While this is a fairly apt explanation regarding the hows and whys
of the sub-prime mortgage crisis, it was also written almost a year ago
and is therefore somewhat outdated. Consider this not so much commentary
and more of a guide to the roots of the housing crash and the recession in
general.
Real estate has provided the foundation of social wealth for centuries.
It has been asserted that approximately 7 in 10 millionaires made their
money in real estate. The dependable income streams and asset appreciation associated
with most types of real estate offer steady, predictable returns based
on a physical "brick and mortar" asset. These returns can be amplified
through easily accessible credit. In the simplest mortgage transaction,
the bank looks at the borrower's financial status, reviews the asset in question
for quality, and assesses the market conditions to determine the level
of risk in lending for the mortgage. The quality of this underwriting has a
direct correlation with the quality of the mortgage income stream and the stability
of the related cash flows. Mortgage lending, due to the general high
quality of traditional underwriting, has been viewed as a high quality stream
of income. Entities called Conduits and Brokers came into existence to extract
more value from the system by making mortgages more accessible on more borrower-friendly
terms. This shift away from direct bank lending resulted in a reduction
of underwriting quality. Large pools of mortgage debt were sold to consumers
and then resold in bulk to Wall Street in the process of securitization. These
mixed pools of mortgage income were then taken and mixed together into
increasingly complicated financial derivatives, certified as investment grade,
and offered for sale to banks, governments, and investors. This process was
seen as an effective means of spreading the default risk and overall risk across
the entire financial industry.
As these Conduits and other institutions began to chase borrowers
with increasingly competitive and attractive leverage terms, a liquidity
bubble was created in the real estate market. By selling off the risk of their
mortgage pools to Wall Street, the lending institutions no longer felt the "fear" associated
with poor underwriting standards as the risk was now owned by others.
The underwriting standards fell across the industry as competitive pressures
favored the borrowers. In order to continue building momentum by selling new
mortgages to fuel the booming mortgage-backed securities market, the industry
crafted creative mortgages designed to entice people into borrowing, people
who otherwise would not qualify. Some of the creative mortgage loans offered
to borrowers include:
- - where the principle is never repaid
- - where borrowers pay LESS than the
interest payment and the debt actually grows
- - where initial low rates reset in successive
years to much higher levels
Over the last several years, it became common practice to refinance existing assets and thereby extract stored equity. Real estate became the U.S. economy's liquidity engine as people tapped into the equity built up in their assets to fuel consumption of non-equity goods and services. This trend led to a speculative frenzy of both buying and building. The explosive growth in the supply of cheap and accessible debt drove new buyers into the market like never before. Asset prices soared as scores of people leveraged themselves dangerously based upon inflated asset prices which were being driven upwards by the boom. This process effectively drained the equity out of the system as assets began depreciating.
Speculation was rampant as many gambled that the boom would continue long enough for them to get out. Borrowers, intending to refinance their assets and secure the capital gains reaped as market prices skyrocketed, were caught unaware as liquidity dried up overnight. Once the market slipped into decline, many homeowners found themselves unable to service their debt commitments, and as a result, are now forced to liquidate assets to stay solvent. As the crisis unfolds, we are faced with a rapidly growing body of renters for whom ownership is no longer an option.
The mortgage-backed securities made widely available by Wall Street
contain many sub-prime loans in their mix. They were sold to banks, governments,
businesses and the like on a global scale. The supposed value of these
securities can be traced back to the very simple cash flow coming from sub-prime
mortgage payments. These securities contained investment grade mortgages alongside "junk" mortgages, making it impossible to tell how much of the content is "junk".
This makes valuing them challenging. The entities and governments who
funded the real estate boom in the U.S. by buying these securities are now left
holding paper whose value, and therefore liquidity has all but disappeared.
The damage created by this situation extends beyond the real estate industry.
Banks and other financial institutions are grappling with their exposure to
this crisis and many homeowners face the prospect of losing all of their equity,
while still being required to service large debt payments. Many will try to
refinance and stem the bleeding but a large portion of the population will be
forced to liquidate their holdings at rock bottom prices. Out of this turmoil,
a tremendous opportunity is materializing. Bad times for some represent an opportunity
for those with money to invest, and multifamily real estate is an excellent
place to profit from the current situation.
Everyone wants to get in on the ground floor. Don't you wish you had invested in the Microsoft IPO? One share of stock purchased for $21 in 1986 is worth $7,200 today. Or Berkshire Hathaway, Legendary investor Warren Buffet's compay? $89 invested in 1976 was worth over $112,000 at the end of 2008. I could go on and on.
We all have the gift of hindsight, but few of us have the power of foresight. In 1976, Buffet was not looking nearly as smart as he looks today. His investment in the textile company Berkshire Hathaway was a money loser from day one. His $10.6M investment in the Washington Post lost 90% of it's initial value in the bear market of the mid-70's. Everyone knew he was a smart guy, but really began questioning his touch.
He has what we call the Power of Foresight, which is the ability to look beyond past the 24 hour news cycle and focus on real value. The Power of Foresight allows us to see investment conditions, as they are, regardless of prevailing opinion. It allowed us to:
- Purchase apartments in Fox Creek, Alberta and Yorkton, Saskatchewan,
at a time when Real Estate agents were having trouble getting anyone interested
in these buildings. Subsequent returns of better than 800% in one case (over
a period of a year and a half) and the hundreds of percent in other cases
reinforced our investing philosophy
- Begin short selling oil in July 2008, beginning at $117/barrel and closing
out the trade at $38/barrel.
- Purchase property in Windsor, Ontario and Winnipeg, Manitoba at a
time that they were ridiculously out of favor (in one case a building in
Windsor for under $20,000 per unit).
You see, getting in on the ground floor is only good when it's combined with the Power of Insight. And we're offering you that opportunity right now. Because we think we're at a historic place in history - and it's probably not the one that you may think.
While most commentators are warning about the dangers of inflation, we are far more aware that the environment we are in is deflationary. While the governments around the world have poured money into the system, they have not been able to come close to keeping up with the amount purchasing power that was actually taken out. The thing that most people don't realize is that we are de-leveraging, and that always means removing credit, reducing the amount of money available for investing and discretionary purchasing. And with less available credit, most assets, especially financial ones, decline in value. We've already seen huge deflation in stocks and residential real estate. It becomes a perpetual cycle, feeding on itself, because as the assets decline in value financial institutions are reluctant to extend credit for their purchase or, more importantly, to re-finance them at the same value, forcing foreclosures, a new round of forced selling and even lower prices. With the stock market the effect is even more dramatic and self perpetuating, leading to historic volatility and losses.
But you can profit from a deflationary environment - in fact, this is the most fertile environment for developing wealth since, well, the Great Depression. It was during the Depression that the savviest of investors made huge fortunes, mostly because they recognized that they could purchase fantastic cash-flowing assets for a mere fraction of their true value. The secret was that instead of counting on making money in asset appreciation, they concentrated on maximizing the cash flow.
The economist John Maynard Keynes, who is credited with many of the economic policies that lead the U.S. out of the Great Depression, called gold a "barbarous relic". Gold "bugs" consider it a true store of value. Indeed, in times of inflation it seems to hold up much better than paper currency. But it doesn't really "create" any wealth. Aside from gold miners and jewelers, gold has no real practical application. A lump of gold yields no dividends or income of any kind. And in a deflationary environment, gold goes down in value because money goes up in value.
It'll come, eventually it must. But you'll need to be prepared, and in the current economic environment is perfect for that preparation, especially if you know where to look. Here's what we do know - inflation requires a vibrant economy, one that's kicking on all cylinders and approaching full employment, because it's demand for higher wages that fuels inflation. Courtesy of Gluskin, Sheff, here is a chart showing the latest PPI and CPI figures
You see those big spikes up during the 70's? Now that was inflation, but it also happened to be a time of incredible economic expansion - businesses were booming and real wealth was expanding, so of course prices were going up. But with North Americans increasing their level of savings and unemployment approaching 10% (and promising to get much worse before it gets better) this is not your Dad's garden variety recession, where we just bounce back after a year or two of belt tightening thanks to a hodge podge of government spending, rekindled consumer demand and the need to finally rebuild inventories.
It sure has - but if you look really closely you'll see that it has done it on ever decreasing volume. In fact, most of the buying is the result of investors who had massive short positions while the market was falling and are now covering those positions (at still massive profits). Adjusted for various programs like the "Cash for Clunkers", retail sales are still falling; house prices are moribund (the market rallies when it gets a statistic that is "less bad"). By no means is the stock market reacting to increased economic activity. It's what we call a head fake.
But hold on, I'm just getting to the good part
You - and we - can profit from this sea change transition, and we've been working on a fund that will fully take advantage of exactly the conditions that I've just been describing. We've studied geographic factors, industries, markets and different approaches to investing. It will not only survive the deflationary conditions of the next few (maybe more than a few) years, and explode when inflation finally comes storming back (believe me, it will, but it will be once no one believes it will). The funds holdings will consist of (percentage of fund in paranthesis):
Probably my favorite investment and the cornerstone to our strategy,
apartment buildings, when managed correctly and purchased for a good
price, are simply cash flow machines. We mostly employ a contrarian
approach, of buying in places that are out favor because they usually
have the highest cash yields. We will consider properties in other
markets if they meet our cash flow objectives - that is, a net yield
of at least 2% above our mortgage rate. Our objective with any building
is for it to produce a net income before interest payment of at least
10% within 3 years. With interest rates at record lows, our return
on cash is high enough that our attitude toward asset values is somewhat
agnostic. Yet, when inflation does come the effect of the increased
rents will be to increase both the income stream and the value of
the property. In the meantime we are happy to wait.
There are lots of other opportunities that we find that we may
want to take advantage of - such as a single condo, a share of another private fund that specializes in something other than what we do, a resort property or different combinations. We have large interests in agricultural real estate in South America and plan on adding to them at some point in the future - prices there for producing agricultural property are among the lowest in the world. I personally own (together with the investors in our Argentina Rural Development LP) a large amount of Argentinean property that is completely undeveloped - and it's increased in value by almost 300% since I bought it two years ago. And yet it's
still cheaper than anywhere else in the world for similar property.
As well, because of our backgrounds and experience we are well suited
to evaluate other private real estate investments offerings.
It is important to create liquidity for our fund so that our
investors can withdraw their funds when necessary, and so at least
25% of the fund will be in a combination of liquid investments. Publicly
traded REITS and mortgage funds that have a redemption period of
no more than 3 months as well as a small portion in managed futures.
We will rely on outside money managers to manage this portion of
the fund.
Managed futures are the funds that look to profit from many different
markets and can benefit from markets whether they go up or down.
Traditional funds only profit if the investments owned go up in value.
Managed futures make money from movement and many different types
of markets - crude oil, agricultural commodities, stocks, bonds, or even gold and silver. Studies prove that any portfolio will benefit from a certain portion of it's assets in managed futures as they do not correlate with any other markets. In fact they tend to do best when other traditional markets are experiencing difficulty. We will rely on Superfund, the world's largest managed futures company (awarded 5 stars by Standard and Poor's)
and the Horizons AlphPro Gartman Fund.
- investors are required to commit funds for at least one year,
after which they can redeem their funds upon 3 months notice for
the NAV price less a small penalty (declining to zero by the 5th year)
- while enjoying the safety and advantages of well managed
residential rental real estate, you have the added protection of other managers,
which provides further geographical diversification and will tend to reduce
any potential volatility.
- The fund is priced at $1,200.unit with an option
for monthly payments of $120 for 12 months if that is your preference.
- we always pay out excess cash flow at the end of each
quarter. Because of the nature of this fund it will vary accordingly.
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