Guru Strategy: Gary Shilling says the economy needs another trillion dollars
With stocks surging -- the S&P 500 is up more than 37 percent from its low in March -- we turned to Shilling for his view on the economy and whether the government's strategy of pumping trillions of dollars into the market will help to end the recession.
DailyFinance: The government has allocated trillions of dollars to bailout programs, and by some measures, the economy appears to be improving. Can this strategy succeed in ending the recession?
Gary Shilling: It is stabilizing the financial side, but consumer retrenchment is now front-and-center. So I think that what the government has done so far, despite the trillions of dollars, is questionable. People are miserable. They are saving all their cash, their social-security checks, and many people are still in big trouble. Modifications of troubled mortgages are proceeding slowly, and those that are modified are proving to be serial defaulters. More than 50 percent are behind in payments.
What people need is a consumer subsidy to help them handle their mortgages. The government gave trillions of dollars for bailout programs -- now it should give another trillion to consumers. A trillion here, a trillion there will get things stabilized.
So do you think that the first trillion or so dollars is at least showing signs of helping? It's a good sign, isn't it, that some banks passed the stress tests and are now even paying back funds?
They were watered-down stress tests, and while they passed them, the big banks have raised $65 billion in equity, relieving some financial pressure. And after the easing of mark-to-market rules, banks don't have to mark down those toxic assets to market prices. So in my view, they risk becoming zombies like Japanese banks in the 1990s, with assets that everyone knows are overvalued, but with no pressure to mark them down and clear them out. For example, as of March 31, HSBC Holdings carried bad U.S. assets at $90 billion but admitted that the market price was $57.5 billion.
What about commercial real estate?
That's in big trouble. Very few transactions are taking place, the spreads are huge, and pricing is not at the point where hedge funds are jumping in. Price declines of 40 percent to 50 percent aren't enough -- 75 percent down would be attractive.
Will the Fed's TALF program help?
The program supports credit card, student and other consumer loans by buying indirectly triple-A tranches of their securitizations. It will probably be extended to commercial real estate, which is in serious trouble, but TALF may be of little help. Standard & Poor's recently announced the likely downgrading of many triple-A securities issued from 2005 through 2007 because of "aggressive underwriting" in those years. That would make them ineligible for TALF.
At the same time, commercial-real-estate borrowers are defaulting on their loans.
Of $3.1 trillion in total commercial real estate debt, banks and thrifts hold $1.7 trillion in mortgages. Another $700 billion is securitized, and the delinquency rate more than tripled in six months, to 2.7 percent in May, the highest in a decade. Default rates are expected to hit 30 percent or more, and loss rates could reach 13 percent. In boom-and-now-bust Las Vegas, Fountainbleau Las Vegas just filed for bankruptcy, and inadequate financing has delayed three big projects: Boyd Gaming (BYD)'s Echelon project, Las Vegas Sands (LVS)'s condo towers and Harrah's expansion of Caesar's Palace.
Elsewhere, the low-end Red Roof Inn hotel chain has defaulted, and Sunstone Hotel Investors (SHO) is forfeiting its W San Diego luxury hotel to lenders after defaulting. Defaults on securitized hotel-related mortgages were 5 percent of the total in June, up from 0.55 percent a year earlier.
Can you put this in perspective, looking back through history?
In 1993, two percent of banks had commercial real estate loans that exceeded five times their basic capital. At the end of 2008, it was 12 percent, or about 800 financial institutions. Banks and thrifts hold $1.8 trillion in commercial real estate debt. Nearly 3,000 banks and thrifts have commercial real estate loans that are over 300 percent of their risk-based capital, a level that worries regulators.
In residential real estate, overbuilding is one cause of all the problems. Is this true for commercial real estate as well?
Except for hotels, the commercial real estate woes aren't so much the result of overbuilding, but due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants. In the first quarter, downsizing companies disgorged a near record 25 million sq. ft. of office space, driving up vacancy rates and driving down rental rates.
In New York, commercial real estate properties are far below their regular rental rates.
In Manhattan, retrenching hedge funds and others are subleasing space 30 percent below their rental rates. A record 8.9 million sq. ft. of high-quality, class-A office space is available in Midtown -- the equivalent of three Empire State Buildings. In Greenwich, Connecticut, financial firms have dumped about 10 percent of the towns' mid- and high-end commercial space on the market.
In earlier years, and in part due to limited new building, the prices of commercial real estate were bid up, depressing capitalization rates, which link property values to rental income. But now cap rates are leaping as sale prices slide.
So we should see a flurry of refinancing in the future.
The estimates are that $155 billion in securitizations are coming due by 2012, and two-thirds won't qualify for refinancing as prices drop 35 percent to 45 percent from their 2007 peaks. Meanwhile, $525 billion of commercial
mortgages held by banks and thrifts will come due by 2012. About 50 percent won't qualify for refinancing because they exceed 90 percent of the underlying property value. Lenders prefer loans of no more than 65 percent.
Given the money the government is throwing at the economy and the problems in the real-estate sector, do you think the plan will end the recession?
Probably not anytime soon. I have been saying it will go for a second stimulus package. The first one was for education, health and the environment, and was intended to put people to work. There is a lot of resistance to another package, though, and further increases to the deficit. Our estimate is that $200 billion went to stimulus for infrastructure, unemployment and tax cuts, and the rest was for social agenda: education, health and environment. You probably won't see anything done until Congress gets back after Labor Day at the earliest, and by the time they get the rest of the program in place, the recession will be over.
So you do see the recession coming to an end?
It will extend into early 2010. Only by then is enough fiscal stimulus likely to be pumped out to stabilize consumer retrenchment. By then, enough excess house inventories may be absorbed to moderate the downward pressure on prices. By then, most of the global financial woes should be at least stabilized. Nevertheless, a weak recovery is likely to follow, one so tepid and with such high unemployment that you may not know it has arrived.
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