David Stockman: Blackstone Double Dip

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David Stockman, Budget Director under President Reagan and partner at private-equity firm Blackstone Group, lashes out at the Fed-induced LBO of Extended Stay America that amounted to a scam, made Blackstone Group billions, and saddled taxpayers with the detritus. This is the fourth installment of the Extended Stay debacle. It’s from Chapter 26 of his bestseller, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.

But the worst effect was that the Wall Street machinery and principal participants in the financial engineering régime were soon back in business. This cardinal reality was made starkly evident in the court papers issued upon Extended Stay America’s discharge from bankruptcy in May 2010. The hotel company’s proud new owner was, well, the Blackstone Group. And to underscore that speculators had returned to the scene of the prior strangulation, as it were, its partner in the deal was the John Paulson hedge fund.

The ever gullible financial press was wont to characterize this outcome as a triumph of capitalism; that is, the mobilization of flexible private equity capital to reorganize and recapitalize a failed business enterprise. But that was dead wrong because the Blackstone-Paulson partnership didn’t recapitalize anything. What it did, instead, was utilize the same cadre of Wall Street lawyers and bankers to shrink and shuffle the busted debt paper from the Lightstone deal into a new deck of about $3.5 billion of notes, bonds, and preferred stock.

The second Blackstone deal, therefore, brought only trivial amounts of actual fresh equity—a couple hundred million—to the table. The Blackstone-Paulson investors essentially performed the same old trick that had become standard fare before the Wall Street crisis: they bought another call option on a debt-laden enterprise that was leveraged at 10:1.

Whether the resulting 50 percent haircut on the total capitalization, from $8 billion to about $4 billion, was the right value for the 76,000 aging hotel rooms in the Extended Stay portfolio would be determined by real-world events. But the underlying facts were not encouraging: the financial deformations that had led to Extended Stay’s boom, crash, and rebirth had produced a giant malinvestment in the overall hotel sector.

In fact, the ultimate indication that the Wall Street playpen known as the US hotel sector is not on the level lies in a startling statistic: there are 13.2 million hotel rooms in the world, and 5.6 million of them are located in the United States. Thus, with 4 percent of the global population we have 42 percent of the hotel rooms.

The American economy is drastically overhoteled in part because a significant swath of its labor force has become nomadic. Some of this may be attributable to new-style traveling tech workers and old-style traveling salesmen. But mainly it is due to a drastic policy-induced deformation. The Fed’s massive creation of dollar liabilities drove tradable goods production to the mercantilist “cheap labor” regions of the Asian rice paddies. At the same time, it fueled an orgy of real estate development and construction on the “cheap land” precincts of the sun and sand belts at home.

As previously explained, at least 10 million tradable goods jobs had been off-shored during the Greenspan era, meaning that jobs had become scarce where people used to live (Flint, Michigan). At the same time, the debt-fueled boom in the Sunbelt—health care, retirement communities, resorts and leisure, and endless construction of new housing developments, shopping malls, and other commercial real estate projects—happened on the margin, where people didn’t yet live (Ft. Myers, Florida).

Not surprisingly, the extended-stay hotel segment, where business travel accounts for 75 percent of room night demand, grew like Topsy during the two Greenspan bubbles. It provided a way station for nomadic workers and populations in transit. As in the case of all malinvestments, however, the music eventually stops when the speculative bubble which finances them implodes. That has now happened, thereby causing the ranks of nomadic finance, construction, leisure industry, and retail and consumer service workers to significantly diminish.

Accordingly, the extended-stay hotel segment remains overbuilt and overvalued a half decade after new construction peaked. Yet the Fed’s ZIRP (zero interest) policy perversely thwarts the free market’s curative capacities to punish speculation and liberate assets from the encumbrance of excessive debt. Instead, it perpetuates the “extend and pretend” illusion that the debt is money good because it encumbers an asset that is vastly inflated in value.

Economic Suffocation by Bernanke’s Rentiers

In effect, Bernanke is the godfather of the debt zombies. His radical interest rate repression campaign has not created much new lending, but it has disabled and overridden the free market’s capacity to liquidate bubble-era credit. Instead of taking the drastic debt write-downs which are warranted, banks and other lenders have been enabled to pursue the “extend and pretend” route; that is, extending maturities on debt that can never be repaid while booking it at par because borrowers stay current on interest payments.

The low interest rates on bubble-era debt, as well as post-crisis restructured debt, are laughable by all historic standards. Banks should be reserving heavily against the maturity cliffs ahead, but are not being required to do so owing to the utter folly emanating from the Eccles Building; namely, the Fed’s fatuous promise that one day it will be able to “normalize” interest rates without triggering a debt-impairing conflagration on Wall Street and another plunge on Main Street.

So by not taking the deep reserves required, Wall Street banks are (again) reporting phony profits. Indeed, led by JPMorgan they are massively reversing out reserves they had previously taken in order to goose their earnings and levitate the value of executive stock options. And phantom banking profits are only the surface issue.

The real economic problem is that by keeping properties and businesses encumbered with too much restructured and rescheduled zombie debt— as was evident in the so-called restructuring of Extended Stay America by Blackstone and Paulson—free cash flow is siphoned off to pay what are essentially unearned rents. These ill-gotten receipts are collected by Keynes’s famous rentiers who nowadays are called PMs (portfolio managers) at fixed-income funds.

Stated differently, bubble-era properties and companies are being bled to death by uneconomic interest payments and thereby precluded from reinvesting in plant, equipment, technology, new products, human resources, and all the other ingredients of sustainability. After a decade as a debt zombie, therefore, the typical commercial property will have lapsed into a state of terminal decay and the typical operating business will have become a hollowed-out cipher.

None of this would have been a surprise to pre-Keynesian-era economists because they knew that credit inflations are tricksters. They fund artificial demand which gives rise to secondary and tertiary waves of additional demand, usually to build new infrastructure and production capacity that ends up redundant when the bubble pops.

This crack-up boom cycle so well known to the ancients was vividly at work in the extended-stay hotel segment. At the peak of the bubble, nomadic workers in construction, finance, and real estate were actually creating part of their own demand; that is, they were filling rooms that justified even more construction. Yet developers couldn’t fill up rooms with their own workers indefinitely, nor could the Fed permanently extend the speculative building mania in commercial real estate.

As a result, the nation is now saddled with vastly more capacity—malls, lodging, restaurants, car dealerships, office buildings, movie houses—than can be justified by the sustainable income and spending capacity of the American economy. Ironically, the monetary central planners take this overhang as evidence of insufficient “demand” and therefore a need for more money printing. Like nineteenth century practitioners of the bleeding cure, they single-mindedly press ahead toward the patient’s eventual demise.

Check out his book at your favorite bookstore or at Amazon…. THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.

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