Episode 145 – Fed Up With the IRS with Mark Calabria

Announcer:
This is The WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes.

Tom Wheelwright:

Welcome to the Wealth Ability Show, where we're always discovering how to make way more money and pay way less tax. This is Tom Wheelwright, your host, founder, and CEO of Wealth Ability. So we have an economy in flux, an economy in crisis. Nobody quite knows what's going on in the economy, what's going to go on with real estate, what's going on in the banking sector. And then on top of that, the Democrats and Republicans have decided to fight over the debt ceiling, right in the middle of that.

So today what we're going to discuss, we have an amazing expert on this and I'll let him introduce himself, but seriously that we got this guest for this topic is simply amazing. We're going to talk about actually discover what do we see happening over the next six to 12 months in this economy? What is the… not what could the Fed do because we can't control the Fed, but what are they likely to do. And what's likely to happen in the banking sector as well as the real estate sector? So with us, we have Mark Calabria who has an amazing resume including basically handling Fannie Mae, Freddie Mac during the pandemic, being Mike Pence's, chief economic Advisor. But Mark, I'll let you introduce yourself, give a little more of your background because it's pretty impressive.

Mark Calabria:

Well, thank you Tom. Very kind of you to say. And while I'm currently at the Cato Institute in Washington DC as you mentioned previously, ran the Federal Housing Finance Agency, which regulates Fannie and Freddie and kept that market going during the pandemic, which of course is the topic of my new book, Shelter From The Storm: How a Covid Mortgage Meltdown was averted.

As you mentioned, I spent two years as a chief economist for Vice President Pence. Happy to say during that time, did take an important role in the 2017 tax reform bill. So for those of you who were able to get tax cuts out of that, you're welcome. We can always pay lower taxes better. Also worked on trade issues and relevant as well during my time at the White House, worked on debt ceiling issues and happy to talk about really what the likely path of that is right now. And previously on Capital Hall, but began my career at both National Association of Home Builders, National Association of Realtors and was really monitoring real estate markets. So 25 plus year career of following pretty closely real estate markets, and of course a proud alumni of George Mason University's PhD Economics program.

Tom Wheelwright:

Awesome. Well thank you for joining us, Mark. So I want to start right into the banking crisis and what's going on because really when you look at it, if there weren't runs on the banks, the banks would be okay. The banks have had major billions of dollars being pulled out of them. And I'm curious why you think that is and what do you think is going on?

Mark Calabria:

Let's start with the observation that during COVID, you saw about 5 trillion in deposits enter the system and that was on a base of 13 trillion. So almost a 40 some percent increase in deposits during the pandemic. Of course, some of this was people were getting relief payments, you weren't spending that money on the European vacation, so you're putting in the bank. Now that was never going to be permanent. Some of that was always going to go back. And in fact, in about the year leading up to the failure of Silicon Valley Bank, you saw about 800 billion in the deposits leave the system. This is first and foremost simply because many of us looked at our near zero return our deposits and said, at worst you can get 4% in three month T bills. Why would you leave something in the bank?

And so one takeaway from this, my view is you're going to see another trillion probably leave the deposit banking system over the next year, that's going to have a lot of stress on these institutions. So the biggest decline is really going to be those institutions that were heavily dependent on uninsured deposits like Silicon Valley Bank. The big takeaway is that while Silicon Valley Bank had about half a dozen problems wrong with it, most banks only have one or two of those. So you've got a core part of the banking system. I do expect another four or five regionals to get in serious trouble, if not outright fail. They've got very thin capital. And the reality is they're heavily dependent on short-term funding via uninsured deposits. And they've got a lot of long-dated securities, treasuries, mortgage backed securities that have declined in value because of interest rate changes.

Tom Wheelwright:

Yeah, so let's talk about that just for a second here. Let's get really basic here. What's really happened is the banks have taken short-term deposits, which are really like a short-term loan.

Mark Calabria:

Absolutely.

Tom Wheelwright:

That's what a deposit is, it's a short term loan. In fact, it's a demand loan, meaning that the lenders, meaning the depositors can pull that money out anytime they want, immediately. They don't have to ask permission, they don't have to do anything, they just pull it out. And so that basically the bank has this line of credit with their depositors and the depositors are making no money on it. So then what the bank does is they put it into long-term securities because the long-term securities were doing 3, 4% and they weren't paying anything on it. So the banks are like, they've got all this excess money, they're putting it into long-term deposits and that's really what caught them off guard.

Mark Calabria:

That's absolutely the case. But an important takeaway is not every bank handled it in the same way. So almost every bank in COVID saw a huge influx in deposits. And of course banks like Silicon Valley saw even a bigger influx. Now, Silicon Valley Bank was a bank that took all these deposit flows coming in and put them into long-dated securities and bad timing took off the hedges. They were trying to hedge that interest rate risk and they took off their hedges of course to try to be more profitable just as rates were going up, so just when you didn't want to take away your hedging position.

Now a lot of bigger institutions or even smaller institutions have taken those deposits and say put them in reserves at the Fed, which we're certainly… you're matching your duration. Deposits are short term, reserves of the Fed are short term, you don't have any duration risk. And so it's important to recognize that the business strategy of Silicon Valley Bank is not the norm. So you should not take away from this that the entire system is cratering down, because that's not the case. But again, they were an outlier, but they weren't alone in some of these practices, which is why I say there has to be a couple more shoes to fall.

Another big takeaway, we've seen a lot of reports come out of this by the Federal Reserve and FDIC and others, and the probably biggest thing the investor needs to take away is you really have to have faith in the management at a bank. If you've got uninsured deposits or you've got significant business relationship. And I'm a former financial regulator, so it pains me to say this, but if you think the regulators are going to catch these problems before you're too late, you're going to be sorely disappointed. And so there is a degree of your own due diligence you simply need to do. And I would put it this way, if you feel that management is untrustworthy or incompetent or you have the slightest qualms about management at a bank, take your business somewhere else. Because again, by the time the regulators figure it out, it's too late.

And so again, I do want to emphasize this isn't a system-wide effect. And some of this of course is regulatory reasons. Banks were highly incentivized to hold long-dated assets, but most of them kind of figured. And it is certainly worth saying, Chairman Powell, the Fed has raised rates at a rate that is almost unprecedented. So other banks are able to figure this out. I know the CEO of Silicon Valley Bank has been out there kind of blaming it all in the Fed. Who knew rates were going to go up so much? Well, I mean that happens in banking and it certainly happened in the eighties. It's not unhistoric and you got to be prepared for that interest rate risk.

But again, the big takeaway is there's a lot of variance among banks and you need to do your homework and don't treat the sector, because at the end of the day, I mean JP Morgan bought First Republic, got a great deal from what it looks like. And so there will be deals, there will be winners and there will be losers. And of course, being well diversified is the best advice you can be and don't have it all in one institution. But again, be weary of banks that grow really quickly, and you saw over the pandemic Silicon Valley Bank tripled in size, that is a red flag for any kind of financial institution. That might be fine in the tech world, but that's a red flag in the banking world.

Tom Wheelwright:

Okay, so let's look at down the road, next six months, six to 12 months, what do you see in the banking world? I mean, you said you're going to see a few more banks probably fail, the regional banks, but for example, will the Fed continue to raise rates, because there's been some indication just in the last little bit that they're going to continue to raise rates. I mean, logically they would need to raise rates higher than inflation in order to bring down inflation and they haven't done that yet. So what do you see coming in the next six to 12 months?

Mark Calabria:

They're getting close with that. So let's do, if you will, a little backward induction and to keep in mind that the Fed is, despite claims otherwise, a political institution. And the relevance here is that you'd really have to have extremely high inflation or extremely strong economic disturbances in an election year for the Fed to do much of anything.

So their strategy 2024 is largely going to be to sit on their hands, with a few targeted assistance at Fin institutions. So my point being, and they're going to look at next year as starting actually December, November. So latest you would see a rate increase will be the September meeting. I think we've got at least one more increase coming. So the last rate increase in my opinion will either be September or July for the Fed. And after that, again, situation could change and the economy could get worse and they could cut rates. But I really don't see them cutting rates until really 2025 and I don't see them getting to their inflation target until early 2025 either.

So we'll still have 3, 4% inflation at a minimum for the rest of the year, with a couple more rate increases that will be quarter points. So they're not done yet and they are willing to see a little bit of stress. And the best parallel to this is, we kind of forget that while Paul Volcker broke the back of inflation in the eighties, he also engaged in a number of bailouts of financial institutions and there was a sense of, well, we're going to break some eggs to tackle inflation and then we'll bail them out in the backend. And that's what we're seeing now with Silicon Valley Bank and others, and that's what we're going to see going forward.

So there'll likely be assistance provided to banks from the government. There'll be some allowed mergers, and this is where people, JP Morgan is an example of somebody who's come out of this okay and will likely come out better. And for a number of regionals and the bigger banks, there'll be purchase opportunities that will actually be probably value enhancing. So there will be some good purchases, but how do you figure that out? Which one is going to take some due diligence?

Tom Wheelwright:

Well, UBS seems to have come out okay with this too.

Mark Calabria:

Yeah, exactly. There'll be winners.

Tom Wheelwright:

So let me ask you this question. So what do you think that interest rate's going to get to? And when you look at that target interest rate and you think it's going to hold for a year, year and a half, what do you think that target rate is?

Mark Calabria:

I think we're looking at another probably 75 basis points of an increase. And again, keep in mind too, that the Fed really has the biggest lever on short term rates in that the longer term rates are also impacted essentially by inflation expectations. So if the Fed is successful at taming those inflation expectations, and I don't really think they're there yet. I mean we're all rightly to be skeptical that given how behind the curve the Fed was, you don't quite want to believe that they're there yet. But you could actually start to see rates moderate in the long end of the curve, so if you're, you're borrowing for mortgages or long term business or even a seven, 10 year timeframe in terms of a small business loan, those rates could start to moderate in the next six months. But you're going to start to see short term rates come up.

And of course an inverted yield curve is always very difficult for the banking industry and the financial services industry, writ large. So you're going to see some bumps. Now of course, one of the big takeaways from the recent bank failures is there's nothing like a bank failure to embarrass the regulators. And when regulators get embarrassed, they overreact in the other direction and you're already seeing a tightening of credit. So if you're involved in commercial real estate, it's going to be much tougher to get commercial real estate loan, an acquisition development, construction lending, all of this stuff is going to get a lot tougher, and already is getting tougher for the next 12 to six months.

And of course that's not withstanding that there are certain parts of that market like the apartment building market where I already believe we're overbuilt. Of course, should caveat, it really depends on location. We are obviously in this weird environment where Bay Area of California, coastal California property market's fallen off a cliff, but Florida's doing great. So the old adage location, location, location matters more now than ever.

Tom Wheelwright:

Yeah. So let's get into real estate a little bit because we're seeing a phenomenon that we've seen before, which is where what the sellers think something's worth and what the buyers think something worth is very different. So our cap rates have not caught up with the interest rates. So now we have cap rates, lower the interest rates, which means you have negative leverage, which means that you're not going to buy something in that scenario.

So how long do you think it'll take? We've seen one or two big defaults. How long do you think it's going to be before we see more and more defaults or basically selling it back either to the bank or at a deep discount?

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Mark Calabria:

So I think we've got another 12 months of the commercial real estate market really going through some distress. And so whether it's REITs that are going to have a lot of problems in that environment, certainly some of the banks that are heavily exposed, and again, one of the big problems at Signature Bank in New York that failed was their commercial real estate and they were very big multifamily lenders and were heavily exposed in that area.

And you're really just starting to see the stress in the apartment market, but the office retail market has been under stress for some time. And again, you're a year away from having this truly shakeout. So while there were deals to be had in any market, and again, I really do emphasize that there's such regional variance in this that it's going to depend on where you're at. But from a national perspective, I think for the real estate market, the best thing to do right now is sit on the sidelines because again, prices will adjust, they just haven't yet. And you haven't had that flow through the rest of the supply chain. So while some materials, I mean lumber, aluminum, these things have come down considerably, it's still pretty expensive to build, you haven't fully seen an adjustment in land prices.

So to me, we're not at the point where the market has adjusted enough to be attractive to get back in the real estate market. But again, I think this is something where you can see that over a 12-month period. But I do want to emphasize there's deals in every market. Cash buyers, this is something where maybe a great environment for cash buyers. Of course the problem for a lot of real estate is anybody with a mortgage is sitting on a pretty low rate and they understand the value of the property is not what it was. But I think we're still third or fourth inning of the adjustment in commercial real estate.

Tom Wheelwright:

So my understanding is about 87% of commercial real estate mortgages out there are adjustable rate mortgages. And so what we saw was they had a rate cap that they bought for $80,000 a year ago and today it's $3 million, so that's what's hurting them so much. So you are going to see this continuing to go on for the next 12 months where really you're going to have these probably just more and more capital calls in the real estate market, you're going to have to put more capital in really just to make the banks comfortable with the rate caps.

Mark Calabria:

And the banks are going to take some hits here and it's a great point to remember that unlike the single family market where you may typically get a 30-year fixed, that's not the commercial real estate market. If you get a fixed, maybe you're fixed for 5, 6, 7 years, 10 at most really, but the norm is going to be more a five to seven year period. And so yeah, you're having commercial property deals that were done at very low rates five, six years ago start to reset. And again, it's going to be extremely painful.

We've also seen in the last couple years sort of like debt service ratios edge up in many parts of the market. So there's going to be some distress, some banks are going to take some hits, you're going to get a lot of pressure, however. If there's a silver lining to this, banks do not want those properties. So you're going to see a lot of bending over backwards. And if you unfortunately find yourself in the position of being the owner of one of these properties, it's not pleasant to have that reset but you do have leverage with the bank. They don't want the property, the willingness to work out will be there for a while. So an aggressive negotiator, of course don't make it so hard that you're not going to be able to get to a deal. But there are workout opportunities with these institutions.

And of course the other side of this is it really, just if you think about the real money to be made 2010, 2011 was in the distressed property market. And you think about the Invitation Homes and companies like that, and of course individual buyers who came in those markets. And so you're going to see distressed real commercial real estate is going to be a great buy-in opportunity if you do your due diligence. So there's that silver lining.

Tom Wheelwright:

So let me go back to something you said earlier. I want to make sure everybody, our listeners understand what you were talking about, and that's the inverted yield curve. I think that is something that people don't quite get.

Mark Calabria:

The yield curve is really just the grafting of short-term, long-term rates. So if you think about, it's usually upward sloping because of course it usually, lenders like to get paid more to take to compensate for being told to wait longer to get their money back. So short-term rates tend to be higher than long-term… short lower than long-term rates. It inverted your covers when you have the opposite, when short-term rates are actually above long-term rates in, A, this tends to be historically a pretty good predictor of recessions, in part because it also tends to put a lot of stress on banks. And if you think about Silicon Valley Bank, your short-term deposits, so you're pricing your deposits off the short end of the market, but you've got these long-dated assets like treasuries and mortgage backed securities. Normally your deposits, are going to cost you less than your long-dated assets.

But when you hit an inverted yield curve, you're suddenly paying more to borrow than you're getting on your assets, which means of course you're losing money. And that's part of what hit Silicon Valley Bank as well. It's fundamentally, what blew up Bear Stearns back in 2008 was an inverted yield curve. Not to set aside that they also at that time had problems in the commercial real estate portfolio. But anybody who really… And we saw this in 2020, there are a lot of handful of mortgage REITs that their funding is overnight repurchase of a repo. And so they're very exposed and they hold long-dated mortgage backed securities. So I would say if you are investing in something where the funding mechanism is extremely short term overnight and they're invested in long date assets, it's going to be a rough ride.

Tom Wheelwright:

Got it. So one other thing…. Thank you. That was terrific explanation. Thank you. One other thing you mentioned was about Paul Volcker and he's credited with breaking the back of inflation. But something else happened and it wasn't just Paul Volcker, Ronald Reagan at the same time enacted tax cuts. And you'd mentioned earlier that you'd been part of the 2017 tax cuts and what we see right now is actually an administration that wants to raise taxes as opposed to cut taxes. So what's the relationship that you see between the tax system and what's going on in the economy?

Mark Calabria:

So let me put it in two buckets. We'll put it in the broad and then in the particular, because part of the boom we're seeing in multifamily construction today is the biggest since we've seen since the seventies and eighties, and the early eighties was in part driven by tax changes. So '81, '82-

Tom Wheelwright:

Exactly.

Mark Calabria:

There were tax changes. I mean it was crazy enough in the early eighties where you could do commercial real estate deals that were actually money losers, but you'd still make money because of the tax Offsets it. I mean it was bad tax policy, and of course the '86 Tax Act unwound that. But the side impact of the '86 Tax Act was to pull the air out of the bubble in real estate, which of course was extremely painful, but you had to do it eventually.

And so that's the specific, and so there are conversations, I mean this administration, for instance, has proposed to get rid of 1031, the starker exchanges. But again, I want to emphasize, I think that's extremely unlikely to happen, but part of the debt ceiling negotiation is the administration is asking for some changes to what they call tax loopholes. I certainly don't necessarily think 1031 is a loophole, it's something congress intended to do.

Tom Wheelwright:

It's a code section. By definition it's not a loophole.

Mark Calabria:

Every person's deduction is somebody else's loophole. So I do appreciate that the tension there. So you certainly have seen, and it's also we've seen record in increases in taxes already. Part of what came out of Inflation Reduction Act was minimum tax increases for corporations. So I do think that the 2017, what we were fundamentally trying to do, particularly on the corporate side, was incentivize greater investment and incentivize money to come back to America. You remember the companies like that, the people who would park a lot of money in Ireland and stuff like that. Well, we incentivize bringing it home so it could be invested here. And I do think that's contributed to the strength of the economy.

And I worry about this administration is really focused on raising corporate taxes, raising taxes on individuals who invest and they're very skeptical of corporate gains. But if there's a silver lining, I think their ability to do much of this is going to be limited. But of course, they've hired a bunch of new agents and I think the reality is that people should expect to have a much higher probability being audited. So the administration does believe that they're going to raise taxes by simply scrutinizing individuals more heavily. And so this is certainly an environment where I would say don't ride the line. You're asking for trouble.

Tom Wheelwright:

Here's part of the challenge with what's going on the IRS that I see as a tax guy, is that these new auditors are not going to have a lot of training.

Mark Calabria:

Correct.

Tom Wheelwright:

So they're going to come in with a checklist and if you don't match their checklist, they're going to give you an assessment and then you have to take it to court. And that's very expensive. So what's going to happen is taxpayers are going to pay assessments that really are not valid assessments. For example, we have two issues right now going on, the conservation easement and the captive insurance that are not loopholes, they are in the code. They are very specifically in the code and they have public policy behind them. And yet you have the IRS who says that we don't like them, and because we don't like them, we're going to disallow them. Not that the taxpayer's done anything wrong, but simply that we don't like them. So how much of that do you see coming with all those new audits?

Mark Calabria:

I see a lot. And so you're certainly right that the administration is trying to change policy via enforcement. And obviously there are a lot of things in the tax code where, I don't want to say is great. If you're getting something assessed, what is the appraised value of whether it's property for a conservation easement or if you're gifting a property-

Tom Wheelwright:

That's a fair question.

Mark Calabria:

And these things, I mean, there is wiggle room. So my bottom line advice would be, as much as it sucks, the risk is really just high right now from an enforcement point of view that my recommendation would be to suck it up and take a conservative view of valuations, which means you're going to leave money on the table, which is a tax increase, which is unfortunate, but it is a better path to the penalties. And this is an administration that's got to go after people, particularly if you are a small business owner, you're self-employed, there's going to be much bigger scrutiny. And I don't like it, but again, the advice I have to give people is err toward the side of safety and be a little less aggressive than you might be tax planning in normal years.

Tom Wheelwright:

All right, not music to my ear.

Mark Calabria:

I mean, I'm trying to help, I'm trying to keep you out of trouble, Tom.

Tom Wheelwright:

You know what? Here's the challenge. The challenge is the law's, the law and the IRS doesn't get to make the law. They just think they get to make the law. But let me go to one more little thing that a lot of people haven't noticed, but I think it's in a major policy change, which is these new fees for good credit when you're taking out a mortgage. First of all, would you quickly explain it and what's going on, and why in the world would you punish somebody who's done the right thing?

Mark Calabria:

So since about the '80s, we've developed a system, a mortgage market where pricing a mortgage is more and more reflects risk. Mean before the 1980s, you largely had one price, and if you were bad credit, you didn't get a mortgage. Now it's the case where if you're a bad credit, you can get a mortgage and you pay more. And over time, that has become more and more of a tighter relationship. So again, you have a strong credit, as in a strong FICO or Vantage or whatever the metric might be, you pay a lower rate.

So the administration has put a proposal out there that would still be risk-based, but less so. So they're trying to flatten that relationship. And the intention absolutely is to subsidize poorer credit borrowers. That's something they're trying to do, that's something you're geared at. And of course, it's administration that decides that you don't need to pay your student loan for three plus years.

So I mean, it really is meant to try to turn our financial system into a subsidy system, which I think is very problematic. Obviously many of us have worked very hard to get good credit. Many of us have taken years to build up big credit. And again, I want to be very clear, don't go ruin your credit because you think you're going to get a better mortgage rate. That's not the case. You still want to have good credit, but the reward for having good credit in the mortgage market will be less than it is otherwise.

But also important to keep in mind, especially if you're high net wealth or you're in the jumbo market, this applies to Fannie and Freddie loans. So if it's a lender that's a portfolio lender, someone like Chase who may make it and keep it on their balance sheet or jumbo market, what this actually means is you have a greater incentive now to shop around. So definitely, if you get quoted a rate, don't take that as necessarily the best rate, because that may be the Fannie and Freddie rate. And again, if you're getting a loan that's an excess of really not even plus the million loan limit. But if it's an excess of six or $700,000 for a mortgage, you may get a much better deal from a portfolio lender. So again, I disagree with the policy. I can tell you agree with me, Tom. But the takeaway for people at Wealth Management is it pays to shop around more now than ever.

Tom Wheelwright:

Great. Thank you. So Mark Calabria, the book is Shelter From The Storm: How a COVID Mortgage Meltdown was Averted. There we go. Mark, thank you so much for joining us. And just remember, this macroeconomics is important to us because it determines microeconomics. And so you can't really operate your business, you can't look at your cash flow without looking at what's going on in the banking system, the Federal Reserve, et cetera. So thank you so much, Mark, and thank you all for listening. Remember, when you get this kind of broad education, which becomes specific education, you're always going to make way more money and pay way less tax. We'll see y'all next time.

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