ProLogis' Rebound
In late November the industrial property REIT ProLogis (PLD) was on the verge of collapse. Its stock almost reached $2.00. Today its stock is near $14. It's still well off its early September levels, but a nice rebound all the same. A refinancing and a few property sales have helped the stock price. Its 2009 dividend is projected at half of 2008's. Here is a chart for the past three months:

AIG Part Two
Here is the second part of the Post's three-part series on AIG and its role in the Credit Crisis. AIG's collapse really was Spitzer's fault.

It's All Eliot Spitzer's Fault
Here is part one of a three-part series from the Washington Post on AIG and the growth of its Financial Products division. This is a fascinating story about the creation and growth of the exotic financial products, built on cheap credit and complex financial models, that lead to AIG's collapse and exacerbated the Credit Crisis. One theme of the article that sticks out to me is the involvement of Hank Greenberg in the Financial Products division, even from its start-up phase. He had the pluse of AIG and its wide range of businesses. When I worked for a subsidiary of AIG (that was nothing more than a pimple on the elephant's ass) the fear of Greenberg was palpable. I am sure that when he was forced out by Eliot Spitzer the oversight of the Finanical Products division became less intense. Greenberg could not have stopped the Credit Crisis, but AIG's fate may have been different.

Madoff's Strategy - As I Understand It
From what I have been able to gather from reading news reports on Bernie Madoff and watching CNBC, it appears that Madoff was managing money based on a strategy using options on an index. He would buy a stock or index, sell a call option and buy a put option. For example, he would:

• Buy the underlying stock at $100
• Sell a call option at $105, giving the buyer of the option to purchase the stock if it reached $105
• Buy a put option at $95, giving Madoff the option to sell the stock if it dropped below $95

What this strategy, known as a collar, did was limit the upside because the stock would get "called" if it reached $105, and protect the downside because if the stock dropped below $95 the put option would be exercised and the stock would be sold at $95 no matter how much below this amount the stock had fallen. The money received for selling the call option should have offset the cost of buying the put option. This collar strategy is generally benign, as it limits gains and losses to the range between the exercise price between the two options. Success is through repetition of the process over many stocks and having the underlying stocks increase in value slowly.

This strategy is marketed to conservative investors. It is usually only successful when markets are rising slowly and orderly (so the stock does not get called away or the put option exercised), which rarely happens. Consistent, long-term returns are hard to achieve because winning positions tend to be offset by losing positions.

A mutual fund group called Kelmoore has run a similar option strategy and has posted poor returns. I remember this fund group from the late 1990s when its funds came out at $10 per share. Financial advisors at the brokerage firm I worked for screamed for these funds because of their alleged safe, solid investment strategy. Over the several years that I followed the funds, shares in various Kelmoore funds dropped to less than $5 per share. Bad returns for a conservative strategy.

I searched for updated data on the Kelmoore funds. I found limited information on a few financial websites. It looks like the Kelmoore funds had some kind of reverse stock split in 2005, and continued their losing ways. The Kelmoore funds were acquired or taken over by another fund company, Dunham, earlier this year and have slipped into obscurity. Here is a chart of one Kelmoore fund's performance:


Ouch. It looks like the original $10 investment has lost nearly 90% of its value. This strategy is also a tax disaster as all gains and income are short-term. So you lose money and get a tax bill.

I don't know how similar this is to what Madoff was doing, but it could not have been that much different, especially since Madoff's bogus black box strategy was a fraud, and his consistent returns a lie. The simple rule is avoid people selling "safe" covered call strategies.

Madoff Feeder Funds
Here is an article from yesterday's Wall Street Journal. It details the people and organizations that acted as marketing arms for Bernie Madoff. Some of the guys were just salesmen that sold Madoff's false returns. One firm, Tremont, a sponsor of funds-of-funds had $3.3 billion with Madoff. My guess is that it will be hard for Tremont to survive this as it touted its due diligence and diversification while limiting information on the managers it used. Assets will flee Tremont over the next months and quarters.

The one guy in the article that stood out to me was a Los Angeles financial advisor that formed various partnerships that in turn invested all their assets with Madoff. Here is the outtake:

Mr. Chais charged substantial fees, according to the statement from the Marloma partnership -- 4.5% of clients' assets.

I don't know if this is an upfront fee or annual fee, but if it's an annual fee, the clients in this advisor's partnerships were paying an outrageous level of fees. This advisor raised capital through his partnerships, invested all the capital with Madoff, and then did nothing but collect fees. The ultimate something for nothing - and nothing is what he and his clients have now.

The Madoff scandal is exposing ugly fee arrangements - and who said rich people hated paying fees. Many Madoff investors were paying multiple levels of fees, with both annual fees and performance percentages, for a strategy, if executed without fraud, that by design limits returns. I will explain the basics of how I understand Madoff's strategy in a later post.

I Was Wrong
My anecdotal evidence of packed malls did not translate to sales. This Wall Street Journal says that retail sales "plummeted" this year.

Update: Sales did not stink at all retailers. Amazon has its best Christmas ever.

Just a Thought
I know from watching CNBC and reading the Wall Street Journal that the economy is in a deep recession, unemployment is soaring and that retail sales are awful. But every store and mall I have been to this Holiday Season has been packed. This may be anecdotal, but I can't see sales being as bad as reports are predicting.

What's the Difference?
I wonder what the difference between the Brent Crude and West Texas Intermediate. I know they are produced in different places, but other than that I am at a loss. The price for the two types of oil is shown on commodity tables and across the CNBC tickers. What is interesting to me is that the two oil prices never seemed to me to diverge more than a dollar, but this is anecdotal from watching CNBC. Today the two have diverged by almost eleven dollars. With oil at $15o a barrel this divergence may not be that significant, but at $33.87 per barrel, the differnce seems significant. Brent is at $44.50, indicating that West Texas crude is 24% cheaper. I don't know why these seemingly similar benchmarks would move so far apart.

Update: Problem solved, and I better undo my arbitrage trade. The West Texas price reflects January futures contracts while the Brent reflects February futures. The February West Texas futures contracts closed at almost $43. This shows the importance of comparing apples to apples.

Doctor Chutzpah
I just tried to make a doctor's appointment and was told the first available date is in late February. Jeez, I'm glad I am not dying. Doctors' collective arrogance never stops amazing me. The first question in any doctor's office is never how you are feeling, but instead it's about your insurance. Doctors and their staff have no problem keeping you waiting for extended periods - I'd love to send a doctor a bill for the time wasted during business hours sitting in a waiting room or an exam room - but all have draconian policies about missed appointments or arriving late for an appointment. And their billing is a freaking mystery - no posted prices and no negotiation - there must be a class on opaque pricing in medical school. OK, I feel better.

Greed is Good - Until It's Bad
Here is a New York Times article on the outsized bonuses paid on Wall Street over the past few years, with a focus on Merrill Lynch. Executive decisions, in my opinion and experience, are almost always made on how the executive is going to be compensated, not on the business school mantra of shareholder wealth maximization. The past few years will be studied in business schools for years, as decisions based on executive compensation destroyed shareholder wealth.

More Madoff
Bernie Madoff's sons were smart enough not to invest with their father. Here is the post from Talking Points Memo discussing the Madoff foundations' investments.

Madoff Comments
The list of victims is staggering. I am still not sure how he stole $50 million, and I think when the dust settles the amount will be much less. I also think that he did not start with a plan to steal money but probably got sideways, made a few false statements to retain assets, and built his scam from there. Once a scam is started it can't be stopped without exposing the entire crime. If Madoff really pulled a Ponzi scheme, I wonder if the people who got paid out in full will have to give all or part of the money back? I suspect they will because the payments were made fraudulently.

Madoff reported year-end 2007 assets of $17 billion. This guy obviously could attract assets. Between trading revenue and management fees this guy could have lived large without the scam. If he had produced legitimate return figures and lost assets because of it, he still would have had significant money because people trusted him.

More sordid revelations about Madoff will surface over the next few days. The Madofff fraud is going to give the fund-of-funds business a permanent black eye. I never understood the wisdom of these funds with their high fees and low returns.

Oil Slick
Here are two articles on the drop in drilling activity. One from yesterday's Wall Street Journal and one from today's New York Times. This logically follows the huge drop in prices. Oil seems to have found a temporary floor near $45 a barrel. Experts are predicting $25 a barrel oil, but these are the same guys who said oil was heading to $200 a barrel. The next set of articles will report the drop in alternative energy investments, but that's not the point of this post.

To me, the key to the oil drilling business over the past four years was buried in the New York Times article:

One reason projects are being shut down so fast is that costs throughout the industry, which had surged in recent years, are still elevated despite the drop in oil prices. Many companies are waiting for those costs to come down before deciding whether to go forward with new projects.

Many investors who thought that oil investment was sound because of high prices did not realize that high operating and drilling expenses offset the high oil revenue. This is why so many oil and gas direct investment programs have had such poor returns in recent years. The 0perating cost of these programs increased as fast as the the price of energy. The only programs that are going to have decent returns were the ones that were able to lock in leases and drilling contracts in the early 2000s and had production with high prices. Programs offered over the past few years that are not in a position to wait until prices rebound - because eventually they will rebound - will have poor returns.

Gold Question
The price of gold has been between $750 and $850 an ounce for a month despite wide scale drops in commodity prices. I don't know whether it is a fear play or a future inflation play. Recently, I find myself looking first to the price of gold and the overnight banking spreads than to the movements in the stock market. Times are strange.

Auto Crash
The auto bailout crashed and burned this evening, so look out for a wild day on Wall Street tomorrow. It seems strange that the Government gave Wall Street banks $350 billion, with another $350 billion on the way, with little oversight or preconditions, but the Big Three automakers had to go through a weeks long proctology exam to get $14 billion, and still Congress said no. It does not make intuitive sense to me.

The bailout died in the Senate, as the House passed a bailout today. The lead Senator against the bailout was Alabama's Richard Shelby. I don't know much about him, but hearing him talk he does not seem like the brightest light in the Senate, especially on financial matters. He is a career politician, starting his political career nearly forty years ago in 1970. He nearly scuttled the financial bailout earlier in the Fall. Alabama has three large manufacturing plants - Mercedes, Honda and Hyundai - and you can bet these played a large part in his opposition to the bailout.

I am still ambivalent on the idea of an auto industry bailout. Bailing out every troubled industry is an untenable position for the Government. But I am also aware of the wide employment base, especially in the Midwest, dependent on the auto industry. The potential of putting this many people out of work is scary, and the repercussions will be felt throughout the country. No one will buy cars, not even Richard Shelby's Alabama-made Mercedes, Hondas or Hyundais.

Update: Looks like the bailout will happen under the TARP, which is probably where it should have been in the first place. I was harsh on Senator Shelby above, but Senator Corker from Tennessee was key in scuttling the deal. Tennessee, like Alabama, has a large foreign auto manufacturing base. It should be noted that I think it's great that foreign auto firms manufacture here in the United States. It blurs the lines between what is a foreign and domestic auto maker.

Layoffs Getting Ridiculous
Here is a Wall Street Journal article announcing that the NFL is laying off 14% of its workforce. The NFL expects the job cuts to result in $50 million in savings. If this is an annual savings, it works out to $333,333 per employee. At that salary, I want to work for the NFL. Last I checked the NFL has a monopoly and long-term TV contracts with every major network, and it even has its own network, so future revenue does not seem in doubt. Ticket prices to an NFL game are so expensive that most people can't afford them anyway, let alone the unemployed, under-employed or those hurt by the recession. Hell, if people in Detroit are still paying to see the Lions, I'd argue that the NFL is more recession-proof than any business in America.

Firms, like the NFL, that are laying off people just because they think the recession may impact them are idiots. Needless layoffs, while theoretically prudent, are going to make the recession a self-fulfilling prophecy. A dip in profitability is not the end of the world, especially for a private club like the NFL.

Update: I just saw this article on finance.yahoo.com. Here is a quote from Barry Diller:

"The idea of a company that's earning money, not losing money, that's not, let's say, 'industrially endangered,' to have just cutbacks so they can earn another $12 million or $20 million or $40 million in a year where no one's counting is really a horrible act when you think about it on every level," said Diller, who's been known to lay off workers from time to time. "First of all, it's certainly not necessary. It's doing it at the worst time. It's throwing people out to a larger, what is inevitably a larger, unemployment heap for frankly no good reason."

I guess I am not the only one who thinks needless layoffs are stupid.

Stupid Is As Stupid Does
Readers of this blog know my opinion of the brain power at AIG. Here is some proof from a Wall Street Journal article:

American International Group Inc. owes Wall Street's biggest firms about $10 billion for speculative trades that have soured, according to people familiar with the matter, underscoring the challenges the insurer faces as it seeks to recover under a U.S. government rescue plan.

The details of the trades go beyond what AIG has explained to investors about the nature of its risk-taking operations, which led to the firm's near-collapse in September. In the past, AIG has said that its trades involved helping financial institutions and counterparties insure their securities holdings. The speculative trades, engineered by the insurer's financial-products unit, represent the first sign that AIG may have been gambling with its own capital.

And here is the dilemma:

The fresh $10 billion bill is particularly challenging because the terms of the current $150 billion rescue package for AIG don't cover those debts. The structure of the soured deals raises questions about how the insurer will raise the funds to pay the debts. The Federal Reserve, which lent AIG billions of dollars to stay afloat, has no immediate plans to help AIG pay off the speculative trades.

Dumb:

The $10 billion in other IOUs stems from market wagers that weren't contracts to protect securities held by banks or other investors against default. Rather, they are from AIG's exposures to speculative investments, which were essentially bets on the performance of bundles of derivatives linked to subprime mortgages, commercial real-estate bonds and corporate bonds.

These bets aren't covered by the pool to buy troubled securities, and many of these bets have lost value during the past few weeks, triggering more collateral calls from its counterparties.

And dumber:

Some of AIG's speculative bets were tied to a group of collateralized debt obligations named "Abacus," created by Goldman Sachs. The Abacus deals were investment portfolios designed to track the values of derivatives linked to billions of dollars in residential mortgage debt. In what amounted to a side bet on the value of these holdings, AIG agreed to pay Goldman if the mortgage debt declined in value and would receive money if it rose.

It is not surprising that AIG came out on the short end of a trade with Goldman Sachs.

Anecdotal Aspirations
In my opinion, there is a strong correlation between this year's economic collapse and sky-high energy and commodity prices earlier in the year. The recession was pegged as starting in December 2007, just as oil started its massive upward lunge. Now that oil has collapsed and is trading near $45 a barrel and gas prices are near $1.75 a gallon, this is going to ease pressure on the economy. While I don't think low oil prices are permanent, I do believe they will be stimulative in the short-term.

Depressing Article
Here is an article on trouble at Extended StayAmerica. Lightstone's April 2007 acquisition of Extended Stay was one of the last highly leveraged real estate deals before the Credit Crisis began in August 2007. Extended Stay has not defaulted yet, and according to the article, any action is a month or two off. Here are some interesting quotes from the article:

One wrinkle in negotiations is that Extended Stay isn't likely to file for bankruptcy protection, because of provisions common in commercial mortgage-backed securities deals that would expose more properties of its founder, David Lichtenstein. A more likely path is for Mr. Lichtenstein to turn Extended Stay directly over to lenders or to swap enough equity for debt to give bondholders control of the company.

Here is more cherry news:

During the real-estate lending boom, Wall Street originated $600 billion of commercial mortgage-backed securities. The default rate on commercial mortgage debt has remained near historic lows, even while residential-related debt suffered a severe downturn.

But that is now beginning to change, sending new shock waves into much-battered banks, private-equity funds and other financial institutions that participate in the $1 trillion commercial real-estate debt market. Hotel landlords typically are the first to feel the pain in a downturn because hotels have the shortest leases in real estate -- one night at a time.

The article also states that commercial real estate value have dropped 15% to 20%, but doesn't give sprecifics. The article ends on this note:

Troubles also have surfaced at Lightstone's Prime Retail division, which owns roughly 30 malls and shopping centers in the U.S. and Puerto Rico. Lightstone has sought to turn over at least six of its malls to lenders after falling behind on debt payments.

Debt-laden landlords of all types of property are beginning to struggle staying current on their mortgages as rents fall and vacancies rise. New York City office space that had been renting for $120 a square foot is now being dumped on the sublease market for about half of that amount.

CNL Goes Skiing
CNL Lifestyle Properties REIT just bought three ski resorts, Crested Butte in Colorado, Okemo Mountain Resort in Vermont and Mount Sunapee Ski Resort in New Hampshire. It will pay $132 million for the three properites, using $82 million in cash and the balance in seller financing. I guess this explains the drawdown of Lifestyle's $100 million line of credit last month.

More Housing Help
Fed Chairman, Ben Bernanke, made a speech this morning saying more help for homeowners is needed. Hopefully, it's not too late in the game, but the Treasury and Fed have now determined that stopping foreclosures and the downward spiral in home prices is necessary to get the economy stabilized. I agree that housing is at the root of the economy's problems. Lower mortgage rates will not only help the housing market but also the overall economy by increasing disposable income for those that are able to refinance at low rates. Taking this further, low mortgage rates when combined with new low energy prices could provide a strong economic stimulus.

Developers Diversified and Inland
In early 2007, Developers Diversified (DDR) acquired the Inland Retail REIT. I think DDR paid about $14 per share for the Inland REIT. It was $12.50 in cash and the balance in DDR stock. I just saw this evening that DDR is trading at $4.80 per share. It was trading in the mid-$30s in September and has a 52-week high of over $47. In late November it hit a low of $1.73. I hope most of the Inland REIT investors took the cash and put it somewhere safe. The realist in me says that a large chunk probably went to Inland American REIT.

LandAmerica Bankruptcy
This is a disaster. LandAmerica, in capacity as a 1031 accomodator, had $400 million of short-term 1031 exchange money in illiquid auction-rate securities. Because the auction-rate securities became illiquid, it could not meet is accomodator obligations, which lead to the bankruptcy filing. Most of the money was in co-mingled accounts. Investors now have to go through the bankruptcy courts to attempt to get their money back.

New Paradigm Skepticism
I get a smirk when I hear talk of new paradigms in investing. Fundamentals don't change, business cycles and asset valuations change. Yesterday's Wall Street Journal had an article on Goldman Sachs' Whitehall real estate funds and their losses. While the article did not state that real estate was going to experience a new paradigm, I got the sense that the article was implying that real estate investing had changed. It has not. Real estate investing has always been a function of two things - income and debt. I know the old saying - location, location, location - but even a property in a good location needs quality tenants paying consistent rent, which will allow an investor to get a favorable mortgage. Credit is tight today and many tenants are feeling the impact of the recession. But credit will return and the business cycle will improve. This will make real estate investments attractive again. I would not bet against Goldman Sachs. When someone talks of new investment paradigms its time to start buying or selling, which ever is opposite of the so called new paradigm.

Makes Sense
Treasury is thinking of using Freddie Mac and Fannie Mae to bring down mortgage rates. This idea seems smart to spark the housing market, and maybe should have been considered earlier. I know the government did not control Freddie and Fannie until September, but it could have exerted some pressure to get the rates down.

Captain Renault Strikes Again
News that the economy has been in recession since December 2007 caused the Dow to drop nearly 700 points. This should not be a surprise to anyone who has watched the markets and read economic data this year. I am more surprised that data does reflect the recession starting in the summer of 2007. The market needs to look forward not backward.

Ten-Year Well Below Three Percent
The markets are off to a bad start this morning. The ten-year Treasury, which dipped below 3% on Friday, is now solidly below 3%. It is trading at 3.81% about a half-hour into the trading day.

Five and Less Than Three
The Dow extended its gains to five days. It is the first time since July 2007 - before the credit crisis started - that the Dow has put together five consecutive up days. The ten-year Treasury dropped below 3% today, ending at 2.96%. This is near its lowest levels since daily tracking began in 1962. I know this low rate indicates deflation, but to me if it translates into lower mortgage rates it may spur the housing market.

And the Fair Land
The Wall Street Journal has run this editorial every year since 1961 and I read it every year. This year I think it is more appropriate than ever, despite being written forty-seven years ago. Here are a few passages that struck me:

This is indeed a big country, a rich country, in a way no array of figures can measure and so in a way past belief of those who have not seen it. Even those who journey through its Northeastern complex, into the Southern lands, across the central plains and to its Western slopes can only glimpse a measure of the bounty of America.

And a traveler cannot but be struck on his journey by the thought that this country, one day, can be even greater. America, though many know it not, is one of the great underdeveloped countries of the world; what it reaches for exceeds by far what it has grasped.

And it concludes with this:

But we can all remind ourselves that the richness of this country was not born in the resources of the earth, though they be plentiful, but in the men that took its measure. For that reminder is everywhere -- in the cities, towns, farms, roads, factories, homes, hospitals, schools that spread everywhere over that wilderness.

We can remind ourselves that for all our social discord we yet remain the longest enduring society of free men governing themselves without benefit of kings or dictators. Being so, we are the marvel and the mystery of the world, for that enduring liberty is no less a blessing than the abundance of the earth.

And we might remind ourselves also, that if those men setting out from Delftshaven (Pilgrims) had been daunted by the troubles they saw around them, then we could not this autumn be thankful for a fair land.

Happy Thanksgiving.

Before You Invest or Approve That Natural Gas Deal...
Here is a post from the naked capitalism blog that has an extensive quote from Platts. In summary, it says that a warm winter could lead to natural gas prices near $4 / MMbtu. Oil and gas deals had trouble paying sizeable distributions over the past year with energy prices soaring. This is due in part to their structure - too many fees - and the cost and expenses of drilling that increase along with energy prices. Now that oil and gas prices have fallen and expenses have likely remained constant, oil and gas deals may have difficulty making distributions.

Mortgage Rates Drop
After the Treasury's announcement this morning, mortgage rates dropped more than 75 basis points, and at one point were down more than a full percentage point. The thirty-year mortgage is now near 5.50% after starting the day at 6.38%. If this rate can be sustained and drop even further, it will should help the housing market.

Three-Day Gain
I just heard that today's gain in the Dow marks the first time since late August that the Dow has put together three consecutive gains in a row. That is pretty amazing.

I am tired of hearing that we are headed for bad recession. We are not headed for a recession, we are in a recession. My guess is that it started sometime in the late spring. The debilitating impact of high energy and commodity prices, when added to the housing mess, started the recession. The financial crisis added fuel to an already growing fire.

If Treasury's move today boosts housing it will have been a success. The recession and financial mess started in housing and needs to end there.

Interesting Tidbits from the 10Qs
I finished the going through the 10Qs for some select non-traded REITs. CNL Income Properties, as a subsequent event (to September 30, 2008), entered into a $100 million line of credit and withdrew all of it for future acquisitions and working capital. This puts its cash position at nearly $300 million. One of its tenants, EAGLE Golf is having financial problems.

Wells REIT II has a $351 million line of credit due May 9, 2009. It has $45 million in cash and has been raising equity at a rate of approximately $60 million per month. I would not be surprised if a big chunk of the $351 million is converted to permanent debt. With the line of credit and term loan, Wells REIT II's leverage ratio is 26%, lower than the other REITs I reviewed. Wells REIT II did not provide FFO data this quarter.

Dividend Capital Total Realty Trust is sitting on $541 million in cash with only $11 million in short term debt.

Harry Dent
Harry Dent is on CNBC talking about The Great Depression ahead. Here is a search on Amazon for Dent's books. Looks like he's a better marketer than economist.

I remember sitting through his presentations in the 1990s, when he was a paid speaker by AIM Mutual Funds, and he was predicting a 30,000 Dow. Oops.

It is comforting that he thinks we are heading to a Great Depression, because we know he will be wrong.

Capitulation?
Did the market reach capitulation today, or is it the beginning of the end. The statistics are ugly and the pit in my stomach is awful. I heard a commentator on CNBC say that today is the bottom as the mood is the polar opposite of when the market was at the top. Let's hope he is correct.

Fine Line Between Chutzpah and Stupidity
Executives for the three automakers (Ford, GM and Chrysler) went to Washington with hat in one hand and cup held out in the other looking for a Wall Street-style bailout. Unfortunately, the PR-challenged executives from the cash-strapped automakers all flew into Washington (hat tip Talking Points Memo) on separate corporate jets. It was a case of poor little rich boys and poor judgement.

In another example of of the denseness of the auto executives, any deal with Washington is going to require the replacement of all the executives that paraded in front of congress today. Unfortunately, I don't think these numb-nuts see this irony.

Citi's Gone, Time To Move On
It's been a slow death, but let's face it, Citigroup is done. The sell pressure on its stock is too great. The culmination of its death spiral needs to happen fast because it's dragging down the entire market. The market has been anticipating Citi's death for weeks so there is no need for a Captain Renault moment when it actually happens.

Commercial Mortgage News
Here is a Wall Street Journal MarketBeat blog post on the perceived problems in commercial mortgage backed securities. Note the chart and the low current default rates and the high protection spread. The market is sure expecting the default rates to increase.

Automaker Ambivalence
I am not sure how I feel about a bailout of the automakers. As companies, I don't really care whether the firms succeed or fail. I am more worried about the impact of a bankruptcy on the greater economy, and wonder if an implosion of the auto industry could tip the economy from recession to depression. The auto industry is more than Ford, GM and Chrysler, and the ancillary impact across the Midwest and the entire country is what troubles me.

Eventually, the government is going to get stuck with the auto industry's legacy pension and health care issues. It is just a question of time.

Third Quarter Non-Traded REIT Filings
Many non-traded REITs filed their third quarter 10-Qs over the weekend. I have not finished reading them yet, but have not seen any surprises. New equity is down and redemptions are up, but this is not surprising. I will post anything I think is wild, although recent market gyrations and the revelations coming out of DBSI have numbed my sense of shock.

More On DBSI
I missed this in my first read of today's Wall Street Journal article (linked in previous post):

DBSI also had investments in raw land and development projects and raised $275 million from thousands of small investors through private bond placements. It owns several small technology companies.

I knew about the raw land investments. I knew DBSI had offered private debentures before, too. I did not know it still had $275 million in debentures outstanding. What did DBSI do with all the money. In previous articles it was alleged that DBSI relied on syndication fees to support its master leases, not debenture proceeds, and when the credit crisis caused new deal flow to slow there was no longer syndication fees to supplement master lease payments. This is what supposedly caused the bankruptcy.

None of this makes much sense. Syndication fees, while they may be high on a particular offering, cannot support a portfolio of poor performing properties. Blaming the bankruptcy on DBSI's inability to sell new deals is a red herring. This morning, the $275 million in debentures is the big story. Is this number accurate and how did DBSI allocate this money? Even if it used the debenture proceeds for mezzanine financing, the bulk of this should have been repaid, at some point, by investor equity or permanent financing.

Many TIC investors should be OK. They should (and at this point who knows) own the properties. Each TIC investor group will have to deal the properites, and it will be messy, but there is an asset supporting the process. TIC investors need to keep cool and look to the long term. Rash decisions on particular properties could make this situation worse.

DBSI In The WSJ...Again
I tried to take a news moratorium this weekend. But checking tomorrow's headlines quickly brought me back to reality . Here is a detailed article in the Wall Street Journal on DBSI and the tenant in common industry. I don't think it sheds anything new on the situation. Here is one take away to look forward to:

Before anything can be settled, DBSI's investors are left to deal with one of the hairiest legal unravelings in real-estate history. "This will be an order of magnitude that has not been seen in terms of the complexity," says Bradley Williams of Best & Flanagan LLP, a Minneapolis law firm that represents a lender who holds mortgages on some DBSI managed properties. Each TIC investment, which owns a single building, contains as many as 35 investors who must make all major decisions unanimously.

A Big Deal
Hartford is converting to a savings and loan to qualify for federal assistance under TARP. This is a big deal, maybe even a huge deal if the market continues to have days like today. Here is the take-away paragraph from the news story:

The (insurance) industry has been suffering in recent months with billions of dollars of investments losses and concerns about whether the firms have sufficient capital amid emerging problems in their commercial real estate and annuities portfolios.

Variable annuities with their death benefits and riders that guaranteed specific returns are causing concern for insurance companies. No one is hoping for a market rebound more than insurance executives.

DCT Industrial Trust
After my last post on ProLogis, I pulled up information on DCT Industrial Trust (DCT), the formerly non-traded, public REIT, which is now listed. Today, it is trading at below $4.00 per share. I guess it caught the ProLogis flu. Investors paid $10 per share earlier in the decade and it went public at over $10 per share. Based on assets, it is about 80% smaller than ProLogis.

I quickly read through its 10-Q, filed last week. Its ratio of debt to total assets is 42%. DCT's board of directors announced last week it was cutting the dividend by 50% to $.08 per quarter, or $.32 per year. The board's projections for FFO in 2009 is $.50 to $.58, and the difference will help improve its balance sheet. The yield, after the rate cut, is now approximately 8%. Another development to watch is DHL's exit from the United States delivery market. DHL is DCT's largest tenant, although it leases less than 5% of DCT's space (exact figures were not provided in the 10-Q other than to say that no tenant leased more than 5%). DHL announced this week its plans to close its US operations.

It is a strange coincidence that DCT and ProLogis announced 50% dividend cuts within a week of each other.

ProLogis, REITs and the Denominator Effect
ProLogis (PLD), the company started by some of Dividend Capital's principals, is having a tough week and has lost nearly 90% of its value this year. Its CEO resigned and it announced a dividend cut of more than 50%. There are plenty of articles on PLD and I am not going to link to them, just type in its symbol in finance.yahoo or the other big financial news sights and you'll receive options for multiple articles. At June 30, 2008, PLD's ratio of long-term debt to total assets was 53%. This ratio does not strike me as out of line for a publicly traded REIT.

ProLogis', and other REITs, have likely seen their assets drop while their debt has stayed fixed. The Wall Street Journal had an article the Denominator Effect earlier this week, in respect to pension funds. The point of the article was that pensions have seen their real estate exposure increase because of the drop in stock prices. This does not account for, as the article states, any change in real estate values. REITs are going to experience the same Denominator Effect for their balance sheets, and what were considered moderately leveraged companies are going to have larger debt ratios than they have had historically.

DBSI In Today's Wall Street Journal
DBSI's bankruptcy made today's Plots & Ploys section of the Wall Street Journal. Here is a link to the article. A couple of bullets stood out:

Complicating DBSI's unwinding, the company is unique among TIC sponsors for structuring deals with master-lease agreements in which DBSI guaranteed rental proceeds to the investors. DBSI also used its corporate balance sheet to guarantee each property's underlying mortgage. Lenders can prevent the TIC investors from canceling the master-lease agreements, according to people involved in the case.

I don't see how DBSI can guarantee mortgages and these TIC deals still qualify as a real estate exchange and not a partnership.

And here are the last two paragraphs:

Only 18 of the 237 properties aren't meeting debt service, but overall DBSI wasn't generating enough revenue to pay investors. DBSI ran into problems when fees from originating new deals evaporated as property markets slumped. Then underlying properties saw rental income drop as the economy tanked.

DBSI attorney Stephen Burr, of Foley & Lardner LLP said: "We expect that the bankruptcy proceeding will allow us the time for an orderly transition of the properties to the investors or to new TIC sponsors."

These two paragraphs are huge. Only 18 under water properties triggered the bankruptcy? DBSI is obviously worried about something else. The quote from the attorney is troubling. How can the bankruptcy proceedings allow for an orderly transition of the properties to investors? These were TIC deals, the investors already own the properties. If investors somehow don't own the properties this debacle is going to go from bad to horrendous. Finally, last part of the quote from the attorney indicates DBSI is shopping deals to TIC sponsors. This would have been much easier before a bankruptcy filing.

Monday Was an Awful Day
The bankruptcy of DBSI stole the headlines on Monday, but it was not the only bad news of the day. It was an ominous day for commercial real estate. I don't have time to go through all the news, but the following headlines stood out:

• Circuit City's Bankruptcy. It was already slated to close 20% of its stores and the bankruptcy will lead to more closures and possibly shutting down the entire chain. More big box space will be available.
• Las Vegas Sands Demise. More news today, but Monday was a key day. Las Vegas Sands is stopping construction on its residential tower. It is looking for capital to complete its foreign developments.
• Donald Trump's Windy City Problems: The Donald's development in Chicago is in trouble so he is suing his lenders. (As an aside, the building is butt-ugly. Trump's taste is what should be sued.)
• General Growth Properties Threatening Bankruptcy. This is not surprising, but more fuel for Monday's bloodbath. It harbingers more problems for retail real estate.

There was probably more bad news, but above struck me as relevant.

QE2 - RIP
Friday is the fourth anniversary of my father's abrupt passing from a heart attack. Several years before he died, he and my mom traveled on the QE2. They had a great time on their trip for a variety of historical and sentimental reasons. I was sad to read this article on the QE2's last voyage. It is traveling to Dubai where it will be partially scrapped and converted into a land locked "hotel, retail and entertainment destination." An inglorious end to an illustrious career. It is ironic that the news of its scrapping broke so close to the date of my father's death. I am sure he and my mom would have been saddened the QE2's fate.

TARP Scraped
Treasury Secretary Paulson announced this morning that the Treasury is scrapping plans to acquire troubled assets from banks, and will use the portion of the $700 billion bailout allocated to troubled assets to instead continue to invest directly into banks. This will improve banks' capital structures. The government is also giving explicit instructions to banks to start lending to businesses and consumers. My immediate opinion of this change in plan tells me that the Treasury determined that the troubled assets have little or no value, and the government's acquisition of these assets would be a financial disaster for taxpayers. Since the assets apparently have no value, the banks need write the assets off and start selling them for whatever they can garner on the open market. This will help clean the banks' balance sheets and inject additional cash into the banking sector.

More DBSI
DBSI has a blog were it will post information: http://blog.dbsi.com/

Here is a section of today's DBSI blog post announcing the bankruptcy:

DBSI's businesses have been significantly impacted by the recent turmoil in the real estate financial and credit markets, the general deterioration of the economy and the historic declines in the stock market. These problems were exacerbated recently by the actions of the various parties and, in the last week, the commencement of legal actions that DBSI submits are without merit and only serve to impede DBSI’s efforts to effectively address its financial difficulties.

This paragraph reminds me of John Belushi's famous line of excuses to Carrie Fisher in The Blues Brothers on why he could not marry her. What does the stock market have to do with real estate? (And why does only six weeks of stock market turmoil trigger more than 140 bankruptcy filings?) What were the "actions of the various parties" and who are the various parties? What is the real estate financial market? DBSI is blaming everybody and everything for its problems. I would expect better writing and more clarity from a middle school student.

It's Official, DBSI Files for Bankruptcy
DBSI Inc, and more than 140 of its entities filed for Chapter 11 bankruptcy in Delaware, earlier today. Here is a link, via CNBC, to a Reuters article announcing the filing. I guess this filing throws the good properties in with the bad properties. I would not doubt that properties that are cash flowing, but subject to the DBSI master lease, will now see their distributions stopped. DBSI, at first glance, appears to be looking out for itself first, and not its investors. I wonder what this does to many of its mortgages? I would not be shocked if even good properties are in technical default now that DBSI filed bankruptcy. There have also been several lawsuits filed that will likely seek class status. Investors' rush to file lawsuits and DBSI's rush to file Chapter 11 has made this a nightmare. At the bottom of the Reuter's article is the meme blaming the bankruptcy on the housing market. This is BS. DBSI's problems started long before the housing market collapse.

Chapter 11
I heard that DBSI and many of its entities are going to file for Chapter 11 bankruptcy. This, I guess, is an attempt to break its obligations under all its master leases. This is the obvious step and therefore, I do not find it much of a shock. Without looking at any DBSI property, I am guessing that problems arose long before the current credit crisis, although the credit crisis will be blamed.

Microsoft and Yahoo
Why does Jerry Yang still have his job? A CEO's job requires corporate stewardship and maximizing shareholder wealth. I don't remember the exact price Microsoft was willing to pay for Yahoo last year, but I think it was in the mid-30s per share. Microsoft is no longer interested and today Yahoo is around $12. Yahoo's board of directors needs to act fast and decisively.

Unemployment and Captain Renault
I posted last week about the market's overreaction to seemingly obvious events. This morning's release of unemployment numbers came in worse than expected (6.5% unemployment actual v. 6.3% expected) and the market is up. I am glad the market is bucking the Captain Renault trend.

Election Postmortem
The following are a few thoughts on the election:

• No one can say this was not an interesting election.
• The election cycle is too long. It feels like Hillary Clinton started her presidential campaign right after Bush was elected. My guess is that Sarah Palin will start her 2012 presidential bid faster than Clinton did. This is good for talk radio and cable news but bad for the country.
• The Democratic Congress needs to cool its jets. In my opinion, last night's results did not reflect a huge, national shift left. We are a conservative nation that needed to purge and move beyond the last sixteen years. Yes, I think last night was as much a referendum on divisive government and partisan politics as it was on Obama. Rancor was as much a part of Bill Clinton's presidency as it was George W. Bush's, and Americans are tired of it. From Obama's acceptance speech, it think he understands he needs to govern from the center. And from McCain's concession speech, I felt he too knew it was time, and voter's wanted, to break from politics as usual.
• Unfortunately, I think Congress may be more divisive as Democratic gains came at the expense of moderate Republicans. Obama will need to bridge this gap.
• I would not want to be Joe Lieberman.
• It's the economy, stupid. It's always the economy.
• Can Sarah Palin please start speaking in complete sentences. And can she stop using "also" repeatedly to connect unrelated fragments.
• I think Obama will slow his rhetoric on raising taxes. The economy is too weak to withstand any tax increase. He could not do this before the election for political reasons, but I would not be surprised to see the postponement of any tax increase in the near future.

Master Lease Mess
Master leases were common structures for tenant in common programs. The structure was the only way certain property types - hotels, retirement homes - worked in a securitized TIC transaction. (I am not going to go into the whys here.) Master leases, like any lease provided investors a stated stream of income over a set period of time. Many of these leases are now in trouble. DBSI, the Idaho-based TIC sponsor that did most of its TIC deals in the master lease structure, is likely going to cancel the leases at it cannot support the lease payments. I heard yesterday that another large TIC sponsor is going to follow suit. One of the problems with master leases was that they were only as good as the credit of the master lessee. The master lessees are going to prove lousy credits.

Investors, in their anger over defaulting master lease payments, need to be careful. Rash decision can have big impacts - i.e. canceling property management agreements that leave no property management, or lead to technical mortgage defaults - that may be worse, much worse, than canceling the master lease and converting to a traditional property management structure.

More Inland Western Retail REIT
I just had to check. The REIT had a debt ratio of 63% at December 31, 2007 based on property cost less reserves. Unless some debt was paid down this year this ratio is going to be higher with sofening commercial property values. This debt ratio is higher than many of the other non-traded REITs. From year-end December 2007 it had Funds From Operations (FFO) of $.64 and paid a dividend of $.63. I did not check to see what FFO and distributions have been in 2008. Investors' request for redemptions and Inland's response makes sense.

Inland went full-cycle on its two public non-traded REITs that preceded Inland Western. The first, Inland Real Estate Corporation (IRC), was listed on the NYSE and the other was sold to Developers Diversified Realty (DDR). Both transactions allowed investors in the two REITs to sell their shares at prices higher than the orginal offer price. It is my opinon that an IPO for Inland Western looks remote at best given its debt ratio and the status of the market. Things may change in the future, but today, investors in Inland Western should have a long time horizon.

More Inland Western Retail REIT
I just checked Inland Western's property list and see that it owns twenty-five Mervyn's in California and Texas (two properties). Mervyn's is closing all its stores after Christmas. Inland Western bought the twenty-five properties in what looks like was a portfolio acquisition in September 2005. This acquisition occured after Mervyn's was sold by Target to two private equity firms. Somehow I don't think that Inland Western got a discount on its acquisition.

Inland Western lists 335 current properties, so the 25 Mervyn's account for less than 10% of the portfolio (there is no data on what percent of revenue they comprise). I know several of the Mervyn's locations in Southern California, and while in solid shopping centers, they are older, in need of some renovation and no longer the best location in the immediate retail area. Ten of the Mervyn's locations are in California's Central Valley that has been hard hit by the housing slump.

Inland Western REIT
It filed an 8-K today stating that its quota for redemption requests for 2008 has been met and no further redemption requests will be honored in 2008. The 8-K went on to state that Inland Western REIT is suspending its redemption program indefinitely. What did this real estate investment trust buy, the Hotel California ("you can check in anytime you like, but you can never leave")? Seriously, the decision to indefinitely suspend redemptions will have an impact on Inland American REIT's capital raising efforts.

When Will They Ever Learn?
A hedge fund, Pershing Square, is interested in buying Target. Here is a quote from the Bloomberg article:

Pershing, which controls almost 10 percent of Target's stock, will discuss a deal that ``will be of particular interest to investors and analysts focused on retail, real estate, fixed income and credit,'' according to a statement today.

Ackman (runs Pershing Square) has pressed Target executives to buy back shares, sell the company's credit-card unit and extract more value from its real estate holdings. Target announced a $10 billion share repurchase program in November and sold almost half of its credit-card portfolio to JPMorgan Chase & Co. for $3.6 billion earlier this year.

Part of me is glad that some form of business is happening in this market. But I look at private equity and hedge fund retail forays and it has not been pretty. Mervyn's and Linen & Things are going dark, and I suspect other once-public retailers will follow suit. I just don't see the benefit of financial engineering the retailers. Retail success comes down to good management and good locations that can drive strong sales, not balance sheet reconfiguring. Target competes well with Wal-Mart. I'd be scared if I was a landlord and had Target as a tenant.

Department of Energy?
The Department of Energy may make a $5 billion loan to GM so that it can buy Chrysler. The world is really upside down.

New Solar System
This has nothing to do with finance or alternative investments, but I find it cool that another solar system may exist. It's from a star, Epsilon Eridani, that is not even that far - about 10.5 light years or 63 trillion miles - from our solar system.

Captain Renault Market
"I am shocked, shocked to find gambling going on here" is a famous line from Casablanca when Claude Raines' character, Captain Renault, shuts down Humphrey Bogart's Rick's American Cafe. Of course it was obvious that gambling was going on, Rick's was part casino. This line reminds me of the market since the Credit Crisis ebbed. The market somehow is surprised by events that are so obvious. It is obsessing that a global recession is either coming or already here. The bigger shock would be no recession. The credit markets essentially stopped in late August. For several weeks there was the real fear that the entire global financial system would collapse. Even the best corporate credits had difficulty accessing the credit markets. And consumers hit by the barage of bad news and declining stock portfolios are scared and scaling back purchases. How can this not translate to a slowing broarder economy. This is common sense.

Today the fear was hedge funds imploding. Hello! It's a miracle more have not blown up yet. Most hedge funds use leverage (how else to maximize manager fees) and we all know what happens to debt ratios and margin calls when equity evaporates. This should not come as market shaking news. Hedge funds are going to collapse, it's only a matter of time. This news needs to be priced into the market.

Update: The unemployment rate is going to shoot up. I read that Rhode Island is already at 8.8% unemployment. The market will be shocked by the pending bad news, but it should not surprise anyone.

Update Update: I saw this morning that the Wall Street Journal also used a Captain Renault reference last week. The Real Time Economic blog used it to describe Alan Greenspan's testimony before Congress and his comments about trading in the mortgage market. False indignation does not seem in short supply.

Mervyn's To Close After Christmas
Mervyn's will close all its stores after Christmas. Mervyn's was sold by Target to a private equity firm in 2004. Mervyn's filed for bankruptcy protection last summer. This, obviously, is a negative sign for west coast retail real estate.

Thoughts on Timberland
Wells Timberland REIT has struggled under the weight of its massive debt. Until the debt gets repaid it will not be able to acquire any more timber properties. Investors in Timberland have an investment that for the foreseeable future is a highly leveraged and non-diversified. I am stating the obvious in saying that in a deleveraging economy is not an ideal position.

Much of my focus has been on Timberland's mezzanine debt and not Timberland as an investment. Does Timberland make sense as an investment? I am not sure it does. Even if the mezzanine loan is paid on schedule, Timberland will still have a sizable debt load and only one property. Timberland has a $212 million senior loan that is due 2010 and $42 million of preferred stock. I don't see Timberland acquiring additional timber properties until this debt is repaid or refinanced. I don't see any distributions to investors until Timberland's debt load is reduced. More properties that will diversify the portfolio and cash returns to investors are not in Timberland's near-term future.

The risk / reward ratio of Timberland is heavy on risk and light on reward. It has one property, and as noted above, it will likely be a long time before another property is acquired. The lone property was so expensive it will remain the 800-pound gorilla even if additional properties are acquired. An investor would have to look long and hard to determine whether this investment is appropriate and fits in their portfolio.

Dodging Another Bullet
Wells Timberland REIT filed its 8-K late today and it has received an extension on its mezzanine financing that had a large payment due today. The loan has been extended from March 2, 2009 to September 30, 2009. The principal reduction payments have also been modified. The next payment is due December 30, 2008, and the principal needs to be reduced to $67 million, then on March 30, 2009 it needs to be $45 million and on June 30, 2009 it needs to be $25 million and any remaining principal is due September 30, 2009. The interest rate did not change and stays at 11%, up from the original 9%. The balance on the mezzanine loan at October 15, 2008 was $81,857,312. Wells Real Estate Funds, as part of the negotiations, agreed to pledge its preferred stock in Timberland as collateral and agreed to pay a fee of $127,500 and give Wachovia 600 (1,000 per share that accrue 8.5% interest) preferred shares in Timberland.

Timberland dodged a bullet again. I see no sign of any German capital, and due to the Credit Crisis I'd be surprised to see any sizable German equity. Timberland is raising $8 million to $10 million per month. At this rate, it looks like Timberland will be able to meet its obligations under the new terms without any additional, outside capital.

Wachovia extracted more than its share of pain for this extension. The 11% interest is high and the preferred stock Wells had to give, basically came out of Leo's pocket. I will post more on my thoughts on Timberland later.

Fannie Freddie Update
The Wall Street Journal has a story this morning on Fannie and Freddie. The article states they are not innocent in the mortgage mess, but not the lone culprit either. This quote sums up my opinion:

Fannie and Freddie do share some of the blame for the mortgage and housing bust. They recorded a combined $14 billion of losses in the 12 months ended June 30, largely because they lowered their credit standards and purchased or guaranteed dubious home loans.

But "they weren't the leaders in lowering credit standards," said Andrew Davidson, a mortgage industry consultant in New York who has done work for Fannie and Freddie and also criticized them for taking excessive risks. He noted that the worst-performing mortgages are those that were originated by subprime lenders and packaged into securities sold by Wall Street, rather than by Fannie and Freddie. And while loans for low-income people -- programs championed by Democrats as well as many Republicans -- have contributed to Fannie and Freddie's losses, they aren't the biggest part of the problem.

It's important to note that some of the pressure for Freddie and Fannie to lower its lending standards came from banks that were underwriting the loans Fannie and Freddie acquired. The article notes that the mortgage giants' political clout grew as its assets grew. For many years the two companies were too big to fail and this market proved that.

VIX(en)
The VIX volatility index was over 81 this morning. There is no wonder why I have had a pit in my stomach for six weeks. The VIX typically trades around 20 or below. When it gets to near 30 stocks are getting wild and at the bottom of the market's drop in 2002 I think the VIX peaked in the low 40s. Trading at levels over 80 is almost too hard to fathom. Here is a one-year VIX chart:

8-K Watch
I am checking for an 8-K filing from Wells Timberland REIT. Its next mezzanine loan payment is due on Thursday and I suspect an 8-K filing will provide information on the loan's status.

IMH Secured Loan Fund
I have posted before on IMH Secured Loan Fund. This is an Arizona-based mortgage loan company that made early-stage development loans to primarily home builders. It has most of its mortgage investments in California, Nevada and Arizona, but has also made loans in other parts of the country. It announced that is suspending withdrawals and new capital. It's 8-K stated the following:

Management Policies

•

Maintain capital to honor all Fund commitments and obligations.

•

Manage and protect the existing portfolio effectively.

•

Remain steadfast against “fire-sale” liquidation of Fund assets.

•

Continue to make meaningful pro-rata cash distributions on a monthly basis to Fund members.

Management Actions

•

The Fund will suspend accepting any additional member capital.

•

The Fund will suspend re-investing monthly distributions.

•

The Fund will pay all future monthly distributions in cash.

•

The Fund will cancel all pending redemption requests in order to safely maintain capital for managing, protecting and preserving Fund assets.

•

The Fund will not accept any new redemption requests.

•

The Fund will continue to work toward meaningful distributions to its members.

The 8-K said that since the credit crisis started it has experienced unprecedented withdrawal requests. This is not surprising. What is surprising is how much money IMH has raised over the past year ($127 million of new investor contributions through the first six months of 2008) despite problems in the credit market and the housing market. The third quarter 10-Q should provide more insight.

Rally Thoughts
Yesterday's market rally was a welcome relief. I'd like a few steady days. I just saw this article from the Financial Times that brings up some good points and historical perspective. Here are a few paragraphs that stood out:

As for the trend, when the Lehman Brothers collapse started this phase of the crisis, the S&P 500 stood at exactly its average for the previous 50 days. Even after Monday’s bounce, it would need to rise 20.5 per cent more to get back to that average.

Further, we need to look at what prompted the bounce. The latest actions to bolster the international banking system are extreme. Other actions that looked extreme at the time had no impact. It would have been alarming if they had not had a response now.

How could the bounce turn into a rally? First, stocks need evidence of a thaw in money markets. Once there is no need to price in some chance of an all-out banking collapse, equities should be able to rise.

Second, the market needs to gauge the impact of this financial distress on profits. Earnings season for the third quarter is just starting; it is far more important than usual.

The last two paragraphs are what to watch for in the very short term. I would add that fourth quarter earnings, which will show the impact of the banking bailout, will also be important.

TICA Update - DBSI and Thompson National Properties
I was at TICA's annual conference for one day last week. I found out news about two prominent TIC sponsors. DBSI is in trouble and Argus threw in the towel. DBSI, the Idaho-based sponsor, was a no-show at TICA. I saw one of its principals, John Mayeron(?), talking with people, but its booth was empty and it canceled its presentations. DBSI fired all its sales force late in September. It is reviewing all its programs - TICs, Notes and funds - and may reduce distributions. DBSI had opaque financial statements and its TIC deals were master leased, with DBSI responsible for payments if the underlying properties were unable to support the distributions. This implosion will get blamed on the Credit Crisis, but it has been in the works for several years. DBSI's master lease structure, which was supposed to protect investors by having DBSI ensure lease payments (distributions to investors), is going to prove worthless, as DBSI will break its lease obligation. This is not surprising, and unfortunately, DBSI will not be the first.

I also heard, and this was later confirmed, that Thompson National Properties, is entering into a joint venture with Argus Realty Investors. I am not sure why it's being called a joint venture. (Maybe because Argus, as a TIC sponsor who gets all its payments up front, is worthless and therefore could not be an acquisition because there was nothing of value to acquire.) Thompson is taking over management of all Argus properties and the two principals of Argus, Dick Gee and Tim Snodgrass, are joining Thompson. Call it what you will, but there is nothing joint about this takeover. The betting now starts on how long Snodgrass and Gee stay with Thompson.

Toxic Debt Purchase Morphs into Bank Nationalization
The Credit Crisis keeps getting wilder. Here is a must-read from tomorrow's New York Times. I won't re-hash it, but the idea of buying mortgage securities is now secondary to the Government investing directly in banks. This is so radical I don't even have an opinion, other than if it stops a depression it is probably a good idea. I do think it's a Hotel California-type investment - easy to get in but hard to get out - that may be good for the immediate-term but the long-term implication is open for debate.

Here are a couple of parts of the article that stood out to me:

Two weeks after persuading Congress to let it spend $700 billion to buy distressed securities tied to mortgages, the Bush administration has put that idea aside in favor of a new approach that would have the government inject capital directly into the nation’s banks — in effect, partially nationalizing the industry.

As recently as Sept. 23, senior officials had publicly derided proposals by Democrats to have the government take ownership stakes in banks.

The Treasury Department’s surprising turnaround on the issue of buying stock in banks, which has now become its primary focus, has raised questions about whether the administration squandered valuable time in trying to sell Congress on a plan that officials had failed to think through in advance.

I think that the Credit Crisis is moving so fast, that the nuclear option of nationalizing banks was far down Paulson's list of options.

Here is a funny blurb that is full of irony:

Treasury officials began canvassing banks and investment firms about the possibility of having the government buy stakes in them. The new bailout law gave the Treasury the authority to buy up almost any kind of asset it wanted, including stock or preferred shares in banks.

Industry executives quickly told Mr. Paulson that they liked the idea, though they warned that the Treasury should not try to squeeze out existing shareholders. They also begged Mr. Paulson not to impose tough restrictions on executive pay and golden-parachute deals for executives who are fired.

Mr. Paulson heeded those pleas. In his remarks on Friday, he carefully noted that the government would acquire only “nonvoting” shares in companies. And officials said the law lets the Treasury write most of its own restrictions on executive pay, and those restrictions can be lenient if they are applied to a set of fairly healthy companies.

At this point, beggars can't be choosers. First, many executives will probably get fired, like at Freddie Mac, Fannie Mae and AIG, and get a nominal severance package. Second, executives that don't get fired should be happy to get any compensation. They only need to look what happened to executives at Bear, Lehman and AIG who lost most everything. Heck, if the plan works and confidence is is restored, banks will be able to retire the preferred stock or other Government investment and then pay themselves a huge bonus for management expertise during the Credit Crisis.

A Return to the 1930s?
I was at the Tenant In Common Association's annual conference in Las Vegas on Monday. I will post more about it over the next few days, but one episode has stayed with me. One of the keynote speakers was an economist named Todd Buchholz, a smart guy and an entertaining speaker (despite his persistent book pimping). The question and answer session was more illuminating than the speech. The first questioner, an obvious oil and gas sponsor, ripped into Buchholz for not knowing the exact figures for oil and gas demand v. production, and vehemently objected to Buchholz's assertion that the price per barrel of oil was going to drop to $60. The second questioner - more like commentator - wanted confirmation for his opinion that an Obama presidency and Democratic Congress would usher in the return of powerful labor unions, and the disastrous impact this would have on the economy. Buchholz did not feel his concerns were warranted. The final questioner/commentator wanted to know why the United States isn't breaking all trade agreements.

Talk of another depression, nationalistic tendencies and fear of all-powerful labor unions bring to mind the 1930s. This Credit Crisis has turned the world upside down. I am waiting for calls to bring back the gold standard. I think I just saw in what direction the far Right's talking points are headed. I am scared to think of the far Left's talking points.

More Fannie
I was sent this fascinating New York Times article from 1999 in reference to my previous post. It describes Fannie Mae's pilot plan to relax underwriting standards to allow more subprime mortgages. Here are some interesting quotes:

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.

It is amazing the pressure Fannie was under to expand its loan programs. Here is an initial description of the loans Fannie was going to underwrite:

Under Fannie Mae's pilot program, consumers who qualify can secure a mortgage with an interest rate one percentage point above that of a conventional, 30-year fixed rate mortgage of less than $240,000 -- a rate that currently averages about 7.76 per cent. If the borrower makes his or her monthly payments on time for two years, the one percentage point premium is dropped.

I don't think these are loans that are exploding now. The article's author either makes the understatement of the past ten years or shows incredible prescience:

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

From reading this article and seeing what happened in the housing market, the governement wanted to expand home ownership and banks and mortgage companies wanted more potential home owners. Many firms, in addition to Fannie and Freddie, stepped into this market. The loans got more creative and the lending standards got more lax. Non-subprime as well as subprime borrowers took full advantage of the easy credit boom. Fannie's no innocent, but they are not the lone scapegoat either.

Freddie, Fannie and the Credit Crisis
I am hearing pundits blame Freddie Mac and Fannie Mae for the Credit Crisis gripping the world. Not only is this disingenuous but it is wrong. Freddie and Fannie have helped millions of Americans buy homes. For years, Freddie and Fannie bought most of the mortgages originated by banks, and then packaged and sold them to pensions and mutual funds. Their securities are considered some of the safest investments available, and it would be hard to find a government bond mutual fund that did not hold Fannie and Freddie bonds. Freddie and Fannie, using their low cost of capital, borrowed huge sums that allowed them to buy mortgages. They made money on the spread between their low borrowing cost and the interest they earned on the mortgages they acquired. This process allowed banks to make more mortgages than if they were to hold their mortgages. The mortgages Fannie and Freddie would acquire had to meet strict guidelines and this made banks make loans to to creditworthy borrowers who put down equity to acquire their homes. Through this process, Fannie and Freddie not only allowed banks to make more home loans, their low cost of capital kept interest rates low for consumers.

Banks have always had programs for subprime borrowers. These loans had higher interest rates and banks kept loan loss reserves for these loans. The implication I am hearing is somehow these niche programs, and poor, uncreditworthy borrowers, have sunk the financial world with Fannie and Freddie as the facilitator. No way. In many cases, until late 2006, Fannie and Freddie could not even buy subprime mortgages due to their strict underwriting standards. Fannie and Freddie securities primarily held traditional thirty-year mortgages and other, similar mortgages made to good credit borrowers that had made down payments of 20% or more. These are not the mortgages causing today's problems.

The idea that poor people suddenly decided to buy a home, paid too much and then stopped paying their mortgage is false. Yes, this did occur, but traditional banks have dealt with this type of borrower for years and knew the risks they posed. The problem is, and will continue to be, the non-subprime buyers that used subprime financing to support their lifestyle, and then could not afford the mortgage payments when the terms of their mortgage reset. Borrowers across the credit spectrum used subprime mortgages because of their low "teaser" rates. Home buyers looked for low monthly payments - the lower the better - and subprime mortgages had the lowest monthly payments (and most brutal reset terms). The home buying process became akin to buying a car. Mortgage brokers started with the amount a buyer could pay per month and then worked backwards to find a mortgage that fit the needed payment schedule.

No one worried about subprime mortgages' nasty resets when the "teaser" periods ended, the loans were going to be refinanced anyway. Mortgage brokers had solved the historic boom / bust cycle of the mortgage business. All they had to do was sell home buyers mortgages that had to be refinanced every few years and a steady stream of customers kept coming back and paying the refinance fees over and over. Borrowers had low payments and lived large, and mortgage brokers had high fees that recurred every couple of years - everyone was a winner.

The banks and finance companies, using the same process as Freddie and Fannie, stepped in to meet borrower demand. They would borrow money, allow banks and mortgage companies to create arcane mortgage products and then package and sell these mortgages to other firms. Banks jumped at the new sources of capital and business opportunities. Firms like Washington Mutual, Countrywide and New Century Financial, unleashed from the shackles of Freddie's and Fannie's old fashioned underwriting, boomed with their new banking friends.

The securities backed by the new mortgages got ever more inventive and complicated. The securities were so new and had so many different terms, the models used to price them could not incorporate all the various market scenarios (and no packaged loan security could ever have been sold with a 20% plus default assumption). None of these mortgage-backed products were Fannie or Freddie bonds. They were created and issued by Bear Stearns, Lehman Brothers and a host of other Wall Street firms. These are the mortgages that cannot now be priced.

Here is a quote from Warren Buffett from a recent article from the New York Times:

He called the current crisis an economic Pearl Harbor, requiring immediate action. Its biggest single cause, he explained, was the real estate bubble. “Three hundred million Americans, their lending institutions, their government, their media, all believed that house prices were going to go up consistently,” he said. “Lending was done based on it, and everybody did a lot of foolish things.”

As far back as 2003, Mr. Buffett had warned that the complex securities at the center of today’s troubles — once so profitable, but now toxic — were “financial weapons of mass destruction.” These securities were engineered by the math quants on Wall Street, and in the interview Mr. Buffett expressed his disdain: “Beware of geeks bearing formulas.”

I know several non-subprime borrowers who used subprime mortgages due to their low rates. The whole real estate bubble was caused by people thinking they had to get real estate because prices were always going to rise, or felt that the equity in their house was a source of idle cash. Mortgage companies met consumer demand, and subprime mortgages with their variable payment options were their prime tool. These mortgages allowed people to live way beyond their means. When people saw friends, co-workers and neighbors buying new cars, motor homes, home theaters, and taking first class vacations due to these new-fangled mortgages, the race was on. In many cases subprime mortgages, with those attractive teaser rates, were the easy answer. Homes became quasi-banks providing a seemingly endless source of lifestyle cash.

These mortgage securities, not Fannie and Freddie bonds, are the securities that cannot be valued and lead to the Credit Crisis and the $700 billion bailout. Freddie and Fannie bonds are some of the most liquid, and highest quality bonds in the world. The exotic mortgage bonds that were created by investment banks using complex mortgages and complex pricing models and formulas are what cannot be valued. The pricing models are worthless in today's turbulent financial markets. No one wants to be the first to buy these securities because of the fear of paying too much. This is why the Government is going to make a market in these securities. None of the securities the Government will buy are Fannie or Freddie bonds.

Fannie and Freddie are huge government bureaucracies and are not above reproach. They have historically been the domain of Democrats and championed by left, and have been full of corruption over the years. But they have played an invaluable role in expanding home ownership in the United States. However lax Congressional oversight has been, Fannie and Freddie are not responsible by themselves for the Credit Crisis.