The Economic Collapse

The move out to Las Vegas has been wild, and we’re glad we made it. Yes we’re making returns that outstrip anything you’ll see in conventional products, but that’s not the point. People assume that because we’re investing in real estate, we are betting on an economic recovery; they don’t realize that we’re investing on the premise that we are on the verge of a profound economic collapse. Real estate will only provide a temporary hedge against a failing economy. Quite frankly, the only real estate we want to hold for the long run is that which we’ve purchased with 30-year fixed money at below 4%. Otherwise, we are aware that prices are going to rise only in line with inflation over the long-term, and that real estate should be viewed much like a bond in the 1980′s. If you have an “unlimited” time-frame (like we do), buy real estate; if you have a 5-year time frame, flip real estate or buy gold. Our outlook is naturally going to be a little different because our portfolio is bigger. We can handle the swings in real estate and collect our 10% (on bad deals) to perpetuity, and we’re fine with that.

At the end of the day, we want what’s best for our investors. The only reason we are investing people’s money is because we know we are doing them a service to protect them from an economic collapse. If we can roughly double their money in 7 years, we’re happy because it means one more person is better positioned to survive the storm. Raising capital is not really an issue at this point; we are more focused on getting our own money in these deals. What’s more important to us is educating as many people as we can about the impending financial storm. And if the past year and a half has given us more credibility, great.

Economic Collapse: The Elephant in the Room

It’s really hard to articulate the magnitude of the economic crisis that is on the horizon. Even if you lucidly explain why a collapse is coming, most people won’t listen. That’s just human nature. We all like to think of ourselves as open-minded and unbiased, but when it really comes down to it, only a minority of people actually are. This is just the truth, and you see this axiom expressed most clearly at turning points.

The way our minds work, we believe in business as usual, “this time is different”, and that history won’t repeat. However, the collapse of great nations always occurs due to finances. This is not so much a conspiracy theory as it is the statement of a plain fact. So instead of blindly prognosticating rosy scenarios, or “doom and gloom” for that matter, it’s intellectually honest to look at the financial situation in the U.S. with unbiased eyes. As an investor, it’s all about making money, whether it’s going long or short.

The sovereign debt crisis stems from this entire notion post-WW II that governments could spend like drunken sailors without a viable plan to pay the money back. It’s really that simple. Paul Volcker accelerated the debt cycle in the 1980′s by raising interest rates to curtail inflation. Unfortunately, Volcker forgot that the U.S. government is the biggest borrower out there, which meant he was increasing the rate of growth of U.S. debt. Oops! A 5 year old could tell you that the rate of growth of debt has accelerated since Volcker. Currently this curve is exponential. Why? Compounding interest.

When you study the composition of national debt, you come away understanding that compounding interest is the problem, and there is no plan to stop this process. The majority of the national debt at this point is composed of accrued interest payments. Think about this for a second. Even if our government magically closed the deficit of over $1 trillion annually (unlikely), the interest payments would continue to compound. Given current interest rates, the annual interest payments on our debt will rise to roughly $500 billion in 2017. And this is assuming record low interest rates. To put that in perspective, interest payments on our debt by 2016 will outstrip the combined spending in: The Department of Education, Department of Homeland Security, Department of Energy, Department of Justice, Department of Agriculture, Department of Transportation, Department of Interior, and Department of Commerce. So this policy of austerity and spending cuts in a recession sounds nice, but it is entirely misguided without the understanding that our monetary system is the problem.

The CBO, aka the government, is predicting over $5.3 trillion in interest expenditures over the next decade. Common sense tells us the numbers will be far worse because of flawed CBO assumptions. The CBO assumes that the 10-year Treasury yield will rise from 2.3% this year to 5% by the end of the decade with the yield on 3-month T-bills increasing from 0.1% to 3.8%. However, during the majority of the 30-year bull market in government bonds, interest rates were above 5%. The bull market will end simply from a cyclical perspective, and as you can see from the chart below, when interest rates rise, they rise very quickly. Assuming interest rates between 7-10% is much more realistic. 15-20% is not really out of the question either. But our point is that even with a modest rise in interest ratesthe interest payments alone will consume the majority of our tax revenue.

The interest payments on our debt are such a nuisance because of the increase in the foreign ownership of our debt. If Americans owned American debt, then interest payments would actually stimulate our economy. As it stands, we are providing the greatest stimulus to a foreign country (China) that the world has ever seen. The problem with quantitative easing is that even if the Fed purchases bonds, there is no guarantee that the bonds were even held by Americans, meaning there is no stimulus. This is incredibly porous strategic thinking.

Attack the interest payments, you have a chance of coming out of this alive. Attack the deficit problem through austerity measures and you are headed straight off a cliff.

Lowering Interest Rates

The entire field of economics has it wrong with this crazy notion that lowering interest rates stimulates growth. First of all, retirees are the only ones who maintain their consumption patterns when a downturn hits. Lowering interest rates takes away their income and is akin to banning short-selling in a stock market collapse since short-sellers are the only buyers at the bottom. Anyway, where’s the empirical evidence that lowering interest rates stimulates the economy? During the Great Depression asset prices collapsed as we lowered interest rates and rose as we increased interest rates. People will borrow money as long as the perceived profits are greater than interest rates. If there is no expectation of profits, people will not invest no matter how low you bring interest rates. And this is fact, not theory; after all, where is the boom in investing activity that was supposed to come with lower interest rates?

The Japanese Model

The true movers and shakers are the macro hedge fund managers that understand the global economy is connected. The U.S. is not the only economy in the world and our domestic policies have bigger implications than people appreciate because capital knows no borders. If you understand capital flows, you understand where all the best investments of the future will be. If you just play around with discount rates on an excel spreadsheet to “analyze” a stock, you’re bound to live in the crevices of your mind.

The Japanese policy of lowering interest rates to 0% didn’t stimulate the economy and instead created the carry trade (borrowing in a currency with low interest rates to buy a currency with higher interest rates), which ironically sent money abroad. Good one. If lowering interest rates to 0% were the solution, then Japan wouldn’t be mired in a 23-year downturn. Why people continue to accept this conventional piece of wisdom is one of the true mysteries of life.

Bond Market Collapses vs Stock Market Collapses

Stock market collapses are really not that big of a deal; stocks typically are back in rally mode within a year or so. But bond market collapses wipe out capital on a much larger scale, which is why bond market collapses create Depressions. The Great Depression was not caused by the stock market collapse any more than the crash of 1987 created the subsequent boom in America. In 1931, we were in the middle of a sovereign debt crisis very similar to the one we are witnessing today. Capital reacted in the same way that capital does now. Greece is going down, so who’s next? Ok, let’s attack the bonds of Spain, Ireland, and Italy. When Europe falls, Japan is probably next, then the U.S. You can be the prettiest pig of the bunch, but at the end of the day, you’re still a pig.

Is a Crisis Ahead?

It always takes people a long time to figure out what’s happening. The housing/stock market collapses of 2008 were pretty easy to predict, but the majority of investment professionals were blindsided. In the current environment, states in the U.S. are no different from Greece. They are essentially pushing forward the day of reckoning with shoddy accounting while continuing to under-fund their pensions. And the pensions are locked in AAA-rated assets that are in fact the most toxic assets in the world: U.S. Treasuries. But trying to tell the average person that Treasuries will implode is like trying to convince them that stocks and housing were set to crash in 2007. It’s just not happening.

The way this will all play out is pretty obvious. We have rising taxes, and more importantly, more stringent enforcement on tax collection. This is deflationary and will create a hoarding mentality in the population. But we also have unlimited money printing and an impending bond market collapse that will force capital into assets. This is inflationary. So what do we get? Stagflation. Forget about economic growth when tax rates are going up and there is literally no instance in history where a sovereign debt crisis was resolved by higher taxes and austerity. Politicians always try to manipulate the business cycle with their braindead plans and it always results in more misery for the people. Anyway, it’s pretty ironic that the people who are running up our deficits are “Keynesians” who believe in higher taxes. Keynes actually believed in lowering taxes in a downturn, but somehow that important piece of information gets lost.

Conclusion

We are neither perpetual bulls nor perpetual bears. We are realists. We understand that in a no yield world, the 10% yield, no capital appreciation asset is king. This means real estate, some stocks, and any productive asset like oil wells. Gold is probably headed to $5,000 and this is NOT abnormal in terms of asset appreciation.

When bond yields peaked in the early 1980′s, it was not the professional who bought- it was actually the normal person who saw bond rates at 15%, shrugged their shoulders, and bought. The same thing goes for real estate. When gloom and doom enters the picture, professionals will be telling you to sell real estate! The average person with some income to spare will shrug their shoulders and buy. Yes real estate is likely to stay flat for 20 years or so, but what are your alternatives?

Home prices in Las Vegas will probably fall somewhere between 10-20% next year or in 2014. This is not that big of a deal because this just increases the return on investment. And believe it or not, Las Vegas enjoyed the 2nd largest growth in tech jobs in the country in 2011. It is not all hotels and hospitality anymore; Vegas is evolving. Taxes are going to insane levels, especially in California, and expect an exodus of biblical proportions in the years ahead. The tax structure in Las Vegas is still attractive, and we should see new hubs of industry appear.

The government is clamping down on capital movements (i.e. $3,000 minimum wiring reporting requirement from $10,000) and this should have you all concerned. The entire mentality of government has changed to one of desperation. This tends to happen when your obligations are underfunded. As we’ve said before, the collapse in pensions will force retirees to withdraw money from banks just to survive, and this will create an artificial bank run. The banking system fundamentally is a leveraged system that relies on confidence. What we are witnessing now, and very few people can deny this, is a collapse in confidence. There is a clear logic to all of this if you can connect the dots.

We will see a crisis by 2016 that makes the 2008 crisis pale in comparison. Those who don’t believe will see their financial lives collapse before their eyes. There’s really not that much time, and things should start unraveling in 2013. We personally plan on buying all the real estate we can in 2013 and 2014 before it really hits the fan.