The real bubble is not in the stock or bond markets but in leveraged finance transactions in commercial and residential real estate, private equity and other asset based businesses. The Federal Reserve’s balance sheet is approaching $4 trillion and all this additional liquidity (money printing) is raising the value of all types of assets from commercial real estate, mansions in New York, to public and private companies and Picasso paintings. The yield curve is also steepening with the difference between the 30 year T Bond and 1 year T Note at 3.73%, a historically high spread. The high price of these assets is being financed in many cases with short term debt at very attractive but risky low rates. Investors are being lured into high leveraged returns on equity with low short term rates. Many commercial real estate deals today are being funded with fixed interest only 3-5 year term loans at 2%-3.5% or LIBOR floaters at 1.5%-2.5% that are secured by long term real estate assets. This is very dangerous and if interest rates spike or short term liquidity dries up, this where the next big bubble could pop. Borrowing short and investing long has been one of the primary causes of almost every financial crisis since the Great Depression. It was the cause of the commercial real estate and S&L debacle in the late 1980’s and early 1990’s as deregulation of the maximum rates paid on savings deposits (i.e., Regulation Q) caused the cost of S&L liabilities to rise while the return on their assets (mortgages) were fixed. Long Term Capital Management, the high flying hedge fund that imploded in 1998, could not roll over its short term repo financing which funded a convoluted portfolio of currency futures, bond futures, mortgage backed securities and interest rate and other swaps. The current housing and financial crisis was also partly caused by borrowing short and investing long when Wall Street investment banks who borrow short in the repo and commercial paper market could not roll over their loans and were forced into a distressed sale (Bear Stearns) or bankruptcy (Lehman Brothers).
In a review of the third quarter 10Q’s of various real estate and private equity firms, we found the following companies that have shorter duration liabilities to finance longer term commercial real estate, private equity and other assets.
|Company||Type||Short Term Debt (term debt, secured notes, credit facilities, mortgages and/or repurchase agreements)||Weighted Average Term||Long Term Investments (funds, real estate and/or private equity)||Short Term Debt as % of Long Term Investments||Source|
|Blackstone Group L.P. (BX)||Global Investment and Advisory Firm||$9B||4.2 years||$20.1B||44%||Q3 10Q|
|Realty Income Corporation (O)||Net Lease REIT||$2.3B||2.5-5 years||$9.7B||24%||Q3 10Q|
|American Realty Capital Properties, Inc. (ARCP)||Net Lease REIT||$1.17B||3-5 years||$2.9B||40%||Q3 10Q|
|Annaly Capital Management, Inc. (NLY)||Mortgage REIT||$69.2B||200 days||$79.9B||87%||Q3 10Q|
These companies are just a few of the large real estate and private equity firms that have longer term assets funded by shorter term liabilities. All of these firms are well managed with substantial financial expertise; however, they may be adding interest rate and refinancing risk to their balance sheets. If there is a steep increase or spike in interest rates, then the value of their investment portfolios will fall as the cost of capital to value these assets increases and the spread between the return on the investment assets and the liabilities to fund those assets narrows. It may also be difficult to refinance or roll over the short term financing except at higher rates.
The great and somewhat unknown economist, Hyman Minsky, who died in 1996, posited the famous “Financial Instability Hypothesis”, that generally states that the more stable a financial market, the more unstable it will become. This is because in a stable market, the participants strive to increase their investment risk. Under Minsky’s hypothesis, there are three phases of a financial market that lead to financial Armageddon, the Hedge phase, the Speculative phase and the Ponzi phase. Under the Hedge phase, borrowers of debt have sufficient income to make principal and interest payments on the debt. In the Speculative phase, borrowers only have enough income to make interest payments on the debt and principal payments are deferred. In the final and destructive Ponzi phase, borrowers do not have the income to make any payments on the debt and principal and interest accrues increasing the debt over time and borrowers are relying on the asset to increase in value to pay of the ever ballooning debt. The financial markets are now in the Hedge phase and if no changes are made by the Federal Reserve in tapering the $85B per month security purchases and its ZIRP, they will quickly move to the Ponzi phase due to billions of short term debt financing long term assets.
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