Norris Bruce
Oct 12, 2012

Christopher Thornberg, Principal at Beacon Economics, Joins Bruce Norris on the Real Estate Radio Show #299

Christopher Thornberg

On Friday, October 19, the Norris Group proudly presents its fifth annual award-winning event I Survived Real Estate. An incredible line-up of industry experts joins Bruce Norris to discuss perplexing industry trends, head-scratching legislation, and opportunities emerging for real estate professionals. Proceeds for the event benefit Make a Wish and St. Jude’s Children’s Research Hospital. This event would not be possible without the generous help of the following platinum partners: ForeclosureRadar and Sean O’Toole, the San Diego Creative Real Estate Investors Association and President Bill Tan, Investor Workshops, Invest Club for Women and Iris Veneracion and Bobi Alexander, San Jose Real Estate Investors Association and Geraldine Berry, Frye Wiles, MVT Productions, and White House Catering. Learn more about the panel and how to attend at isurvivedrealestate.com.

Bruce Norris is joined this week by Christopher Thornberg. Christopher is the founding partner of Beacon Economics LLC and widely considered to be one of California’s leading economists, an expert in economic forecasting and regional economics, economic policy, and industry economics. He was one of the earliest and most adamant predictors of the global economic recession that began in 2008. Since 2006, Dr. Thornberg has served on the advisory board of Wall Street Hedge Fund Paulson and Company, Inc. Between 2008 and 2012 he served as a chief economic advisor to the California State Controller’s Office and was the Chair of Controller John Chang’s Counsel of Economic Advisors. Dr. Thornberg holds a PhD in business economics from the Anderson School at UCLA and a B.S. in Business Administration from the State University of New York in Buffalo.

Bruce wondered if Christopher was comfortable with the direction of the U.S. economy, which Christopher said he actually is. He said there seems to be this need in the popular press today to continue to beat this drum of decline. In reality, when you look at the data it is quite far from the opposite. We are three years into the current expansion, and numbers look okay across the board in the private sector. The weakest part of the U.S. economy overall is the public sector. You could argue this is almost a normal expansion. Bruce asked if you would want expansion in the public sector. Christopher said over the long term the government spending tends to grow more or less in proportion to the rest of the U.S. economy. Therefore, it is a contributor to overall economic output growth, at least from the demand framework that is typically used when examining the macro economy.

There are many among us who believe a smaller government is better; and from that perspective you could look at the current statistics and say they are good things. Ultimately, we may be right if we continue to see the public sector downgraded and people feel it is a hindrance to the economy. Ultimately, you would suggest that it will bring better growth rates at some point in time in the future. In the short run, when you shrink government, it is a drag on the economy. The idea that you can shrink the government and promote greater economic growth right now is just false and not how it works. You are creating structural transitions inside the economy, which are painful in the short run.

Across the seas they are having an exaggerated example of this. They want to cut back and expand the economy at the same time, and it is very difficult to accomplish both of these. Christopher would argue that it is not quite the same thing. The new insults in politics is to call you Greece. We are not anything like Greece. Greece is where it is because for years it was vastly over borrowing and had a level of debt relative to its economic output that was at one point in time at least twice if not over that larger than the U.S. economy. On top of everything else, the underlying Greek private sector economy is one of the least competitive and least efficient in the world because of all kinds of crazy rules, regulations, and corruption. This is not like the United States, which still has one of the most competitive private sectors in the global economy today.

Bruce asked Christopher how he interprets having a 1.7% ten-year T-bill. This says two things. For one, it shows people are willing to pay a premium for safety. Second, they continue to see the U.S. government as a place for safety and fully expect the money they give the Federal government today to eventually be paid back to them. It is like saying we are afraid, concerned, and conservative. To us, yield is not the big thing and we wonder if we can just get our money back at some point. To simplify things, there are two kinds of assets in world today. There are safe assets and risk assets. The demand for safe assets is enormous today, and this is not just driving interest rates on T-bills. Mortgage rates are incredibly low right now because people are willing to buy Fannie and Freddie bonds for very low rates. If you are a large, global corporation, you can borrow at incredibly cheap rates because you are considered to be safe. There is a lot more demand than there is supply for those types of assets, and this is what puts interest rates where they are.

Bruce wondered where California real estate fits into the risk quotient. Christopher said it should be very good, although he would argue that you are seeing money moving into California real estate at both the commercial and the residential level. We know cap rates are down, not just for apartments but are also slipping in terms of Class A properties, retail, and office as well. The housing market here is also really starting to tighten up. Bruce has been counseling for a while that people should be moving heavy and hard into residential real estate, and numbers confirm this. Another interesting thing is some of the hedge funds have moved some serious money into California and other states that have had downturns. This is a brand new occurrence for real estate, at least for housing, to have that kind of money interested in setting aside scattered homes in addition to apartment buildings with the intent of putting together a REIT. Christopher said he has seen some of this, and it is probably a pretty good financial plan.

What you are dealing with here are two things. For one, California still lacks housing supply. Over the last 4 years, for a variety of reasons the state has not come anywhere close to producing the quantity of new homes necessary for population growth. This is one of the reasons why we never took the same hit that Vegas or Arizona did. We did not have this vast, excess supply that those other economies did in terms of housing. At the same time there is something else going on out there. With this enormous wave of foreclosures, most of the new demand in the U.S. overall and in California is moving not into owner-occupied housing, but rather moving into rental housing. As a result of that, people see that there is a good potential to buy these homes in the short run, then rent them out since we know there is a lot of demand. Ultimately, you can turn around, flip them, and make good money selling them when the market is back towards a more focused, owner-occupied type of demand situation.

When you have an economic downturn like we had, Bruce wondered if this stunts household creation. Christopher said it really doesn’t even though you may have heard the theory a lot. The Harvard Joint Center for Real Estate Studies said that there is a vast, pent-up supply of 20 year olds desperately trying to get out of their parents’ homes. The Joint Center was also the same people who told us in 2006 and 2007 that there was no extra supply of housing and prices would go up forever. This is why when he looked at the recent numbers he did not find them true.

When you sit down and look at the numbers, you see there was some modest evidence of doubling-up, but it was pretty small. You could say the slowing of household formation was really in part economic to some small extent, but just as much we have to keep in mind that between 2002 and 2006, we actually had an excess supply of new households. What you had was a lot of 27 year-olds who would typically be living in an apartment with a roommate going out and buying homes because they could. The money was there, and it seemed like a path to quick riches. They took the chance, most of them probably foreclosed on. Now, they are back living in the apartment they would have lived in anyway. Those folks are the excess supply in the short run, and that part is starting to turn around.

Bruce wondered about the fiscal cliff in 2013. We have heard the term fiscal cliff so many times, and there is no such thing. The concept of fiscal cliff sounds like on January 1 taxes go up, spending goes down, and on January 2 we are in a recession. Christopher said he would not really call it a cliff, but rather a fiscal hill. The difference is for a shock to the U.S. economy to have recession-causing effects; the shock has to be large, rapid, and sustained. The fiscal cliff is large and rapid, but it has to be sustained for it to cause a recession. Christopher said the reason he is relatively confident it will not cause a recession is because he remembers what happened back in the mid-90s when Newt Gingrich and company were in the midst of their partisan battles with Bill Clinton and decided to shut down the Federal government for a period of time. A lot of it was over the budget of which they did not approve.

It is funny how Americans can seem so oblivious to the public sector and what is going on in our state capital. They seem to be far more inclined with whatever star is doing whatever horrendous thing. This is until the checks stop going out and they suddenly start paying attention in a very loud way. We saw this in 1995 when within 2-3 weeks the political crescendo was deafening. People were infuriated; and it single-handedly led to the Republicans losing the house and the collapse of what Gingrich pledged to America. Ultimately, it made the rest of Clinton’s stay in the White House much easier for him. Christopher’s feeling is by January 1 it seems highly probable we will not have a compromise by then. Even so, you can expect when the checks stop going out and the taxes start going up, you are going to hear an enormous outcry. This pressure is going to continue to ratchet up until such a point in time when they realize it is their neck on the line and they have to do something. Then something will be accomplished.

Bruce wondered if we have to get closer in line to a balanced budget for all this to happen. Christopher said ultimately we have big problems in our budget, especially with Medicare, social security, and defense spending. This is all obvious, and most of this shows up within 10-15 years, not now by any stretch of the imagination. We would be better off if we started dealing with it now, but we probably are not. We need to start dealing with it and dealing with it at many levels now. We have not had these conversations yet; and Christopher said he can speak for one to be very frustrated with the fact that we keep ignoring the issues as obvious as they are. At the same time, we are not going to solve this with partisan lines being drawn in the sand. You have one side of the equation, the tea partiers, who are screaming all kinds of crazy things. Then on the other side you have those saying you can’t touch things like Medicare no matter what. That is not how we solve these issues.

Another issue is with state insolvency where you have Chapter 9 bankruptcy. One of the things that seem to be virtually untouchable is people’s retirement plans. At this point in time this seems to be the case. One of the reasons they can get away with it in the short-run is because of the fact that the pain has not kicked in. There will come a point in time when CalPERS becomes so underfunded that they are going to have to acknowledge that they are going to have to acknowledge the obvious and that one of two things is going to happen. They are either going to have to start passing the costs onto current employees by raising up their contributions; or they are going to send giant tax bills to state and local-level governments. This is going to create taxpayer revolts. Another option is they are going to have to figure out some way of breaking that log jam and find some legal way to reduce the benefits of people currently being paid.

Sadly, the people who are probably most to blame for this issue are the people already in retirement who will probably not even be there when we come to that point in time. This is too bad since these are the people who spike their pensions and are making ridiculous amounts for 40 years and are going to get away with it scott-free. It is going to be current-state and local employees who are going to be ultimately left holding the bag because they will be paying for years. They will not get anything close to what they were promised because it is simply not sustainable. This goes back to the argument that we need to do something about this now, but there is no possible way of doing this within this typical political climate.

We have moved incrementally in the right direction since the governor did some modest reforms. They were very small and not enough for the long-run, but at least he is moving in the right direction. Christopher said what worries him to death is we had a very similar thing happen in the early ‘90s with Pete Wilson. He understood the long-term problems and moved in aggressively to take care of them. We then had the internet boom and the big surge in revenues. Gray David came in and quite cavalierly reversed everything Pete Wilson had done and made it worse. We saw Gray Davis wondering around California like this elder statesman. Christopher said he puts the blame for our current budget situation on him almost more than any other individual in this state. It would be a sad day if he ever gets any credit for anything he did.

The worst thing you can do is have excess revenue as a government. They have tried various sorts of controls to try and stop the incentive to spend all the money immediately. Unfortunately, the very people who make the lock boxes are the very same people who want to leave a back door open so they can sneak in when they want. It becomes very complicated to set something up that would actually work.

Bruce wondered if Christopher sees any big changes to real estate coming in next few years with policy changes, specifically with mortgage deductions. Christopher said it is hard to say. He would have liked to have seen Fannie and Freddie removed from the scene, but seems to have died in the vine and it’s likely they are not going anywhere. The mortgage deductions should go away since the don’t do anything for anybody. People who gain from that are the people who own homes when the first one went into play. Otherwise, the rest of us are just paying more for the house, which is an offsetting effect. This should go away since it is a ridiculous thing to have. However, it is so fundamentally popular that he has trouble seeing it going away. Sadly enough, you are seeing securitization of mortgages starting to grow and occur again. We don’t seem to have learned much from this crisis. We want our houses to go up at all costs. It is frustrating to see that we have learned so little, but perhaps this time we will at least be able to see the signs of impending doom a little better.

One thing about having a very low interest policy is it’s great if you are a borrower, but if you are a saver it has not turned out very well. The only exception is these long-term interest rates are not a function of policy. This is nothing Obama or Bernanke did. With Quantitative Easing 1 and 2, economists say it has maybe reduced interest rates by 3-4 tenths of a percent maximum. These interest rates are low because there is a lot more supply of capital in the world today than there is demand. This is not going to change any time in the near-term. This means for those people out there thinking ahead and planning for their future, they need to understand that ultimately the best way of saving for the future is to spend less. The yields just aren’t going to be there the way they were in the past. At this point the Fed is buying a lot of the debt, about $40 billion a month. Interest rates are low again ultimately because there is a lot more supply of capital in the world today than there is demand. There is all kinds of work done showing that the actual impact the Federal Reserve can have on long-term rates is much less than what we would typically think given the tone of the news. This really is a market-driven situation.

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