“God gave us the gift of life; it is up to us to give ourselves the gift of living well.” Voltaire
Hang on Voltaire… You mean to tell us if we want something that we must earn it ourselves or if it is meant to be it is up to me? What unusual propaganda…
Welcome back to Bygone Relics, I’m C Thomas Printer and last week we discussed how the US Treasury might not be as risk free as advertised. When risk is elevated the borrower should require a greater yield to lend you money and that is what is happening to the US. That is federal debt and the US is having to borrow money at a higher rate of interest. The Federal Reserve is raising the interest rate on the short end of the curve. They are doing this to combat inflation. Inflation represents risk to the borrower because over time the dollars that they get paid back with will be worth less. This has not been a problem in an era of low interest rates, but it is certainly something to address when rates are as high as they are now. Lost on the public this last week was the inflation report that came in better than expected. True, but it also came in higher than last month. We went from 3.0% to 3.2% That is the wrong direction to get Jerome Powell to lower interest rates. If the Fed can’t lower rates for awhile and truly stay higher for longer what does that look like? That is the focus of today.
If the Fed keeps interest rates at 5+% and they continue quantitative tightening, what does that look like? Well it is tough to tell, but I think you can see some of the consequences already happening. In the spring we saw banks fail as their bond holdings decreased in value and if the Fed hadn’t stepped in and guaranteed depositors there would have been more bank failures. Banks were left holding bonds that matured in 5-10 years versus depositors who were taking their money somewhere else for a higher interest rate and needed liquidity now. A bond having to be sold early means taking a loss. If you hold that bond until maturity you get the full value of the bond, but a depositor isn’t going to wait 10 years for you to give them their deposits back. Banks have had to go to the Fed to sell their bonds for the full value to meet liquidity needs now. This is quantitative easing despite many people disagreeing. It isn’t permanent because the Fed will have those bonds on their balance sheet and they will mature and the Fed will be made whole, but the liquidity addition provided by the Fed is an injection and a necessary firehose to put out the fire in the banks.
The bank’s customers are choosing to go somewhere else with their money. TINA, there is no alternative was a phrase used very often when cash earned very little to nothing when interest rates were low. Now investors are seeing short term treasury bills as an alternative to having their money sitting in a checking or savings account and drawing one tenth of one percent. Banks used that money sitting in those checking accounts for profit. They would pay out one tenth of one percent and then turn around and make loans and pocket the spread. That source of income is gone except for the biggest of banks now who are still paying next to nothing on checking and savings accounts. Banks will be forced to set aside more capital and make less loans. Less loans for businesses is a tightening of credit conditions and deflationary. Since they will make less loans they can charge more for the loans that they do want to make. That is more profitable for banks per loan, but bad for businesses that will have higher capital funding costs. This is a credit crunch. There is a good article on CNBC that I will attach that shows more fallout when this happens.
Customer behavior hasn’t just shifted with their banking deposits. They are taking some of their investable capital and looking at bonds as a long term investment vehicle. For the last 7 weeks equity flows have been coming out of the stock market and into bonds. I keep asking “Who is going to buy the bonds…and at what price?” The answer is the US and foreign investor right now. However, what has happened to interest rates? They are approaching last fall’s price levels. More supply means that a higher rate is required to sell those bonds. This is the dilemma that I want to point out. We have been in a low level of interest that people see a 4.25% 10 year bond as being a very good return on a bond, but historically it just isn’t. Quick thought experiment, what if bonds go to 5% of 6% or even higher? The investor will be locked in at 4.25% and unable to make market rates for 10 years just like the banks. People do not think that rates can stay high, but if we look at history, we see the exception has been the last 20 years not the other way around. Keep in mind that the Federal government is running a $1.5 trillion deficit which means that they will have to hit the market with even more bonds next year to finance all the programs on the books and the ever increasing debt expense of the debt itself. More bonds aka more supply means higher rates or yields will be required to sell those bonds. Don’t think for a minute that rates can’t go up or can’t stay up.
What effects will that have on business? The first effect will be when they try to refinance. Most treasury departments did a good job of locking their businesses into low rates when they were available and they are still operating under that rate structure, however they have been unable to refinance their debts at comparable levels. Access to credit is imperative. Mark Zandi, chief economist at Moody’s Analytics says “Credit is the mother’s milk of economic activity.” Companies need debt like we need oxygen. We won’t last long without it, and if you want to see panic just take it away. Let’s say a company gets a loan from a bank and it has a 5 year window. Let’s say the company was doing a good job at managing it risks and in February of 2020 it locked in a 5 year interest rate right before Covid and the crazy spending that changed the course of interest rates. That 5 year rate is their operating environment today. However, when they go to refinance in the next 18 months, they will be met with far higher interest expense charges. That means lower profits. If they weren’t earning profits that means that they might struggle with getting financing at all. Some banks and lending companies are leaving industries completely like Capital One exiting a lending business that car dealerships use to buy inventory. If companies can’t get new credit to pay their bills they will go into bankruptcy. Companies go out of business because they run out of cash. If I own a bar and I haven’t paid my liquor bill for 3 months, do you think my vendor is going to make the next liquor delivery? If I don’t have something to serve my customers what happens? Lights out the party’s over as Dandy Don would say. That part of the business cycle is ahead of us with this debt maturity wall coming in 2025.
Higher interest rates will also hurt the real estate markets. It seems strange to see froth in a market that crashed so bad just 15 years ago. Inflation hasn’t been around for 40 years so seeing people react strangely in that environment is one thing, but real estate should have more recent teachings for us to learn from. Homes were gobbled up by individuals that had read a book on how to make money in real estate or taken some weekend course. They had a little jingle in their pocket and so did most of America. They were buying homes as rentals, they were buying homes as Airbnbs, and they were using their current projections in those units as a guide to acquiring more and more of them. The bank was able to make loans so business was good. The consumer had been kept at home and had an itch to travel and they were out in waves and business was good. Remember, these aren’t owner occupied 30 year loans that were made but largely the 5 year commercial variety and now they too are coming up against a debt maturity wall and it is time to refinance. They will have much higher capital costs, and they have an occupancy problem. During the Super Bowl one manager who manages 95 rental units in Phoenix thought he could get $1200 a night with a five night minimum and then was surprised that his occupancy in his units was only 45%. Why is this? It always comes back to economics and supply vs demand. The amount of Airbnb and VRBO listings in the Phoenix area had quadrupled from 5,000 listings in 2017 to 21,000 listings in 2023 according to AirDNA. When people say that we have a housing shortage, we do not. We have a shortage of type. This housing supply is sitting in hotel stock, and now that the consumer is starting to travel less because they aren’t getting free government money and tax credits from the government. The consumer will have to start paying their student loans again next month, that will take away discretionary income. Airbnbs will have to cut rates to fill units and when one does it they will all be forced to do it. When companies can’t get credit they will have to file bankruptcy and lay off their workers and when they do those people won’t be traveling which means less occupancy and more price cuts until eventually the first Airbnb owners won’t have enough revenue to cover their debt expense and they will have to sell the property. This will put pressure on the real estate market as a tsunami of Airbnbs, which are now unprofitable, will hit the market and when people see their own rel estate values dropping they will feel poorer in their 30 year mortgage but they will travel less and that will cause more pain to the Airbnb market and more units will go on sale and it will get worse until we have a glut of homes on the market with no buyers. This will humble the mini real estate barons but in actuality is just the bubble popping in a real estate market the was enabled by easing credit. How can we be sure let’s look at the titans of real estate and see how this is playing out among real estate professionals.
Back in Feb 22, 2023 on our Looking Backwards Looking Forwards episode we mentioned that people like Barry Sternlicht were talking their book. I got after him a little bit and I will attach the link in the show notes, and it isn’t personal against him, but I recognize what he and Jeffrey Gundlach and Elon Musk are all doing and I called them out on it. Barry is a real estate billionaire and over 30 years has been a ruthless but very successful real estate investor. His timing and ability to take on risk by buying into distressed time periods is admirable. In February he said the Fed needed to lower interest rates, but I pointed out it was a plea. He said he was comfortable with 3-4% inflation rate. I said of course you were Barry, you own real estate, but the common person seeing prices continue to rise isn’t in their best interests as they don’t own assets like billionaire Barry. I shushed him. Meanwhile, he was gating his fund so people couldn’t get their money out of his fund. He has restrictions on how much people can takeout of his real estate investment fund and I pointed out that if he didn’t there would be a bank run like phenomenon with his company and his financial survival would be at risk. Well now he is giving the real estate back to the bank. We are seeing the Fed’s fight against inflation is actually hurting the rich and helping the small person. Prices are coming down at the pump year over year and at the egg store but not as fast as Jerome Powell would like. But billionaires like Barry are being exposed. Barry, the billionaire is smart unlike the Airbnb baron, and he is getting out early versus trying to hang on. There is a first mover advantage to selling first as the price is higher than it will be when everyone else sells. Now he is giving his real estate back to the bank. On July 18 bloomberg reported that his company Starwood is in default on an office tower in Atlanta. They are currently late on a package of 4 malls originally worth $725 million. According to Sasha Jones at the Messenger, Starwood has a commercial mortgage backed security loan remember those form 2008? They have a $800M loan entering special servicing. They sold of 46 hotel properties trying to make payments and buy themselves some time until Feb 2024. The loan is worth $570 million now. What does he need? He needs rates to go down so he can refinance. This would help the Airbnb barons as well. They need some relief. Barry has other problems. On Friday Cano Health a special purpose acquisition vehicle (SPAC) backed by Barry saw its shares fall 70% as the company warned it won’t be able to continue operations due to a lack of what? Cash. In the third quarter they have already cut 700 jobs, people that won’t be traveling and staying in Airbnbs. This phenomenon will repeat itself again and again and again in the coming months…
Sincerely Yours,
C Thomas Printer
On this date in history… 75 years ago and 46 years ago today to be exact… America lost two of its biggest icons of all time. Babe Ruth and Elvis Presley.
This week’s thought experiment was the entire subject today. How would higher rates affect you? You personal finances, your employer or your business. Things are changing rapidly and it is best to be prepared. Think now so you can act later.
Also born on the date T.E. Lawrence, the fascinating and daring British Indiana Jones who will forever be remembered in the movie about his life Lawrence of Arabia.
Barry Sternlicht gives back a building
Barry Sternlicht said not to worry
Barry Sternlicht Spac is failing
Sternicht’s empire has a debt problem
how-to-prepare-for-a-credit-crunch