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oftwominds-Charles Hugh Smith: After Seven Lean Years, Part 2: US Commercial Real Estate: The Present Position and Future Prospects

oftwominds-Charles Hugh Smith: After Seven Lean Years, Part 2: US Commercial Real Estate: The Present Position and Future Prospects.

The fundamentals of demographics, stagnant household income and an overbuilt retail sector eroded by eCommerce support only one conclusion: commercial real estate in the U.S. will implode as retail sales and profits weaken.

 
The first installment of our series on U.S. real estate by correspondent Mark G.focused on residential real estate. In Part 2, Mark explains why the commercial real estate (CRE) market is set to implode.
 

In the early stages of the sub-prime mortgage crisis it was widely believed that US commercial real estate (CRE) would manage to dodge the bullets. In the end CRE was found to be as vulnerable as anything else.
© 2014 Real Capital Analytics, Inc. All rights reserved. Source: Real Capital Analytics and Moody’s Investors Service. http://www.rcanalytics.com Used by permission.

These three graphs of relative prices show that in CRE the “core” is doing better than the “periphery”. The gap in relative price performance of major metro CRE over smaller cities and towns has approximately doubled from where it was in 2008.

And as with residential real estate, some CRE sub-sectors and cities are obtaining far greater benefit from bailout, stimulus and quantitative easing programs than other areas:


© 2014 Real Capital Analytics, Inc. All rights reserved. Source: Real Capital Analytics and Moody’s Investors Service. http://www.rcanalytics.com Used by permission.

Commercial real estate has a more complex structure than residential real estate. There is greater specialization in function. For instance strip shopping centers and indoor malls are generally not exchangeable with warehouse facilities.

We can simplify this a bit by classifying CRE by consumer sector and function. Industrial real estate will not be considered in detail. Current industrial construction spending is near a record high. But the value of current industrial CRE can still be depressed due to existing plant obsolescence and rapid shifts in activity location.

This leaves us to consider consumer retail and consumer service CRE.

Consumer Retail Spending & Retail CRE

The value of commercial real estate is driven by the revenues and profits earned by the businesses occupying CRE. This relationship is similar to the relationship between residential real estate prices and average household income.

The Two Drivers of Consumer Spending: Population Size and Average Household Income:

These two parameters show continuously increasing population size and declining average household incomes. The subsequent data shows this is resulting in a small increase in total consumer spending and also large shifts in spending patterns.

Real inflation adjusted total retail spending has increased slightly over its peak in 2007.



Essentially all of this increase has occurred in food spending. (A smaller portion has gone into clothing). And this is the only reasonable expectation given the twin conditions of an increasing total population and a declining average income per consumer. We can also note that “food” is a minuscule part of eCommerce. The retail food trade occurs almost entirely in neighborhood groceries, markets and convenience stores. The other non-food retail sectors are flat to declining. But within these sectors there is a large zero-sum game being played out between eCommerce and local bricks ‘n mortar stores:

The Rise of eCommerce

Since 2008 eCommerce retail sales have nearly doubled. But as we just saw, the entire increase in total consumer spending since 2008 is accounted for by the increased food sales which occur at local markets. “eCommerce” is therefore taking sales away from other local retail sectors. And the biggest single loser is:

Local Retail Department Stores

This macroeconomic data is well-supported by the current financials of both Sears and JC Penney. Sears’ trailing twelve month (ttm) earnings per share are – $14.11. This loss will increase once Sears reports its fourth quarter earnings at the end of February, 2014. Sears is widely expected to lose one billion dollars in 2014. J.C. Penney meanwhile is currently reporting ttm losses of -$7.32 per share.

One or both of these chains will be in bankruptcy by 2015 even if the current “recovery” continues. And outright liquidation of one or both companies is at least as likely as reorganization. There is little reason to believe either of these companies would be more viable following mere debt reduction.

The third major department store chain is Macy’s, which is still reporting profits. Oddly enough Macy’s management celebrated their 2013 holiday season by announcing 2,500 permanent layoffs from their local retail department stores. This was paired with a mid-December announcement of an increase of 1,500 employees in a new eCommerce fulfillment center in Oklahoma.

In these circumstances it is unsurprising that retail CRE prices are showing weak recovery.


© 2014 Real Capital Analytics, Inc. All rights reserved. Source: Real Capital Analytics and Moody’s Investors Service. http://www.rcanalytics.com Used by permission.

The Coming Implosion of the Regional Indoor Shopping Mall
(and adjacent strip shopping centers)


There are approximately 1,100 indoor shopping malls in the USA. Sears has about 2,000 stores. JC Penney’s has almost exactly 1,100 stores. There are very few malls that don’t have at least one of these chains. The vast majority of malls have both as major anchor stores. Macy’s is typically the third major anchor now. A regional department store chain or two round out the large anchor stores.

A virtual stroll down the typical mall concourse will reveal plenty of other money losing chain retailers with names like Radio Shack et al. Adjacent strip shopping centers
This should not be surprising. The regional indoor mall is a middle class income institution. It grew up with the post-WWII rise in average incomes. As middle class incomes now disappear so are the former favorite shopping venues of the middle class.

Every time a mall store closes shoppers lose another reason to go to the mall. “Dead mall” syndrome will soon afflict most of this sector.

In addition to decaying tenant revenues the mall owning Real Estate Investment Trusts are dangerously overleveraged with low-cost to free ZIRP and QE funding. Now that the Federal Reserve is tapering QE their financing costs will be rising as commercial balloon mortgages come due and have to be rolled over. And since the typical commercial mall mortgage does carry a large balloon payment at the end they have to be refinanced. Assuming honest loan underwriting a higher risk premium will also be attached due to the deteriorating retail fundamentals of the tenants.

General Growth Properties (GGP) is probably in the best condition. This is because GGP just exited a Chapter 11 reorganization in 2010. It was placed into involuntary bankruptcy in 2009 by two mortgagors holding matured recourse balloon mortgages. GGP was understandably unable to refinance these balloons in the spring of 2009.

This entire sector will collapse when the next recession appears.

And since history hasn’t ended, the next recession will appear at some point. It may be appearing already. At the beginning of October, 2013 the analyst consensus for retail profit growth for the strongest October – December holiday quarter was 5.5%. At the beginning of the reporting cycle in January expectations were down to 0.5% profit growth. That is a 90% reduction in analyst expectations in just three months.

Barring a turnaround, many retail chains still reporting profits will be reporting quarter-on-quarter profit declines in April. And by the end of the third quarter more will start reporting outright losses.

Part 3 will examine the other major part of local consumer oriented CRE. These are consumer services like neighborhood banking, investment, insurance and other services. Experience to date demonstrates that in the next few years the internet, expert software systems and robotics/automation will eliminate 50% and more of the jobs formerly associated with these businesses. These same trends will also shift most of the surviving positions away from the traditional storefront strip center and local office park locations.


 
Thank you, Mark, for this comprehensive analysis. We look forward to reading Part 3.

Catholic Diocese Of Stockton Files Bankruptcy; Priest Sexual-Abuse Scandal Blamed | Zero Hedge

Catholic Diocese Of Stockton Files Bankruptcy; Priest Sexual-Abuse Scandal Blamed | Zero Hedge.

Between lack of cash flows, insurmountable liabilities, an untenable pension funding, even insider fraud, we thought we had seen all the various reasons for filing for Chapter 11 bankruptcy protection. And then along came the Catholic Diocese of Stockton which announced that it would join its host city and seek bankruptcy protection “in the wake of the church’s sexual-abuse scandal.” As WSJ reported, Bishop Stephen E. Blaire said in a news release Monday that the diocese would seek bankruptcy protection Wednesday, explaining that reorganization was the only option for dealing with mounting legal costs related to abuse by priests. The bishop said the diocese has spent $14 million in legal settlements and judgments over the past 20 years dealing with abuse allegations, and doesn’t have funds available to settle pending lawsuits or address future allegations. The punchline: “Very simply, we are in this situation because of those priests in our diocese who perpetrated grave, evil acts of child sexual abuse.

In the Stockton diocesan bankruptcy, the parties will likely agree on a figure that the diocese would pay, in addition to potentially pulling in funds from insurers. However, the diocese says it holds “relatively little property and assets.” Other holdings, including schools, parishes and several parcels of land, are incorporated separately.

And so the Stockton Catholics became the 10th US Diocese after Milwaukee; San Diego; Spokane, Wash.; Davenport, Iowa; Portland, Ore.; Tucson, Ariz.; Fairbanks, Alaska; Wilmington, Del.; and Gallup, N.M. to file bankruptcy.  In addition, the Christian Brothers Institute, which operates Catholic schools and orphanages, also filed because of sexual abuse liabilities.

The Chapter 11 filing would halt pending litigation against the diocese and likely would ultimately allow it to discharge liabilities stemming from sexual-abuse allegations by setting up a trust to compensate victims. The diocese said it hopes to arrive at a resolution with victims and insurers through the process.

 

Joelle Casteix, western regional director of the Survivors Network of those Abused by Priests, called the bankruptcy “problematic on a lot of different levels,” noting that it would let the diocese avoid future civil cases.

However, while the local catholics’ financial woes may be put on temporary hold, their civil troubles are only starting:

Separately, a grand jury Monday indicted a former priest with the diocese, Michael Eugene Kelly, and a warrant for his arrest has been issued. Calaveras County authorities are seeking Mr. Kelly’s extradition from Ireland to face charges of three counts of lewd and lascivious conduct on a child, and one count of oral copulation with a child. Mr. Kelly faces 14 years in prison if convicted.

Not surprisingly, the Catholic church which itself is embroiled in numerous financial scandals recently, was unable to come to the Diocese’s rescue even though it has already paid out an estimated $2.2 billion to cover settlements, therapy for victims, support for offenders, attorney fees and other costs, according to a report by the U.S. Conference of Catholic Bishops.

And with this filing, we are fairly confident we have seen every possible bankruptcy filing reason.

To This Day, No One Knows What Financial Firms Are Sitting on | Zero Hedge

To This Day, No One Knows What Financial Firms Are Sitting on | Zero Hedge.

As powerful as it may be, the Fed is not the market. And since the Fed failed to restore trust in the system by forcing all bad debts to light, the financial world has grown increasingly volatile and broken as investors grow increasingly distrustful of the system and begin to pull their money from it: see market volumes continuing to plunge.

 

Nowhere is the lack of trust more apparent than in the financial sector. Indeed, it was a lack of trust between banks (inter-bank lending) that caused the credit markets to jam up in 2008, which resulted in the Crash.

 

That lack of trust continues to this day. In the post-Lehman collapse, instead of forcing real derivative and credit risk out into the open, the Federal Reserve and regulators instead suspended accounting standards and allowed financial firms (and other corporate entities) to continue to lie about the true state of their balance sheets.

 

As a result of this, the financial sector remains rife with fraud and impossible to accurately value (how can you value a business that is lying about its balance sheet?).

 

Those times in which a company was forced to value its assets at market prices have always seen said values losing 80%+ value in short order: consider Washington Mutual, which sported a book value north of $70 billion right up until it was sold for… $2 billion.

 

This type of fraud is endemic in the system. Indeed, we got a taste of just how problematic a lack of transparency can be with MF Global’s bankruptcy, in which a firm with $42 billion in assets lost over 80% of its value since August only to reveal in bankruptcy that it had stolen over $700 million worth of clients’ money.

 

That MF Global engaged in fraud and stole clients’ money is noteworthy. However, the far more important issue is:  HOW did this company receive primary dealer status from the NY Fed nine months before imploding?

 

The Primary Dealers are the banks that actively engage in day to day activities with the New York Fed regarding the Fed’s monetary policies. Primary Dealers also participate in US Treasury auctions.

 

Put another way, Primary Dealers are the most elite, well-connected financial firms in the world.  They have unequal access to both the Fed and the US Treasury Dept. In order for MF Global to have attained this status it must have passed through a review by:

 

1)   The New York Fed

2)   The SEC

 

This is not a quick nor superficial process. According to the NY Fed’s own site:

 

Upon submission of a formal application, a prospective primary dealer can expect at least six months of formal consideration by the New York Fed. That consideration may include,among other things, on-site reviews of front, middle, and back office operations, review of compliance programs and discussions with compliance and credit risk management staff, discussions with senior management about business plans, financial condition, and the ability to meet FRBNY’s business needs, review of financial information, and consultation with primary supervisors and regulators.

 

MF Global passed through all of these reviews to became a primary dealer in February 2011. A mere nine months later, the firm is in Chapter 11 and has admitted to stealing clients’ funds to maintain liquidity.

 

These developments reveal, beyond any doubt, that financial oversight in the US is virtually non-existent. This returns to my primary point: that trust has been lost in the system. And until it is restored, the system will remain broken.

 

A final note on this: the NY Fed is the single most powerful entity in charge of the Fed’s daily operations. How can any investor believe that the Fed can manage the system and restore trust when the NY Fed granted MF Global primary dealer status a mere nine months before the latter went bankrupt?

 

If the NY Fed cannot accurately audit a financial firm’s risks during a six month review, then there is NO WAY an ordinary investor can do so.

 

This is one of the biggest risks in the system: that no one has a clue what financial entities are sitting on in terms of garbage derivatives and debts. As MF Global proved, this risk can result in a TOTAL loss of funds.

 

This type of fraud will continue until the system breaks. At that point hopefully the bad debts will finally clear from the system and we can actually lay a foundation for growth.

 

For a FREE Special Report outlining how to protect your portfolio from this, swing by: http://phoenixcapitalmarketing.com/special-reports.html

 

Best Regards

Phoenix Capital Research

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