It’s been a busy week of alarming financial news!
Of course, events that rattle financial markets sometimes barely register to real estate investors. That’s because rents and property values aren’t directly involved in the high-frequency trading casinos of Wall Street.
So while paper traders frantically scramble to avoid losses or skim profits from currency flowing through the machinery …
… real estate investors calmly cash rent checks and wonder what all the fuss is about.
However, as seasoned investors discovered in 2008 …
… Wall Street’s woes sometimes spill over and become Main Street blues … primarily through the linkage between bond markets and mortgages.
So even though the Saudi oil almost-crisis garnered a lot of attention …
… something BIG happened in an obscure corner of the financial system which has alert observers concerned …
Repo Market Chaos Signals Fed May Be Losing Control of Rates
Repo Squeeze Threatens to Spill Over Into Funding Markets
And no, this isn’t about people losing their cars or homes. It’s about a systemically important part of the financial system.
Before you tune out, remember …
… when you see words like “chaos” and “losing control” and “spill over” in the context of interest rates and funding markets … it’s probably worth digging into.
When credit markets seize up, asset prices collapse. While this is troublesome for Main Street … it’s DEVASTATING to the financial system.
And when the financial system breaks down, it affects EVERYONE … even smug real estate investors who might think they’re immune.
So grab a snack and let’s explore what’s happening …
Wall Street operates on obscene amounts of collateralized leverage. Real estate investors use leverage too, but there’s an important distinction.
There are no margin calls on real estate. So when property values collapse temporarily for whatever reason, positive cash flow let’s you ride out the storm.
Not so in bond markets. When the value of a bond that’s pledged as collateral falls, the borrower faces a margin call.
This means the borrower needs cash FAST. This is a risk of the game they play.
But when traders are confident they have ready access to cash at predictable and reasonable prices, they stay very active in the market.
This is important because healthy markets require an abundance of assets, cash, buyers, sellers, and TRUST to keep things moving.
When any one falters, markets slow down … or STOP … credit markets can freeze, economic activity stalls, and it hits real estate investors too.
Fool us once, shame on you. Fool us twice, shame on us.
Meanwhile, we’ll hit the high notes to get you started …
In short, the repo market is where short term borrowing happens. It’s like a pawn shop where market participants hock bonds to raise some cash.
But when repo rates spike like this …
… it means there’s not enough cash to go around.
Cash is like oxygen. You can live for a while without food (profit) or water (revenue) … but when you’re out of cash, it’s game over.
No wonder Wall Street freaked out …
‘This Is Crazy!’: Wall Street Scurries to Protect Itself in Repo Surge
Of course, we don’t really care if Wall Street takes it on the chin.
But when craziness on Wall Street has the potential to spill over to Main Street, we pay attention.
In this case, the situation is dire enough the Fed stepped in with $53 billion of emergency cash … in ONE day.
This is the first time since the 2008 financial crisis the Fed’s needed to do this.
The next day they added another $75 billion.
Then the Fed announced another rate cut … and hinted at more rate cuts … and suggested a willingness to print more money.
Then the VERY next day …yet ANOTHER $75 billion.
$53 billion here. $75 billion there. Pretty soon you’re talking serious money … in this case about $200 billion in THREE days … and quite possibly a serious problem.
So what? What does any of this mean to real estate investors?
Maybe not much. Maybe a lot. We certainly hope the Wizards behind the curtain pull the right levers the right way at the right times.
But if this is a pre-cursor to The Real Crash Peter Schiff is concerned about, things could become more complicated than “just” a 2008-like collapse of asset prices.
Meanwhile, negative interest rates on nearly $17 trillion in global debt is a symptom of a huge bond bubble today.
Here’s why …
Just as rental property cap rates fall when investors bid prices up … so do bond yields fall when investors bid bond prices up.
And just like when over-zealous real estate speculators bid property prices up to negative cash flow … so over-zealous bond speculators have bid bond prices up to negative yields.
Negative yields are a symptom of a speculative bubble.
These unsustainable scenarios typically end badly when there’s no greater fool left to bid the price up further.
And then, when the market goes “no bid” … prices collapse. Bad scene.
Remember, bonds are the foundation of the credit market and financial system.
This repo problem is like finding a big crack in the foundation of your favorite property.
The bigger concern is the size of the building sitting on the faulty foundation … and how much it might take to patch the crack.
So here’s the inspection report …
Global debt is around $250 TRILLION. These are bonds … many of which are pledged as collateral for loans … creating an almost incomprehensible amount of derivatives.
Worse, many of those pledged bonds are subject to margin calls.
This is a HIGHLY unstable situation and operates largely on trust.
Think about what happens if bond prices fall …
Borrowers who pledged bonds are upside down and need to raise cash fast.
When they get to the market, they find there aren’t enough dollars to go around. Cash starved sellers start discounting to attract buyers … causing rates to rise.
Again, it’s just like trying to sell an apartment building in a slow market. As you lower the price, the cap rate (yield) goes UP.
As yields rise, bond values everywhere fall … triggering more margin calls, more demands for cash, more desperate sellers … and a dismal downward death spiral.
And then it spreads …
As the demand for cash grows, anything not nailed down is offered for sale … often at a steep discount to compete for a limited supply of dollars.
This is contagion … falling prices spreading like wildfire across daisy-chained balance sheets.
Yikes. (Of course, if you have cash, it’s a shopping spree)
Enter the Fed’s printing press to save the day. But this ONLY works long-term if the market TRUSTS the Fed and their printed product.
In 2008, the world worried as the Fed took its balance sheet from $800 billion to $4.5 trillion. And that was just to paper over the now relatively small sub-prime mortgage mess.
It worked (temporarily) partly because the world didn’t have much choice. Dollars were the only game in town.
Today is much different than 2008. The world is wiser. Alternatives to the U.S. dollar and financial system exist or are being developed.
And the SIZE of the potential implosion is MUCH bigger than 2008.
Meanwhile, the Fed has already returned to lowering rates … and now is injecting substantial amounts of fresh cash into the system.
The question is … can the Fed print enough dollars to paper over a serious bond implosion … and if they do, will the world still trust the U.S. dollar?
Perhaps this is why central banks have been loading up on gold.
Coming back down to Main Street …
Whether the repo market is a canary in the coal mine signaling looming danger … or just a friendly wake up call to stay aware and prepared for something else later …
… there are some practical steps Main Street real estate investors can take to build a little more resilience into their portfolios.
First is education. The more you understand about how things work and how to recognize warning signs, the sooner you’ll see shifts so you grab opportunity and dodge problems.
It’s why we constantly encourage you to study, attend conferences, and get into meaningful conversations with experienced investors.
Next, it’s important to pay attention.
Most of what’s happening is widely publicized. But things are easy to miss when events don’t seem directly relevant to your Main Street life. They often are.
From a practical portfolio management perspective, it’s probably a great time to lock in low rate long-term financing, cash out some equity and retain a good level of liquidity.
When prices collapse, cash is king … and credit doesn’t count.
Be attentive to cash flows in current and future deals.
Invest in keeping your best tenants and team members happy. Look for ways to tighten up expenses and improve operations. Cash flow is staying power.
Focus on affordable markets and product niches supported by resilient economic, geographic, and demographic drivers.
Real estate is not a commodity or asset class. Certain markets and niches will outperform others. Be strategic.
Most of all, stay focused on the principles of sound fundamental investing. Be careful of having too much at risk on speculative plays.
As we’ve said before, an economy can be strong based on activity, but fragile based on systemic integrity.
If the system breaks down, then economic activity slows … sometimes dramatically … and if you’re only geared for sunshine, the storm can wash your wealth away quickly.
Until next time … good investing!
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