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Where’s the Financial Bubble, How about Leveraged Finance?

December 06, 2013 | About:
Joseph Ori

paracap

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There has been a lot of talk lately in the press and financial markets about a bubble in the stock market and treasury securities. The S&P 500 Index is up 26% year to date, the current price earnings ratio is 19.85 times and the dividend yield is 2.01%. Junk bond yields are at an all time low of 5.6% and according to S&P, the ratio of distressed securities to junk bond issues is at a post financial crisis low of 5.8%. These metrics should be of concern to investors, but they do not signal a stock and bond market in bubble territory. The stock market is due for a correction as any asset would that has increased in price in eleven months by 26%. The bond market is also looking at higher interest rates as the 10 Year T Bond has increased by 75% from 1.6% in May to 2.85% today.

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.

© Copyright 2013 Paramount Capital Corporation


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Comments

superguru
Superguru - 3 months ago
Thank you for such a useful article. Learned a lot.

Lot of investor cash is flowing into residential real estate. Most residential real estate txn

in California I hear nowadays are cash and with heavy over bidding effectively shutting out middle class folks like me.

Your doomsday scenario will play out only when, " If there is a steep increase or spike in interest rates,...".

And we know that it eventually will happen. Current market expectation is that ZIRP will last most of 2015. Fed will only steeply increase rates if growth and/or inflation increases.

Do you think we can invest in these companies till any of those signs shows up?

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