In a Mall of Pain

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This Note Was Updated May 13, 2017 at 8am

Central banks have done it again, eight years of an easy money gravy train have led to a colossal overbuild in the mall – commercial real estate space.  Secular forces like Amazon and changing habits of shoppers are a factor, but this kind of divergence has a lot to do with too much bored capital reaching for yield in the WRONG places.

As America shifts to core urban sectors, there’s a substantial amount of real estate that becomes obsolete.  There are a lot of loans that NEVER should have been made – high debt levels exacerbated the overbuild disconnect.

BA data reits

A secular change in retail consumption is taking hold, department store year over year spending is off nearly 20%, BAC data.  Mortgage Daily reported this month – the rate of late payments on securitized commercial mortgage backed securities (CMBS) funded loans is surging at an alarming rate. The record number of balloon payments coming do this year means defaults will rise substantially in 2017.  The major correction in the retail sector is only making the situation worse.

Some US$6.6bn of property loans packaged into CMBS deals since 2010 could be impaired, Morningstar Credit Ratings estimated in Q4 of last year.  We think this number is closer to $40B, ultimately – when the dust settles.

Core CPI, the Credit Contraction Connection

At what point does the credit contraction in commercial real estate, auto loans, credit cards and student loans – leak over to core consumer prices?

U.S. Core CPI ex Shelter

2017: -0.9%*
2016: 2.2%
2015: 1.4%
2014: 0.8%
2013: 0.2%
2012: 1.9%
2011: 2.4%
2010: 1.1%
2009: -0.3%
2008: 0.4%
2007: 2.1%

*weakest quarter in at least 17 years

Bloomberg, Nordea Markets

IHS Markit CMX BBB- Series 6 Price Index

CMBX PainWith the U.S. economy at “full employment” and the Federal Reserve hiking interest rates – credit risk is surging.  We believe 2017 will be a watershed moment, an acceleration of retail store closures and rent reductions – leading to credit risk contagion.  Structured leverage creates asymmetric credit risk as the cycle turns.  Retail assets make up over 40% of the debt load inside the CMBX 6 indexes, but only 10% are in the riskiest slices, the regional mall category

Traditional – on the ground retailers have announced nearly 3000 location closures through May 1st — including closing involving a number of national chains. The shutdown data for 2017 double those announced across the same period one year ago.

CDS Risk Surge

CDS Retail

Credit risk in the retail space is rising at its fastest level since the financial crisis.

Based on the ongoing rate, projections through the end of 2017 are ugly.  Retailers are expected to close over 9000 locations by the time 2018 rolls around, substantially higher than the numbers seen following the 2008 financial crisis and recession.

CMBX6 in Some Pain

File_000 (14)

Off nearly 10% on the year, CMBX6 is the “big short” in the mall space.  Hedge funds focused on rising consumer credit risk have been buying default protection on this tranche because of its heavy exposure to U.S. mall REITS.

The Bloomberg Reit Regional Mall Index (BBREMALL) plunged another 4% this week – lowest intraday print since March 2014 – off 33% since August 2016.  This week, Macy’s and Kohl’s 1Q comp sales missed estimates.

File_001 (107)Shorts have been focused on CMBX6, focused in HIGH mall exposure.  In CMBX6 there are sub-indices, each referencing 25 bonds from a portfolio of 25 CMBS offerings issued in 2012. Deals were be selected using rules-based criteria, such as deal size, pricing date, and the applicable rating and credit enhancement of the offered bonds.

Looking at equities, PEI is the worst performer – down as much as 3% to the lowest intraday print since 2012.  These names are not far behind in terms of pain; SPG, MAC, SKT, GGP, TCO, CBL and WPG.

This week, M shares are down as much as 20% to the lowest since 2011, while KSS fell 10%.

Mall Pain BBREIT

REITs with exposure to M include NYRT, PEI, ESRT, VNO, SPG, and WPG, according to a JPMorgan report from March, while REITs with exposure to KSS include UE, DDR, KIM, RPT, KRG, CDR, ESRT, WPG, BRX, REG.

Office REITs are also moved lower this week; NYRT fell 10% after its liquidation estimate trailed expectations, and CLI dropped 4% after BTIG questioned 1Q results.

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China Leveraging Up Global Equities

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The popular global growth story gets some important data points next week, China comes in with their import and export data on Monday May 8, 2017.

Street forecasts for China’s April import growth are wrapped around 18% year over year, that’s compared  to a 20.3% March reading.   Looking at export growth, the Street consensus is at 11.3%, compared to 16.4% in March.   We’re looking for much softer reading from both, oil is telling us something here below.

Everyone is Bought In

MSCI World vs OilIn recent days,  markets have witnessed significant weakness in the commodity space, especially focused toward the growth sensitive segment – oil, gas  and base metals.  On the other hand, global equities are surging while the growth story is faltering.

MSCI Global Earnings Growth Estimates are Sky High

2017: +13.7% (record high)
2016: +1.9%
2015: -0.7%
2014: +4.2%
2013: +6.5%

MSCI, Datastream

LEVER UP then LEVER DOWN

In front of their 19th National Party Congress this Autumn, China is finally introducing some more meaningful regulations into their banking and credit systems – they’ve been levering up for the last twelve months, trying to juice equity market returns – now they’re taking the foot off the gas pedal.

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We have always believed a major reason markets and the global economy reflated last year was influenced by China’s levered fiscal policies put forth last summer.  They fueled a recovery in their industrial sector. As that happened, commodity prices ripped and developed markets in Europe and the U.S. saw economic expansion. This is at great risk now, China is tightening liquidity and interbank lending rates are surging. We saw the effects of a China slowdown on Fed policy in 2015, this could be round two.

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Forty Minutes with Charlie Munger

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Every investor should attend the Berkshire Hathaway Annual Meeting in Omaha, Nebraska. It’s filled with good times, friendly people and a lot of wisdom.

Packed with 35,000 shareholders and friends from all over the world.   After four trips to this spectacle, we still have never seen anything like it in all our years in finance.

Warren Buffett and his lifelong business partner,  Charlie Munger, sat on stage for nearly six hours, dazzling the crowd with financial acumen, incredible energy, and offer a unique look into their world of money management. In a marathon five hour question and answer session, they gave everyone a chance to be heard. This was the most impressive display of corporate transparency I had ever seen. Everyone there, most of them scribbling notes, heard firsthand the thoughts of these two billionaires on an abundance of issues: Greece, the Euro, the International Monetary Fund, Goldman Sachs, Derivatives, High Yield Bonds, the Stock Market, Politics, Renewable Energy, Ethics, the US and Global Economy, the Emerging Markets, Finance Reform, Philosophy, History… they covered it all.

Meeting Munger, an Invitation to Omaha

But the highlight of the trip was a 40-minute, one-on-one meeting we had with Charlie Munger, who had read “A Colossal Failure of Common Sense,” and actually wanted to meet our Larry McDonald.   Munger is considered by many to be Buffett’s alter ego, the conservative skeptic who keeps the Oracle in check.  Or just a loyal friend and business partner for over 40 years.  It’s all true.  It was an honor to meet Mr. Munger, not because he’s a billionaire, but because he represents the end product of a life built on a 24-carat gold business character.

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Imagine the tallest and widest of the great California Redwood trees just south of the Oregon border.  When you look at this magnificent 2,000 year old Sequoia, over 375 feet high, it’s what you can’t see that’s most impressive; a root system over 250 feet wide that runs deeper than tree’s actual height. Now that is a foundation.

Munger and Buffett have run their business, Berkshire Hathaway, with that type of foundation in mind.  They operate in a completely opposite way from most public companies.  They run their business, and let the stock price take care of itself.  Most CEO’s try and manage the stock price first and the company second.  This was the problem at Lehman Brothers…  ethics, treating your employees right, putting your customers and shareholders’ interests first, all came second to running the stock price.  Whether it be accounting gimmicks or raising our dividend when we were almost bankrupt, it was all about trying to fool investors and shareholders into thinking we were just fine.

When it comes to ethics, character, and treating your employees and shareholders the right way, Berkshire does it like no other.  They are a model for business ethics, and I could tell both men were torn over Goldman Sachs.  Berkshire made a bold investment in Goldman during the depth of the financial crisis, plunking down $5 billion for a 10% convertible preferred stock which pays Berkshire $15 a second, every hour, of every day.  One of Buffett’s first thoughts of every day was the $432,000 Berkshire Hathaway had made while he was sleeping. And sitting in that shareholder meeting a few days ago, I got the feeling Buffett and Munger were in a real dilemma. First, Goldman is probably their oldest of friend. Buffett pointed out to the audience back in 1967 he and Charlie were trying to borrow $5.5 million in a bond offering and there were not enough takers. But it was Goldman and Kidder Peabody who came to their aid with an extra $400k to complete the deal.

To Buffett and Munger loyalty is everything.  They’re torn, because they want to stand by an old friend, one who’s paying them very well. Buffett and Munger spoke at great length about their dark days around their large investment in Salomon Brothers.  In the late 80s Berkshire ended up owning over 12% of Salomon but a few years later they all ended up in hot water after a scandal broke out in regards to Salomon’s business practices around trading treasury bonds.  Back then, Buffett made a famous stand to Congress, the regulators, Berkshire Shareholders and Salomon employees.  Buffett is not only a brilliant investor, he knows how to relate to people in very unique ways.  Back then, he talked about ethics, and conducting business as if your actions were on display in your hometown newspaper for everyone to see.  He replayed the grainy 1970’s C-SPAN video with him in front of Congress last Saturday. It obviously still means a lot to him. He plays it every year.

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Larry was blown away with how much we agree with Charlie Munger’s ideas on finance reform.  He feels like we do… that JP Morgan, Citigroup and Bank of America have no business sitting on top of $3 trillion of FDIC insured deposits, and $15 trillion of derivatives.  As Charlie said, “if I had it my way, I’d make Volker look like a sissy.”  He was referring to the Volker Rule which would force the banks to abolish big risk taking, investing in hedge funds, private equity and derivatives from traditional banking.

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Mr. Munger, like myself, would like to see more standardized accounting practices between the big four accounting firms and Wall St.  All firms should be treated the same way, no matter which accounting firm is signing off on the books. Abuses and innovative accounting moves like Repo 105’s must be made a thing of the past if we want to reduce systemic risks between the big banks.

Both Buffett and Munger are bullish on the future, especially the United States, and all of the advantages our capitalist republic provides.  But in the near term they seemed very cautious. Their main worries are centered around Greece, and the equity market pricing in higher taxes for the US.  Munger said of Greece, “high drama is on the way,” and the Eurozone “experiment” will be stress tested.

QUOTES
“Honey, if I lost everything, would you still love me?” “I’d love you, but I sure would miss you.” -Munger

“If I had to bet my life on higher or lower inflation, I’d bet a lot higher.” – Buffett

“Every one of my failures in investing brought me closer to that sweet smell of success. Just learn from each one. Humility builds character through hardship.” – Munger

“I like owning a company where your customers tattoo the name of that company on their chest. That’s why I own Harley Davidson.” -Buffett

“If I could only invest in the USA, I’d be just fine with that.” – Buffett

“Budget deficits of 10% of GDP are a lot of fun, but they can’t be sustained over long periods of time.” – Buffett

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