzy and unprofitable one. That isn’t growing a business; it’s liquidating one.

It’s all fun and glam right now, with interest rates so low. However, as debt needs to get turned over next decade, we’ll get to see who was actually working for their company versus who was trying to rob it.

It All Comes Down To Trust And Timing

Do you trust your management, or don’t you? Secondary offerings and debt issuance can both go bad if the mood is right. What is the money being used for and what are the risks?

Is the company pulling a lot of strange moves on their filings? Are the cash flows pages telling the story of a company that isn’t actually taking in more cash, despite a great “growth” story? Are classes of shares being thrown around like a bowl of alphabet soup?

And what are prospects of the business looking like? Is demand for products growing? Does the company have more business than they can possibly service? At the end of the day, this is likely to be the biggest factor in the success or failure of any business. Debt versus secondary offering will probably play a backseat, if management is working as a proper fiduciary in a hot business cycle.

Update: I purchased more shares of HCLP for $62.47

First The Good News, Then The Bad

Most of my portfolio is now solidly shrugging off Yellen’s slip of the tongue. Our good bankster friends over at JPMorgan said it best – Yellen is fresh and inexperienced, and she still needs to learn how to speak without actually saying anything.

It will come. It will come.

Despite my state of shock at watching Yellen crack the market like an egg yesterday, I didn’t react. I want to watch a few more days before I make a move, even if they should lose me money. With a +14% year going, I have buffer room.

Now, the good word here is that CCJ and BAS are both moving higher. I suspect HCLP will join in soon as well (that position can be rewarded a little breather, it’s come a long way). The energy themes are solid and intact.

The bad side of the coin is that fear/reality of higher interest rates is going to just ravish the REIT and associated housing space. Check out VNQ over a five day period, and you can almost sink the cracking point up with Yellen’s comments. My current position AEC is breaking down again this morning, and an old position MAA is following.

This has to be treaded carefully. If you’re juggling garbage like NLY, I’d say you’re one four day panic away from another round of 30% losses.

I’ve said well before today, back when I never imagined Yellen would spook interest rates higher, that I was interested in rebuying MAA. This is sort of a blessing in that regards. I’d venture a guess that long term damage to multifamily REITs from higher interest rates will hover somewhere between “negligible” and “not damaging, actually positive”.

But well before that point, there will probably be a lot of indiscriminate selling from emotionally driven fund managers. The climax of that, if it should materialize, is the buying opportunity.

Between then and now, it’s important to keep a wary eye on reform efforts to Fannie and Freddie. There’s been some “bipartisan chatter”. Mortgage origination is >70% dominated by the government backed mortgage giants, and the entire housing market is totally dependent on them. A poorly thought out reform effort could rain chaos. But there’s no sense even having a discussion about that just yet. First things first, interest rates.

Soon Government Will Be Incentivized To Have Higher Interest Rates

For the moment, the Fed remains leading the charge to hold interest rates low, based on what I would say is a faulty premise that the US economy just needs more expensive homes and homeowner tax income to get out of the hole it finds itself in.

The primary advantages of low interest rates are:
1) Cheap borrowing/refinancing, taking pressure off consumers
2) Allegedly easier to acquire homes, raising tax receipts (except for banking restrictions on lending)
3) Increased home sales enable retirees to downsize without collapsing pricing/bankrupting themselves
4) Support prices of goods and services, avoiding debt spiral

Each of these virtues, however, comes at the assumption that the consumer had the leeway to borrow more, and would take the pause to put themselves on solid footing, paying down debt and restructuring. Cheap credit was (and is always) supposed to be a momentary stepping stone to a better tomorrow.

In reality, it always becomes a game a chicken.

Consumers haven’t repaired their savings accounts at all. Debt levels should be something like three quarters of what they are – we’ve had near zero interest rates for five years and banks have so many programs running to help consumers pay off loans, it’s ridiculous. But it hasn’t happened. Consumer finances remain horrible, the money has largely been spent in ways that haven’t strategically benefited the recipients, and the low interest rates have seeded a newer, more dangerous problem.

The nation’s retirement system is on the rocks.

Looking at the state of public pensions and private 401k’s, the baby boomer’s retirement is in peril. Misallocations into housing and malinvestment have taken their toll. This isn’t exactly breaking news.

However, heretofore the assumption has been that the Fed’s knee jerk reaction to keep rates low was the only pathway and that there would be no push to counter this until unemployment levels and economic prosperity returned.

I would suggest that within the next few years, as baby boomer retirement heats up and the ability to create a virtuous cycle built on higher home prices and cheap credit slips away, the pressure on the Fed to maintain low rates will actually begin to cave to a growing murmur from the crowd demanding higher rates to maintain retirement obligations.

While this move will be a death knell for economic growth, from the point of view of aging boomers (the reigning political powerhouse and largest voting segment) economic growth would be a hollow victory as their own retirement obligations come under pressure and we increasingly see benefit cuts, such as are being witnessed in Detroit or California. Maintaining the status quo at the expense of economic growth puts them ahead, as they have a larger share of current goods and services, whereas permitting growth would ultimately lead them personally to greater poverty.

High interest rates takes pressure off of pension systems, and enables savings accounts to grow rapidly (such as those of boomers who have taken the final steps of downsizing homesteads and transferred much of their wealth into fixed income investments). It also improves quality of life for those savers by putting pressure on pricing.

Within three to five years, I expect interest rates get pushed up above 6% annually, for the purpose of refinancing retirement accounts for the benefit of boomers, at the expense of the rest of the country (planet?). When this occurs, I don’t think it will be because the Fed has lost control of the bond market. I actually believe it will be done intentionally, driven from political expediency.

Select Multifamily REITs Benefit From Higher Interest Rates

I’ve been sleeping on several issues that impact my two multifamily companies (AEC and CLP).

These issues are the effects of higher interest rates as they determine mortgages, the subsequent demand for rental units, and the ability of the space to borrow money to finance growth.

It’s a pernicious structuring, for sure. No easy answers here; as the effects seem to run counter to one another and can vary immensely depending on who you are and what your positioning is.

However, my general feel for the situation is this:

For the moment, financing for multifamily/REITs is generally secure. Conservatives are salivating to dismantle Fannie and Freddie, and the public probably concurs with those sentiments, but that would strike at the heart of liberal incentives. So any attempt to reform those institutions will probably be shut down or deflected.

However, this financing is set to get more expensive, if bonds keep rising. If you’re a company saddled with debt, this could cause all sorts of trouble. I remember back when I was first perusing through the space for purchases, I saw a lot of multifamily REITs that were knee deep in loans with bad cash flow and not enough on the books. If financing for apartment construction goes up and you’re holding the wrong companies, growth will go out the window and these badly situated players turn into takeover targets for the best of breed.

Meanwhile, there will most likely be shown to have been a small upsurge in housing purchases this last month. Players on the sidelines who became fretful that the window of opportunity was permanently closing likely rushed out to lock in a house purchase. After that surge though, the path to homeownership is getting harder, not easier, with the treasury selloff. This should solidify the 95% occupancy rates these companies have been experiencing, and get any apartment communities they construct filled.

I like AEC and CLP because they have had a vigilance about paying off debt, improving credit ratings, reinvesting into the business, and controlling operations. Their cash positions are well padded, and if push came to shove, they could quickly turn their cash flows on the liabilities, locking the companies down. I’m not worried about either of these two companies getting swept away from higher rates.

AEC just finished their second equity offering, and CLP is busy merging with MAA to make one of the largest multifamily REITs in the country.

Thus, until I see contradictions to these beliefs, I’m inclined to feel that both AEC and CLP will benefit on net from raising interest rates, even though it may momentarily hamper their growth. They are in superior positions relative competitors thanks to smart management decisions. And I am holding firm here.

The Bond Story No One Is Talking About

Greece’s 10 year has soothed down tremendously, now trading inside of 10% yield, just above 8%. It was above 30% just this time last year.

It appears that a Greek default has been taken off the table. If anyone actually made a pile of money on that move (as opposed to averaging down or getting back to even) well then, I congratulate you. I certainly wasn’t going to touch it.

So what happens now?

Well, 8% is still very expensive. Greece has a host of problems mostly stemming from economic contraction and, I suppose if you really believe they even tried to implement any, austerity. And I believe the europroblem demands further attention and, most importantly, central bank intervention. If the EU ultimately holds it together, or if they decide to part ways, the euro will need to be accommodating in either case.

Now I think it was a year ago, I ran into a piece that was analyzing the behavior of countries who had debt market problems – I can’t quite remember who was the author.

But the gist of the material was that countries actually don’t tend to default on their obligations in the middle of the crisis. They wait until they have things under control and are in a more stable position. And that’s when they look at their books and realize how well they’d be doing if they didn’t have to be making payments.

It’s when the country is in a good place that they actually hit the switch.

The study looked at places like Russia and Argentina and the defaults they underwent; which were largely unexpected.

Another paper I was able to track down comes from Stanford University, authored by Mr. Tomz and Mr. Wright. The good folks at Stanford found that countries do default more during the middle of crisis, but that the correlations was remarkably weak: http://www.stanford.edu/~tomz/pubs/TW2007.pdf

In any sense, the development in the Greek bond market is a remarkable turnaround. I am not convinced that we’ve seen the last of the consequences to come from the last twenty years. And I would not be surprised if, at some undisclosed time in the future, the market was ear holed by a surprise default from at least one of these countries.

But at present the Greek turnaround is incredible to watch. One can only marvel at it all.

Danger Passing For Now, Or So It Seems

I have to hand it to the EU countries. We are now years into this crisis, and still they manage to keep their bonds funded. Spanish bonds are easing back down from the 5% mark that had me on my toes. It would appear that the flare up has been contained…for now.

But that’s not the name of this game. They can save themselves as many times as they like. It would be better to ask, “what are the odds they save themselves every time one of these crises kicks up.” Much like a kid juggling eggs in his mom’s kitchen, the prudent bet is that he drops them. The moments leading up to the inevitable wrath bearing down on him are of entertainment value only.

Gasoline prices are imploding. That is merely a factual statement. I can’t decide what to think about it yet. Lower gasoline prices are inherently good for the consumer, it is true. But following the economic reports we’ve been receiving, and right out of Christmas and the optimistic projection parties that come with that time of year, and I’m not entirely sure of the thing being good.

My preference remains withdrawn defensiveness. Lots of cash, hand picked hedges. And only names of quality that I don’t mind being left holding without a bid.

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