Masters Series: It Can Always Get Worse

Editor's note: If you think things in Detroit can't deteriorate any further... The owners of the Penobscot Building there have a warning for you...

As we explained in yesterday's edition of weekend Masters Series... Porter has long held up Detroit as a harbinger of the economic crisis all of America faces... He first detailed the confluence of problems that has destroyed that city in a 2009 essay, which we republished yesterday.

Last June, he updated the situation for his Investment Advisory subscribers. We're excerpting that work in today's issue...

It Can Always Get Worse
By Porter Stansberry

The Penobscot Building is a hallmark of downtown Detroit.

It was built in 1928. At 47 stories, it was the eighth-tallest building anywhere in the world when it was completed. It was the absolute tallest building anywhere in the world outside of Chicago and New York. It remained the tallest building in Michigan for almost 50 years.

It's much more than merely a local landmark. It is Detroit's trademark tower. The landlord lights the tower at night to celebrate Christmas and Independence Day. The building is ornate and beautiful, done in an art-deco style reminiscent of Rockefeller Center in New York. Yes... two other buildings in Detroit are now taller, bigger, and newer... but the Penobscot Building is still, even after all these years, considered Class-A commercial space. She's the grand dame.

Buildings like Penobscot would cost hundreds of dollars per square foot to build... perhaps even $1,000 a square foot, considering all the ornate stone work on the exterior. That's not including the value of the land where the building sits – square in the middle of Detroit's financial center.

We all know commercial real estate hasn't done much in terms of price appreciation since the crash of 2008. Class-A commercial space like this is selling for around $200 per square foot, on average. My company, for example, is in negotiations to buy an office building in Delray Beach, Florida for around $240 per square foot. At 776,000 square feet, a building like Penobscot, in good condition, might cost $150 million-$200 million to buy, on average, in cities across the U.S.

Unfortunately for the previous owners, Detroit isn't anyone's idea of a great place to start a business or to move headquarters. Class-A commercial real estate in Detroit has been trading around $28 per square foot in the last year. That's roughly 86% less than the national average... And probably 90% less than new construction.

While owners are not technically giving these properties away (at least not yet), these prices indicate the city has suffered a total collapse. Surely things can't get any worse, right?

That's exactly what many investors thought back in 2007, too. And I admit... I was one of them. In fact, I asked my analyst Tom Dyson to spend some time in Detroit. I wanted him to find a few different ways for our subscribers to buy assets there. After spending a few weeks in Detroit, Tom came back with lots of good ideas. One was to buy the skyscrapers, which were selling at the cheapest prices available anywhere in the world.

Why on Earth was I interested in Detroit?

I wasn't naïve. I knew a lot about the city's history. I've probably written as much about Detroit's woes as just about any financial analyst. I've long believed that Detroit is a kind of petri dish... a place where various ideas about how governments and societies ought to be organized were tested. It's a long story...

The short version is simple enough to understand... Since 1960, Detroit has been ruled by the Democratic Party. In particular, it's been ruled by the African-American wing of the Democratic Party, which came to power through the Civil Rights movement. These politicians have imposed their taxes and plans on the city, in progressively more authoritarian ways. The result has been a complete collapse of civil society. A huge percentage of the hard-working, honest people fled the city, leaving those who remained to be preyed upon by a government nearly consumed with avarice, greed, and corruption.

The situation was further powered by the economic might of the major car companies, which themselves had been captured, in effect, by the Democratic Party's union operatives.

Anyone who's spent any time studying the outcome of socialist societies or the real impact of unions on an industry won't be surprised by the outcome. Detroit lost 80% of its population and nearly all of its working and middle classes. What was left was the poorest, most violent city in America.

I believe it's a warning to all of us... about what might happen if we continue down the path we're on today. Anyone who believes more debt, taxes, and government will save our economy and lead us to prosperity ought to move to Detroit for a year. Let me know how it turns out.

In any case, the point I'm trying to make is... I wasn't ignorant of the risks Detroit posed. I simply figured things couldn't possibly get any worse.

You have to remember... as early as March 14, 2007, when I published my first "Letter From the Chairman," I was predicting that a GM bankruptcy filing was inevitable. Lots of people forget this, but with the stock then trading around $40 per share, my call was so far outside the consensus... many subscribers thought I was out of my mind...

Yes, I thought it was likely that Chrysler would go under too, as its balance sheet was in the same poor shape. Ford was different, only because it had borrowed a huge chunk of cash in 2006, money that did, in fact, see it through the crisis.

So... why was I bullish on Detroit real estate in 2007 if I was expecting a GM bankruptcy?

Because a real bankruptcy of GM... a true liquidation of the company's assets and restructuring of its liabilities would have transformed Detroit into one of the most vibrant and fastest-growing cities in the world. I was even looking to buy a house there. Yes, really.

You have to imagine what might have been...

Imagine what would have happened if the company's pension obligations had been discharged through the bankruptcy process. Imagine if all the real estate, all the machines... all the brands... and all the employees... would have been set free from the corrupt regime that's been slowly strangling them for decades.

Believe me, the people of Michigan can build cars that are just as good as the Germans and just as cost-effective as folks in Tennessee and South Carolina. The differences between GM's operations in Michigan and BMW's in South Carolina come down to legacy costs (pensions) and union rules. When the local economy has to support a union-enforced "jobs bank" – where employees are literally paid to sit in a cafeteria all day – the local economy is doomed.

That's not just because of the lost productivity and the expense of paying those 10,000 folks. It's because of what a "job bank" communicates. It's a constant message of hopelessness, futility, and dependency. These ideas, these expenses, this hopelessness have been dogging Michigan for almost 30 years.

But bad ideas don't last forever...

I assumed the failure of GM would wipe away this stain. Surely GM's assets would be auctioned off to the highest bidder. Surely the pensions would be restructured, the insane job banks destroyed. And the union rules gutted.

Call me a heartless capitalist if you must... but then explain under what other set of conditions could 70,000 employees at GM today be expected to care for the 700,000 retirees depending on them? (Yes, those are the real numbers.)

If GM's managers were to have any hope of honoring even a part of the commitment the company owed to its retired workers, the existing employees would have to be free to work in the most efficient ways. They'd have to become some of the most productive workers anywhere in the world.

You don't find those kinds of people sitting in a jobs bank.

Post-bankruptcy... the entire culture in Detroit might have changed. It has happened before in many different industries that failed after decades of union oppression. Witness the transformation of the U.S. steel industry after the industry collapsed in the late 1990s.

But... as you probably know... that's not what happened in Detroit.

Rather than letting the free market take its course, the U.S. government refused to allow the existing bankruptcy laws to shape the outcome. Instead, the president (Barack Obama) appointed one of the most corrupt political operatives in America – Steve Rattner, who was under investigation at the time for bribing state pension officials in New York – to oversee a "reorganization." His real job was to deliver still more power to the unions who'd help re-elect Obama. And sadly, that's what he did.

The government and the bondholders both had about $50 billion invested in GM. So after the bankruptcy and restructuring, it was surprising to find that the union was awarded 40% of the restructured company's equity, wiping out about 80% of the bondholder's claims. Worse, nothing... not one thing... was done to address the company's soaring pension obligations.

And so... what do you think the outcome has been?

When union rules, unlimited medical obligations, and pensions have destroyed one of the greatest industrial corporations in American history... what do you think will happen when you leave the union with 40% of the restructured entity and take away none of its power and pension claims?

You will never guess what happens... Take a look at this chart...

[Editor's note: GM shares are up since Porter wrote this essay. However, they remain more than 30% off their January 2011 peak.]

Former GM President Charles Erwin Wilson is famously quoted as saying, "What's good for GM is good for America."

But the inverse is certainly true, too. What's bad for GM is also bad for America. By postponing the liquidation of GM's assets and preventing a genuine restructuring of its obligations our political leaders and their union backers have condemned Detroit's economy to still more decline – perhaps additional decades of decline.

You can see this by looking at the local real estate. Rather than rebounding after GM's government-led bailout, Detroit's commercial real estate sector has continued to collapse.

Take the Penobscot Building I mentioned earlier. It was bought in 2005 for $14 million, or about $18 per square foot. It seemed like an incredible deal at the time. But just last week, the building sold again after a long, drawn-out bankruptcy proceeding.

The buyer, a Toronto-based real estate company, paid $5 million. That's $6.44 per square foot, a 64% decline since only 2005. And to us, 2005 looked like the bottom. As unpleasant as it is to imagine, things can certainly get worse.

What should we do about it?

As I've long explained, the ultimate endgame to this crisis will be a massive collapse in the global monetary system. We're not there yet. You've still got time to buy real assets like gold, real estate, agricultural real estate, timber, and oil and gas reserves. You've got time to buy certain kinds of operating companies that tend to prosper during periods of inflation – businesses like insurance companies. These kinds of investments will survive the ongoing global currency "reset."

But the one key thing to remember is, while there will be lots of volatility (lots of ups and downs), this crisis won't go away until the debts are handled. And as we've seen with GM, the political class will do almost everything but deal with the root of these problems.

That means these problems won't be solved for a long, long time. And I believe... despite the low yields we're looking at in the Treasury... despite the huge run we've seen in gold and silver... that things will still get a lot worse in the real economy before they get better.

Regards,

Porter Stansberry

Editor's note: Porter has written many times that generations of spending on socialist programs has spawned a U.S. populace that believes a great lie... that you can live at the expense of your neighbor. As the example of Detroit shows... the result is an enormous debt load that the country can never repay by legitimate means. Instead, we face an inevitable collapse of the U.S. dollar... a scenario Porter has described as the "End of America."

Porter's controversial video detailing this became one of the most frequently watched financial presentations in the past 25 years, with more than 20 million viewers. He just completed a follow-up video. In it, he talks about a specific event that will take place in America's near future... that could bring our country and way of life to a grinding halt.

The End of America is already having serious consequences for millions of Americans. And you absolutely MUST understand the intricacies of this situation if you hope to survive and prosper over the next few years in America. To learn how to protect your wealth and safety, click here.