Tuesday, April 7, 2009

Macro to Micro

Interesting quote from Bloomberg this week:

“The U.S. government and the Federal Reserve have spent, lent or committed $12.8 trillion, an amount that approaches the VALUE OF EVERYTHING PRODUCED in the country last year.”

$12.8 trillion. In a six month period. Wow.

We talk a lot about the big picture here, and focus on the losses from a global perspective. But where do these losses come from? How is it possible that we are looking at a number that large, that quickly? And if we've done that in six months, where do we go from here? Have we hit a bottom?

Lets take a look at what is happening on the front lines....down on the battlefield.

In the past week I have had conversations in great length with custom home builders, land developers, and commercial real estate property managers.

Let's start with the custom builders:

The Charlotte market was strong up until the summer of 2007 (about two years longer than the rest of the country). Custom home builders were building homes on speculation up until that point, meaning that they would build a home before someone had a contract to buy it. Inventory homes.

The market for homes above $700,000 collapsed here that summer, and any home that had not sold at that point is probably still sitting on the market today. The builders have to carry interest on the mortgages every month on these properties until they sell. The typical range for total inventory homes from the builders I speak with is in the range of 5 to 40 homes.

Here is the problem that builders are facing:

The builders took out a loan from the bank in order to build these houses. Lets say a typical builder took out a loan of $1,000,000 to build a home they were hoping to sell at $1,200,000. Today that home is now worth $850,000. If they take an offer at that value then they have to go to the bank with what is called a short sale. This means the bank can decide if they would like to accept an offer at $850,000. The problem with this scenario is that that when the offer is accepted the bank will then go after the builder for the remaining $150,000.

Remember, most builders are holding multiple homes with this scenario. They are paying interest every month on these homes.

So here is what they do instead:

They take all of their assets: money in the bank, homes, second homes, businesses, etc., and they are moving it all into separate LLC's. They are taking everything they own and taking it out of their name, and the reach of bank. They then walk into the bank's office on Monday morning, and hand them the keys to their 5, 10, or 15 houses, and they walk out.

The banks then foreclose on the properties, but are unable to go after the builders for the losses.

A builder I know said he was in the bank last week and someone came in and dropped off 43 sets of keys. Another builder he knows dropped off 15 the week before.

As the months go by, and builders realize that the market is not returning, they decide that they don't want to play anymore.

Will it hurt their credit? Absolutely. But most of them will just retire. They've made millions over the past 15 years during the housing mania, and they would rather quit the business than give their life savings to the banks.

The developers are in a similar situation, except on a much larger scale. Unknown to most of the population here (and around the country), every developer in the city is taking orders from the bank right now. They are in complete control of their properties.

For example, there is a neighborhood here in Charlotte that developed over 2,000 lots in 2004. 98% of that neighborhood now sits empty, and belongs to the bank. The developer is still the face of the operation and is managing the community, but the bank owns the property. Before giving all their land back to the banks, the developers did the same thing the builders did that I just discussed. They protected all their assets, then walked in and said, "I don't want to play anymore."

This same process is just now beginning in commercial real estate. The owners of these buildings will take the same route as the custom home builders and developers.

All the builders and developers went insolvent on paper, and they transferred the losses to the banks. All the banks then became insolvent on paper and these losses were then transferred to the taxpayer.

But where did they go? Did the losses then just disappear? The average tax payer has not seen an increase in taxes. Obama has not said he will cut back on spending in order to cover the difference? So who will take the losses, where will they appear? Were we able to avoid all pain for our mistakes?

You know the answer by now. The losses will build and build until they are reflected in the value of our currency. They will appear as a loss of purchasing power from every dollar holder. This process will take time to work out, but once it begins to unravel it will be over fairly quickly.

The opportunity to board a lifeboat is still available. Its up to you if you want to risk going back onto the ship for one more drink and dance.

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