The Problems are the Path: SILICON VALLEY BANK..Higher Interest Rates Take No Prisoners

When the FED started raising rates, I stated that the inflation the FED saw was in realty Asset Inflation.  Yesterday March 9, 2023 we saw the results.

The seizing of Silicon Valley Bank, the 15th largest in the United States, was the largest such failure and seizure since the Washington Mutual seizure.  

There will be ramifications!  SVB the darling of the Valley has been one of the Prima's of our area.  One that WHO WAS ANYONE AND who wanted to be SOMEONE mentioned them as "Their Bank" during cocktail parties.  It was the bank that all funds from IPO's and formation funding that the Venture Capitalist put the new business proceed in to await to be drawn during the rise of the new company from birth to growth. 

My thoughts are that History Does Repeat Itself.  This happened in the late 70's and early 80's when higher interest rates caused the abandonment of venture capital funding.  Take a risk or leave your investment money in T-Bills the question is not easy to answer when the future of rates were higher. Now it will especially be the case in future VC promotions

In this case the very people who helped form and allowed SVB to prosper where the ones for its undoing.

Every morning I read the Bloomberg Opinion of Matt Levine.  An old habit as a stock trader, investor and investment manager when it was only on a Bloomberg terminal on my desk.  It was a must read by all Wall Street before the market's opening, just as much as the Wall Street Journal was a must as I sat  at my desk waiting for the Stock Market to open.

I am copying Matt's comments here for all of you to read to understand What Happened?

"Programming note: Money Stuff was supposed to be off today, but: bank run!

SVB

The lesson might be that there are some industries that are bad to bank. Imagine that it was 2021, and someone was like “do you want to start the Bank of Crypto? What about the Bank of Venture-Backed Tech Startups?” You’d be tempted, right? Those industries had so much money! They seemed cool. If you were their bank — if you were the specialized bank that exclusively focused on those industries — influencers on Twitter would tweet nice things about you, and you’d get invited to fancy parties. Also, as their bank, you’d probably find a way to get a cut of growing industries with lots of potential. Provide banking services to tech startups, get warrants in those startups, get rich when they go public. Provide banking services to crypto exchanges, start some sort of blockchain-based payment network, get rich through the magic of saying “blockchain” a lot. 

But the structure of being the Bank of Crypto or Startups was a bit rickety. Traditionally, the way a bank works is that it takes deposits from people who have money, and makes loans to people who need money. The weird problem with focusing exclusively on crypto or startups in 2021 is that they had too much money. If you were the Bank of Startups, the main service that you provided to startups is that equity investors  would give them a truck full of cash and they’d deposit it at your bank. Here is how SVB Financial Group, the holding company of Silicon Valley Bank, describes the vibe of 2021 and 2022 in its Form 10-K two weeks ago:

Much of the recent deposit growth was driven by our clients across all segments obtaining liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions and other fundraising activities—which during 2021 and early 2022 were at notably high levels.

People kept flinging money at SVB’s customers, and they kept depositing it at SVB. Perfectly reasonable banking service. 

But the customers didn’t need loans, in part because equity investors kept giving them trucks full of cash and in part because young tech startups tend not to have the fixed assets or recurring cash flows that make for good corporate borrowers.[1] Oh, there is some tech-industry-adjacent lending you can do.[2] Tech founders want to buy houses, and you can give them mortgages. Venture capital and private equity funds want to manage liquidity and/or juice their reported return rates by paying for investments with borrowed money rather than drawing from their limited partners, so you can get into the capital-call-line-of-credit business. There are vineyards near Silicon Valley and you can develop an expertise in vineyard financing. And, sure, some of your tech-company customers do need to borrow money, and are creditworthy, and you lend them money and that works out. But there is a basic imbalance. Customer money keeps coming in, as deposits, but it doesn’t go out, as loans.

So you have all this customer cash, and you need to do something with it. Keeping it in, like, Fed reserves, or Treasury bills, in 2021, was not a great choice; that stuff paid basically no interest, and you want to make money. So you’d buy longer-dated, but also very safe, securities, things like Treasury bonds and agency mortgage-backed securities. We talked yesterday about how this worked out at Silvergate Capital Corp., the actual Bank of Crypto. And as of the end of 2022, Silicon Valley Bank, the actual Bank of Startups, had about $74 billion of loans and about $120 billion of investment securities.

Crudely stereotyping, in traditional banking, you take deposits and make loans. In the Bank of Startups, in 2021, you take deposits and mostly buy bonds. Again crudely stereotyping, corporate loans often have floating interest rates and shorter terms, while bonds have fixed interest rates and longer terms. None of this is completely true — there are fixed-rate corporate loans and floating-rate bonds, traditional banking tends to involve making lots of loans (like mortgages) with long-term fixed rates, you can do swaps, etc. — but it is a useful crude stereotype.[3]

Or, to put it in different crude terms, in traditional banking, you make your money in part by taking credit risk: You get to know your customers, you try to get good at knowing which of them will be able to pay back loans, and then you make loans to those good customers. In the Bank of Startups, in 2021, you couldn’t really make money by taking credit risk: Your customers just didn’t need enough credit to give you the credit risk that you needed to make money on all those deposits. So you had to make your money by taking interest-rate risk: Instead of making loans to risky corporate borrowers, you bought long-term bonds backed by the US government.

The result of this is that, as the Bank of Startups, you were unusually exposed to interest-rate risk. Most banks, when interest rates go up, have to pay more interest on deposits, but get paid more interest on their loans, and end up profiting from rising interest rates. But you, as the Bank of Startups, own a lot of long-duration bonds, and their market value goes down as rates go up. Every bank has some mix of this — every bank borrows short to lend long; that’s what banking is — but many banks end up a bit more balanced than the Bank of Startups. At the Financial Times, Robert Armstrong writes:

Few other banks have as much of their assets locked up in fixed-rate securities as SVB, rather than in floating-rate loans. Securities are 56 per cent of SVB’s assets. At Fifth Third, the figure is 25 per cent; at Bank of America, it is 28 per cent. 

For most banks higher rates, in and of themselves, are good news. They help the asset side of the balance sheet more than they hurt the liability side. … SVB is the opposite: higher rates hurt it on the liability side more than they help it on the asset side. As Oppenheimer bank analyst Chris Kotowski sums up, SVB is “a liability-sensitive outlier in a generally asset-sensitive world”.

But there is another, subtler, more dangerous exposure to interest rates: You are the Bank of Startups, and startups are a low-interest-rate phenomenon. When interest rates are low everywhere, a dollar in 20 years is about as good as a dollar today, so a startup whose business model is “we will lose money for a decade building artificial intelligence, and then rake in lots of money in the far future” sounds pretty good. When interest rates are higher, a dollar today is better than a dollar tomorrow, so investors want cash flows. When interest rates were low for a long time, and suddenly become high, all the money that was rushing to your customers is suddenly cut off. Your clients who were “obtaining liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions and other fundraising activities” stop doing that. Your customers keep taking money out of the bank to pay rent and salaries, but they stop depositing new money. 

This is all even more true of crypto — I mean, the Fed raised rates once and the entire crypto industry vanished?[4] — but it is not not true of startups. But if some charismatic tech founder had come to you in 2021 and said “I am going to revolutionize the world via [artificial intelligence][robot taxis][flying taxis][space taxis][blockchain],” it might have felt unnatural to reply “nah but what if the Fed raises rates by 0.25%?” This was an industry with a radical vision for the future of humanity, not a bet on interest rates. Turns out it was a bet on interest rates though. 

Here’s Bloomberg’s Katie Greifeld:

Silvergate and SVB “in fact are victims of the same phenomenon as Fed tightening extinguishes froth from those parts of the economy with the most excess — and it’s hard to find more excess than in crypto and tech startups,” said Adam Crisafulli of Vital Knowledge.

And my Bloomberg Opinion colleague Paul Davies:

Both crypto and venture capital booms were children of the ultra-low rates of the past decade and a half. Now, rising rates and the shrinking of the Federal Reserve’s balance sheet have burst those industry bubbles and increased the competition among banks for funding. 

And so if you were the Bank of Startups, just like if you were the Bank of Crypto, it turned out that you had made a huge concentrated bet on interest rates. Your customers were flush with cash, so they gave you all that cash, but they didn’t need loans so you invested all that cash in longer-dated fixed-income securities, which lost value when rates went up. But also, when rates went up, your customers all got smoked, because it turned out that they were creatures of low interest rates, and in a higher-interest-rate environment they didn’t have money anymore. So they withdrew their deposits, so you had to sell those securities at a loss to pay them back. Now you have lost money and look financially shaky, so customers get spooked and withdraw more money, so you sell more securities, so you book more losses, oops oops oops.[5]

As Armstrong puts it, SVB had “a double sensitivity to higher interest rates. On the asset side of the balance sheet, higher rates decrease the value of those long-term debt securities. On the liability side, higher rates mean less money shoved at tech, and as such, a lower supply of cheap deposit funding.”

Also, I am sorry to be rude, but there is another reason that it is maybe not great to be the Bank of Startups, which is that nobody on Earth is more of a herd animal than Silicon Valley venture capitalists. What you want, as a bank, is a certain amount of diversity among your depositors. If some depositors get spooked and take their money out, and other depositors evaluate your balance sheet and decide things are fine and keep their money in, and lots more depositors keep their money in because they simply don’t pay attention to banking news, then you have a shot at muddling through your problems.

But if all of your depositors are startups with the same handful of venture capitalists on their boards, and all those venture capitalists are competing with each other to Add Value and Be Influencers and Do The Current Thing by calling all their portfolio companies to say “hey, did you hear, everyone’s taking money out of Silicon Valley Bank, you should too,” then all of your depositors will take their money out at the same time. In fact, Bloomberg reported yesterday:

Unease is spreading across the financial world as concerns about the stability of Silicon Valley Bank prompt prominent venture capitalists including Peter Thiel’s Founders Fund to advise startups to withdraw their money. …

Founders Fund asked its portfolio companies to move their money out of SVB, according to a person familiar with the matter who asked not to be identified discussing private information. Coatue Management, Union Square Ventures and Founder Collective also advised startups to pull cash, people with knowledge of the matter said. Canaan, another major VC firm, told firms it invested in to remove funds on an as-needed basis, according to another person.

SVB Financial Group Chief Executive Officer Greg Becker held a conference call on Thursday advising clients of SVB-owned Silicon Valley Bank to “stay calm” amid concern about the bank’s financial position, according to a person familiar with the matter.

Becker held the roughly 10-minute call with investors at about 11:30 a.m. San Francisco time. He asked the bank’s clients, including venture capital investors, to support the bank the way it has supported its customers over the past 40 years, the person said.

Nah, man, you don’t get to be a successful venture capitalist by taking a long view or investing in relationships or being contrarian. I’m sorry, I’m sorry, this is unfair. Of course they were right — Silicon Valley Bank did collapse, and if you got your money out early that was good for you — but that is largely self-fulfilling; if all the VCs hadn’t decided all at once to pull their money, SVB probably would not have collapsed.[6]

But it did:

Silicon Valley Bank collapsed into Federal Deposit Insurance Corp. receivership on Friday, after its long-established customer base of tech startups grew worried and yanked deposits. 

The California Department of Financial Protection and Innovation in a statement Friday said it has taken possession of Silicon Valley Bank and appointed the FDIC as receiver, citing inadequate liquidity and insolvency.  

The FDIC said that insured depositors would have access to their funds by no later than Monday morning. Uninsured depositors will get a receivership certificate for the remaining amount of their uninsured funds, the regulator said, adding that it doesn’t yet know the amount. 

Receivership typically means a bank’s deposits will be assumed by another, healthy bank or the FDIC will pay depositors up to the insured limit. 

SVB’s capital stack looked roughly like this, as of Dec. 31:

• A tiny sliver of insured deposits (that is, deposits under the $250,000 FDIC limit), something like $8 billion worth out of $173 billion of total deposits.[7]
• Roughly $165 billion of uninsured deposits. 
• Roughly $13 billion of “short-term borrowings,” meaning mostly Federal Home Loan Bank advances.
• Roughly $2 billion of long-term FHLB advances.
• Roughly $3 billion of long-term bonds.
• Maybe $4 billion of other liabilities, for a total of $195 billion of liabilities.
• About $3.6 billion of preferred stock.
• Common stock with a book value of about $12.4 billion and a market value, on Dec. 31, of about $13.6 billion.

It had assets of about $212 billion on that Dec. 31 balance sheet, though since then it has had to sell some assets and mark others down, and it’s not clear what they’re worth today. The California Department of Financial Protection and Innovation cited “inadequate liquidity and insolvency” when it put SVB into FDIC receivership, suggesting that the assets are worth less than the liabilities. The FDIC’s job, in receivership, is “efficiently recovering the maximum amount possible from the disposition of assets” to distribute to creditors.

One obvious question is: If you are “another, healthy bank” working through this weekend to buy SVB and assume its deposits, how much would you pay for the assets, which were worth $212 billion in December?[8] I am pretty sure the answer is higher than $8 billion, the amount of insured deposits: The FDIC will not be on the hook for the insured deposits. The $15 billion of FHLB advances are also quite senior and will presumably be no problem to pay back.

I would also guess — not investing or banking advice! — that the answer will also turn out to be higher than $188 billion, which is the total amount of deposits plus FHLB advances. I say this not because I have done a detailed analysis of SVB’s assets but because it seems bad for the FDIC to wind up a big high-profile bank in a way that causes significant losses for depositors, including uninsured depositors. There was a run on SVB in part because there hasn’t been a big bank run in a while, and people — venture capitalists, startups — were naturally worried that they might lose their deposits if their bank failed. Then the bank failed.

If it turns out to be true that they lose their deposits, there could be more bank runs: Lots of businesses keep uninsured deposits at lots of banks, and if the moral of SVB is “your uninsured transaction-banking deposits can vanish overnight” then those businesses will do a lot more credit analysis, move their money out of weaker banks, and put it at, like, JPMorgan. This could be self-fulfillingly bad for a lot of weaker banks. My assumption is that the FDIC, the Federal Reserve, and the banks who are looking at buying SVB all really don’t want that. If you are a bank looking at buying SVB, and you do a detailed analysis of its assets and conclude that they are worth $180 billion, and you come to the FDIC and say “I will take over this bank and pay the uninsured depositors 95 cents on the dollar,” the FDIC is going to look at you and say “don’t you mean 100 cents on the dollar,” and you are going to say “oh right yes of course, silly me, 100 cents on the dollar.”[9]

Maybe I’m wrong about that, but if I am it’ll be bad!

Above that, though, I have no idea. The stock closed at $106.04 per share yesterday (a $6.2 billion market cap, roughly 50% of book value), and was halted today. The preferred was trading at about 60 cents on the dollar yesterday, also closed today. Byrne Hobart wrote the bull case yesterday:

The simple way to look at SVB from an investing perspective is to separate the ongoing business from the balance sheet for a moment, and ask: what premium does SVB's business deserve to book value, in a hypothetical world where they didn't make a massive rates bet? Over the last twenty years, they've traded at an average of 2.3x tangible book value, and generally at a premium to their banking peers. So a simple way to value the business is to say that the fair value of the business is generally ~100 cents on the dollar in liquidating value and another ~130 cents on the dollar in franchise value. If that liquidating value has been vaporized by a rates bet, the surviving business is still worth a premium to book.

But that was yesterday, and the franchise value melts pretty quickly when you go into FDIC receivership. The bear case is … well, back in November, when crypto exchange FTX was still looking for a rescue (it never found one), I wrote that the traditional price for that sort of rescue is “we will buy your exchange, make sure that all your customers are made whole, and give you a Snickers bar in exchange for 100% of the equity.” That may be where this is heading.

More From Bloomberg Opinion

• Silicon Valley Bank’s Swoon Should Scare Us All.
• Why Is the US Regulating JPMorgan But Not SVB?
• SVB and Silvergate Tumult Has Echoes in Texas Bank Crisis.
• Crypto Carcass Will Attract Hedge Fund Vultures.
• Banks Throw Markets a Curveball.

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[1] Similarly in crypto, on 2021, crypto exchanges had tons of cash that they needed to park at a bank, but were not really in the business of taking loans from banks. There was a lot of lending in the crypto world, but it was all loans secured by Bitcoins and stuff and that is mostly too spicy for a bank; it was mostly done by crypto shadow banks (including exchanges themselves). Though Silvergate did some of it.

[2] Here I am sort of summarizing SVB's discussion of its loan portfolio on pages 70-71 of the 10-K.

[3] Oh it’s way too crude. Here is “Banking on Deposits: Maturity Transformation without Interest Rate Risk,” by Itamar Drechsler, Alexi Savov and Philipp Schnabl, in the Journal of Finance in 2021, making the case “that maturity transformation does not expose banks to interest rate risk — it hedges it,” even in a model where banks lend long at fixed rates, because depositors are not very sensitive to interest rates.

[4] Oh I am exaggerating for effect, please do not email me to be like “by summer 2022 there had been a string of actual and projected Fed rate increases” or “actually there is still crypto,” I know.

[5] This oversimplifies the mechanics of how you lose money, and I recommend Marc Rubinstein's explanation today. Basically SVB ended up with a large portfolio of held-to-maturity bonds with an average duration of 6.2 years at the end of 2022, “and unrealised losses snowballed, from nothing in June 2021, to $16 billion by September 2022.” These losses “completely subsumed the $11.8 billion of tangible common equity that supported the bank’s balance sheet,” meaning that SVB was technically insolvent. But mark-to-market losses on held-to-maturity bonds don't count for bank accounting purposes; the theory is that you will just hold the bonds until maturity, they will pay back par, and you won't have any losses. So SVB was still solvent and fine. “Sell even a single bond out of an HTM portfolio, however, and the entire portfolio would need to be re-marked accordingly”: If you have bonds in your held-to-maturity portfolio, you have to be really confident you can hold them to maturity. SVB’s bonds kept maturing, providing cash to pay out depositors who wanted their money back. But: “What neither the CEO nor the CFO anticipated, however, was that deposits might run off faster” than the bonds. They did, SVB sold its available-for-sale bonds, it wasn’t enough, and here we are.

[6] Other things might have prevented its failure. Daniel Davies points out that Silicon Valley Bank, though it is big, is not quite big enough to be subject to the Federal Reserve’s post-2008 liquidity regulations, which would have made it more, you know, liquid.

[7] The FDIC’s statement says “At the time of closing, the amount of deposits in excess of the insurance limits was undetermined,” and presumably the mix has shifted since Dec. 31.

[8] They were not: Again, that was the book value, and the unrealized losses on the held-to-maturity bonds would reduce that. On the other hand, maybe they've gone up since then? Byrne Hobart tweeted: "One irony of all this is that a flight to safety is disproportionately good for exactly the long-duration low/no-credit risk stuff that caused this problem in the first place."

[9] When IndyMac Bancorp failed in 2008, uninsured depositors got back 50 cents on the dollar, though they were relatively small. Since then, it seems to be an FDIC goal to get the uninsured depositors paid."

In the 70's and 80's more people invested in real estate than I ever experience.  It was the Real Estate!

The biggest loser, in my opinion, will be the stock market, crypto and other esoteric investments.  Real Estate and Gold the beneficiary.

As before, call or write for any question you may have and think of me of your "in the know real estate agent"

The Problems are the Path: Interest Rates a Useless Strategy?

There was a time in my past newsletters/commentaries I believed the rise in interest rates would dampen real estate prices and cause the affordability index to move in favor of buyers, which we had.  I then went to look at "Asset Inflation" to put down speculation and lower asset prices of Stocks, Bonds, Real Estate and Esoteric Assets, which we had.  

The rise in interest rates have had an impact, but far from what the FED expected, and many economic analysts expected.  The main reason, in my opinion, is that the Money Supply has not contracted.  Some +$9 trillion was pumped into the economy from 2020 to 2022.  Of that only a small percentage has been spent.  Goldman Sachs has stated that 65% of those saving will be expended by the end of 2023.  

What we have is a little below $9 Trillion in the FED's balance sheet.  The FED has not contracted Money Supply as they raised interest rates.  There could be some political reasons as higher interest rates bear down heavily on Technology Stocks and investments.  The technology bulls eye is a target that has united both sides of the political spectrum.  You be the judge.

If this is a political action without contraction of Money Supply, then why should there be a pressure on Home Prices?  From the Fidelity reports I have added to the past commentaries it is very clear increasing rates are not affecting the demand for low to mid value properties.  From East Palo Alto to Menlo Park, Los Altos, Redwood City, San Carlos and other SF Peninsula cites the demand for housing has not abated.  They are all in a strong seller's market.  

If there is something to be garnered from that observation is the examination of condition of the house for sale and the concurrent price action that follow.  Location, Location, Location are always the main driving force of real estate.  The next is Condition, Condition, Condition.  This last "3 C's" is what makes home sales distinguished from the first "3 C's".  

Buyer's have a unique ability to distinguish from what is for sale to what they want.  What they want is a "Move in condition home". Not a fixer upper, not a contractor's special. It is my observation buyers want a disclosure package that is clean of any future work needed; along with, a matching  interior and exterior.

With the "Condition" quotient  the buyer's have distinguished what they will pay.  Now here comes the key element.  Their cash reserves are in liquid, safe investments that have no risk of capital and return a handsome rate of return that pays increasingly larger amounts of interest as the FED increases interest rates.

The result is the multiple offers and over bids for those properties with "condition, condition, condition" and "location, location, location".  For those properties that are over priced with missing parts to the two "3 C's" there are price cuts, no offers and under bids.  

On a daily basis I watch the 7-day results of Atherton, Menlo Park, Los Altos, Palo Alto, Redwood City, San Carlos, South San Francisco, Woodside and Portola Valley.  I see very little change in the daily new listings, but do note that those properties that go pending and sold have the two "3 C's" and those that do not, linger and have price cuts!

I also have Zillow, Realtor.com send me results of "move to locations" of the California/SF and Bay Area Exodus.  Those areas show a distinct drop in home prices, more new  homes for sale by developers, and greater number of homes for sale with longer duration of Days on the Market.

We may be in a market in which there is the "Willing buyer and the Willing Seller' meeting more evenly, than the past of "make me an offer I can't refuse" 

That could be the reason that Fix and Flippers, contractors and investors are able to pick up homes and turn them around into move into condition homes and turn a handsome profit.

It also could be a reason the rental prices are dropping and the new level of buyers come from this frustrated market made by reason of abusive landlords and the realization of renters that they are not building equity.

Outlook For 2023:

From my experience in Listings, Buyers and Broker Price Opinions I see: 

1.    Demand and interest rates moving in reciprocal condition.  As interest rates on 30-year mortgages approach 7%, Real Estate sales decline.  As interest rates on 30-year mortgage approach 6% the Location and Condition houses move quickly.

2.  I do not see any drastic movements in average home prices unless there is a surprise of increases in listing inventory.  I expect a return of listings in the next few months from those properties that were taken off the market in December.  Once moved the inventory should remain light.

3.  The "Black Swan" is the FED's action on inflation control.  The FED may see a move to reducing Money Supply.  That occurred in the mid to late 70's.  It drove down Stock and Bond values and the seekers of store of value, income and appreciation went to real estate.

Again as always, if you have any question and or need assistance; do not hesitate to call, email or text me.

Gary

The Problems are the Path: Statistics and Probability

One of the most enjoyable classes I had in college were in the Statistics and probability classes.  I must admit my greatest source of successes from these classes in my formative days was Black Jack.  A colleague of mine named Tony, who looked like Tony Soprano and was from New Jersey, and I were so successful at in that in the mid 70's we were told not to come back to Las Vegas.  So it became a rather humorous endeavor when I listened to Economists talk about the various forecasts they had on the economy and where the future was going.

Another  benefit  was in viewing the FED and their attempts to use interest rates to solve and economic situations.  The Federal Reserve of St, Louis published an economic report which detailed the past actions of the FED with interest rates.  I can say, that my interpretation was the FED was alway Behind the Ball.  They either failed to cease their interest rates cuts until inflation started and ceased to act fast enough to stop inflation without aggressive interest rate rises that eventually affect the economy and employment.  They always had the rhetoric that it was being done to stop inflation and its affect on the economy.  Of course, I saw the economy as my neighbors, my parents, my relatives and those I knew who needed to work to earn a living and support a family.  I could never see how some overly educated members of a Federal Reserve, appointed by politicians, who were wealthy and in no need of earning money to support their families.   If they were laid off or unemployed.  They either went back to Wall Street, or an endowment their family established or the academia to write books.  

When the failure of their actions resulted they went back on an Economic term that bailed them out.  We simply know it as "the past is no guarantee of the future".

Through all my years on this planet I too looked at the various formula's and computer devices to forecast the economic future and profit from the forecasts.  "Too Soon Alt and Too Late Smart" is a Milwaukee German emigrant saying.  

The brain we have been given with is far more able to quickly adapt than any computer, silicon chip or formula.  

As we started 2020 the forecasts were for a advance in home prices, then as interest rates rose no growth.  By the time we were into the 4th quarter a negative performance after athe first 6 months had a double digit return.  We ended up with double digit decline.  Some areas in the peninsula had 11% decline in the last two months; while others had no decline for the entire year.  As I look at the Fidelity reports on various towns and cities in the Peninsula I see 25% declines, year on year.

So where does that put us for 2023?  One thing to remember is that stocks, bonds and real estate are not in the same bucket.  Again, going back to college and "Money and Investing", Real Estate is called that because it is your "real estate".  It is the estate you leave in your will.  Stocks and bonds are store of value assets.  Real estate is purchased not for a store of value.  It is shelter, a home, a source of income; something we can see and feel.  We don't need to sell it because interest rates went up because our mortgage is fixed, if we have one.  The rise in interest rates is matched with a rise in income from the  income producing real estate owned.  We use it to grow flowers, vegetables, food products. maybe even entertain ourselves, family and friends.  Shares of companies and bonds pay dividends, interest and are there when we need money for emergencies or planned expenses as retirement, household emergencies and our children's education.  Inflation is great for real estate as it creates increased value from inflation and the income rises due to inflation.  So why is it so BAD?

So where are home values going?  First, I do not see the supply and demand changing since last letter.  I watch the MLS statistics on "new listings". "contingent", "pending" and "sold" on a daily basis.  We started out a week ago at 37 new listings went to 51 and dropped back to 46 as of Sunday  February 26th.  

Homes that were taken off the market in November and December have not come back on the market.  Once we get past St Patrick's Day we may know where we will be heading.  Right now home prices will not be a run away.  More homes will be over priced as owners refuse to admit or realize and or real estate agents are more interested in getting a listing; than being honest with there clients on the real market value of the owner's property.  Home prices are less now than they were last year.  What is useful is that with each decline, no matter how minuscule, the level of prices bring in another level of buyers.  Irrespective of what interest rates are.  Buyers will see the lower price of a home as a good entry point to buy their life time shelter.  Unlike stocks lower prices do not breed lower prices, they breed new buyers!

For those of you who think that I will wait until a bottom occurs you live in a fantasy land of denial.  Homes are unique, they fit individual likes and dislikes. Neighborhoods are also likes and dislikes.  Some neighborhoods are listed very seldom have a limited supply.  The neighborhoods are so enjoyed by owners that the sales are only from divorce, death and relocation.  All three are rare in occurrence.

Yes, there are those who would like to move to another "neighborhood".  They are cautious as the extra money needed to move up are in cash accounts with substantially higher returns than anything in the past 15 years.  Then they need to rationalize to themselves the capital gain taxes, the higher mortgage rate and higher property taxes.  To make that move there must be a very advantageous situation.  The additional consideration is amount needed to make the exterior and interior to the buyer's liking.

Now the interior and exterior liking is the next step in a healthy housing market.  Most buyers DO NOT WANT to remodel, paint and landscape.  This is the opportunistic investor/contractor known as the Fix and Flipper.  As long as the Fix and Flipper are active in the real estate market there is a "Seller's Market".  So far, that has not changed since interest rates have risen. It does not appear it will end soon.

To summarize, do not believe in the statistics and probability of real estate professionals.  Use your intuition, if you like it buy it.  If you want to sell, do not let taxes influence you.  I have too may times found in my life time in investing when a client did not want to sell due to taxes and lost as a result.

I recall a client I had as a stock broker who bought Warrants in Atlantic Richfield at the time of the Alaska Oil discovery.  About a $100,000 in warrants which were the right to buy shares at a set price by a set date.  Any time between now and then they were tradable on the New York Stock Exchange.  Within months his return was over 50%.  I advised to sell as the warrants had only a few month to last.  He refused due to sort term capital gain's taxes.  The warrants expired worthless!  

As stated in my last letter, if you have questions, need help buying or selling property.  Do not hesitate to call, email or text me.

Thank you

Gary McKae

The Problems are the Path: Affordability

 The National Association of Realtors, NAR, creates and Affordability Index on a regular basis.  It really defines how the FED uses certain tools to determine inflation. It also gives insight on how various real estate markets will perform.  I see the CPI as being 30% home prices and rents.

The index is simple, the higher the number the greater the affordability.  The lower the number  the more unaffordable the area.  

Last letter I took a swipe at our state legislature and those who support multiple housing units in all the state towns.  I spent too many years in local politics not to realize that politicians want to get elected.  It is not logic of the laws they pass.  They capitalize on voter ignorance more than voter intelligence.  If the voter based elections on their representatives intelligent work there would be a 99% turnover in all political posts!  In my opinion and experience.

Woodside, as an example, is to put in multiple housing they would need a very large septic system.  The present sewer systems is limited in Woodside by capacity of the sewer project servicing Woodside.  Woodside septic systems are plagued with high water tables which flood septic drain fields.  Woodside has  impermeable soils, that makes the drain field unable to filter out the septic water.  Next is the cost of construction.  An acre of land in Woodside per San Mateo County Health will only tolerate a 3 bedroom 3 bath home's septic system.  5 acres may take five three bedroom/bath homes of 2000 square feet.  Woodside also has a limit on the size of a house to about 6000 SF; therefore, only three houses.  Cost of construction is about $500/ sf for a Home Depot house.  The cost of the land $5 million, if you can find a level one without slope to handle a large septic system, and if the town laws allow the building of more than total 6000 sf of covered area.  The rough total cost is $10.25 million, or $2.05 million per unit.  Is that affordability?

Now we get to Affordability, a score of 100 equals income to needed to qualify.  The Least affordable homes in our area are 1. San Jose, Sunnyvale, Santa Clara with a rating of 38.5 with a medium income of $159K and Income of $414K to qualify for a home.  2. San Francisco, Oakland, Hayward with a rating of 44.3 and median income of $141K and qualifying income of $319K.  

It comes to affordability not on supply to create affordable homes!

Now when it comes to affordability, let's look at those areas that Californians have migrated to.  A score of 100 equals income to needed to qualify: Boise ID @ 114.3, Boulder CO @ 101.3, Charlotte NC @ 153.1, Dallas @ 167.4, Austin @ 137, Houston the new home of HP @ 169.9, Memphis @ 175, Phoenix @ 139, Portland @ 117, Tucson @ 142 all show why Californians have moved out.  In fact; over the past 2 years 700,000 have moved out of California.  

Next to consider is "market vulnerability".  Sorry to the doomsday folks, there is no recession that will collapse our local economy.  Buyers and sellers are in a stand off. Buyers have cash and can pay all cash.  Sellers can hold until economics make them adjust their home price.  That leaves unfordable housing to exodus to areas in California that is affordable or a move out of the State.  Many of my low income buyers are looking at new housing projects of east bay and central valley

The recent 7 days is a clear example of that to me.  Each week this year there have been increasingly less new listings. Sales are eating up inventory.  This will happen until demand out distances supply and price will move up not down with interest rates increasing.  Again this past week I have seen homes that have hung on the market 20-30 days plus and BOOM 15 offers!  Boom; multiple over bids after a price cut or several price cuts. Fidelity Title weekly reports keep all our area in a sellers market based upon homes for sale, inventory and days on the market.

One last comment on interest rates and inflation. I have stated in past newsletters that the FED is looking at Asset inflation more that real inflation.  While many of the media reports focus on prices of eggs, gas, and consumer items, the real issue is asset value.  They are like politician's selling their services not reality.  Nothing to me means more than AFFORDABILTY in housing.  

My additional comment is on the Stock Market. Interest rates increases are a death knell for growth stocks!  Growth stocks pay no dividends.  Go back to the Schwab money market account.  Do you want the volatility on FAANG or a steady 4% return that could go higher?  The FED will continue to raise interest rates in the near future, in my opinion.  I don't think higher mortgage rates will affect buyers, except the potential affordable stressed buyers will move out of state to affordable areas.

There are opportunities here in our area.  Investors continue to look for a home to fix and flip.  Buyers do not want to fix a home and will pay for an up to date interior with new paint and landscaping.  The difference between "what was and what is",  is a handsome profit for the investor.  

As long as those factors remain the same we have a healthy real estate market!

Need Help?  Let's talk!

The Problems are the Path: Clearing the Road Part II

Interest rates rise.  No end in site, YET!  CPI rises, the best Valentines gift for your Lady Faire is a Dozen Eggs.  Price cuts are beginning to tumble out in the Ultra High End and Luxury Markets.   Spec Builders in the Luxury Markets are trying to sell projects on a "To be completed basis".  Once in demand "medium priced homes" are beginning to see price cuts.  The Medium Price of an Oahu Home has now broke below $1 million to $986,000, inventory doubles.  Locally, the real estate forecasts bounce like a drop of water on a hot skillet.  The latest forecast is a rise for 2023 of 1.5%, from a slight decline.  We will not know what the future will bring until 30 days from now. Then, the inventory of homes once taken off the market at the end of 2022 may come piling back on the market.  Real Estate Markets across the Nation are all seeing price cuts.  The once "hot markets" that the "Work From Home" group flooded to are weak.  Slowly there appears to be a dribble back to San Francisco and the Bay Area as the mobile work place returns to the office.  The Commercial Market is in the worst condition I can remember since the Great Recession of the 70's.  Google and Meta are reconsidering their Real Estate Projects in the Bay Area.  Affordable housing is a joke as the homes built cannot be afforded by the income of those on the street.  Progressives seem to think by making Atherton and The Curry Family build an apartment building will solve the inability to pay for housing.  Something wrong with the Economics I was taught here!  That is all we need here is for Atherton, Hillsborough, Portola Valley and Woodside to have "The Projects" to end the Camelot of Silicon Valley.  Good Job to all the Progressive Politicians in Sacramento!  Where Khrushchev failed, you Won!

Keep the faith, you will not have a bell ringing when the bottom occurs.  So buy what you can afford and wish to live in for the next 20 years.  Sellers get off the idea "it always comes back".  Tell that to the fellow who bought Nvidia at $330 per share!

Bond Traders and Junk Bond Investors say...NO RECESSION, as highly indebted companies, the first to go into bankruptcy during a recession, have seen loan prices rally and defaults remain low.

BTW: Happy Valentines!

No greater gift than wife, daughters and granddaughters wishing Happy Valentines!

The Problems are the Path: Clearing in the Road

The problems we have seen in the real estate market started with the aggressive push in values due to cheap money by the FED and the expansion Money Supply of over $9 Trillion to the FED's Balance Sheet.  Today the FED's Balance Sheet is $8.58 Trillion.  FED rates have went from below 1% to 5.25-5.75.  That relates to Morgage rates of less than 3% to a high of 7.3% in 9 months!  Or; $2,500 per month Interest Only mortgage on $1 million to $6,083 per month.  A rather large jump in a period from roughly March 2022 to November 2022.  

In my past commentaries of early 2022, I had forecasted a decline in the average price of homes in the Bay Area which occurred. What did also occur was a decline across the US in home values.  The largest declines where in areas where the "work from home gang" went to live.  San Francisco saw the biggest drop in home values in the Bay area and Rents.  

I was amazed on how well the Santa Clara valley, aka  Silicon Valley, held up and more surprised in the areas that stood firm against price declines.

The supply demand curve from ECON 101 would have indicated that a rise in interest rates would correlate to demand to decrease homes; along with,  price decrease.  Not so in all cities in the Santa Clara Valley.  Of course the outer areas of California that benefited from migration out of SF and surrounding Bay Area Cities, and areas out of the State of California had some substantial declines as the desire to move was negated by costs and job security.

It was my belief, if you are constant reader, is to remember the FED was not really after inflation per se, but after Asset Inflation.  Asset Inflation in terms of Stocks, Bonds, Commodities and Esoteric Investments outside the realm of the Securities Exchange Commission or the Federal Reserve oversight.  The result of the rise in rates was to correct the Risk Free Rate of Return when investors consider investing.  When investors then look at investing they look at what if I did noting.  What would i get in T-Bills and Bonds? Today using the Bond Curve, the yield on 1 month Bills are 4.56%, 3 month are 4.66%, 6 month are 4.88%, 1 year are 4.86, 2 year are 4.45%, 10 year 3.63% and 30 year are 3.67.  What is that yield curve telling you about the bond market's forecast on inflation and interest rates?  To me it is saying that the FED will raise rates  for most of this year.  Thereafter the FED will let the rates alone. within 2 years rates will be lower and 10 years plus no inflation and possibly rate cuts.

Blood letting in high tech growth names have been shattering.  From any of the FAANG stocks to other Techies, they all went to declines have been in high double digits. We started out the year with Media forecasts of lower home prices of 10% or more and negative forecasts on Tech names.  What happened?  The tech stock rallied.  Home prices did not decline measurably in Santa Clara Valley.  The Bond market is forecasting what is reasonable for rates which should be a good indication of mortgages.  Tech stocks were, in my opinion, Short Cover Rallies. That rally maybe short lived as President Biden plans to attack Silicon Valley that has a universal support of a divided Congress.  This is music to the ears of Investment Bankers as they envision Mergers, Take Overs, Spin Offs and restructuring.  The Asset Managers that will be in vogue will be Risk Arbitrage.  For better information on that subject look up Risk Arbitrage on Google and seek out Ivan Boesky's, Risk Arbitrage, a book I contributed to.  Ivan was very clever.  Inside information made him the darling of Wall Street and time in a Federal Prison.

In home prices:

• Rates down: since November, 30-year-mortgage rates fell from 7.3% to 5.99%, lowering the typical U.S.  mortgage payment by $260 per month.
• Sales are up: from November to December, pending home sales increased 2.5%, the first month-over-month increase since May.
• Competition is stronger: in January, 37% of newly listed homes had accepted an offer within two weeks of their debut, faster than at any point since last July.

Supply/Demand has given me a reason for the stability of prices in our area.  78%, per US Census, home ownership in the U.S. is in Baby Boomers.  Baby Boomers are not selling!  They will not pay higher property taxes to downsize or move.  They will not pay high Capital Gains Taxes on sales.  They will wait until they die, or at least one of the spouses die.  At that point there will be a step up in valuations to current market appraisals.  Sales will then create "0" Capital Gains taxes.  What is left is property taxes.  At death proceeds go to heirs and no property taxes.  The end result is home buyers will still be faced with low inventory.  Inventory will increase only subject to Baby Boomer death rates.  Compared to their parents Baby Boomers are in better health.  They have better health care.  They diet and are aware of what they eat and the conditions that are detrimental to their health.

There is one measurement of real estate health that is difficult to follow.   It is the Fix & Flip market.  This is a very difficult market to trace and measure.  F&F buyers directly solicit the Baby Boomer+ market with no commissions, no disclosures, immediate cash payment, no repairs, and move in a time schedule that fits both our calendars and no Real Estae Brokers or Agents.  With that the homes that come on the market on the MLS are once they are repaired and updated.  There is no prior sale in MLS records.  The only method to find out the history is to search County Title Records to discover sales and change of ownership.  This is the most interesting part.  The sale are well below list.  The repairs are noted in the improvements for tax basis and the ownership is not in individual name but LLC or Cooperate entities.  Sales are Cash and there are no mortgages.  As long as this market remains strong Bay Area Real Estate will remain strong.

Buyers will find there is less competition, there will be less over bids, seller's are more realistic in sales prices than the "Pie in the Sky" attitude that dominated in the prior years.  Sellers still have a slight advance  from the sales of homes in and around list price as inventory will remain low!

The Path has more Problems

Welcome 2023 with an out pouring of new listings.  As we ended 2022 the number of active listings began to lessen by the month, week and day; until we had the old stand firm group who just wanted out.  As I look at the Hot sheet I have established with MLS Listings I see all the new listings for the past 7 days; along with, sold, pending, contingent, list price decreased, canceled, expired and withdrawn.  The new listing's out distance the sold's so far.  Price cuts are starting to emerge.

Market Watch

New Listing (51)
List Price Increased (1)
List Price Decreased (6)
Transaction Fell Through (1)
Listing Back On Market (0)
Contingent (5)
Pending (14)
Changed to Sold (13)
Changed to Rented (0)
Listing Expired (0)
Listing Canceled (0)

This action is unusual for the beginning of the year.  It is not abnormal for listing's to expire and cancel or withdraw at the end of a year.  They normally stay off until after Valentines Day and then flood the market.  How best to understand the increase is to think about the economics in our situation.

The Media Commentary is now on higher interest rates a Recession and unemployment.  What is unique about this time around is that the inventory is still low and buyers are still active.  This is irrespective on economics.  We have seen a 10% drop in housing prices in the past 12 months.  More of that decline came in March after the FED increased rates by 3/4%.  Commercial properties have been the hardest hit as Virtual work places are more common.  San Francisco is a Ghost Town as compared to the past.  Financial firms which dominated San Francisco were replaced by Technology firms.  Technology firms went Virtual during the Pandemic never to return back to the office.

What is unique about our Silicon Valley Residential Real Estate Market is we are still in a Seller's Market.  Irrespective of the price cuts and sale less than list, buyers are picking up new properties.  Over priced homes languish on the market as they should.  Under priced home are bid up.  Speculators, Fix and Flippers are still active and now looking at listing's to find their next target to update and sell for profits.

In the past Commentaries I stated that the FED was after the Inflation in assets and not necessarily food and goods prices.  When I look at the tech stock prices seeing 60% or more declines all seem to be the norm.  Expansive hiring and real estate purchases or leases have stopped.  Now comes the point that layoffs of the expansive strategies; along with, reducing footprints in real estate to match layoff and virtual employees.

As my Mother once said, "The Road of Life is full of potholes and unexpected delays", so we are here.  We will not know if this is a delay or pothole until it passes.  

What we are in is an Era of Opportunistic Strategies.  Opportunity will come only when we look and have the right agent to direct the search or sell real estate.  Opportunistic Strategies will be in the Depressed Properties Category.  Foreclosures will not be as common as they have been in the past.  Today we will see Estate/Trust Sales, Relocation and Divorce.  The former two will dominate, in my opinion and experience.  

According to the U.S Census report at year end, the State of California had a net movement out of the State of some 340,000 or so.  When one considers the in coming new Californians were dominated by those crossing the border, income and tax revenue must be looked at carefully.  Corporations have moved out, individual of upper incomes have moved out.  That in itself will stop any aggressive pricing and multiple offers.  

Mortgage rates have declined while the talk of another increase in rates by the FED has been dominant. That tells me that the rate increase will be minimum, 1/4%, and that the top of the rate rise is either here or in sight.  I also look at the 10 Year US Treasury bond at 3.42% and a 30-year Mortgage at 6.09-6.15 and see the spread has narrowed.  At one point the spread was 4.00 interest rates and now it is less than 3.00 interest rates. We call that Basis Points.  one basis point is .01 of a percentage point or .0001%

My call is buy a home and negotiate a price that is reasonable based upon must recent sales 30 days is best.

Sellers must become realistic.  The days of over bids are gone.  The days of putting in aggressive pricing is gone.  The day of pricing below last sale is here!