The REALTORS® Commercial Alliance (RCA) hosted a conference call event on August 23, 2007 with Peter Linneman titled “Linneman's Take on the Credit Crisis.”

Download the Linneman Conference Call (MP3 8 MB)

A full transcript of the call is below.

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Will the capital market turmoil derail the economy and bring the current commercial boom to a grinding halt? Or will we dodge the bullet with no worse effects than slightly higher cap rates and LTV requirements?

The REALTORS® Commercial Alliance (RCA) is here to help you answer those critical questions, with the help of noted real estate economist Peter Linneman, Ph.D.  Hear what this real estate thought leader believes the future holds for commercial property owners, brokers, and managers.

A noted expert of real estate investment, Dr. Linneman is the Alfred Sussman Professor of Real Estate, Finance, and Public Policy at the Wharton School of Business at the University of Pennsylvania. He also serves as a principal of both Linneman Associates and the American Growth Land Fund, a $100 million investment vehicle focusing on land development. His numerous publications include Real Estate Finance and Investment: Risk and Opportunities, which has been adopted by leading universities such as Yale, Brown, Columbia, and Wharton. His quarterly research newsletter, The Linneman Letter, is a valued source of market insights for many of the country's leading real estate firms.

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Female Speaker: Go ahead.

Female Speaker: Good afternoon. On behalf of the National Association of Realtors, you are entitled to receive the most updated information on the programs, products and services offered by the Association.  We will now begin with the presentation which is the purpose of this conference call. 

Peter: Good afternoon. This is Peter Linneman at the Warden School of Business and Linneman Associates. To reward those of you who arrive on time, we’ll start punctually. I am going to speak for about thirty minutes, twenty-five to thirty minutes, on my take on what is happening today in today’s capital markets and a bit into today’s housing markets at which point, when I conclude, we will open it up to questions which the operator will handle and when I’m finished with my comments I will turn it over to her and she will describe how you do your questions. I figure we will do about a half an hour or so of questions. To be fair to everybody, we will do questions with an answer rather than dialog. It will just proceed a little simpler, I think, that way and allow more people to have questions. If anything tragic happens and you can’t hear me, send me an email at plinneman@linnemanassociates.com. Also if you want to follow up, that is a good way to always get a hold of me.

It is a pleasure to do this in conjunction with National Association of Realtors. These are very interesting times that are going on in capital markets and in a way it is much more interesting what is happening in capital markets than it is in the housing markets. Because the housing markets are going through a relatively typical industry excess, almost every industry at one point in time or another overproduces and goes from a period of the joy that is experienced while you are overproducing to the suffering that occurs as you work through the overproduction. I will come back to that theme. I know that is something that you are suffering but it is not what the market general is going through right now. I think it is important to understand that just as the tech melt down, for example, was something that had implications for all of us as investors, unless you were really in that sector, the meltdown was not primarily on your mind. I think the same thing is going on today. The capital markets are reacting to something very different.

I’d like to start out by pointing out two things that we tend to forget. One is that one of the fundamental problems of investments and that capital markets face is that fundamentally, most assets are long term assets. That is in almost all instances what you are investing in is a long term stream of assets that you hope generate cash flow and appreciation over time. The problem is most of the capital available in life is short term in nature. The obvious example being bank money which tends to be short term debt and in fact, one of the things we find out is that even though equity is theoretically, infinitely lived, in fact all too often equity holders even behave as if they are short term investors. And so a general problem that exists in capital markets, always, since the dawn of man, have been these are long term assets but we tend to match them with short term liabilities. That works fine as long as everybody is very optimistic about the future. Because if people are optimistic about the future, they either want to hold on to these long lived assets or if they want to sell, there is no shortage of people who want to step into their shoes. It creates an undue image of liquidity and an undue comfort of liquidity that is wonderful as long as everything is going well.  But the problem is, as soon as people lose confidence and become pessimistic about the future instead of optimistic, what will happen is that seeming liquidity disappears. Not just for thinly traded stuff but even for some fairly well traded instruments.  Since most debt and most credit instruments are fairly thinly traded, as soon as people lose confidence it becomes very clear that this mismatch of long assets and short liabilities is a major problem. Anybody who has financed themselves on these long term assets with short liabilities find that they are in a squeeze because their assets are unsellable at any reasonable price and yet they can have their loans called. That causes them to sell to a margin call and as they sell the price goes down even more which causes even greater margin calls. Those margin calls are usually met by then selling liquid assets. You can think of stocks, IBM stock, GE stock, but of course as they sell those assets if they have to do things in any notable degree, those asset prices get depressed.  In fact there is a knock on to all asset pricing if the original is very large because of this fundamental mismatch.

The second issue is that much has happened since human nature. Certainly the investment markets are a constant battle between fear and greed, between pessimism and optimism, between what can go wrong and what can go right. Now if you think about human nature, greed usually wins, another way of saying optimism usually wins. How do we know this?  Well we know this several ways. One way we know it is most of us don’t commit suicide. Most of us go through the day even though we could slip in the shower, choke eating our food, be in an auto crash, be in an elevator crash, etc and we go through it not thinking much about it most of the time. And then every once in awhile a friend or a loved one has one of them things happen to them and it throws a scare into us. It does change our behavior, at least in the short term, until our optimism wins out. Capital markets are no different. What happens is that greed generally wins out over fear. Investors generally see what good can happen to these long term cash streams rather than the bad that can happen. And in fact sometimes greed gets extreme which pushes up prices and then every once in awhile fear wins out. When fear wins out, you look at the same objective information but you look at it in a very different way. By focusing on what can go wrong you seek shelter in lower prices giving you bigger cushions setting off this movement we were talking about before in terms of the mismatch of liabilities. Now in the last twenty years, we have had now five capital market events where greed has lost out to fear.

The first one that I will mention is the 1987 stock market crash where in one day the stock market fell almost 23%. To this day we still don’t understand why other than it certainly triggered fear in a way that caused people to sell everything, not just some things, but everything. It was a flight from risk. In fact when people flee from risk, low betas and low correlation don’t mean much because that is based on normal times. In abnormal times you get abnormal behavior. In fact one of the things that quants always forget that their models are based on normal times but their biggest risk exposure is abnormal times when fear is the enemy and risk is what people avoid and they want to avoid it in every way, shape and form. Things end up being extremely, highly correlated. Far more highly correlated than in normal times which means if you think things were largely uncorrelated, if that was your bet, which is a quant type of bet, you are going to lose big. So the stock market crash of 1987 occurred into a very strong economy, at that point everybody said will it have a knock on effect on the economy and the answer was no. The economy went on quite nicely with one very notable exception, New York got hit very hard in its economy and that is because New York is a finance city and suddenly the year end bonuses disappeared, suddenly guys couldn’t afford the fancy condos, suddenly they couldn’t afford the fancy restaurants, suddenly they didn’t hire people, they laid people off and suddenly the masters of the universe were looking for jobs. That was basically concentrated in New York City, not the rest of the country. Not surprising, if the agriculture market was in disarray, would you be surprised to find that the U.S. economy went on quite nicely but that Iowa City and Des Moines suffered? That is what the guys in New York forget, is they are just another place with another industry.

In 1990-1991 we had the S&L crisis. That took place during a recession that was already underway, a national recession was already underway and in fact it was really that recession that in many ways keyed the S&L crisis along with some bad regulation. In that case there was no additional impact on the U.S. economy from the S&L crisis. Though again, since it threw the capital markets in disarray, New York suffered notably. Once again no year end bonuses, once again big cuts in jobs in New York rather than expansion.

The third episode was the Russian ruble crisis in 1998. The economy was doing very well. Suddenly a country that never paid back its debts announced that they weren’t going to pay back their debts. People who had underwritten as if they would saw the value of their assets fall. As they fell, everybody else started asking well what else has been badly underwritten? Spreads widened on all credit underwriting. As those spreads widened, prices fell. Anybody whose price fell what you suddenly had was, if you were mismatched, asset liability, there were margin calls and it reverberated through the capital markets. Everybody asked would it spill over to the economy and it did not. With the notable exception of New York City because at those spreads and pricing and interest rates, there were no M&A deals, there were no year end bonuses and New York got hit quite hard because it was their industry in disarray. 

The fourth episode was 9/11. 9/11 occurred about six months into a recession, obviously was a devastating phenomena psychologically, deeply affected the capital markets including being closed for almost a week. There was a limited impact on the rest of the economy from 9/11, the recovery was quite quick. In fact, if you think about it, it has not even been six years and the recovery in the economy has been extraordinary. Obviously the travel and tourism sector was hit for a long time and New York was hit from a capital market’s perspective because there was not a lot of activity, but the rest of the economy recovered pretty nicely and certainly no evidence of capital market eroding it.

And now we have the subprime triggered event. Subprime triggered event is very similar to what we’ve seen before. There was clearly terrible underwriting of the risks by the capital markets on subprime. As it became clear that the underwriting was terrible and that underwriting was aided and abetted by the rating agencies, who once again told you that things were going to default after they’ve defaulted. And one can only guess if the fees they received for rating that sort of delays their willingness to point out that the emperor has no clothes, but that can be for another time. The cash flows of subprime eroded, as they the price of subprime eroded. But more fundamentally people asked what else was misunderwrote and so across the board credit instruments have been repriced because people fear what they don’t know instead of relish what they don’t know. Greed changed to fear very rapidly. It happened in a strong economy. Anyone who was matching short term debt to long term assets has been crushed and it has spread out to other parts of the capital market. However there is no reason to believe that this spreads to the wider economy any more than the previous episodes. So I do not see that this spills over to the wider economy. I don’t think we get a recession until 2009 or 2010; this is something that I have written about at length in Linneman Letter over the past year. But it will have a real impact on New York’s economy because a lot of guys aren’t going to get year end bonuses and the reason they are not going to get year end bonuses is that they are not going to be there at the end of the year. So New York will suffer in the short term. Long term New York wins. Even if you think of New York, suppose you’ve run a hedge fund and that hedge fund has somehow managed to make money through all of this, would you expand your space into this market? I doubt that you would.  There is no reason. So what you have had happen is fear has routed greed over the last four or five months, history shows us from these previous episodes that greed will return. Greed has won basically fifteen out of the last twenty years so it is a seventy-five percent bet that greed will win out but it will take twelve to eighteen months for greed to come back into favor.

What will it mean to have greed come back into favor? Credit spreads will drift back down slowly over the next twelve to eighteen months towards normal. Not necessarily to record lows because what we had in March were record low credit spreads, whether it was on mortgages or junk bonds or foreign debt in developing countries, spreads were very narrow, stock markets were very high. Prices for equity on the private market were very high. Prices for real estate, prices for homes, everything was up because you had this optimistic view. It is funny because it is a little like when you were a kid you may have played this carnival game where you hold your hands on something that gives you an electric current and slowly the current goes up and you see how long you can hold on to it. As that current goes up you look braver and braver and braver and you tighten your grip more and more. To the outside observer you look fearless but in fact your fear level is going up inside of you as you hold this and then suddenly you let go. That is what I think happened in the capital markets. As things go higher and higher fed by greed, people get more and more fearful but they don’t show it. And suddenly when something acts to trigger the fear then everybody backs away. They let go, try to find a new bottom, a new bottom will be found where at those prices even if there were big underwriting mistakes, you will make money. That is what is going on right now.

The Federal Reserve has played a notable role in all of this. In 2002 to 2004 the Fed, as I have written extensively about, kept the interest rate way too long, way too low. Effectively what the Fed said is, even if you are going to lend your money on a very short term basis, you are going to get a negative real rate of return. Well, or another way of saying it is, and if you happen to borrow short term, your borrowing costs in real terms is basically zero to negative. So what did you have happen? Anybody who could borrow short, did. Think of those people who borrowed floating rate home mortgages and nobody wanted voluntarily to invest short. Because why am I going to invest short when I know I get a negative real rate of return? What is a negative real rate of return? Treasury was at one percent and inflation was two percent. So if you gave the government your money for six months, at the end of it you would have less purchasing power than you started with guaranteed because of where the Fed had interest rates. That encouraged people to look to long lived assets because anything is better than a guaranteed real loss. People look to long lived assets, as they moved away from short into long, the price of long went up.  Which meant yields went down, dividend yields went down, credit spreads went down, buy outs got higher prices and done at pricier multiples in the search for anything other than a guaranteed negative real rate of return if I go short.

This also had the effect when they kept the rates that low of pumping excess liquidity in the system. So this desire to avoid short assets was fueled by liquidity that was fueled by the low interest rate.  When you think of it in those terms it is not hard to understand why long term asset prices, most notably including home prices, soared. It wasn’t a bubble; it was the Fed keeping interest rates very low, forcing people to go long, that many of them otherwise would have invested short. What happened was the Fed then finally raised the rate to squeeze out some of the excess liquidity. First of all, it was a little late.  But more importantly over the last year they have kept the rate ridiculously high.  And how do you know that it is ridiculously high? Well the interest rate on the Fed’s fund has been five and a quarter percent. I ask you, if I gave the government my money for six months and inflation is two and a half percent, why do I deserve a real return of three percent for giving the Federal Government my money for six months?  It is absurd. What is the risk? In fact maybe you get a fifty basis point real return or maybe even a hundred basis point, but three hundred basis point real return? So what has that done? Yes it has sopped up some of the liquidity and as it sopped up that liquidity it has made credit tighter. It has also punished anybody who borrowed short. Because if you borrowed short, you are not only paying a higher interest rate, you are paying probably an interest rate as much as one hundred fifty basis points too high. Strictly because the Fed has said that is the interest rate you are going to pay, not the market. I often remind people that the Fed is a remnant of Central Planning where nine smart guys know better what the market than the market; I don’t believe that. They kept the rate too low and that created a lot of the misincentives, they have now kept it too high.

The other thing that happened is, once the market finally came to understand how good of investment, investing short was, and safe was, and it took a while because we got so fixated in looking long, once you realized what a great deal investing short was, people moved from long term cash streams to short term cash streams, from looking at credit to fleeing to safety. The flight to safety wasn’t even driven by fear, it was driven by greed. And the greed was I can get a guaranteed three hundred basis points real return for giving my money to the government for six months. That caused, this high rate has caused more defaults of subprime borrowers than would have otherwise occurred and it has raised the payments of any floating borrower substantially. But more importantly for the capital markets, it has whipped sawed people from looking long at the incentive from the Fed to looking short and safe. As people move from long assets to short assets, what you saw is, it was hard to sell the long assets because there is usually not a lot of people that want them unless everything is good. As those prices on the long assets fell, anybody mismatched with short term liabilities got crushed and there is no surprise in that; it has happened every time before.

By the way, it is not a surprise that the quants got crushed in such a scenario because essentially they did not build their models on an assumption that the Fed would whip saw and that everybody would want to get out of the theater at the same time. As a result you have seen spreads on everything go up, you have seen pricing on everything go down.  The correlations are probably not 0.5 – 1.5 like normal betas might be and normal correlations might be. The correlations are probably 0.95 – 1.05, that is everything is down. And I mean everything. The Fed should have cut rates three to four months ago, they didn’t. They should have cut it two weeks ago, they didn’t. They have done some silly interventions. A couple of my classmates, former classmates, are on the Fed open market committee, one of the things I always tell people is they are well intended and honest, but they are just guys.  They are making an enormous mistake here, they need to cut the rate, not to bail people out, that is this mythology, they need to cut the rate to bail people out, the moral hazard.  They need to cut the rate because it is absurdly high.  They need to cut the rate to set up the incentives for long and short investment to be appropriate. And in so doing reduce the payments born by floating rate payers, many of whom are subprime, back to normal. Inflation is running about two percent, that should not be the concern. Containsion, so far all of the containsion is in the financial markets. We have seen nothing happen in the real markets. In fact if you read papers in America, this is a non event, much in the same way of corn prices were highly volatile, in most of America it is a non event. In New York and in London it is a major event. For those of you in the capital markets it is a major event.  The good news is that most corporations and most people are not in the capital markets most of the time and therefore since most people in the economy and most companies in the economy are not in capital markets, they are absolutely unaffected by this. What about if you have to be in the capital markets right now?  Well it is a horrible time to be a borrower because spreads are large. It is a horrible time to be a seller because prices are down.  That is not just in real estate, that is of everything.  The good news is the balance sheets of most corporations in the United States have never been stronger. They have never had more cash on hand.  The good news is the wealth of American citizens has never been higher and the liquidity in general has never been higher. So things are in pretty good shape that way.  One of the real blessings is that although people give a lot of bad mouthing to collateralize debt obligations, so called CDO’s, they have done a lot to stabilize the system. Because what they did is take piles, trillions of dollars of short term debt and convert it into long term debt. By doing so took a lot of mismatched assets with mismatched liabilities and matched these long term cash streams to long term liabilities. For example, you have not seen nearly the margin calls this time around as in the Russian ruble situation of nine years ago. That is because you’ve got nearly two trillion dollars of short term debt that was converted into long term debt by CDO’s and so that even though the assets may be down in value, there is no mark to market event and there is no capital call on a margin, that has helped enormously.

Let’s talk about subprime. Basically subprime is going to end up in about eight to ninety billion dollars in losses. Another way of saying it is if you were going to give that much money to those people, you needed to get eighty to ninety billion dollars higher in cash stream from them during the life of the loan. That is a big miss. The good news is our economy is a more than thirteen trillion dollar economy and the net household worth is more than fifty seven trillion so that while none of us like to lose eighty to ninety billion, we’ll survive. But it was a massive mistake.  It was not the only underwriting mistake but it was the most egregious. It went on really for two years, 2005 and 2006. The good news is that unlike some other excesses, like the S&L crisis resolved, it only went on for about two years. Had it gone on longer I think it could have brought the economy down. I don’t think it will because it didn’t go on long enough. The other thing to bear in mind are much of what are called losses and appropriately so by Beer Sterns and Goldman Sacks and others, are losses for those firms but they are transfers. They are transfers from the lenders on subprime debt to the borrowers of subprime debt. Think of it, imagine if those guys gave money away for free, no interest rate, no payback requirement, well obviously the lenders would have lost a lot but the borrowers would have made a lot. One of things that is carrying the economy is that these are not losses to the economy because somebody else has an offsetting game, the subprime borrower, the home borrower, the people who sold their assets rather than bought assets, the people who borrowed rather than lent. So there has been an enormous transfer of wealth from lenders to borrowers, so the losses to society are quite small compared to the losses you read about. Think of the American home buyer who locked in, and about seventy percent of them did lock in, long term interest rates for seven, eight, ten years on money that they never deserved and they got it cheaper than they ever deserved. Well that is money that they now can use to subsidize their lifestyle for several years to come. That is why you are not seeing weakness in the economy. People also forget most homebuyers did fix loans. The ones that make the press are the ones that went short but the norm was long.

The real social loss is that we probably built about five hundred thousand homes sooner than we needed them. This includes condos. The five hundred thousand homes is a lot of homes. Think of it this way, we are going to have five hundred thousand homes in this country that are going to sit empty for a year or two. Where is the productivity in that? So that is the real loss to society, is that we build five or six hundred thousand homes with money that could have otherwise been put to use generating a return for society over those years. That is the real loss. Now how do I know it is five or six hundred thousand homes?  Well you can track through the data, you can see that home builders have about two hundred, two hundred and fifty thousand units of excess inventory right now on a national level and there is probably another two hundred, maybe three hundred thousand units held in inventory by speculative investors who bought in ’05 and ’06. These investors have to work through that inventory as well.

As you know this is not spread evenly over the country, south Florida being worse, Arizona being worse, Duluth, Minnesota being better. But about, let’s say five hundred thousand homes too many right now in inventory. That is a little over five months, four months of normal production of housing. How do I get that? Well we add about three million people to the population each year, that amounts to roughly 1.3 million households a year, slightly rounded up. In addition in a normal year, and I do stress normal, about one hundred thousand second homes are needed to deal with the demands of these extra people. On top of that about three tenths of the existing housing stock gets wiped out every year. If you add those together, year after year on average we need about a million nine units.  We under produced in 2001, 2002 and 2003 and we massively over produced in 2004, 2005 and 2006.  Net met we end up over producing by about five hundred thousand. That is about one quarter of a year of production but of course you don’t just stop in your tracks, you continue to produce more so that will take until late ’08 to work through. If you are in south Florida condos, it will take much longer. So it is local but it is important to understand where things are from reality. We are going to go under producing in ’08, we are going to under produce in ’09, which means we will have a shortage by the beginning of ’10 and there will be a catch up game again. It happens in every cyclical industry. It is another interesting to point out; people say why do these hedge funds close on these big losses? It is funny, you have a hedge fund that loses three billion dollars on a ten billion dollar fund, they still have seven billion dollars of assets to operate and if you go through the fee that they get, I think they could get by on a two percent fee.

So why do they shut down like you’ve seen? The answer is very simple; they have a high watermark clause that says they don’t get their carried interest until they get above values previously established. So what you are going to see is the guys who are closing up funds are going to give the money back, say “oops, I’m sorry”, they are still pretty bright guys, they are going to restart their funds, they’ll have half as much money but they will be back in the money on their carried interest. So it is not like those guys are going to go out of business, they are just going to go out of the particular business. In a lot of businesses there are deals that were made in March, April, May and June whether it is Sally May or whether it is Arch Stone, there are a number of deals that were made. Right now what is happening is, those deals are sucking either because the investment bank cannot put together the debt for the deal and hence the numbers don’t work at the price they agreed to and in fact, if you buy a company at the price you agreed to four months ago, you are almost guaranteed you are paying ten to fifteen percent than it is worth today, or they are sucking wind because the investment bank agreed absolutely to fund the debt. And of course they thought it would be easy to place the debt because greed was winning, but of course now no one wants to buy that debt and the investment banks and banks are looking at huge losses and huge exposures versus anything they thought they could get.

It is funny, I’ve been around now three times to watch Wall Street bridging work and it works beautifully and it is extremely profitable right up until it doesn’t work anymore and then it almost crushes the banks. A lot of buyers are going back to sellers trying to retrade and basically the sellers are saying two things, one, “I was only selling because of the price you offered, and the price you want to retrade to, I am a buyer not a seller.” The second thing they are saying is, “go talk to my lawyer because I am not in the mood to retrade.”  So this is interestingly a period that is somewhat unusual. It is the period of the distressed buyer instead of the distressed seller. Spreads are going to remain wide and it is going to be tough and you will see pricing on almost everything stay low but come back eighteen months from now and things will look good. So for example I am a big buyer of long term debt that has matched against the long term debt, playing that the spread will narrow over time on the asset and the debt is locked in at its rate and you can buy very cheap that way. Also I am very bullish on home builders right now as long as they don’t have a lot of short term debt. The reason being they have an expertise which is long term, people are going to need homes, we are still adding three million people a year, we only have an excess of five hundred maybe six hundred thousand homes tops, we are going to produce a lot of homes but I don’t want anybody who may get squeezed. So I am very bullish on home builders but only on the long matched kind of basis right now. I think they are very under valued.

What else can I say? I do not, I repeat, see a knock on the real economy, with New York as an exception. This would be particularly true if the Fed gets realistic and lowers their rate. It would be tough on New York and London. The housing market and condo market will continue to suffer exactly commensurate to over building. I wrote about this in my stuff in Linneman Letter, gave speeches on it, the kool-aid that home builders were drinking in ’05 and ’06 was a big demographic shift was causing all of this to occur. Well it wasn’t. It was, demographics don’t move fast, demographics move like glaciers. So anytime you see a sudden surge in demand, I guarantee you, it can not be due to demographics. I kept telling people this.  I was due to the Fed having kept interest rates too long, feeding liquidity and forcing people long. Up to the point where idiots lent to idiots. Who were the idiots that lent to idiots, the guys who lent to subprime borrowers, especially when those subprime borrowers were buying speculative homes with the money. My estimates are that probably eighty to ninety percent of all the speculative homes that were bought were financed by subprime or alt A money. When you are lending money to somebody without doing any documents, without doing any verification and you are willing to give them a couple of hundred thousand dollars, that is an idiot. And when the borrower is somebody who believes that real estate can only go up in value and that they are going to flip it like a late night television tele-ad for double their money for sure in six months and that is the borrower, that is what I mean by idiots lending to idiots. The beauty of the capitalist system is idiots who lend to idiots tend to lose their money eventually. So actually what is going on is healthy though painful for certain individuals. I think that is one of the things that we tend to forget. I will repeat that this will create better underwriting for a while. It will create better discipline for a while. We have had five of these episodes in twenty years; I hope I live long enough to see five more. With that, let me come to a halt and Angie, we are ready for questions. And Angie, why don’t you give them instruction on how to do questions.

Angie: Thank you. If you have a question or a comment simply press star one on your telephone keypad, this will place you in our question queue and then we will individually open your line for you to be able to ask your one question. Again that is star one on your telephone keypad. As your line is opened please provide us with your name. We will begin with our first caller.

James Morelli: Thanks for doing this for us. I’ve got two issues I wanted to run past you, both seem to be systemic. One is the issue where it seems like most Americans have a line of credit now on their house and using it to finance what probably is short term consumptions, cars, weddings, things like that. That seems to be a problem, I think.  I would like you to comment on it. The other is on the corporate side in terms of cost of capital, we see a big shift now from equity to debt with Blackstone and some of the other partnerships and that seems to be kind of risky as well. I was wondering if you could comment on both of those trends.

Peter: Let me take the latter. Corporate debt is an interesting one. Obviously what happened with the buyouts was that debt was very plentiful and very cheap at the end of the era of greed and the Blackstones and the like were smart enough to take advantage of cheap and plentiful debt. What they bought was cash streams that were long term in nature and they have locked in long term debt, because the typical buyout is long term debt. So in a funny way, if you got your deal closed you are in decent shape although the value, everything has fallen but from a cash stream point of view you are in good shape for some time and then you wait for greed to set in again. The other thing is while the debt on buyout companies is quite high by general standards; one of the things that the buyout companies were reacting to is that because of the extraordinary surge of profitability in 2003 through 2007, most corporate balance sheets were the cleanest they had ever been. Debt was lower than ever on most corporations and in fact cash balances were higher than ever at most corporations and that is still true. So we have this situation where some companies were very highly leveraged but most were never less leveraged than they’ve been and that was almost an arbitrage that the Blackstones etc were playing.  As to the impact of lines of credit on home equity etc, people talk about it a lot; it is not the primary source for most people for their financing themselves. Let’s be honest, most people finance themselves the old fashioned way. They get a paycheck on Friday. That is the number one, number two and number three way that people finance their purchases. After that the normal way they purchase it is a first position note either on their car or their home. On their home, anybody who borrowed long, and that is about seventy to seventy-five percent of all borrowers, had locked in a spectacular rate. So they are in great shape. If you were a floater the Fed has been punishing you. It is just another government agency and nobody is safe when the government is around. As far as home equity lines, those people are suffering at this point. I’ve got a brother who suffers that point. And you know, without being mean to these people, ew, you deserve it. If you are spending beyond your means, come on, be realistic. In a funny way they were part of the problem. It is painful but it is part of the problem of people trying to spend beyond their means. Angie, maybe the next question.

Angie: Yes sir. Caller go ahead with your question, please.

Tom Bothon: Thank you for being with us today. It seems to me that folks at the Fed are fairly bright. How do they get us to this position?

Peter: It is a great question. You know, this is, I keep telling people that we don’t let bright people set the prices of automobiles. We don’t let nine bright people set the price of homes. We don’t let nine bright people set the price of carpeting.  We don’t even let nine bright people set the price of long term debt. But we allow nine bright people to set the price of short term money. That is why I say it is a remnant of the old socialist planning concept that nine well intended, bright people will make better decisions than a market. I have never seen evidence to suggest that is true.  Now I am an old Milton Freedman student so maybe it is my bias. If you say how do they get it that way, they make mistakes. By the way, most of you on this call are bright people, seriously, you are very bright people and you know your business very well.  How many of you have not made a mistake and how many of you have not made a mistake of some magnitude?  Before you answer that, look at your land reserves and look at your home inventories. You didn’t make those mistakes because you weren’t bright, you just made them because you are human and you misread things. Well the Fed misreads things as well. So for example, the two the Fed has misread, they misread in 2003 that falling consumer price index numbers were a threat of deflation. I wrote at the time that service prices, which are sixty percent of what we consume, were still rising at three percent a year. So sixty percent of what we bought was still rising at three percent a year.  About twenty percent of what we bought was falling. They misread that twenty percent by looking at the aggregate as deflationary threat therefore to fend off deflation; they put the rate too low, too long.  By the way, they would admit that it was a mistake at this point much as you guys would admit that the last project you built was probably a mistake if you had it to do over again.  But by then it is too late. The difference is when you make a mistake, it pretty much only affects you. When these nine bright guys, and as I say a couple of them were classmates of mine, reasonably bright guys, reasonably, I wouldn’t trust these guys to pick my stocks for me much less set the price of money. I wouldn’t trust me to set the price of money because if I am wrong the ramifications are too big. And they have misread that inflation is still too high currently even though it is tracking at two percent or so. So it not misintended, it is not stupid, it is that we all make mistakes. And the problem is, is that when you make the mistake on something as big as the price of money it matters a lot. Angie, next.

Roger: I wanted to actually build a little bit on the first question that was asked. It is my belief that a lot of the mismatched financing that is out there, the short term against the long term, is in these variable rate second mortgages. I think because they have a second position on their collateral, a lot of the borrowers may tend to keep the first position people satisfied and default of the second position ones. What is the impact going to be on the liquidity of the lenders as a result of that? Where they won’t, the worst that they can get is a lien on the collateral not a foreclosure on the collateral.

Peter: It is a good question. First of all, the good news from a systemic point of view is the amount of second position money out there is not staggering in the whole big scheme of capital structure. But I think you are right that those are vulnerable positions. By the way, it is not just in homes, right, it is the second position in corporate debt, it is the second position, mezzanine positions in real estate debt, those are the vulnerable positions. That is why you’ve seen the squeeze on the lower rated trounces, on the kind of paper you couldn’t sell right now is the kind of paper you are describing. I do think that it’s short term is affecting liquidity, there is no doubt that it is affecting liquidity in the short term. This is why the Fed is trying these relatively unique ways of injecting capital into the system without really cutting the rate. I think what you’d see is that would largely take care of itself if they would cut the rate. This is not the, by the way we have to be careful, there are people who deserve to lose money here. So the trick is to inject liquidity in the system but not bail out idiots. Angie, next please.

Male Speaker: I would like to know what can happen to the commercial sector and is it going to be following the residential? Thank you.

Peter: Commercial real estate in New York will have some challenges over the next year or two. The good news is it starts from a position of very low vacancy and good occupancy and not much construction. The bad news is it is going to be a year or two until you see some of those rents that people had in their pro form as occurring. This is going to slow down that.  If you move to the other parts of commercial real estate I think basically they are going to be immune to this because the real economy is immune, from a cash flow point of view. However, you can’t have the price of everything else go down by fifteen percent and say commercial real estate is down fifteen percent as well or land isn’t down fifteen percent as well. The truth is, as you’ve seen in the Reets, the Reets which are the most transparent window into the pricing of commercial, are down fifteen to twenty percent.  I had them about twenty percent over priced as of March and now I have them at about eight to ten percent under priced, that is Reets. The private market lags, as always. But I think you hit it which is this has to have a, if every asset from Bolivian debt to IBM stock is down fifteen to twenty percent, real estate prices have to be as well, even for the same cash flow because Bolivian debt has the same cash flow. So it has a knock-on on the pricing, I don’t think it has much knock-on outside of New York, maybe the financial district of San Francisco, certainly London. It has a knock-on on the pricing, on the cap rates. Next.

Angie: Go ahead caller. Caller from the 541 area code.

Mimi Morrisette: I’m curious about these mortgages that are floating around where you take a mortgage out and then you put money back in the fund and don’t have to put interest, don’t have to pay interest on that sum. I think one of them is a McQuarry fund maybe. I want to know what the risk is of putting the money back into those after you’ve taken out the mortgages.

Peter: There are easier ways to make money. Effectively what happens, what you are describing are a good example.  What effectively happens is, I had somebody in my office this morning who said, “Gee, it is hard to make money.” It is supposed to be hard to make money. If it were easy an idiot could do it. So as things got more and more overpriced, you saw more and more gimmicks. And they were financial gimmicks because there was no more juice left to be had. I think what you are describing is one. I guess I am just old enough that I like making money the old fashioned way instead of through gimmicks. Gimmicks tend to be nice way to make money short term, very dangerous ways to make money long term. I have never been smart enough to know when the short term is ending.

Angie: We will go with our next question. Go ahead caller from the 512 area code. We will go with our next question.

Peter: I feel like Larry King.

Cindy Chandler (Charlotte, North Carolina): I’m in the markets right now and what I am seeing, I am seeing lending rates similar to what we saw in the early ‘90’s where you could go perhaps to the ______ company with a reasonable spread but all of the other stuff is pretty tough to get. Is that what you are seeing overall?

Peter: Absolutely. And I meant to point that out Cindy. By the way, this is not unique to real estate what Cindy is describing. Essentially what has happened is the fixed rate market is dead unless you’ve got a relationship with a life company because the fixed rate market has essentially been composed of life insurance companies who have long duration and various forms of securitization.  The securitization part of the long is gone. The reason it is gone is nobody can price the volatility of matching their liabilities. So there is no CDO market of any type therefore nobody is issuing long notes because they don’t believe they can match them with a long CDO because there is no CDO market because of the volatility. Therefore the long market has absolutely disappeared unless you go to a life company. There what you will find are spreads, it depends on the loan to values, but you will find spreads anywhere from fifty to maybe one hundred and fifty basis points wider, interest coverage not going much below 1.2 and what you will find is loan to values that won’t be able to go above about seventy five percent. If what you are willing to do is float, the floating market is alive and well. Spreads are wider in the float market.  Spreads are wider perhaps by eighty to ninety basis points or seventy to ninety basis points in the floater market but it is alive and well. The reason is there is no mismatch problem for the lender. Yes their cost to capital is up seventy basis points but their lending rate is also up seventy basis points and there is no mismatch. So you should find that the float market, if there is cash flow there, is quite strong. The fixed market is dead unless you can go to a life company that has a relationship. The only, I am now about to generate a lot of business, the only exception are a few of the less sophisticated capital market lenders like some of the German banks and some of the other European Continental banks, they just aren’t very clever capital market players and some of them have really not changed their spreads very much and they are willing to go five to ten years. Land loans and dead, to say land loans are dead overstates how alive they are. I mean too many lenders have too many loans. They are not idiots, they know they are going to have a hard time collecting as it comes due in the next six months to a year and obviously again if you have spectacular track record and you are willing to pledge, but the days of fifty to ninety percent land loans on land that was overpriced by at least one hundred percent are gone. That is a great question; I should have pointed that out. 

Shawn Mandelbaum: I have a question regarding consumer spending and the health for the overall economy. Over the last couple of years my understanding is that consumer spending has exceeded sort of the income of consumers. And I believe that to be financed by home equity loans and the like. If that is no longer available, if consumer spending has to pull back, doesn’t that threaten the health of the overall economy?

Peter: The good news is the consumer is in great shape. By the way, people ask the question, a variation of Shawn’s, which is how long can the consumer carry the economy?  The answer is forever. All there is is that people like you woke up this morning having more crap than you’ll ever need saying honey I am going to go to work and make some more money so I can buy even more crap. The consumer will carry the economy to the dominant part of the economy.  They are very slightly spending more than their income. Let me take an extreme case though just to show the generic issue. Suppose Bill Gates was getting zero, back in the days when Bill Gates was getting zero dividend from his Microsoft shares, and by the way he was taking a dollar a year in salary. Bill Gates was negative saving every year in the sense that he was spending more than his income. That is kind of a trivial, he had no income and he was spending. Yet, his wealth was rising. The reason his wealth was rising is his assets were rising in value more than his dissavings out of his income. That has been what the American consumer has done for the last decade. Is that yes we are spending more than our income but the increase in the net value of our assets rises faster than the amount by which we dissave. Therefore while they may not be Bill Gates, it is not so stupid. Think of it differently. The typical American has about two hundred thousand in net worth, if that goes up five percent a year that is ten thousand dollars increase in their wealth each year. If they spend two thousand more than their income they still have added eight thousand to their wealth each year. That has been what is going on. That, you can just do the math that we just did, that is completely sustainable. A five percent appreciation on assets is not an unbelievable rate of appreciation historically and that can go on and on and on with Bill Gates being the extreme example. So I don’t see that as a challenge though it is a great question because it is a very misunderstood phenomenon. Maybe let’s do two more questions.

Fred Higgins (Austin, Texas): Peter I haven’t heard you reference our dependence on international capital sources other than a brief reference to Bolivia and Germany. I am going back to when you were talking about the Fed keeping rates too high. Isn’t there some danger if they lower rates at this point given our currency exchange rates we are endangering international investment in our economy?

Peter: Good question. International, let’s touch on a couple of pieces on that. First of all, it relates to the question that was just asked prior to that. Which is we have a trade deficit and people get very disturbed that we have this trade deficit. But if you think about our trade deficit, we don’t have a trade deficit because people don’t want to buy our goods and services. We have a trade deficit that has exploded since 1990, no matter who is in office, no matter what the interest rate is and no matter what the exchange rate is for one simple reason. People in China and India and Bulgaria use to be imprisoned behind communism and socialism and they were freed and as they got money, the got money to invest faster than their capital markets evolved. Therefore the only place they could invest safely was here and in Western Europe. To invest here they have to sell us more than they buy from us because they need dollars to do the investment here. So our trade deficit is simply about the explosion in developing countries wealth and their desire to save in a safe place and we are the safest market around. That is why we have a trade deficit. It is a great thing. It shows we are the most liquid, safest, most transparent market in the world. Our trade deficit isn’t a bad thing even though related to the previous question it is often linked with this misunderstanding about dissavings. Now on the subprime it is very interesting how internationals fit into this. One of the real good pieces of news, and nobody knew this until it starts to unravel is a lot of the ultimate lenders on subprime debt, which was very badly underwritten, are Germans and Irish and French and Italian and Japanese and Dutch. Why do I say that is a good thing? Well it is a good thing because otherwise that money would have been lost by Americans and to the extent that money would have been lost by Americans, it would have been less money available to save. The fact that we were the seller at overpriced prices to foreigners actually was a good thing. In fact, put it differently, don’t you wish with hindsight all the subprime debt was currently in the hands of Germans or Swiss or Irish, big problem for them, less problem for us. In terms of cutting the interest rate, the dollar is probably twenty percent over valued at this point. It continues to be because people are misinterpreting the trade deficit as reflective of exchange rates being too low instead of a fundamental desire to invest here.  I think that we need to cut interest rates not to worry about foreign balances and exchange rates. They will take care of themselves, they are market prices. We need to lower the interest rates, we being the Fed, to rebalance the incentives to invest long and short which have not been neutral for some time. Maybe do one last question.

Angie: We have one more for you.

Peter: Thank you.

Chuck (San Diego):  In regards to that last comment, do you think the Fed will lower the interest rates prior to their next meeting here in about three weeks?

Peter: I was shocked they didn’t lower it, whatever it was, time flies, a week ago.  I was shocked, I was just floored that they didn’t. I do not think that they are going to cut it in the interim for a very human reason. Every one of us on this call has made a mistake that we realized was a mistake after we did it. Most of us don’t have the courage to say, “Oops, big mistake, I am changing it now by doing something special.” And especially committees don’t do that, individuals may do that but committees rarely do that. Therefore I don’t think they will cut until the next meeting. What I think they will do in the meantime is more of the shilly shallying they’ve been doing of telling banks we will take mortgages as collateral even though we would never take them before and in that form injecting capital. They may even lower the discount rate again. But I don’t think they touch the Feds funds rate until a scheduled meeting for fear of panicking people which is a bizarre statement because it would actually be putting them at ease.  With that we’ve been at it for about seventy minutes. I appreciate you giving me an opportunity to do this for your audience. If Linneman Associates or I can help you in any way feel free to contact us. We hope this has been helpful and I think NAR deserves tremendous, my praise for putting this together, it was their idea. Doing it in short order I think was very productive. With that I bid you all good bye and Angie will end the call on that. Thank you.

Angie: Thank you so much. We do appreciate your participation today and wish you a good day; this will end our conference call.