Economy, Pensions, DiMartino Booth, Danielle DiMartino Booth, Money Strong LLC, Fed Up: An Insider's Guide to why the Federal Reserve is Bad for America,

Retirement in America: The Rise of the Velvet Rope

Before there was the One Percent, there was the velvet rope at Studio 54.

Gaining entry to the divine disco, with its adherence to a strict formula, was just as exclusionary. This from Mark Fleischman, the Manhattan haunt’s second owner in a memoir released to mark the 40th anniversary of the club’s opening:  “A movie star could bring unlimited guests, a prince or princess could invite five or six guests, counts and countesses four, most other VIPs three, and so on.”

Andy Warhol called it the, “dictatorship at the door.” Brigid Berlin, one of Warhol’s Factory workers and guests, once described to Vanity Fair how she, “loved getting out of a cab and seeing those long lines of people who couldn’t get in.” If beauty alone could sway the dandy doorman, famed for flaunting his fur, a different kind of cordon awaited you once you set foot inside the cavernous strobe-lit mecca, that is a screen hung across the dance floor to separate the chosen from the common. The scrim summarily dropped at midnight, but not a minute before, affording elites ample opportunity to make their escape to the VIP floors above.

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The Smell of Dry Paint in the Morning, Danielle DiMartino Booth, Money Strong LLC

The Smell of Dry Paint in the Morning

Irish Playwright Oscar Wilde defied Aristotle’s memorable mimesis: Art imitates Life. In his 1889 essay The Decay of Lying, Wilde opined that, “Life imitates Art far more than Art imitates Life.” Jackson Pollock, the American painter, aesthetically rejected both philosophies as facile. We are left to ponder the genius of his work, which in hindsight, leaves no doubt that Art intimidated Life.

Engulfed in the flames of depression and the demons it awakened, Pollock’s work is often assumed to have peaked in 1950. The multihued vibrancy of his earlier abstract masterpieces descends into black and white, symbolically heralding his violent death in 1956 at the tender age of 44. Or does it? Look closer the next time you visit The Art Institute of Chicago. Greyed Rainbow, his mammoth 1953 tour de force, will at once arrest and hypnotize you. As you struggle to tear your eyes from it, you’ll ask yourself what the critics could have been thinking, to have drawn such premature conclusions as to his peak. Such is the pained beauty of the work. Rather than feign containment, the paint looks as if it will burst the frames’ binding. And the color is there for the taking, if you have the patience to slow your minds’ eye and see what’s staring back at you.

Perhaps it was the being written off aspect that drove Pollock to embark upon the final leg of his tour de force. We’ll never know. Renaissances to sublimity are the preserve of those with gifts beyond most our grasps. Hence the curious hubris driving so many pensions to reinvent themselves to full solvency by taking on undue risks. Heedless of what should be so many warning signs, so many managers continue to herd blindly into unconventional terrain hoping to find that perfect portfolio mix. The more likely upshot is their choices will drive them straight off a rocky cliff.

For now, the craggy landscape of pension canvases continue to be painted. Or in the case of the country’s largest pension, the stage continues to be set. This from Ted Eliopoulos, chief investment officer of the California Public Employees Retirement System (CalPERS): “We will be conducting quite elaborate choreography, looking at asset allocation, our liabilities and the risk tolerance of our board in conjunction with our expected rates of return for our various candidate portfolios.”

Oh, but for the days of antiquated notions such as matching assets to liabilities. But that’s so 80s. Today, a given public pension’s portfolio is anything but dominated by the Treasury bonds once held to satisfy its future liabilities. Rather, half of a typical portfolio’s assets are invested in stocks, a quarter in bonds and cash, and the balance in ‘alternative investments,’ including private equity, hedge funds, real estate and commodities. (Yes, we are still on the subject of matching current and future retiree paychecks to appropriate investments.)

To CalPERS credit, this ‘elaborate’ mix turned in stellar performance in its most recent fiscal year ended June 30. The $323 billion fund generated a net 11.2 percent return buoyed by a 19.7 percent return on its stocks. Returns of 14 percent on its private equity holdings and 7.6 percent on real estate rounded out the outperformance.

Eliopoulos stressed that, “as pleased as we are with this one-year return, our focus is always on the long-term. We invest for decades, not years.”

As pointed out in Barron’s, it’s been touch and go for the past few decades. CalPERS returned 4.4 percent compared to the S&P 500’s 7.1 percent, and over the past 20 years, 6.6 percent vs. the market’s 7.1 percent. Neither achieved return, it should be pointed out, exceeds the fund’s currently assumed rate of return of 7.5 percent or the assumed rate to which it will be lowered, seven percent, by the end of 2019.

The ultralow interest rate environment engineered by the Federal Reserve and unattained return goals leave CalPERS 68 percent funded. That puts it just about in line with Wilshire Consulting’s most recent calculations, which found the average aggregate funding ratio for state pension plans to be 69 percent.

So very few pensions are where they need to be. And fewer still will ever get there. Pension managers are deluding themselves into believing creativity in asset allocation holds the key to greatness in the after-working-life.

Afraid to say the miracle of alternative investments cannot make up for the average four-percent differential required to make pensions whole – just this year. How so on the math? A blended portfolio of cash, investment-grade and junk bonds today earns 3.5-percent; this compares to pensions’ average assumed rate of return of 7.5 percent. Of course, this gap has been widening for years care of dim-witted central bankers who excel at calculus but can’t manage simple math.

How unfair is it to leave out portfolios’ spice girls of equities and alternatives? Hate to turn down the party music, but starting points do matter. So do fees (hold that thought).

There’s nothing to say pensions won’t eke out another exceptional year of stock gains. The Fed could well be tantalizing investors with chatter of QE4 if the economic data continue to soften. But there’s no silver lining in that potential outcome. Remember that rocky cliff over which current reckless allocations can drive returns? Let’s just say the cliff gets taller, and the fall longer, for every year into which this aged-bull-market rally stretches.

As for those alternatives, for better or for worse, commodities are passé. Meanwhile, pensions have been abandoning hedge funds for years as passive investing takes victim active managers who dare value an asset and invest accordingly. And real estate is on fire. As in, valuations have never been this steep in the history of mankind. You can draw your own conclusions on that front.

That leaves us with private equity, that darling of asset classes and the issue of those pesky steep fees. According to the Pew Charitable Trusts, states bled $10 billion in fees and investment-related costs in 2014, the latest year for which data are available. Not only is this lovely line item funds’ largest expense; fees are up by about a third over the past decade, which conveniently coincides with the greater adoption of alternatives. Gotta love being a taxpayer!

But surely pensioners are privileged to have access to these tony private equity funds? Over the long haul, PE always outperforms those stodgy asset classes every Tom, Dick and Harry can buy online. So what if they’re illiquid. Right?

It’s hard to imagine the shivers sent down the spines of many pension fund managers when they heard the news that EnerVest Ltd, a $2 billion PE fund, had lost all its value. “Though private-equity investments regularly flop,” the Wall Street Journal reported, “industry consultants and fund investors say this situation could mark the first time that a fund larger than $1 billion has lost essentially all of its value.”

Well at least the oil bust is long over. Ill-fated, ill-timed, ill-valued energy investments are to blame for EnerVest’s demise. And surely that’s a comfort. It positively proves the fund’s evisceration is an isolated idiosyncratic incident.

Those other Wall Street Journal (WSJ) headlines don’t mean a thing. Why worry that, “Shale Produces Oil, So Why Doesn’t It Produce Cash, Too?” To wit, over the past decade, eight of the most established shale players have generated a respectable $414 billion in revenue but nary a penny in free cash flow. In fact, this eightsome has had negative cash flow of $68 billion.

Still think EnerVest will be a one-off event? Try this other WSJ headline from early July: “Wall Street Cash Pumps Up Oil Production Even As Prices Sag,” an article that went on to cite one analyst’s observation of, “insufficient discrimination on the part of sources of capital.”

Why, the question must be posed, bother discriminating when you’re sitting on $1.5 trillion in dry powder? Wait, are we still talking about energy? Well, no. That’s the point.

Go back to that last WSJ article for a moment, to what the reporters wrote: “Wall Street has become an enabler that pushes companies to grow production at any cost, while punishing those that try to live within their means.”

Set aside the fact that the analogy strikes closely to that of a drug dealer. Now nix the word, ‘production’ and fill in the blank with whatever your heart desires. THAT is the power of $1.5 trillion in private equity dry powder in all the forms it has the capacity to assume.

Again, starting points matter. That is, unless you are a deep-pocketed price agnostic buyer, one that collects fees for assets under management, regardless of how well the investment decisions fare. Being valuation-insensitive, however, also means you can incinerate your investors, especially pensions, and still walk away all the richer for it.

To its credit, Pew expressed particular concern with respect to desperate pensions playing the game of returns catch-up, as in those that have most recently plowed headlong into alternatives. No surprise, they happen to be one in the same with those sporting the weakest 10-year returns.

Ever heard someone tell you to not put all of your eggs in one basket? This rule of thumb applies in spades to pensions, or at least it should. While alternatives may provide a degree of diversification, Pew reports that that the use of alternatives among the nation’s 73 largest state-sponsored pension funds ranges from zero to over 50 percent.

Arizona tops the far end of that range, with 56 percent of its assets in alternatives. Missouri and Pennsylvania are not far behind with over 50 percent in this ‘basket,’ and Illinois, Michigan, Ohio, South Carolina and Utah stand out as having close to 40 percent in alternatives. Click for link to PEWTrusts.org report.

In the weeks to come, many pensions will excel in the back-slapping department, reporting double-digit returns for the fiscal year ended June 30th. Please keep your salt shaker handy.

For the third time, starting points matter. In late June, Moody’s ran some figures and scenarios to quantify where pensions are today, and where they’re headed. In 2016, total net pension liabilities (NPLs) surpassed $4 trillion. Looking ahead, Moody’s expects reported NPLs to fall one percent by 2019 in an upside scenario, but rise 59 percent in a downside scenario.

Perhaps the fine folks at Moody’s have contemplated what happens when, not if, pensions’ liquid equity and bond holdings lose 20 percent. Maybe they’ve even taken their scenarios one step further and envisioned the return implications for all of these elegant alternatives when a liquidity freeze takes hold amid plummeting valuations.

What’s a pension to do? Fraught managers are apt to throw more of your money at alternatives as tax revenues rise to compensate for what pensions cannot make up in returns. Know this: the more that $1.5-trillion store of dry powder grows, the more it devolves into that much napalm in the morning. The conflagration that spreads will not be containable, and you won’t be able to tear your eyes from it. As the tragic Pollock said of his paintings, and we will one day say of pensions, they have no beginnings or endings, they have lives of their own.

Pension Tension, Part 2: Don’t California My Texas!, Dimartino Booth, Money Strong, Fed Up: In Insider's Take on Why the Federal Reserve is Bad for America

Pension Tension, Part 2: Don’t California My Texas!

What’s the next best thing to heaven?

Ask any Texan. Or better yet, try Tanya Tucker, born in Seminole, Texas in October 1958. She might just answer you by belting out the first stanza of her smash 1978 hit, “Texas When I Die,” in that gravelly voice of hers:

“When I die, I may not go to heaven

I don’t know if they let cowboys in

If they don’t just let me go to Texas

Texas is as close as I’ve been”

 

The point of the song is to glorify the Lone Star State as no other. And make no mistake, true Texans of all ages know and love the song. An out-of-state foreigner might venture that Texas has an ego. Yes, the state, replete with its own rallying cries. Remember “Remember the Alamo!”? Or if you prefer, the modern-day version, “Don’t Mess with Texas!” That last one may or may not have started out as an anti-littering campaign. But Texans cannot be one-upped in the adaptation department.

More recently, a crop of bumper stickers has blanketed the state’s highways and byways. Though state shapes are employed for illustration purposes on said stickers, you see the translation in the title: “Don’t CA my TX!” Ask any Texan about optionality if our taxes (let’s leave it there) even flirt with California’s. They’ll share with you the latest word bandied about: “Texit!”

Let’s use Forbes as the arbiter to explain the corporate and middle class mass departure out of California and into Texas in recent years. In 2016, Texas ranked fourth in Business Costs; California 43rd. Though there are a myriad of contributing factors to the relative unattractiveness of the Golden State, deeply underfunded pensions sit high on the list.

According to one CA resident and close friend, who also happens to be a crack economist, the back-of-the-envelope math works out as such: Stanford figures the state’s liabilities are in the neighborhood of $1 trillion, or $78,000 per household. Narrow it down to her county level, the local liability if you will, and there’s another $2 billion to consider, or $10,000 per household. Now here’s the rub. Double that $88,000 to account for the fact that various groups estimate upwards of half of CA residents don’t pay taxes. For the record, my friend is grappling with moving to a low-tax cold or low-tax warm state. Answer seems obvious but go figure.

The irony is recent headlines might cause her to steer clear of Texas given that the nation’s building pension tension first broke in Texas’ two biggest cities. Legislation is making its way through the Texas State Legislature to overhaul Houston’s firefighter and municipal employee pension. The zinger: the fix involves a cool $1 billion pension obligation bond that would require voter approval. Not to be outdone, subsequently, the Texas House voted unanimously to approve a rescue of Dallas’ Police and Fire Pension, which will also put taxpayers on the hook for a $1 billion, give or take. News that there’s been a run on a pension apparently has a stimulative effect on politicians.

The question is, will Texas begin to lose some of its appeal as the low-cost alternative to just about any other state in the nation? More to the point, are there other states out there that also appear to be dirt cheap but have pricey pension promises that will present themselves the next time markets swoon?

So much for judging low-tax-rate states by their covers. The good news is there’s a somewhat neutral intermediary to help conduct your analysis. You know, the rating agencies. Before you reach through your screen and try to land a knuckle sandwich, consider first that Moody’s and Standard & Poor’s have long been in the business of rating plain vanilla municipal bonds. We’re not talking about securities comprised of toxic mass that’s sliced and diced into credit sainthood. Plus, recent revisions to accounting rules require the agencies to visibly incorporate pension underfunding when scoring credits.

According to a recent Wells Fargo report penned by Wells Fargo Senior Analyst Natalie Cohen, over the last twelve months, this shift in accounting rules has triggered state-level downgrades of Alaska, Connecticut, Illinois, Kansas, Kentucky, New Jersey and West Virginia.

One caveat, especially at the local level, involves termination costs that can be triggered by a downgrade and accelerate payments. Detroit is a classic case in which ‘swap terminations’ tipped the city into bankruptcy. Moody’s, in particular, has devised a methodology to appraise stress using a uniform corporate bond rate; it’s called the “adjusted net pension liability (ANPL)” calculation. Included among those that lost their top credit rating because they had prohibitively high ANPLs are Evanston, IL, Minneapolis and Santa Fe along with a handful of highly-rated Ohio school districts.

It shouldn’t shock that many of the shakiest local credits reside within the weakest states. On a list Wells comprised using Merritt Research Services data, weak pensions contributed to 11 local government downgrades in Illinois, 10 in New Jersey and six in Connecticut. In what can only be described as fiscal hot potato, some states are also increasing the funds school districts are required to contribute to state retirement funds. One case in point:  Local districts in Michigan previously contributed 16.5 percent of payrolls to the Michigan Public School Employee Retirement System; that has since been upped to 27 percent. Cohen calls it the ‘State-Local Trickle Down’ effect.

They say that the best laid plans cannot account for random molecules bumping around the universe. The rub is there’s nothing random about the rot spreading across the municipal landscape. The buck will eventually stop somewhere, even as states and municipalities endeavor to shift their growing burdens from here to there to anywhere. If you just squirmed in your seat, you know where this is going.

The theory is taxpayers will take the tax hikes of the future required to rescue pensions lying down, forcing the actuarial armies’ math to finally work out in practice, not fairyland theory. Let’s just say the jury isn’t even hung on such an outrageously optimistic outcome. Targeted residents are much more apt to follow in Cook County’s fleeing population’s footsteps, that is, pull up stakes and move to lower tax states.

Carry this inevitable, albeit eventual, process to its logical end-point and it’s easy enough to envision the United States having a periphery of its own consisting of shallow-tax-base, budgetary-basket-case, junky high-yielding municipal borrowers. Preening at the opposite end of the spectrum are states that have prudently managed their affairs and prevented unions from ruling the pension roost – pristine and pure investment grade municipals.

An aside if you’ve got the ‘G’ in PIIGS on the mind (remember the acronym for the European periphery?), don’t sap your synapses. There will be no Prexit. The Constitution doesn’t allow for it.

As for tax reform, that’s another story. John Mousseau, Cumberland Advisors’ in house municipal maven, recently published a one-pager titled, “Quick Take on Munis and the Trump Plan.” In the report, Mousseau calculates the math behind the lower tax rate that stems from the elimination of the ObamaCare tax on investment income for families making over $200,000 combined with the nixing of the alternative minimum tax. The first blush take is that taxable equivalent yields of 5.30 percent for the today’s 39.6-percent top federal bracket taxpayers will fall to 4.61 percent as the top bracket declines to 35 percent. That slippage, however, is offset by the closure of the loopholes and deductions proposed.

But what about rendering nondeductible state and local income taxes? Mousseau uses the high-income-tax state of California, where the top state tax rate is currently 13.3 percent on income over $1 million, to illustrate the impact of the proposed changes to the tax laws. Under existing tax law, that rate effectively declines to 7.5 percent. Eliminate both the federal deduction for state income taxes and the Obamacare tax and you land right back at 13.3 percent.

The result would be twofold:  1) demand rises for in-state tax-exempt bonds in high-tax states (prices up, yields down), and 2) major resistance on the parts of state and local governments against tax increases and a push to roll back tax rates as state taxes will abruptly and significantly rise from their current levels.

Mousseau’s bottom line:

“From today’s vantage point, we feel that muni bonds, particularly in the intermediate and longer maturities, should face little adjustment under the proposed plan and that the demand for municipal bonds in high-tax states should advance smartly.”

While a wash for municipal bond holders in general, the implication is that high tax states, especially those with deeply underfunded pensions, will find politicians struggling in their efforts to insure escape eludes essential taxpayers.

The next recession will only serve to expedite the exoduses. That will put the onus on DC politicians to ponder the profound, as in how does the country meet the aggregate challenge pensions present? At some point, clinical calculations will clash with the still-angry citizenry. Making matters worse, both pensioners and punished taxpayers are within their rights in feeling as if they’ve been wronged.

Who will represent taxpaying Californians who prefer to grow old enjoying their perfect vistas of the Pacific? For that matter, who will stand up for Texans who darkly joke that the real wall that will be eventually erected will rise up along the state’s northern border?

The closest thing to winners in this war of states are Texas real estate agents who have never had it so good. Loaded with sales proceeds courtesy of ostentatiously overpriced homes, California transplants tend to buy two homes instead of one, so flashily flush are they when they cross over the Red River. While that extra spacious back yard (of course they raze one of the two!) is all good and well for the eager emigrant jet set, the traffic is worse than ever.

So, is there a Texit in the cards? The late Supreme Court Justice Antonin Scalia assured us the answer is no: “If there was any constitutional issue resolved by the Civil War, it is that there is no right to secede.”

Try telling that to a tenacious Texan. As worthy residents of the state, who find themselves belting out Tucker’s gravelly-voice timeless hit racing down a dusty country road with the windows open will tell you, it’s not bond math that defines the allure of life in the Lone Star State. To the many, the proud, such a futile approach is akin to trying to put into words what the wind feels like to someone who has never felt a warm breeze against their face. Why bother? To borrow from another legendary bumper sticker: “I may not have been born in Texas. But I got here as fast as I could.”

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Will Public Pensions be Trump’s Biggest Challenge?

Dear friends,

Over the past week, as the Trump rally has marched on, I’ve been on the receiving end of an entirely different sort of unexpected acclaim. It started with an hour-long interview I did with Real Vision’s Grant Williams that is going ‘viral’ (I’m still new to these terms given I was inside the Federal Reserve for so long where social media was banned, and with good reason.)

The subjects covered in the extensive interview, filmed just after the election, include prospects for the Fed under the new administration, what had the Italians so piping mad and most of all, public pensions. It was this last subject that most captured the media’s attention, catching me off guard.

Some subjects such as global debt and public pension shortfalls are so massive that most choose to pretend they don’t exist. An entire cottage industry has sprung up to debunk any concerns about that little $200 trillion global debt issue, even as Libor skips upwards. It’s as if Reinhart & Rogoff’s work on record debt inducing stagnation never existed.

As for public pensions, earlier this week, I observed that Meredith Whitney’s bearish call, as aired on 60 Minutes, marked the beginning of the end of the public’s concerns. So coordinated was the campaign to disprove Whitney’s timeline that her entire body of work ended up vanishing into thin air.

And so we have learned to live with elephants in our rooms. The alternative doomsday scenarios are simply too big to get our heads around. That’s all good and well unless our mothers were right, you remember, that thing about ignoring problems not making them go away.

In the event you don’t follow me on Twitter and LinkedIn, a) congratulations as you live a much less frenzied, information-overloaded, cluttered life, and b) please enjoy the links to a five-minute slice of the Real Vision interview as well as the three articles in which I was featured this week.

Wishing you a joyous and warm holiday weekend.

All best,

Danielle

What’s racier than Vegas? Pensions, says former Fed insider .

A Pensions Time Bomb Spells Disaster for the US Economy — Business Insider

Former Fed Adviser: ‘Some Miracle’ Needed to Defuse $1.3 Billion Pensions Time Bomb — Newsmax

Danielle DiMartino Booth on the Trump Federal Reserve — Investopedia


Click HERE to purchase Fed Up:  An Insider’s Take on Why the Federal Reserve is Bad for America

Towers of Dabble

TOWERS OF DABBLEMan’s long determined history of dabbling in the building of touted towers, surely not for his self-gratification, but rather to bring him closer to God, has rarely been met with benevolence. Maybe God doesn’t like man, who He created after all, attempting to smash through His glass ceiling. Consider, if you will, the first known example of such an attempt. Having heeded Noah’s warnings, a postdiluvian band of survivors just couldn’t resist taking a stab at the celestials, raising the Tower of Babel they were sure would be gloriously received.

According to preeminent Bible historian James Kugel, there would be no such reception, just rejection: “The real crime involved in the building project was the tower itself, which was intended for the purpose of ‘storming heaven’ or some related evil desire.”

Though the Old Testament’s telling leaves much open for interpretation, the idea of vengeance being associated with sky-piercing structures seems to have stuck, especially among financial market historians. Analysts at the British bank Barclays originally voiced the idea that if you build it, it will come, as in a financial crisis. That is, every time an erected edifice unseated its predecessor to become the newest world’s tallest building, economically upsetting times tended to follow. It’s uncanny how well that shoe continues to fit.

It all started at the height of the Roaring Twenties on that little 13.4 x 2.3-mile island we know as Manhattan. Walter P. Chrysler was keen to build a monument, namely to himself. But there was competition nipping at Chrysler’s heels with the simultaneous construction of 40 Wall Street, which would indeed be the world’s tallest, that is, for one month between April and May 1930.

On May 28, 1930, it took all of 90 minutes to secret a clandestinely constructed spire atop Chrysler’s building, thus trouncing his downtown architectural rival. Of course, the real victor emerged 11 mere months later when the Empire State Building opened in early 1931 presaging, by the way, the Great Depression. It would be nearly 40 years before a taller tower would rise.

The construction and December, 1970 opening of the World Trade Center would then coincide with the end of the second longest U.S. economic expansion which began in 1961. Chicago’s Sears Tower would go on to wrest away the reign in 1973, a top spot it held for more than two decades. It’s opening’s appeared to herald the nasty stagflationary recession that ended in 1975. Malaysia’s 1996 title sweep arrived alongside the Asian financial crisis. Most recently, the 2007 opening of Dubai’s Burj Khalifa augured the Great Financial Crisis.

Surely these episodes have been sufficient to appease the dieties. In short, quite the opposite. If frenetic skyscraper construction flags misallocation of capital, we could be in for a doozy of a correction in global commercial real estate. Consider the numbers in the aggregate. It took 80 years after the opening of the Chrysler Building to build the next 49 supertall skyscrapers, defined as 300 meters (984 feet) or more.

How on earth, or in the heavens, to put it more aptly, has the hundredth supertall just opened on Park Avenue? It might have something to do with the fact that in the short five years through 2015, a subsequent 50 supertall skyscrapers have been erected.

Economic historians could well have been shaken to their very foundations upon hearing news that financing to construct a historic colossus had been secured late last year. Rising from the sands and promising to reach the seraphs, Saudi Arabia’s Jeddah Tower is to rise 3,280 feet into the stratosphere. That’s 1,000 meters, as in one kilometer, besting the Burj by 591 feet. The question is, will there be economic repercussions?

Judging from the collapse in the price of oil, some might argue divine intervention has already come and gone. It is certainly the case closer to home that the oil patch blues have dragged down commercial real estate. The latest data on commercial mortgage-backed securities (CMBS) delinquencies reads like a who’s who of yesteryear’s shale boom.

Some 17 loans totaling $152 million became freshly delinquent in March, the largest one-month tally since November, 2012, according to a new Morgan Stanley report. Six of these gems are located in ‘oil boom’ territories including Casper, Wyoming; Odessa and San Angelo, Texas and North Dakota’s Dickinson and Bakken Shale regions. Another notch down the distress ladder, 14 loans moved to the status of “specially serviced,” when a new mortgage servicer takes over a loan that’s 90 days or more in arrears; 10 of them had low oil prices to blame.

The working assumption must be that the economic damage inflicted by energy’s woes will be contained. How else to explain the construction of a $1.2 billion mecca in the land of the Saudi kings? Unless, that is, it’s as simple as the money being there for the financing. Stranger things have been known to happen when interest rates are held at low levels for longer than imaginable by yield-starved investors.

History stretching back to Biblical times suggests there will be economic pain between now and the Jeddah’s scheduled opening in 2020.

The fine folks at Jones Lang LaSalle (JLL) would beg to differ. A new study released by JLL, the real estate investment management giant, forecasts real estate transaction volumes will crest $1 trillion by the end of this decade, rising from $700 billion last year. The enabler will be international money flows: JLL estimates $500 billion in annual cross-border activity by 2020.

The movement between regions will be catalyzed by demographics, according to the JLL study, which notes there will be more people over the age of 55 by 2050 than there were inhabitants on earth in 1950.

“This demographic impact will have a profound effect on real estate investment strategies with the amount of private equity capital targeting direct real estate set to increase by over 500 percent, much of it driven by increasing institutional allocations looking at higher yielding opportunities.”

Did you notice something implicit in JLL’s argument? It would seem lower for longer will remain the mantra for the foreseeable future, which suggests frothier markets and subpar growth will continue. The most interesting tidbit comes down to who will be doing the investing, that is private equity.

As it were, private equity “dry powder” directed specifically to real estate investments rang in the New Year at record levels. There is now $231 billion in dry powder available just for properties in the United States after $107 billion was raised in 2015.

For being six years into a recovery in commercial real estate, investors certainly remain enthusiastic, especially public pensions. Pensions have allocated some $207 billion to private equity funds since late 2012. Increasingly, allocations have targeted real estate funds with March of this year providing a perfect example of the merriment surrounding this asset class. Here’s a wee sampling with special notations if the real estate fund is of a particular bent:

Texas Teachers:                                               $500 million
State of Oregon’s Pension:                              $300 million
Pennsylvania Public School Employers:          $307 million
Ohio Workers Compensation Bureau:            $125 million
State of Minnesota’s Pension:                         $100 million (distressed);  $100 million (opportunistic)
State of Maine Pension:                                  $50 million
State of New Jersey:                                       $200 million (commercial)
State of Kansas:                                              $50 million
Texas Municipal:                                             $375 million

“Pensions’ chronic underfunding has prompted them to stretch to achieve unrealistic return targets,” New Albion Partners’ Brian Reynolds explained. Reynolds has been keeping a running tally of these allocations and is quick to point out that leverage is often needed to hit the bogeys, which are 7.5 percent or more. Bear that in mind when you consider the money being shoveled into these funds.

It really comes down to size, that is, of the pension system. In the early 1980s, pension liabilities amounted to about 50 percent of gross domestic product (GDP); today they are 100 percent of GDP. “Because of their growth, their investment flows have led to asset bubbles that have generated permanent losses,” Reynolds added.

Pensions flocked to hedge funds but that strategy blew up after Long Term Asset Management nearly took down the financial system. This strategy was followed by wholesale herding into commodities, which we all know ended is disaster.

The catch is the rate-of-return bogeys have barely budged despite Baby Boomers moving increasingly closer to retirement suggesting some risk should be taken off the table. (Rather than keeping you in suspense, it’s nearly an impossible feat to lower return targets. Less in assumed returns means states and municipalities have to pony up more money they don’t happen to have on hand. The State of Connecticut has reached the point where it is now taking a stab at taxing Yale’s endowment in a desperate attempt to top off its underfunded pensions.)

No matter how you slice it, most public pensions face a dire set of circumstances, which begs the question: Just what are they to do?

Reynolds’ reply: “They have turned to the last remaining asset class with high expected rates of return – commercial real estate. It’s as simple as that.”

Perhaps pensioners should begin praying the JLL report pans out. With commercial real estate prices declining in January for the first time since 2010, the latest data available, and investors balking at rich valuations, it just might take a miracle to keep profitable prospects alive.

In the meantime, all we can do is sit back and wonder what’s to come. Transaction volumes in the trillions and heights exceeding a kilometer – how do tomorrow’s architects top that? Is man’s vanity so great he will risk an even sharper blow to the glass in that celestial ceiling? If he does, what vengeance might follow? The best we can do is hope future history books don’t include records that give new meaning to that old warning, “Look out below!”

Whistling Past the Junkyard

To this day, I still count by the flash of lightning and the thunderclap to guesstimate a storm’s distance. To this day, I make sure all trees are trimmed to be absolutely positive they’re clear of any window in my home. Such is the impression Poltergeist left on yours truly’s psyche back in 1982. For those of you who need reminding, Robbie, the name of the character who played the son in Poltergeist, would count the seconds between the lightning and the crashes of thunder for comfort knowing that the longer the pause, the more distant the storm. In the end, as the unsettled spirits rose through the floorboards beneath which they were buried, the time spans grew frighteningly shorter, culminating in Robbie’s being snared right out of his bedroom by a possessed tree. Though Robbie was rescued from the storm’s grasp, his fictional sister Carole Anne was not so lucky. The demons in the TV grabbed her very body and soul and didn’t let go until her determined mother went into the netherworld to get her back.

For the credit markets, the storm sounds as if it’s closing in. In a genuinely spooky “They’re here” moment, just last week, Zerohedge broadcast the news that the UBS Managed High Yield Plus Fund had announced it would be nailing the doors shut and liquidating their holdings. Slowly. The doomsday blog warned that the illiquidity Minsky moment was finally knocking on hell’s door; big banks’ bond inventories have been decimated and funds’ ability to liquidate in an orderly fashion would be stress-tested and fail. Forget for a moment that UBS is also the name associated with the first stressor to emanate from the burgeoning subprime crisis. This fund, which opened to investors in 1998, had survived both the dotcom bubble bursting and the credit collapse that accompanied the subprime crisis.

There’s no doubt the time should be nigh. Credit spreads, a measure of the extra compensation over Treasurys investors command for the risk of taking on corporate credit risk, for both high grade and junk bonds have gapped out in recent months. Investors are now demanding seven percentage points above comparable maturity Treasurys to hold the riskiest credits, the most in three years. Though nowhere near their post-crisis highs that exceeded double-digits, spreads are nonetheless flashing red. They’re cautioning investors that the distress emanating from commodity-dependent global economies and signs of a slowing U.S. economy could create enough turbulence to derail one of the most glorious credit cycles in the history of mankind.

Aside from macroeconomic indicators, what exactly are spreads tuning into? A recent report by Deutsche Bank’s Oleg Melentyev, whom I’ve known long enough to spell his last name by heart, suggest that the stage is set for the next default cycle. For starters, the current credit cycle is pushing historical boundaries. Going back to the 1980s, high-yield debt creation waves have lasted between four to five and a half years resulting in 53-68 percent debt accumulation from the baseline starting point. Where are we in the current cycle? Over the past four and a half years, junk credits have tacked on 55 percent growth when you take into account the combination of bonds and leveraged loans on bank balance sheets, putting the cycle, “comfortably inside the range of previous cycles,” according to Melentyev.

But that’s just one omen. Issuance aggressiveness is another way to test the credit cycle winds. Cumulative credit cycle issuance volumes of companies rated CCC and below, the junkiest of the junk, half of which can be expected to default over the next five years, casts a light on investors’ true pain thresholds. The mid-1990s and the mid-to-late 2000s saw highly toxic issuance swell by 20- and 18-percent, compared to the current cycle’s 17 percent.

Melentyev hedges the two metrics’ signals with the caveat that he’s using 2011 as a starting point despite clear evidence that the markets were expanding by the latter half of 2010. Erring on the conservative side, in other words, leads him to the ominous conclusion that, “the pre-requisites for the next default cycle are now in place.” Pre-requisites, though, do not make for certain outcomes though other fundamental benchmarks validate Melentyev’s premise.

At the most basic level, companies reassure bond investors by demonstrating they can cover the coupon they’ve promised can be clipped. The higher a company’s credit rating, the greater the probability the firm can make good on its commitment. The question is, what does it say when the presumptive pristine credits that populate the investment grade universe, the ones who disdainfully look down their noses at their lowly junk-rated brethren, begin to emit signs of balance sheet stress? The ratio of debt-to-earnings before interest, taxes, depreciation, amortization and whatever else is left in the kitchen sink for this superior cohort rang in at 2.29 times in this year’s second quarter. That tops the 1.91 clocked in June 2007 before the onset of the financial crisis. So a less cushioned starting point – that is, if this is the starting point and the storm really is fast approaching.

There are plenty of guideposts that indicate we haven’t yet arrived at the beginning of the end. Topping the list is the furious merger and acquisition (M&A) activity dominating the news flow. At $3.2 trillion globally, 2015 was already on track to take out the 2007 record of $4.3 trillion in M&A volume. And then the big guns came out. Michael Dell’s ambitions as a private market tech mogul became crystal clear with the announcement that Dell, partnered with Silver Lake, would take out EMC in a $63 billion transaction that requires at least $40 billion in debt to finance. The kicker is that $15 billion would be junk bonds – the biggest of its kind in history.

To not be outdone, Anheuser-Busch InBev muscled in to buy SAB Miller with a sweetened $106 billion offer giving new meaning to “This Bid’s for You!” As for the financing to consummate this tie-up? A cool $70 billion in debt financing, a figure that tops Verizon’s one-for-the-history-books $49 billion in bonds that helped pay for its acquisition of Vodafone.

In the event these figures have induced a bit of debt indigestion or indignation, rest assured, Standard & Poor’s (S&P), that other mighty credit rating agency, is on the case. In the first nine months of the year, S&P downgraded companies 297 times, the highest pace since that dark year 2009, with liquidity in the bond market one-tenth what it was, caveat clearly emptor.

And yet…there’s that sticky issue of the dumb money that’s on the prowl. This is not some reference to a pile of mutual fund “money on the sidelines,” which history has proven can be as ephemeral as a poltergeist you wrongly conclude has been exorcised. Nope – we’re talking about brand-new allocations to the credit markets.

Brian Reynolds of New Albion Partners, whose name has graced these pages in the past, helpfully keeps a real time score of the number of public pensions allocating fresh funds to the credit markets since August 2012. His most recent reckoning: 782 votes amounting to $169 billion in new monies being put to work in credit funds. Assuming a conservative five times leverage (which beats the 10-50 leverage multiples deployed in pre-crisis days), some $1.2 trillion in new credit flows have goosed the debt markets since late 2012.

What, pray tell, do stock market gyrations the likes of which we’ve seen since August do to pensions’ collective pain thresholds? In a nutshell, it strengthens their resolve to diversify, diversify, diversify away from their stock market exposure. August, September and the first half of October have set a three-month record for new pension allocations. Taking the cake in the “you-just-can’t-make-this-stuff-up” category, the Louisiana Firefighters’ pension is putting $50 million to work in an unconstrained fixed income fund; the funding will be sourced from an equity fund liquidation. On second thought, maybe it’s a good thing they’ve got access to plenty of firehoses.

Looking ahead, Moody’s high yield soothsayer Tiina Siilaberg, (I can spell her name from memory as well), sees clear evidence that refunding risk is building in the pipeline. Tiina’s barometer is the credit rating agency’s proprietary index that gauges the future ability of companies to roll over their maturing debt in three years’ time. The last time this indicator was at its current level was in the depth of the 2009-2010 credit crunch. “A significant contributor to the decline in the index is the increase in upcoming maturities. We currently expect $109 billion of speculative-grade bonds maturing over the next three years vs. $88 billion at the beginning of this year.” Indeed, refinancing volumes are down by some 37 percent over the last year.

Eric Rosenthal, at Fitch, which rounds out the Big Three credit rating agencies, foresees some messiness in the statistics to come thanks to the degradation of issuer balance sheets coupled with the less-than-friendly refinancing landscape. Rosenthal, whose last name practically spells itself, now expects the corporate bond market default rate will end the year around 3.5 percent and keep moving up in 2016. This rate, he cautions, is materially higher than the 2.1-percent average rate that coincides with non-recessionary times. In an conscious nod to $45 oil, nearly half the energy and metals & mining issues are trading below 80-cents on the dollar (par is 100-cents) compared to seven percent for the whole of the high yield universe. Still, the beat goes on, Rosenthal concedes – which is good news for Michael Dell. Issuance may be down 35 percent over last year for the aforementioned beleaguered commodities space but it’s up three percent for the rest of the junk market.

Are the conditions for a meltdown in the bond market firmly in place? Are investors deluding themselves, whistling past the junkyard? Absolutely. But that shouldn’t necessarily keep you up at night, counting the seconds in between lightning flashes and thunderclaps. Or, as Deutsche Bank’s Melentyev’s quips, “A stack of hay is not a fire hazard in and of itself; someone being careless with matches nearby makes it so.” By that same token, Poltergeist’s greedy real estate developer could have ponied up the extra moola to move the coffins of the dead and buried under the subdivision he so profitably erected. Instead, he rolled the demonic dice and simply removed the headstones, whistling past the houses until the unsettled corpses rose through the floorboards, shattering the illusion of suburban serenity.