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By Liu-Yue (Louie) Lam, Co-Founder, Chief Investment Strategist, Oxstone Capital Management,

Crisis Leads to New Opportunities

Recently, many prominent investors have announced optimism on the U.S. economy.  Although I do believe the economy is in a slow and gradual recovery, the impact of the 2007-2009 financial crisis are still visible today – rarely has a single weekend gone by without more news from the FDIC announcing that several more banks have failed.

Over the next four years, we anticipate that over 500-plus banks will likely have failed.  The remaining banks will consolidate and may be too pre-occupied with repairing their balance sheets and complying with new regulatory requirements rather than focus on lending to new borrowers.  In addition, the latest debate in Congress on how to restructure Fannie Mae and Freddie Mac will have serious implications for both the residential and commercial real estate markets.  After 40+ years of subsidizing mortgages, the U.S. government is in serious debate on mortgage finance reform and possibly eliminating federal guarantees.  In most cases, lending in the small loan market will cease.   If you’re a private lender the time to lend is now!

There has never been a better time to be a private lender.  The current environment caused by the 2007-2008 financial crisis and the ongoing mortgage finance reform have created significant opportunities for private lenders to capture market share from banks and build new relationships with high quality borrowers.  Private lenders have an opportunity to enter the marketplace with fewer competitors, depressed asset values, and a greater demand for capital by real estate investors, speculators, and distressed asset investors seeking to capitalize on the demand for capital from small business owners, distressed asset sellers, bank short sells, and foreclosure opportunities.

Bonds, Interest Rates, and Inflation Outlook

We expect that the traditional bond market will soon enter into a secular long-term bear market as interest rates have already bottomed at historic lows and will likely continue to rise substantially over the years.  Bill Gross, the Warren Buffett of Bonds stated that Pimco has already sold their entire U.S. Treasury holdings.  Warren Buffett has also recently commented on the lack of value he sees in long-dated U.S. fixed income assets.  Mr. Buffett mentioned he does not see the U.S. dollar holding its value over time.

The rising interest rate environment is due to chronic government budget deficits that will likely last a generation.  The systematic deficit spending and the continuous need for foreign financing have increased debt supply; crowding out private investments.  The future possibility of additional quantitative easing part III, IV, etc. by the Fed will cause the dollar to continue to lose purchasing power.  In this likely scenario, investors need to prepare for much higher future inflation and rising interest rates, which will subject traditional investment vehicles such as stocks and bonds to greater principal volatility.

Contrarian Investment Idea

As mentioned above, we predict a sustained rise in inflation over the next three to five years.  In such a hostile economic environment we bring you a very contrarian investing idea.  Private commercial loans that are conservatively underwritten at today’s depressed market values may actually provide an effective hedge against inflation.  For example, one form of private commercial loans may be short-term real estate loans which may also perform well in the rising interest rate environment.  Although the face value of a particular loan will not increase, a savvy private lender can adjust loan terms such as increasing interest rates as loans mature thus enhancing overall returns to investors.

During these tumultuous times, an investment in collateralized and cash-flowing private real estate debt can provide a good hedge against inflation as opposed to traditional equity and fixed income investments.  Private real estate lenders can provide investor returns that may potentially exceed the historic average of the S&P 500, while providing the safety of a collateral-backed asset.  Though fixed income products can provide similar returns, they are often not backed by physical collateral like real estate.  Furthermore, as interest rates rise, the face values of bonds decrease.  There is a unique opportunity for private lenders to lend on cash-flowing commercial real estate assets that have fallen through the cracks of conventional financing sources due to a number of reasons such as small loan size, timing and uncertainty of execution for an acquisition, or lack of an established banking relationship.

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