This post first appeared in the June edition of: Cirios Trends: In Search of Real Estate Opportunities

Humans, as a species, are lousy fortunetellers.

A few intrepid visionaries aside, most people simply cannot grasp what the world will look like in 20, 10 or even five years.

And for good reason. Trying to envision the future doesn’t mean picking some individual aspect of society and dreaming up “how cool would it be if …” Proper forecasting requires taking into account all aspects of human interaction, projecting advances in each area out into the future, envisioning a world with those new, unknown rules, then deriving a hypothesis within that framework.

Investing - whether it be real estate or stocks - requires just that predictive aptitude in order to make truly good decisions. The ability to look forward and predict what things may be like based on a set of projections is what separates great investors from those who are content with “market” returns.

In real estate, effective forecasting is impossible without examining and understanding demographic shifts. Populations move slowly, but with great inertia. Trends develop over time, based on fundamental factors that develop over decades, not years or months.

Ask any successful real estate investor and they will tell you that getting in front of demographic movements is the best way to build real estate wealth. Time horizons may vary wildly, whether one is spotting hipster migration within a city that typically foretells more affluent gentrification; or entire towns that over 60 years transformed into an almost exclusively upper middle class Asian-American community.

But how can you know, before, and buy accordingly? And here we are back to the human inability to predict the future.

This month’s Cirios Trends is devoted to one of the most controversial, yet potentially important development projects in the Bay Area, and how its relative success or failure could accelerate a demographic sea change in San Francisco that is already underway.

The Hunters Point/Bayview neighborhood is best known for being the most dangerous part of San Francisco. Gang violence is common, the streets are far from safe and, as one might expect, home prices are lower here than anywhere else in the city.

But Hunters Point also includes the largest untouched piece of land within the San Francisco city limits. Mired in environmental, social and political controversy for decades, plans to redevelop Hunters Point are edging closer to reality. Coupled with ongoing socioeconomic changes in San Francisco, the project is part of a potentially massive shift in demographic orientation within the city.

In the following pages, we barely scratch the surface of what the successful redevelopment of this area could mean for the city. In order to truly grasp the potential opportunities, sit back, close your eyes and imagine a world that is, in a word, unimaginable. (Click here to read the next story)

This post first appeared in the May edition of: Cirios Trends: In Search of Real Estate Opportunities.

Over the past several weeks, the federal government’s increased scrutiny of Goldman Sachs has brought complex financial securities at the heart of the housing market collapse back into the government’s crosshairs. We thought an attempted explanation of not just the case against Goldman Sachs, but of how these instruments in question, CDOs, actually work would be valuable.

On April 16th, the Secuities and Exchange Commission, or SEC, filed a civil suit against Goldman Sachs, and late last week it surfaced that the Justice Department was conducting a criminal investigation into the company’s trading practices.

Both departments are focusing on Goldman’s involvement in setting up collateralized debt obligations, or CDOs. The charge, and one that on the surface sounds like a slam dunk for the folks at the SEC, is that Goldman colluded with a hedge fund to create a security designed to fail, then peddled it to unsuspecting investors while the hedge fund placed huge bets the security would fall in value.

During the boom, investment banks like Goldman Sachs bought up thousands of individual mortgages and packaged them into mortgage back securities. These securities aggregated monthly cash flow payments from individual borrowers, then distributed them to investors based on their risk tolerances. Risk-averse investors (pension funds, big banks, insurance companies, etc) were paid first while more risk hungry investors like hedge funds, were paid second if there was enough money left after the first group was paid.

For taking on the risk of being paid second, investors were paid a higher rate of return.

CDOs function similarly, but rather than aggregating individual mortgages, they group together mortgage-backed securities (stay with us).

CDOs aggregate the payments of individual securities, whose cash flow is determined by the mortgages that make up each one. Investors in the CDO get in line for payments and are compensated based on their place in line for cash flows.

The Goldman security in question, called Abacus, takes this one step further. Abacus was hatched using a collection of what are known as credit default swaps, or CDS, and is thus known as a “Synthetic CDO.”

CDS, for all their complications, are nothing more than insurance policies. Let’s say you own GE bonds, and even though GE is a solid company, you’re a little nervous GE may run into trouble and not be able to pay back its bondholders. To alleviate this concern, you could buy a CDS that guaranteed your investment in the event GE couldn’t make good on its bond payments. The seller of that CDS (think insurance company) only has to pay if GE stops making its payments. So, if news were to break that GE were running out of cash, the insurance would go up in cost (value) since bond holder protection would be in high demand.

An investor in a synthetic CDO is paid from premiums collected from CDS buyers who want to bet that the securities protected by the CDS default, thereby increasing the value of their investments in the CDS (get all that?).

So, here you have two sides of the trade. Synthetic CDO buyers hoping the underlying securities keep paying and that CDS buyers keep paying their premiums vs. CDS buyers who hope the underlying securities fail, thereby pushing up the value of their protection.

Since CDS contracts do not require that the insurance seller (or buyer) own any of the underlying securities, these devices were essentially high risk gambling devices, where many gamblers made large sums of money at the expense of other gamblers. Clear as mud, right? It’s easy to see how these often opaque securities got out of control.

At issue is if Goldman, as issuer of the security, made proper disclosures to buyers about the nature of the security and who designed it.

And while it’s easy to cast the case in the “Evil Wall Street Greed” category, investors too deserve their share of the blame for blindly buying what they were told was good quality.

What ever happened to Caveat Emptor?

This post first appeared in the May edition of: Cirios Trends: In Search of Real Estate Opportunities.

Silicon Valley Defies California Gloom
(Silicon Valley Business Journal)

Even though consumer confidence in California has fallen to a historic low, Silicon Valley residents remain some of the country’s more optimistic folks. California’s Index of Consumer Sentiment registered an all-time low of 68.8, five points lower than last April’s 73.8 tally. Silicon Valley, on the other hand, came in at 75.9. Just 14% of the state’s residents believe they are better off now than they were a year ago. On the flip side, only 13% believe they’ll be worse off next year at this time. So, even though Californians think the current situation generally stinks, by in large we don’t think it can get much worse!

(Read more here: http://tinyurl.com/ciriostrendsmay1)

Calls for a Bottom in Commercial Real Estate Ring … Softly
(Cornish and Carey Commercial Real Estate)

A growing consensus is emerging that despite fears of a collapse in commercial real estate, the market may be quietly healing itself. In its latest quarterly survey of San Francisco commercial real estate activity, brokerage Cornish and Carey reported that Class A asking rents inched up by 0.4% from the previous quarter. A smidgen indeed, but this marks the first Q/Q increase since the market peaked in Q2 2008. Even though unleased inventory still appears massive when you look at the data, most of it is concentrated in vast, empty swaths of space. Smaller chunks and premium view space are in limited supply and deals are on occasion seeing multiple bidders. Recovery? Not yet, but investors are licking their chops.

(Read more here: http://tinyurl.com/ciriostrendsmay2)

Are Mortgage Backed Securities Back?
(San Francisco Business Times)

For the first time in almost two years, investors placed bets that mortgages not backed by the government were a good investment. Redwood Trust, a Mill-Valley based real estate investment firm, issued and sold the first private label jumbo mortgage backed security since 2008. The deal, small by bubble-craze standards, consisted of 255 mortgages issued by Citigroup for a total deal size of $222.4 million. The secondary market for mortgage backed securities not insured by Fannie Mae or Freddie Mac has been literally non-existent, as investors have proven unwilling to buy debt without Uncle Sam’s implicit (or explicit) stamp of approval. The deal, adding more fuel to optimists fire, was over-subscribed.

(Read more here: http://tinyurl.com/ciriostrendsmay3)

Foreclosures Continue Steady March Upwards
(San Jose Mercury News)

For all the signals that the housing market may actually be improving, that nasty fly in the ointment, foreclosures, just won’t go away. Despite hundreds of billions of dollars thrown at the problem, foreclosures in Santa Clara County rose 72% from a year ago. This trend is being echoed around California and indeed the country, where foreclosures, the market clearing mechanism everybody loves to hate, continue to plague local economies. One bright spot, however, is that investors are stepping into the market. 4,000 homes were sold directly to investors at auctions - up almost 4-fold from 2009.

(Read more here: http://tinyurl.com/ciriostrendsmay4 )

This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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A cursory look at the long term trends for inflation and home prices reveal strikingly similar patterns. Until, that is, right around 2003 (see dotted line below).

(click to enlarge image)

In the wake of the short recession caused by the dot-com bust and September 11th terrorist attacks, then-Federal Reserve Chairman Alan Greenspan aggressively lowered interest rates to spur economic growth. Leaving rates at historic lows for several years encouraged active borrowing, helping to bring the US economy out of its tailspin.

Greenspan critics now wonder, at what cost?

As homeowners, real estate speculators, investment bankers, mortgage brokers, real estate agents, appraisers and credit rating companies (among others) rushed to grab their piece of property values, the historic relationship between moderate inflation and steadily rising home prices broke down. Home prices leapt, while inflation continued its casual march upward.

Then, around the beginning of 2007 (the “peak” of our 6-month moving average dataset), the relationship flipped inverse (see arrow above). Rising prices as measured by the CPI faced off with tumbling home prices, feeding the feverish macroeconomic debate of inflationists vs. deflationists.

Now, as what feels like the entirety of the financial world awaits the inevitable inflation that “must” come after trillions upon trillions of dollars in economic stimulus, we hope the following few pages shed some light on what we can expect if it turns out the majority (in this case, the inflationists) prove to be correct. Since policy-makers’ key tool to fight inflation is higher interest rates, and higher interest rates translate into more expensive mortgages, future inflation has serious implications for real estate markets around the country.

NEXT >>

This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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The belief that the Federal Reserve kept interest rates too low, for too long, is one which is now nearly universally held. Well, outside the Fed, that is. Here’s a smattering of quotes which show how the view of Greenspan’s loose monetary policy (and now Bernanke’s) varies from group to group, and from year to year.

“The best response to the housing bubble would have been regulatory, rather than monetary.”
- Fed Chairman Ben Bernanke, January 3, 2010

“Given the decloupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have prevented the housing bubble.”
- Former Fed Chairman Alan Greenspan, March 11, 2009

“The reason I wrote this book was so that the average person could understand the scope of the housing bubble, and what its bursting was going to mean and…where blame should be placed…at Greenspan’s Fed.”
- William Fleckenstein, on his book Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve

“Bernanke has done a great job, post-Lehman. But going into this crisis, he really was the architect, if not the co-collaborator, in creating some of the conditions in the economy that led to the recession.”
- Stephen Roach, chairman of Morgan Stanley Asia, Ltd, August 25, 2009

“We artificially lower interest rates. It’s been going on for 10 years and longer and now we’re bearing the fruits of that policy.”
- Ron Paul (R-TX) at Chairman Bernanke’s testimony to the Joint Economic Committee, Nov. 8, 2007

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”
- Then-Fed Chairman Alan Greenspan, during a speech on February 23, 2004

(click to enlarge image)

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By ANDREW JEFFERY

This post first appeared on Minyanville.

The horses, pigs, cows, goats, sheep, llamas, ostriches, dromedaries and rhinos have all left the barn, yet the US Securities and Exchange Commission (SEC) still thinks it should be minding the door.

In light of its woeful inability to perform even the simplest of tasks — like making sure the biggest hedge fund in the world, I don’t know, makes a trade once every 13 years — the Obama administration is looking to strip the SEC of certain regulatory responsibilities.

And rightly so.

According to Bloomberg, plans could be announced as early as next week outlining just how watered down the SEC’s role in the new Obama regulatory regime could be. It’s expected the Federal Reserve may take over the SEC’s oversight of firms deemed “too big to fail.” Keeping tabs on mutual-fund operations could become the domain of certain banking regulators.

The SEC, for its part, under the new leadership of 20-year veteran of the agency, Mary Schapiro, is fighting back. Shapiro says she’s frustrated the SEC isn’t more involved in high-level negotiations with financial firms like Citigroup (C), Bank of America (BAC) and Goldman Sachs (GS), and is making great strides in repairing the regulator’s tattered image.

Commendable, but too little too late.

The SEC is widely viewed as having committed the biggest regulatory bonk in modern financial history, turning a blind eye to Bernie Madoff’s $65 billion Ponzi scheme, and failing to, even in the remotest way, protect investors from the implosion of the market for mortgage-backed securities and other structured financial products stemming from rampant fraud, scant disclosure and blatant conflicts of interest.

Oh, and just days before Bear Stearns collapsed into the waiting arms of JPMorgan Chase (JPM), then SEC Chairman Chris Cox went on national television, assuring the country Bear was in good shape. Oops.

The SEC is a case study in regulation gone bad. It’s one thing to have openly unregulated markets, where participants understand there’s no one guarding the hen house. But when markets are purportedly policed by a powerful government body, investors assume some level of basic integrity and honesty.

By violating this trust, the SEC proved that weak regulation — and more specifically, weak regulators — do more harm than any amount of deregulation could ever do.

The looming restructuring of the financial regulatory complex will be a messy, political, imperfect process. But if the first step is dismantling the SEC’s web of incompetence, then we’re off on the right foot.

By ANDREW JEFFERY

This post first appeared on Minyanville.

Remember the good old days? Back when you and the credit crunch were young, and only those “subprime” people over on the other side of town — you know, the ones living wildly beyond their means, dependent on credit for the very necessities of life — had to deal with the harsh reality of life without free and easy credit?

Those happier times are long since passed, as the malaise continues to seep its way up the economic spectrum. Now, even the most creditworthy consumers who haven’t missed a payment in years are seeing credit lines cut, interest rates raised and finding it increasingly difficult to get a mortgage. They’d better get used to it - the free lunch is over.

Up in Washington, where economic rationale and populist rhetoric seem to be more mutually exclusive than ever these days, the Senate is voting on a widely debated new set of rules for the credit card industry.

According to the New York Times, although the legislation doesn’t cap the rates companies like Capital One (COF) and American Express (AXP) can charge their customers, they’ll be forced to up rates more slowly — and with more disclosure — meanwhile making it tougher to impose late fees on borrowers that can’t keep up. This will reduce lenders’ earning power, not to mention their inclination to give out credit lines to questionable borrowers.

While risky borrowers will bear the brunt of late fees, over-limit charges and slashed credit lines, the well-to-do are in for the biggest shock. Banks are considering curtailing or doing away entirely with rewards programs, grace periods before interest charges kick in and accounts without annual fees. Gone are the days when paying your bills on time was a path to free credit.

The country’s biggest banks, JPMorgan (JPM), Bank of America (BAC) and Citigroup (C) have already told Congress the new rules will force them to limit credit availability and increase fees. While this may bode well for profit margins in the near term, not so for the broader economy.

In light of the financial implosion wrought by too much debt supported by not enough real income, it’s hard to argue credit card companies shouldn’t be a bit less free-wheeling when handing out plastic. But analysts are quick to point out that paring down consumer credit will have a dastardly effect on our consumption-based economy.

For a country whose economy is two-thirds consumer spending, and whose consumer is (still) addicted to credit, the new legislation is like pumping the economy full of Xanex - everything will just slow down.

And while in the long run, less dependence on cheap and easy credit will help prevent the sorts of credit crisis like the one we’re experiencing right now, we’ll likely look back with 20/20 hindsight and say this legislation went too far, constricted credit too much. This is a shame, since before Congress even cooked up the idea of the new rules, the natural deleveraging cycle was already restricting credit on its own.

Debt isn’t in and of itself, bad. As Minyanville’s Kevin Depew wrote today, “real lending and economic activity will only improve when real savers see real value at the right level of risk. That will only occur in the short-run with vastly lower prices, or in the long run with stagnant prices and the benefit of time.” Indeed.

Credit allows a transfer of risk from those who want to take it, but can’t, to those who can take it, but need to be appropriately compensated for putting their cash on the line. This can foster healthy economic growth - when used properly.

That day will come again, but that day isn’t today.

This post first appeared on Minyanville.

Freedom is back in vogue: Americans are finally growing tired of living in the shackles of debt.

According to the Wall Street Journal, government-led efforts to jumpstart lending are being derailed by weak demand for new loans. As the recession rolls on, an increasing percentage of consumers are opting to pay with cash or (gasp) save their hard-earned money.

Initiatives like the Term Asset-Backed Securities Loan Facility (TALF) aim to free up consumer credit by supporting the market for asset-backed securities. The Federal Reserve and Treasury Department hope their efforts will enable American consumers to start spending again.

During the boom, fixed-income investors snatched up bonds backed by all types of debt - credit cards, auto loans, and, of course, mortgages. High demand for these seemingly safe investments pushed down interest rates, which stretched consumers’ budgets to the brink - and beyond.

But now that investors have been badly burned by such investments, they’re shying away from the market almost entirely. Without Wall Street’s securitization machine, there’s simply nowhere to put new consumer loans.

After years of gorging on cheap credit, Americans are reverting to more responsible fiscal lifestyles. Savings are up, spending is down - which is as it should be. This is reducing the urge to borrow and thwarting Washington’s plans to pass the bailout buck down to taxpayers.

Every dollar we don’t spend or don’t borrow is another that could potentially be handed over to effectively insolvent financial firms like Citigroup (C), Bank of America (BAC) and American International Group (AIG), or failed automakers like General Motors (GM) and Chrysler.

That task is growing increasingly dicey, as it becomes clear that using debt to fix a system already crippled by debt is patently absurd. And even as the US government loads up on borrowing, consumers are doing the right thing: getting out of hock.

By ANDREW JEFFERY

This post first appeared on Minyanville.

Despite Herculean efforts, the Federal Reserve is losing its battle to keep mortgage rates at all-time lows.

As fear that we’re headed for imminent collapse slowly wanes, investors’ appetite for risk is coming back. This renewed confidence has helped buoy stocks, and the major equity indices have rallied more than 30% from their March lows. The shift, however, has come at the expense of the Treasury market, which has been in a 7-week slump.

According to Bloomberg, big money managers like Blackrock (BLK) are betting the Fed will step in to support the Treasury market (again), as regulators hope renewed Treasury purchases will push down mortgage rates (again).

Bond prices and yields move in opposite directions. When investor demand falls, so do prices, pushing up yields. And as investors shun the safety — but relatively low return — of government-backed debt, the impacts are felt throughout the credit markets. Of concern to the Fed, and what has led Chairman Ben Bernanke to increase Treasury purchases in the past, is the effect this dynamic has on mortgage rates.

A mortgage is nothing more than a long term bond, given to a borrower to purchase a home. So when lenders get fearful they’re not being compensated for tying up money for as long as 30 years, they increase rates. Further, as the specter of inflation rises, lenders demand bigger interest payments to keep up with higher prices. In other words, when dollars in the future are worth less than dollars today, banks demand higher payments to make up the difference.

Keeping mortgage rates low has been a cornerstone of Washington’s efforts to jump start the flagging housing market. But with rates at the highest level since April, the “smart money” is betting the Fed may return to the Treasury market en masse.

Paradoxically, even as the Fed tries to keep interest rates low — which are rising in part due to the expectation that higher prices loom in the years ahead — its actions increase the likelihood of future inflation. Running its printing presses around the clock has consequences, even if Fed officials are loathe to admit it.

Minyanville’s Mr. Practical often discusses the fallacy that credit markets are improving. As he points out, only in corners of the market where the government has stepped in to support lending is any so-called “normalcy” returning.

So too in the mortgage market.

Loans backed by Fannie Mae (FNM), Freddie Mac (FRE) and the Federal Housing Administration account for the lion share of mortgages currently being issued in this country. Aside from the occasional jumbo loan written by banks like JPMorgan (JPM) or Wells Fargo (WFC), government mortgages are the only game in town. Coupled with the Troubled Asset Lending Facility (or TALF), which funnels money into the market for mortgage-backed securities, the home-loan market remains completely dependent on government support.

This is one reason recent “strength” in the housing market will provide transitory. There’s a limit on how much government can control markets, as evidenced by mortgage rates that move persistently higher every time the Fed eases its aggressive intervention. Fundamentals, not subsidies, will provide a true floor in prices.

And as banks prepare to unleash a firestorm of foreclosure inventory into the market, fundamentals will remain pointed south, thereby pushing down prices. And as foreclosures continue to infect higher end real-estate markets, these price declines will be felt by a growing — and more prosperous — segment of the population.

Mortgage rates, left to their own devices, would be far, far higher without government support. This is the message of the market - one bureaucrats in Washington seem unwilling to learn.