To get a sense of where things are headed, follow the capital flows. If you observe the dot com crash and the housing induced crash of 2007-08, then you begin to realize that almost all crashes throughout history have been preceded by major inflows of capital chasing higher yield or dream returns. Going back to the tulip mania, or the South Sea Bubble, it is always the same. Investors, homeowners, commodity speculators, or whoever, are chasing a fantasy that inevitably blows up in a banking or capital markets collapse.

Back in the mid to late eighties we had capital flowing to and from savings and loans. Texas banks were lending like there was no end. Starting in 1993, when securitization was about to take off, several of us looked at what we were creating, and we even talked of the eventual crash because we could see how we were creating a massive inflow of capital to real estate to an extent that would eventually run wildly out of control. Some of us were old enough to have understood what was about to happen when too much capital is driven into a formerly controlled product. Which is exactly what happened. It always starts with a good idea and careful underwriting and lending. The underwriting in 1993 was conservative and relatively careful. The early years of CMBS were limited in risk by limited amounts of capital to lend. We could be choosy. The original dot com deals were based on more sound management teams and ideas. Then, as always, came the drive for volume (more capital), lower standards, CDO’s SIV’s, derivatives and in the end, virtual loans and pools. In other words, massive amounts of capital flowed into CMBS and housing in the chase for yield and bonuses. That is why the Europeans and Chinese became buyers of the bonds. In theory they could get better yield than at home, and the paper was “rated”. Investment bankers moved paper off their own balance sheets into CDO’s and SIV’s to make room for more capacity and even more capital raised. By 2007, the capital was flooding into the market from all over the world, at a rate way beyond sound underwriting demand. Because there was a never ending flow of capital to housing, it drove brokers and lenders to dive down deeper into the trash heap to get any garbage they could find to make a loan against. Barney Frank forced the banks to make loans in redlined areas which had been avoided because the lenders knew that meant bad credits and bad loans. When the capital from Europe flowed in to buy the paper, the banks were all too happy to make loans to bad red lined credits and get Barney and the media off their backs. They thought they had sold the garbage to institutional and offshore dumps, only to find that those put back clauses would really be upheld. Massive capital inflows had to get shoved out, so inevitably, as always happens, credit quality went into the toilet and the capital flowed out to the borrowers who had no business getting any of it.

If you go back to hundreds of years of banking history, and the history of bank crisis, sovereign debt crisis, and market crashes, it is always due to too much capital rushing in where angels fear to tread. Too much capital inflowing to a nation brings inflation, and then currencies collapse. We see that happening in some of the BRICs today.

Now we see massive capital inflows to the US as a safe haven. It has driven Treasuries to record low yields. It is funding the massive and destructive federal deficits that are eating the nation’s fiscal lunch. We see the Fed trying to stand in for the failed fiscal policy makers, and try to save the economy, but doing so by flooding the markets with capital. In time this cannot continue. The credit of the US can become vulnerable. When fear and uncertainty ends, either this November, or in four years, then all of that capital will be a burden. It will go into assets like real estate where it always ends up. In time the Fed will have to pull it all back, and it will raise rates to try to reverse the flows. What may seem a good deal today in Manhattan at a 4% cap, may in time not look so good at a 7% cap, with rates at 400 or 500 basis points more than they are today.

My point is, watch the capital move, and be prepared for the next collapse when the amount of capital rushing into a market drives up prices to an unsustainable level. If you think things reach a point in a market where they make no sense, they probably don’t. Trust your gut. Get out. Have the mental strength to walk away no matter how many people laugh at you. Maybe it is not for 10 years, or maybe it is much sooner, but it always happens. It is never different. Maybe after almost 50 years in Wall St and the capital markets, I have seen this movie rerun over and over. The young faces change, they think they are smarter, there is a new angle, or new technology and new story-like, there is diversification of risk in a CMBS pool so you can’t get hurt, but in the end too much capital always over inflates the bubble, and then it bursts. There may be a new technology, but in the end there are certain natural laws, and too much capital chasing too few good deals is a natural law since man crawled out of the cave. The secret is to watch capital flows carefully, and when you see the bubble get too big, like in 2006, just sell and hide. Maybe you missed the last dollar, and maybe everyone tells you that you are foolish, but take it from an old veteran, in the end you will be the winner by getting out before it hits the fan. I sold my entire stock portfolio in May of 2007, only to have my broker and many smart friends tell me I was crazy. I missed the very top, but I still had all of my money in cash two years later in March, 2009, when I went back in.

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Joel Ross

Joel Ross began his career in Wall St as an investment banker in 1965, handling corporate advisory matters for a variety of clients. During the seventies he was CEO of North American operations for a UK based conglomerate, and sat on the parent company board. In 1981, he began his own firm handling leveraged buyouts, investment banking and real estate financing. In 1984 Ross began providing investment banking services and arranging financing for real estate transactions with his own firm, Ross Properties, Inc. In 1993 Ross and a partner, Lexington Mortgage, created the first Wall St hotel CMBS program in conjunction with Nomura. They went on to develop a similar CMBS program for another major Wall St investment bank and for five leading hotel companies. Lexington, in partnership with Mr. Ross established a hotel mortgage bank table funded by an investment bank, and making all CMBS hotel loans on their behalf. In 1999 he formed Citadel Realty Advisors as a successor to Ross Properties Corp., focusing on real estate investment banking in the US, UK and Paris. He has closed over $3.0 billion of financings for office, hotel, retail, land and multifamily projects. Ross is also a founder of Market Street Investors, a brownfield land development company, and has been involved in the acquisition of notes on defaulted loans and various REO assets in conjunction with several major investors. Ross was an adjunct professor in the graduate program at the NYU Hotel School. He is a member of Urban Land Institute and was a member of the leadership of his ULI council. In 1999, he conceived and co-authored with PricewaterhouseCoopers, the Hotel Mortgage Performance Report, a major study of hotel mortgage default rates.