Sorry, Dorothy, but “No!” We’re not in Kansas anymore, but it’s possible we’ll return at some point.
One the best teachers I ever had was my finance professor at the University of Denver, Lou D’Antonio. A New Yorker who had spent time on the bond trading desk of Salomon Brothers, he was tough. Because more than just finance, he tried to teach us how to think. His pet phrase: “When you are spinning your wheels, go back to the definitions.” Somewhere in those definitions you would find the clue as to how to solve whatever problem you were facing.
Beware, this is somewhat of a lengthy read. For those who want to cut to the chase: 1) increase cash to the extent you can, 2) if you don’t have a working capital line of credit, try to get one, 3) use a higher interest rate for capital planning purposes than you have been, and 4) modify the design of your project to fit within the new cost reality. But, if you can spare 15 minutes, I think you’ll get some interesting takes on important subjects that really will affect you.
So, what problems are the charter sector collectively facing? There are numerous, to be sure, but as a financial advisor helping schools to finance facilities, the problem I want to define is how schools need to adapt financially to what appears to be, for the near term anyway and possibly longer, a new economic environment. What is this new economic environment? It’s one where the Fed won’t have your back as it has for more than a decade.
There are some of you reading this who have never known anything in your professional lives other than the Fed “Put” or Quantitative Easing (and if you didn’t get the “Dorothy” reference above, that’s definitely the case. Google “No place like home”). Stock market wobble? Fed response: lower short-term interest rates, increase credit! Dot-com stock bubble burst? Fed response: lower short-term interest rates, increase credit. Housing bubble collapse? Fed response: lower short-term interest rates and buy mortgage-backed assets, also lowering long-term interest rates, and really increasing credit! Stock market fall in response to an attempt to normalize interest rates (2018)? Fed response: back to QE. For over three decades, going back to Alan Greenspan, every time there was some sort of financial turbulence, the Fed came to the rescue with actions that increased the liquidity in the system and the amount of debt in the economy. This has accelerated since the financial crisis of 2008. And, their policy response was always lopsided – it takes much longer to tighten than it does to ease. Much, much longer!
Ben Bernanke just recently (2022) won a Nobel Prize in economics for his reaction to the 2008 Great Financial Crisis, under which the Fed not only lowered its interest rate to zero but also ballooned the balance sheet of the Federal Reserve from less than $1T to over $2T in just 3 months, from September to December 2008, and growing thereafter to over $4T by the end of 2013. His response to the 2007-2009 financial crisis stayed in place until the end of 2014, five years after the crisis itself! I remain in disbelief at this award: the top prize in economics was being given to a person who reacted to a financial crisis with the “Hair of the Dog” remedy. Like so many, the members of the Nobel committee ignored any analysis of what is causing these increasingly frequent financial crises to which the Fed was reacting. Apparently the committee was spinning its wheels as we used to in Professor D’Antonio’s class, believing that the 2007 housing bubble just showed up out of nowhere, much like Bernanke assumed in his research on the Fed’s reaction to the 1929 stock market crash – the crash just happened! People just suddenly stopped buying anything, for no reason.
Well, these things don’t just happen! They are created by: 1) flawed human judgement and a tendency to overdo things (madness of crowds, FOMO, etc.), along with 2) monetary policy that has fostered moral hazard for those flawed humans and created asset and credit bubbles. For the last three-plus decades, policymakers have reacted to every problem from whatever bubble by creating more liquidity, and more low-cost credit, which in turn fuels more bubbles. There is plenty of research out there which you can tap if you are interested, but to quickly point to some examples, just try and digest the following. In late 2021 there was over $17T in global debt that yielded NEGATIVE INTEREST RATES. The prices of some bonds were bid up so high that lenders paid borrowers for the privilege of lending them money, completely ignoring the time value of money, let alone credit risk! Additionally, the Fed was buying over $100B of securities per month, increasing M2 by same, up until March of 2022. This included mortgage-backed securities at a time when the inflation rate had already gone through 7% by the end of 2021 and prices of homes were already unaffordable to most of the population. Whisky Tango Foxtrot!! A non-fungible token (NFT) sold for $65 million last year. (Challenge – what are some creative phrases the acronym NFT could stand for in that circumstance?) Money supply in the form of M2 has increased in two years by 41%, from $15.4T to $21.7T, from the beginning of 2020 to the beginning of 2022. It was $7.1T in 2007, fifteen years ago, one third the current level. We have tripled the money supply in the economy in only fifteen years, and increased it by almost the 2007 amount in just two years since 2020!
Policy makers, in their reactions to various crises, have purposely taken the return of holding cash to zero, and taken short-term borrowing rates to zero (via Fed Funds and T-bills). They have both incentivized and provided the liquidity for the taking on of more debt to speculate in riskier assets in order to make any sort of nominal return (Liability-driven investments, anyone?). And what eventually happens? People lose the sense of risk they are taking on because, Hey, the central bank has my back! It’s privatized profits but socialized losses! It’s like those looters we’ve seen recently, grabbing anything in sight because they think there is no cost to doing so, but in the process driving out businesses that serve their communities. The Fed essentially made money have no cost (and no return), and people reacted by borrowing gobs of it to invest in government-sponsored irrational exuberance. This misallocation of resources hurts the economy – I mean what does a $65 million NFT really do for the economy? Result: creation of asset bubbles and an ever-growing pile of debt!
I read in Roubini’s new book that in 1999, global debt stood at 2.2x global GDP (note: that level was already inflated by central bank policies versus levels from previous decades). It then increased to 3.2x in 2019 (an increase in debt of 100% of global GDP in 20 years), and 3.5x after the Covid pandemic. For advanced economies (using the term “advanced” loosely), the ratio was 4.2x in 2019 BEFORE the pandemic. For the United States, our Federal debt-to-GDP was 107% pre-Covid, went to 132% last year, and now stands at 121% (after the run-down by $1T of the Treasury General Account, which has to date completely offset the impact of the Fed’s QT – but I digress). Total debt of households, non-financial corporations, non-profits, and governments (including Federal) totaled 302% of GDP at the end of 2021 (3x GDP). Household credit card debt just increased since a year ago (Oct 2021) at the fastest pace in 15 years, reaching a record $16.5T. So much for those pandemic savings. We are absolutely awash in debt, and I just don’t know how that can ultimately be a good thing. (If you are a proponent of Modern Monetary Theory and want to joust, bring it on!)
And as they always have, eventually the bubbles created by all that credit will burst! And what has the Fed usually done in response? Because of the ever-growing pile of liabilities which the Fed helped create, it has had to use the Hair of the Dog remedy by either lowering interest rates (if they were not already at zero) or buying more assets, including the debt of corporations rated below investment grade, to increase liquidity and incentivize taking on more debt. And as noted, this is all some of you have ever known your entire work lives. And, it’s called a Debt Trap. We’re caught in this trap (“and we can’t walk out” – name that singer)!
And for years, the charter school finance industry benefitted from this situation as much as we could. Borrowing on a long-term basis for entities who could be put out of business by a change in political winds at interest rates in the 3% range, sometimes in the 2% range, was commonplace. Taking advantage of banks’ liquidity to utilize shorter-term debt at favorable terms for schools with limited direct operating history – been there, done that. But, things are changing. Why? Inflation.
For many reasons I won’t go into here (but would be happy to talk to you about), we are now facing a level of inflation that most of you haven’t seen in your lifetimes. I will only say that, it turns out that when you create in less than two years 35-40% of all the dollars outstanding, that increase in the money supply can end up leaving the financial economy (stocks, bonds, real estate) and entering the real economy (groceries, restaurants, electrical gear boxes, subcontractors, railroad workers, airline pilots). Due to factors of its own making, the Fed now has to address this or face a potentially fatal loss of credibility. And losing Fed cred would hurt everyone.
The Fed is both raising interest rates and, VERY IMPORTANTLY but little discussed, is also taking liquidity out of the system and reducing the size of its balance sheet in order to combat inflation. It is that last process which I am most concerned about having a medium-term impact on the cost of financing facilities, possibly longer. And that is because I am going back to the definitions like I was taught by Professor D’Antonio.
Many very smart people are forecasting long-term interest rates to decrease from here due to the likelihood that we enter into a recession in 2023. Typically, that has been what has happened, and recently the US 10-year Treasury rates have declined from 4.3% to 3.7% (predicated on many things like a downtrend in the US Dollar, but down 60 bps nonetheless). And, the US Dollar still is the world’s reserve currency and the basis for most international transactions, so demand for it remains strong. But one thing is different this time. This time the Fed is tightening going into a recession when usually it eases going into a recession. It has never tightened going into a recession, I am told. Regardless, some math to consider. Under the recent QE program, the Fed was buying about $1T in US Treasury securities per year, and about $500B mortgage-backed securities. The 2022 fiscal deficit was $1.4T. From 2020-2022 the fiscal deficits have totaled about $7.5T and the Fed has net funded over $4T of that, monetizing $4T of debt. So, the Fed has been the marginal buyer of the majority of the increase in US Treasury supply since before the pandemic. To be sure, we have seen a run-up in Treasury yields in 2022 as QE stopped and QT began, all while the deficit ran to $1.4T in 2022. But going forward, the Fed process is reversing (remember, year-to-date the rundown of the Treasury General Account has completely offset QT so far). While the fiscal deficit for 2023 is forecast to lower to “only” $900B (optimistic), the Fed is SELLING over $1T per year of US Treasury securities under the Quantitative Tightening regime instead of buying that $900B as it would have under QE.
So, there is a marginal increase in supply of US Treasuries in fiscal 2023 of over $2T ($900B deficit + > $1T QT) versus 2022, which has to be absorbed somehow. We have lost the largest buyer of US Treasury securities for the last several years in the form of the Fed. We have also lost the second largest buyer of US Treasuries in the form of foreign central banks. Looking further out, by 2032 the CBO forecast is for an AVERAGE of $1.6T in federal deficits per year, adding another $14-16T or so of debt to be absorbed. So, who is going to buy that increased supply of US Treasuries next year and over the next decade, and at what interest rate, if not the Fed? (A lot more to discuss here but that’s for another day).
Typically, when supply increases versus a given level of demand, the price of that “thing” must decrease, and certainly when there is a decrease in demand like losing your two largest buyers the price usually decreases. For bonds, a decrease in price means an increase in interest rates. And, to me, this is why I’m not a “bond bull” as many of those smart people are (which is another way of saying they could be right and I could be wrong. I think I have to include that disclaimer legally, but I hate that so I’m laying out my rationale for you to judge if it makes sense or not.). I’m not saying rates will skyrocket, but I’m not ruling it out, either. I am saying that, by definition, supply and demand matter. Further, unlike what you hear every day in the financial press, I am also saying that an eventual Fed “pivot” and to return to the good old days of yore when the Fed had our backs isn’t coming next year, and not likely in 2024. To believe that, you must believe that inflation will trend downward towards the 2% target before the Fed makes meaningful progress in the downsizing of its balance sheet and the money supply (remember, Fed policy is lopsided – and tightening occurs much more slowly than easing. Also remember, we haven’t yet experienced net QT due to the rundown of the Treasury General Account). The markets want to believe in The Judy Tenuta Theory of Inflation Reduction: “It could happen!” But that is not what typically has happened. I read a quote from Stanley Druckenmiller that inflation has never gone below 5% until the Fed Funds rate has exceeded inflation (i.e. achieving positive real short-term rates). That’s a Fed Funds rate at or above 5%.
Per David Rosenberg, historically the 10-year Treasury rate doesn’t peak until the 2-year Treasury rate peaks, being 98% correlated with the 2-year. And, the 2-year Treasury is 97% correlated to the Fed Funds rate. Dave is one of those really smart guys and I read him every day. But, if that is the case, with the Fed Funds rate is going up another 100 basis points or so (even if the pace does slow) taking the 2-year and the 10-year along with it, how does this translate into significantly lower bond yields, even if we do go into recession? We need to rely on the 2-3% uncorrelated behavior between the 10-year, 2-year, and Fed Funds for rates to decrease? And, should a miracle happen and we avoid a recession, the increase in aggregate demand that implies should have an upward impact on rates, especially if and when the price of oil goes back up due to increased demand that would accompany a return to growth (and also due to the decrease in O&G CapEx since 2014 due to ESG concerns. But, I digress). Of course, the geopolitical crisis-du-jour can cause a run into US Treasuries – as I write protests in China are resulting in a bid for US Treasuries. But, geopolitics are difficult to base your capital plans on. Remember, the Fed is tightening going into an economic slowdown when it usually eases, we are increasing the US Treasury supply necessary to be absorbed by the economy by $2T (7.5% of all Federal debt outstanding at the beginning of 2022), and we have lost our two largest buyers of US Treasuries. If you need a 10-year Treasury bond at 2.5% or lower to have your project pencil out, you are taking a risk that your project ends up under water.
And speaking of an economic slowdown, just look at California. Last year, it had something like a $90B surplus, so much so it gave $10B of that back to voters just prior to the 2022 election (Hmmm!). Next year, it is facing a $25B shortfall (WSJ 11/20/22 – “California Heads for Budget Crunch”) . Remember, we’ve been told that what happens in California eventually happens in the rest of the country. CARES Act funding is running down, which was being used up to plug budgets that are suffering from what seems to be a systemic decrease in ADA as well as funding the extra effort to get students caught up from the impacts on learning of lockdowns. So the forces that some believe will cause a decrease in interest rates WILL CAUSE a decrease in liquidity and funding. And, that is a different financial environment than we have been used to for a long time.
Will we return to Kansas at some point? Maybe, perhaps even probably. At some point, it would not be surprising that the Fed will have to lower interest rates and resort to again buying assets. This is because of the Debt Trap. When Volker was Fed chair in the 1980s, the Federal debt-to-GDP ratio was 32% versus 120-130% now, and he took rates to 16% to combat inflation (inflation that, like today, had begun as a result of loose monetary policy, increased Federal spending, and was then exacerbated by two geopolitical oil shocks). Now, with Federal debt where it is, the percentage of the US Federal Budget taken up by interest expense, and total debt (government, state, corporate, household) at 302% of GDP, the amount of debt in our system just can’t absorb that kind of significant increase in rates to combat inflation. So, we may have to rely on shrinking the Fed balance sheet and/or a hard landing to contain inflation. But importantly, leveraged markets of all types will be adversely affected by the decrease in liquidity, if not actually breaking in some cases.
Since the tightening began earlier this summer, some things have already broken (the UK gilt market, some crypto exchanges and stablecoins) and these issues were liquidity-based (becoming solvency-based in the case of FTX – also fraud – but I digress). It is highly unlikely that nothing else will break, given the amount of leverage in the system. And if something meaningful breaks, financial markets and politicians will have a hissy fit. As a result, many knowledgeable folks predict the Fed will blink at some point, much like the Bank of England just did. But, if something big breaks, it’s because the tightening is still in progress, so we most likely won’t be at the 2% target for inflation when that fit hits the shan. Of course, the inflation rate will face downward pressure almost automatically due to the “base effect” – measuring year-on-year price increases off of higher prices a year ago versus early 2021 increases the denominator, which decreases, well, you guys are educators so you know what happens to the ratio. But, for costs to go down we need deflation, and unless the Fed can make meaningful progress to shrink its balance sheet and reduce the money supply, deflation is unlikely in my opinion. So, the costs of purchasing/constructing your building or buying pencils will likely remain higher than they have been over the last decade or so even if they don’t increase by 8% per year. But they could increase at 4-5% per year. The talking heads on TV often say we’ll have a soft landing – if so, what exactly is the deflationary impact of a soft landing? Higher aggregate demand is deflationary how? To go lower, we’ll likely need a hard landing and the Fed not to blink. Hard landing = recession = lower revenues.
By the way, if the Fed blinks before inflation is at the 2% target, or well on its way to it, we’ll be at what Lyn Alden calls “checkmate” for central banks: the point at which they must print money even though the inflation target has not been reached. In that situation, inflation will be permanently higher than it has been for the last three decades, and we will remain in a more difficult economic environment from what you have been used to, possibly even the dreaded “stagflation”. Lions, and tigers and bears! Oh My! If the Fed doesn’t blink, then the Fed Funds rate continues to go up or at least remains up, liquidity goes down, and we’ll probably experience the much talked-about hard landing.
So, what to do? Your state is likely to experience a decrease in revenues over the next few years as this unfolds. So, first, bolster your cash balances to the extent you can and however you can – again, cash is no longer free and actually will return 4% or so. Also, if you don’t have a working capital line of credit in place, try to get one (such a line of credit may need to work in concert with any facility debt outstanding – there are ways to deal with that so call me.) Remember those deferrals coming out of the Great Financial Crisis? This credit bubble is far larger. Working capital matters. For those of you planning to grow, plan on an interest rate much higher than you have been used to over the past five years to see if the project still pencils out.
How much higher of a rate to assume? That depends on your funding source. For short-term loan situations when the bond market may not be a reliable source for you, those loans are based upon either the Prime Rate or SOFR (the Libor replacement). Currently (Nov 2022) the WSJ Prime Rate sits at 7% and that is before the December Fed meeting. Even the bond bulls project the Fed will increase by another 1% or so, which means somewhere around an 8% Prime Rate at least. SOFR is now around 3.8% and will rise with future Fed Fund increases. Most sources of funding, either from banks or from CDFIs (which often get their funding from banks) will require a spread over the cost of their funds, so expect a spread to Prime or SOFR resulting in short-term rates anywhere from 6% to 9%, in my opinion. You read that correctly.
Bond markets may rally, lowering yields temporarily, but I expect over the course of your planning process that the need to digest $2T of US Treasury securities without the biggest recent buyers will not allow rates to decrease, and may require them to increase. Further, the drying up of liquidity and the prospect of prolonged inflation COULD hamper the demand for long-term bonds. The Fed may have to ramp up its QT program by actually selling longer term Treasuries (versus the passive run off they are using now), in order to steepen the yield curve (increase long-term rates) to get banks to buy those US Treasuries (since the Fed is no longer buying them and due to the banks’ need for an upward-shaped yield curve to make money. But, I digress.) That would result in higher long-term US Treasury rates off which municipal rates are based. So, for even seasoned schools planning to access the bond market for long-term debt, without some sort of credit enhancement the first number you should use in your planning process should be a 6 in my opinion, possibly higher depending on your credit situation.
I realize these rates might cause some sticker shock since they’re so far above what we’ve been used to. At worst, by using higher cap rates, you will improve the economics of the projects you ultimately proceed with. The design of the projects themselves will have to adapt, replacing the “esthetic” with the less expensive “functional.” You just may have to do without some of the extras. If you have to build a tornado shelter because you live in Tornado Alley, further design efficiencies will have to be incorporated. Modulars may be part of the mix. Ground up construction may have to be replaced by buying existing properties and rehabbing them. So far, construction lead times have lengthened, also increasing the construction period and the amount of capitalized interest necessary for a project.
Bottom line: it is important to know that, for some time at least, you are operating in a different economic and financial environment than you have been used to. Liquidity is at a premium now because cash will no longer be free, its supply is decreasing, and it will earn something for those who hold it and cost more for those who borrow it. And, it is likely that more things will break, causing economic disruptions! For the foreseeable future, the Fed does not have your back! But, to the extent I can, I’ll try to have your back, and would love the chance to discuss your situation with you. In the meantime, it could be a while before we get back to Kansas.