What's the Rational Thing to Do in a Bank Run?

Something significant happened last week in Europe that I’m guessing most of my readers overlooked. Ever since the debt crisis hit Europe three years ago, Europe has fallen into very predictable cycle. The cycle goes like this:

• Phase 1 – A financial crisis emerges.

• Phase 2 – After dire public warnings that the world as we know it will come to an end if something isn’t done immediately a meeting of European leaders is held.

• Phase 3 – The meeting is met with hope and trepidation, followed by great relief that an agreement has been reached.

• Phase 4 – Within a few days of the meeting, possibly as long as month, the apparent solution is exposed for what it is: “a band aid for a gaping wound” and the solution unravels.

Last week this cycle was broken. O yes it began exactly the same way. A crisis loomed: What was to be done with Greece? And Phase 2 kicked in, European leaders met. But this is where the cycle stopped. No alternative was found to solve the crisis. And maybe this is a good thing. Maybe, finally, European leaders are realizing that there is no solution to Greece. It’s kind of like an alcoholic who finally admits to himself he has a drinking problem. Until that happens he has no chance whatsoever of living a life of sobriety.

And now that the European leaders admit that there is no solution to the Greek’s financial problems they can now move onto the next phase which is, “How do we allow Greece to leave the eurozone that will minimize the damage?” It is no longer a question of if the Greeks will leave the eurozone it is only a matter of how to do it so that it minimizes the negative consequences from such an event.

And negative consequences there will be. Even now there is a run on the Greek banks. It reminds me of what happened to Washington Mutual a couple of years ago. One moment it was a healthy going concern and within a couple of weeks depositors had electronically pulled out all their deposits from the bank. What is the rational thing to do in a bank run? The rational thing to do is to participate. And that is what’s happening right now with the Greek banks and there is nothing anyone can do about it. The Greek people aren’t stupid. They’re transferring their money into other currencies that have less risk. It’s way too late for the Greek banks to recover.

The really important question is, “Are U.S. financial institutions prepared for what is happening in Greece?” The answer is “It depends on which banks you’re talking about.”

The vast majority of the American banks have no exposure whatsoever to the Greek financial crisis with the exception of our very largest banks – Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley, Goldman Sachs and Wells Fargo. These six banks have definite exposure to what’s happening in Greece. All reports say that their exposure to Greek insolvency is manageable. If you want to believe what the banks are telling you then we have nothing to be concerned about. Call me a cynic, call me a “glass half-empty” type of guy if you like, but I don’t believe it.

Months ago I reported that American financial institutions had only modest amounts of European sovereign debt but they had significantly more risk with credit default swap exposure. A CDS is just a fancy way of saying that they are insuring those who own sovereign debt that it will not default. For a nice fee they are exposed to enormous risk if they are wrong. I believe this is what happened to J.P. Morgan Chase a couple of weeks ago. They bet wrong and voila, they lost $3 billion. Until Congress outlaws these risky forms of investments all bets are off that these six banks will come out of this crisis unscathed.

Sources: Greece and Banks by David Knox, Cumberland Advisors, May 23, 2012; The Rational Thing To Do In A Bank Run, GK Research, May 17, 2012; A Cycle of European Crisis Management, STRATFOR, May 25, 2012.

What the heck happened at JP Morgan Chase?

As you know by now JP Morgan Chase lost $2 billion last week by taking big bets on European bonds. Interesting to note (and telling) I found no article that explained what caused the loss. I scanned the internet and there are plenty of articles talking about whose heads would fly, articles supporting more regulation of the banks, articles about the political ramifications of the presidential race but no article that tried to explain what actually happened.  

Why not? I believe it’s because it’s too complicated for the lay person to understand. The investment that caused the loss is called a “synthetic credit portfolio.” Wow! What does that mean? I would guess that the average investment banker doesn’t fully understand the complexity of the investment vehicle either!  

Should we be concerned about this loss? Absolutely! As long as the American taxpayer has to bail out the banks when things go wrong we have every reason to be concerned. This $2 billion loss last week, although significant, is manageable. In comparison, last year JP Morgan Chase made a profit of $18 billion so a $2 billion loss is not the issue.  

The importance of last week’s loss shows us that we are just as vulnerable to a catastrophic event as we were four years ago when Lehman Brothers started the ball rolling. That’s the lesson we learned from this latest blunder by JP Morgan Chase. No legislation has been enacted, no common sense has been gained, that will prevent us from doing it all over again. How ominous is that.  

So if I were suddenly in charge how would I fix the problem? I would do the following:

1. As I stated in January in this blog I am in favor of the Dodd-Frank bill. Now I’m no expert on the bill but it has a number of common sense ideas that should be fully implemented. I know this is unpopular with many of my readers who believe in free markets but I believe that some regulation is necessary to save us from ourselves.

2. The deeper more penetrating question is, “Should banks in general be doing these types of trades?” I strongly believe the answer is a resounding “no” and agree with the Volker Rule (a section in the Dodd-Frank bill) which bans speculative trading on a bank’s own accounts.

3. I believe there needs to be a change in how investment bankers are compensated. Greed drives risky behavior. If they are on the right side of the bet they’re handsomely compensated. But what happens if they make poor choices? Do they give back some of their previous commissions and bonuses? Hardly! Instead reward employees for making sound investment decisions over time (perhaps over 2 or 3 years) and not on any one particular transaction.

4. The ultimate goal should be that banks should be allowed to fail if and when they make egregious errors in judgment. The federal government should not be in the business of bailing out the banks when things go wrong (though I do believe it was the right thing to do in 2008 to avoid a more catastrophic upheaval). This may mean that banks should be forced to downsize into several smaller financial institutions so that we can avoid the problem we had last time around when many of our bank were “too big to fail.”

Make me king for a day and I’ll solve all the world’s problems. But seriously, what occurred last week should be viewed as a wake-up call to everyone who is in charge of our financial institutions. How vulnerable are the American banks to the European debt crisis? What happens if a sovereign default does occur? Therein lies the great unknown.

 

1st Quarter 2012 Sales Activity - How Did We Do?

From a sales standpoint how well did we do in for the 1st quarter of 2012 compared to previous years? Shown below are the criteria we used to tabulate the results:

• Sales information is from the CoStar database as of March 31st. My guess is that it will take a few more weeks before CoStar has all the 1st quarter sales activity recorded but this is what they’ve recorded so far.
• Transactions closed between January 1st and March 31st, 2012
• Investment properties only (no owner user)
• Property types - flex, industrial, mixed use, multifamily, office & retail
• Transactions with sales prices of $1 million or larger
• Arms length transactions (no partial conveyance of ownership)
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on these criteria the chart below compares the sales activity for the first quarter of 2012 with each of the preceding five years:

As you can see 1st quarter sales activity was less than last year but more than in 2010.  It gives me the impression that that we've bottomed out but we are bouncing along the bottom, ie, it's not getting worse and it's not getting better.  For the past four years, the first quarter sales activity has been roughly the same.   

We then analyzed the 47 closed transactions by property type:

Not surprisingly, multi-family leads the way with the most sales transactions in the first quarter.  What is a bit surprising is the number of office transactions.  This is significantly up from the past few years.  Is this a trend or an anomaly?  We'll have to wait and see how the rest of the year develops. 

Of the 47 transactions, 16 had broker representation on both sides of the transaction.  Eleven had no broker representation.  The remaining 20 transactions had only one side of the transaction represented.

If you add it all up, there were a total of 52 paydays (2 x 16 + 20).  So if you want to know your personal market share of all the broker paydays divide your number of paydays by 52. 

Shown below are the lending sources for these transactions:

The banks continue to provide the bulk of the acquisition financing for Oregon and SW Washington.  There is almost a complete absence by the life companies, Freddie & Fannie, and the credit unions.  A big surprise is the lack of seller financing.  Over the past several years seller financing was the predominant way most non-apartment transactions were financed. 

Shown below are the top 6 real estate brokerage firms based on total broker representation of closed transactions for the 1st quarter of 2012: 

The real estate brokerage community is not dominated by any one firm.  In fact, Joseph Bernard Investment Real Estate, who is ranked #1 on the list with 5 broker representations, represents less than 10% of the total market.  The top 6 firms present only 42% of the total market.

So how do I summarize the first quarter?  It's been surprisingly quiet.  I was expecting more activity than last year, and so far that has not materialized.  That's not to say it won't but it needs to pick it up a few notches if the market is going to show a sustained improvement over the previous couple of years.  Here's hoping that the coming quarter shows improved strength over the one we've just finished! 

There's an App for That! With Rising Gas Prices get GasBuddy

As a result of ongoing geopolitical tensions with Iran, as well as a refinery fire in the State of Washington temporarily reducing supply, it is not surprising that the price of crude oil continues to trend higher.  Since the end of September the price of a barrel of oil has increased by over $30.  And when oil costs more, so will the price of gasoline at the pump.  Shown below is the inflation adjusted price of gas since 1980. 

As you can see, gasoline prices with a couple of exceptions have never been higher than current levels.  Average gas prices are currently $3.59 per gallon and they are expected to top $4.00 per gallon soon.  

So how do rising gas prices affect us?  Not surprisingly, rising gas prices have a cascading affect of negative consequences. 

1. A 10 cent rise at the pump removes a whopping $11 billion annually from consumers wallets leaving less available for other goods and services.  And as you know, current gas prices have increased significantly more than 10 cents a gallon over the past few weeks. 
2. There is a direct inverse correlation between rising gas prices and consumer confidence.  Historically when gas prices have risen significantly in a short time period consumers become significantly more pessimistic.  When they're asked, "Is the economy headed in the right direction?" a majority of them will say "no."
3. When the public becomes pessimistic they get into a "hunker-down" mentality and spend even less than is actually warranted. 
4. Those businesses that are inordinately susceptible to rising gas prices will be affected the most: trucking companies, public transportation, the auto industry, the airlines will all be adversely impacted. 
5. Of course it's a political liability for both state and national politicians of both parties when prices rise at the pump.  But during a presidential year it makes for lots of political hay.  It's no surprise that Republican presidential candidates are blaming the Obama administration about rising fuel costs.  The reality is that presidents can only marginally affect oil prices with their energy policy and usually that takes years before the impact of their decisions are felt.

So the big question is, "How will rising gas prices affect the economy? Although it's hard to believe, the U.S. economy has had 11 consecutive quarters of positive growth.  But rising fuel prices may have a dampening affect on our fragile economy.   Personally, I believe our economy is resilient enough to weather the impact of rising fuel prices.  But a lot of it will have to do with our perception of reality.  If we can remain cautiously optimistic we will get through this.  

On a personal note I was introduced to a free application for my iPhone called GasBuddy.  It monitors all the local gas stations in your immediate area and shows you which gas station has the lowest gas price.  I saved 27 cents a gallon by going to the Fred Meyer gas station on Imbrie Drive instead of the gas station I normally get my gas from.  That's a savings of over $4.00 per fill up.  Not bad for a free app!

Sources: Gasoline (Inflation Adjusted), by Chart Of the Day, February 24, 2012; How Gas Prices Affect The Economy, by Financial Edge, May 24, 2011, Global Tensions put Gasoline Prices in Overdrive, Post-Gazette.com, February 24, 2012; How Gas Prices are Affecting Consumers; ABC News Blogs, by Zunaria Azki, February 24, 2012.

The Fox & The Scorpion

I recently read a short article by John Stossel of Fox News regarding the enormity of the federal deficit. We’ve all heard news stories about the U.S. debt crisis but for most of us, me included, it’s hard to grasp the magnitude of the problem. So here goes:

Imagine that there’s a family that earns an income of $21,700 a year. But this family spends $38,200 a year. The annual difference between income and expenses of $16,500 is added to their credit card debt. This family has been spending more than it brings in for many years and currently the outstanding balance on their credit card is $152,000. The interest expense on their credit card alone now costs them $4,540 annually or about 21 percent of their total annual income.

The family finally recognizes they have a serious financial problem that cannot go on indefinitely so they sit down together to determine what they can do to balance their budget. After much consideration and wrangling between family members they proudly propose cutting $385 from their spending and declare their efforts a success! It makes no difference to them that a cut of $385 is a pittance of what they need to cut in order to balance their budget. A year later, to their surprise, they actually tally the numbers to discover they spent $362 more than the previous year.

We are them! If you add eight zeros behind each of the numbers identified above that is the situation the U.S. government now faces:

The saddest part about this whole mess is no one who has the power to do anything about this seems to take this situation seriously. I believe the American public thinks that some how we’ll muddle through, that we can just borrow some more money from the Chinese if we need to or if absolutely necessary we can print more money to avoid any embarrassing economic catastrophe. Our day of reckoning can be postponed but it cannot be avoided.

Future generations will look back at us and wonder, “What were they thinking? Where was the leadership needed to avoid this economic crisis?” And before you think I’m going to only lambast the Democrats for profligate spending think again. They may talk a good game but when it comes to spending the Republicans are just as bad as the Democrats! A pox upon both their parties! Together they have spent money like drunken sailors! I know of no politician today who is willing to sacrifice his incumbency to do the right thing. Because believe me when I say this: any politician that is successful in turning this around will be voted out of office in the next election (think the recall of the Wisconsin governor). He or she will be vilified for doing the right thing because those who are feeding at the government trough will not go away quietly. They cannot be reasoned with. They will fight to the death to keep getting their government benefits (think Greek riots).

It reminds me of the story of the fox and the scorpion. The scorpion asks the fox if he can hitch a ride on his back in order to get across the river. The fox says to the scorpion, “But if I carry you on my back what will prevent you from stinging me.” The scorpion replied, “Why would I sting you, we’d both drown.” So the fox says to the scorpion jump on. Half way across the river the scorpion fatally stings the fox. The fox says, “Why did you sting me, we are both going to die.” The scorpion says, “Because it’s in my character to sting you.” And they both drown.

Those who are selfishly gorging themselves on government benefits, whether it’s the retiree who is receiving Social Security checks that are 4 times what he’s paid into the Social Security system or whether its corporate welfare in the form of tax breaks for the multinational corporations and everyone in between, don’t care what they are doing to this country as long as they get their’s. They are the scorpion who kills their free ride not realizing if everyone acts like they do that we’re all going to sink in our country’s enormous debt.

Is anyone listening to me? Does anyone care?

Sources: Dangerous Debt by John Stossel, January 5, 2012; Interest Expense on the Debt Outstanding, treasurydirect.gov