Marketplace Scratch Pad

Calling Dr. Doom

Scott Jagow Nov 19, 2009

Thanks for your feedback on topics you’d like to know more about. I’ll try to get to as many of them as possible. Today, I’ll address Scratch Pad reader Matt’s question: Is there another financial collapse coming down the pike?

Matt wonders if the TBTF banks will be in trouble again from commercial real estate loans or the wave of private equity buyouts that occurred earlier this decade. Also, he asks:

…is there any big name economist that is connecting the dots between these impending, systemic risks to the economy? It seems the fed is still fighting, and the media is still covering, the last crisis.

Matt, the big name economist I’ll mention is Nouriel Roubini. He’s been nicknamed “Dr. Doom” for his bearish nature. He’s also been called a prophet for predicting our current economic problems. In 2006, he told the IMF:

“The United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence, and, ultimately, a deep recession.”

Bingo. Here’s what Roubini wrote this week:

As a result of these terribly weak labor markets, we can expect weak recovery of consumption and economic growth; larger budget deficits; greater delinquencies in residential and commercial real estate and greater fall in home and commercial real estate prices; greater losses for banks and financial institutions on residential and commercial real estate mortgages, and in credit cards, auto loans and student loans and thus a greater rate of failures of banks; and greater protectionist pressures.

The damage will be extensive and severe unless bold policy action is undertaken now.

And by policy action he means:

…a bold prescription that increases the fiscal stimulus with another round of labor-intensive, shovel-ready infrastructure projects, helps fiscally strapped state and local governments and provides a temporary tax credit to the private sector to hire more workers. Helping the unemployed just by extending unemployment benefits is not sufficient; it leads to persistent unemployment rather than job creation.

That’s something we debated earlier this week.

There are mixed views about how damaging the commercial real estate bust might be, but the prevailing opinion is that it’ll be ugly. It was a major topic at the Reuters Global Finance Summit this week:

“The commercial real estate business still has not been marked down (on bank balance sheets). It’s not been marked to market,” Cantor Fitzgerald LP Chief Executive Howard Lutnick said. “The economy can’t, in my opinion, grow fast enough that the tenants are going to go out and start hiring and growing and building and take up all these rents at $60 a foot. It’s nonsense.”

…banks have postponed their day of reckoning, extending loans in hopes the economy will improve and demand for space will rebound. Banks have resisted selling assets, or taking them away from underwater borrowers, in fear of setting a new and lower market price.

It is a strategy neatly summarized as “a rolling loan gathers no loss,” Lutnick quipped.

This strategy of postponing the pain for short-term gain is pervasive and insidious, and it extends to the wave of private equity buyouts we saw from 2003 to 2007. I wrote about this a couple months ago:

$430 billion. Deal magazine says that’s the amount of leveraged loans due to mature between 2012 and 2014. This money came from the kingpins of private equity — Apollo, Bain Capital, Blackstone, KKR. They poured dump trucks full of money onto the balance sheets of companies like Clear Channel, First Data and Freescale Semiconductor to make enormous buyouts happen.

Now, with good reason, private equity is worried it won’t be getting that money back, and the market is worried what a disaster that could be.

Matt brought up an interview he heard on Fresh Air with Joshua Kosman. Kosman’s book, The Buyout of America, is about that potential disaster. Kosman believes at least half the companies bought by private equity this decade could collapse under the weight of their debts. Here’s one excerpt from Kosman’s book, via NPR:

These failures are going to occur because PE firms put their companies into crippling debt and, unlike entrepreneurs, who manage their businesses to succeed in the marketplace and grow, they manage their companies largely for short-term gains. They care about the futures of their PE firms but not about the viability of the companies they buy.

So they make deep cuts in spending on current operations and on research to develop new products. They fire not only redundant workers but also many who are essential to producing competitive goods and providing customer service. They raise prices on noncompetitive goods to unsustainable levels. And they use the brief windows when they have nice-looking financial statements from the cost cutting to take on huge new loans to pay enormous dividends.

Like it or not, private equity will keep doing what it does. Just today, we learned that a private equity-owned food company plans to buy Birds Eye Foods. CNN Money sees this as a positive development:

“Private equity firms have raised a significant amount of money and they have to deploy that cash. So they are going to step up and make some investments,” Haag Sherman, managing director with Salient Partners, an investment firm in Houston.

But there’s another reason why more LBOs (Leveraged Buyouts) could actually be good news.

Private equity shops tend to rely on debt to finance their takeovers. As such, their return to the M&A landscape could mean that the credit markets and the banking system really are starting to return to normal.

Dr. Doom says: Nope. Just planting the seeds of the next financial crisis.

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