The Great Debt Ceiling Debate – Part 5

This is the fifth and final part of our five part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”.  You can download the episode on iTunes or find it on our Listen page.

Here we are at our grand finale!  Glad you made it.  Please put on your seatbelt and keep your arms and legs inside the bus at all times.

The Debt Ceiling: What if They Do and What if They Don’t?

For starters, let’s just get clear on what the debt ceiling is.  Since we have people all over the world listening to our podcasts and reading our blogs, we don’t want to assume that everyone understands what the debt ceiling is or even how the U.S. government is organized.  And since there may be a few U.S. citizens who slept through Civics class, it’s probably good to lay a quick foundation.

The debt ceiling is the amount of borrowing the Congress will permit.  Congress (not the President) is in charge of setting the budget.  The President may (and does) submit a proposal, but Congress has the final say.  Then the President’s job is to do what Congress tells him to do.  He’s the Executive, and his job is to execute the will of the people as delivered to him by the people’s representatives, Congress.  Sometimes a President acts like Congress works for him (a dictatorship), or that he works directly for the people (a democracy).  In reality, the U.S. system is really a representative republic.  That’s a whole other discussion, but something you should think about if you’re a U.S. citizen.

Now the Treasury is part of the Executive Branch, so it works for the President.  That is, the Treasury reports to the President, who reports to the Congress, who report to the people.  The Treasury can’t borrow money past the limit Congress says unless the people’s representatives (the Congress) say it’s okay.  What Congress is finding out is that they can’t just say it’s okay if the people (those are the folks who actually have to pay for it all) say it’s not okay.  Right now, there’s a large and loud group of people who are not okay with more borrowing, hence the big debt ceiling debate.

Right now, the Congress has set a ceiling on how much Treasury can borrow, and Uncle Sam has hit it.  If Treasury borrows past that, then the Executive Branch has exceeded its Constitutional authority (like THAT never happens…oops, sorry, did a little sarcasm sneak out?), which, if it happens, would spark a completely different and heated debate.

As stated in our first installment in this series, we’re not here to say what SHOULD happen.  And no one can say with authority what WILL happen.  What we want to do is be prepared for a variety of possibilities. So let’s talk about what some of those various possibilities might be.

What if they DO raise the debt ceiling?

If Congress agrees to raise the debt ceiling, it will rile Tea Party conservatives, but it will calm the markets.  The U.S. will retain its pristine record of having never defaulted.  This may be the closest Uncle Sam has come to defaulting, but it isn’t the first time there’s been a debate about the debt ceiling and warnings from credit rating agencies. Some have said that Uncle Sam’s credit rating is going to take a hit anyway.  It’s something to watch, because a lower credit rating will mean higher borrowing costs for Uncle Sam (higher interest rates paid on Treasury bonds), which means higher interest rates will ripple through ALL types of debt.

One thing new is that with recent financial reform, ratings agencies have less discretion about not downgrading a debt issuer’s rating when problems are apparent.   A problem with the mortgage mess is that the rating agencies overlooked obvious problems and investors got snookered into buying debt that was far riskier than they bargained for.  When the underlying loans started going bad, bond investors got spooked and quit buying.  That meant the flow of money into mortgages stopped, and liquidity drained out of the real estate bathtub causing all real estate “boats” that were floating in that sea of money to drop.

The point is that, like any other borrower, if Uncle Sam’s credit rating drops, then the interest rates he pays will rise.

Let’s stop here and re-visit a previous thought, because it will be part of a recurring theme.

We think Big Ben wants low interest rates because low interest rates will encourage more borrowing and spending, which he thinks is the path to prosperity.  You may or may not agree, but it doesn’t matter what you (or we) think.  Big Ben has the Magic Checkbook (the one whose checks never bounce), so it only matters what he thinks.

So, if anything happens to cause interest rates to rise, the Fed is likely to step in with its Magic Checkbook as “the buyer of last resort” to create demand and bring down interest rates.  And, as we’ve discussed in previous installments, when the Magic Checkbook comes out, inflation happens.  Keep this in mind at all times.

Now, an increase in the debt ceiling means more borrowing, more interest, and more currency expansion.  Why?  Because the open market (think Bill Gross and PIMCO, plus all the warnings from the Chinese) doesn’t appear to have enough appetite for all the bonds Uncle Sam wants to issue at an interest rate that works for Ben and Sam.  So, either interest rates will have to rise to attract more Treasury buyers or the Fed’s Magic Checkbook comes out.  You may have already heard the hints about a possible QE3 coming to a theater near you.

Bottom line:  If Congress raises the debt ceiling, then slow, steady inflation is the best case scenario.  If productivity doesn’t increase (adding more products to the economy) to absorb some of the excess money, prices will rise at a rate that upsets the people and alerts the lenders (the bond buyers) that they’re going to get paid back with devalued dollars.  So slow and steady inflation is the “mandate” that Big Ben talks about all the time.  It’s what he wants to happen.

Of course, if you’re a non-Fed bond buyer (such as China) and you realize the currency of the bond you’re holding (dollars) is dropping by say 5% a year, then you’ll want 5% plus a little bit more to make sure that you really make a profit.  And if you want a higher yield and Uncle Sam needs your money, then either Sam pays or another buyer needs to come in and give Sam a better deal.  Again, that’s when Big Ben steps in with his Magic Checkbook to try and bring yields back down to keep Sam happy, keep bond values worldwide stable (a collapse in the bond market would be a worldwide economic wipe out), and keep interest rates low so consumers can borrow and spend.  Remember, Big Ben subscribes to the notion that borrowing and spending is the path to prosperity.

Yes.  It’s a vicious cycle of persistent inflation.  Go look at a chart of inflation since the U.S. came off the gold standard unofficially in 1933 and then officially in 1971.  What you’ll see is a clear picture of rising debt and rising prices.

What if they DON’T raise the debt ceiling?

There has been a real war going on in the U.S. government about raising the debt ceiling.  What’s all the fuss about?  It isn’t like Congress hasn’t raised the debt ceiling a jillion times before.

It seems that a big and loud faction of the American people is tired of the spending more than you make and borrowing to cover the difference.  There is real pressure on their representatives to stop it.  For them, it starts with refusing to authorize further borrowing.  At least not until an agreement is hammered out as to how to cut spending.

Whatever the details, if the debt ceiling isn’t raised, there are two primary possible outcomes, neither of which is pretty.  And as we’ve already seen, raising the debt ceiling isn’t all that pretty either.  In other words, the U.S. economic picture isn’t pretty, no matter how you look at it.  But remember, inside of all the problems are opportunities, so don’t be discouraged.  Be excited…and keep expanding your education.

So, if the debt ceiling is not raised, then the Fed will need to decide if they want to make the Treasury’s bank account magic also.  That is, the Fed can allow the Treasury to write checks that clear even though there isn’t any money.  This means no default on U.S. obligations.  How can they do that you say?  Well, since the Fed clears the Treasury’s checks, and no one knows what goes on inside the Fed, how would anyone really know when Uncle Sam ran out of money as long as the checks keep clearing?

But overtly giving the Treasury they’re own magic checkbook lets the world know the whole system is a sham, depending on how much visibility anyone has into Uncle Sam’s revenues and expenditures.  Since it’s Treasury’s job to report all of that, we’d guess they’d work to cover it all up.  Some have speculated that it’s already happening.  Who knows?

However, at whatever point the world realizes that the Treasury has a magic check book, investors all over the world will begin to dump dollars and buy stronger currencies and commodities.  Why?  Because they know that spending will continue far in excess of production, and the Treasury can simply expand the money supply at will to cover the deficit.  More dollars out of thin air outpacing production means falling purchasing power (more dollars chasing less goods).  Combine that with worldwide investors dumping dollars, and you have a recipe for hyper-inflation.

Hyper-inflation means that anything denominated in dollars will go up in price fast.  Think Zimbabwe: a trillion dollars for a roll of toilet paper.  Foreigners will be snapping up U.S. real estate (they already are).  And Americans will lose purchasing power all around the world.  Very ugly for Americans and anyone holding dollars.  Look at what gold has done in the weeks leading up to the debt ceiling deadline.  It seems the markets are prepping for long term inflation.

And of course there is the eventual outrage as the American people realize the Executive Branch has now completely circumvented Congress and is at liberty to spend without restriction.  How will the American people respond to that in this age of social media?

Default:  The Doomsday Scenario

The other possibility is outright default.  That is, Treasury will tell the world, “Sorry, I can’t pay you.”

This scenario is being described as financial Armageddon.  Since Uncle Sam has never defaulted, no one can say with certainty what would happen, but common sense says that interest rates would sky rocket.  Why?  Because U.S. debt would no longer be considered risk free and investors would demand a big premium to buy it.

We could speculate on which debt offering would take over as the foundation (“safest in the world”) of all debt risk pricing (interest rates).  But no one knows.  What matters is how the Fed would respond to rising interest rates on Treasuries.

If the Fed is true to form, they will whip out the Magic Checkbook and step into the bond market to create demand in an effort drive interest rates down. Or at least slow down their ascent.

Of course, the amount of Treasury bonds the Fed would need to buy will depend on how the rest of market responds.  But it’s safe to say that it will take LARGE purchases (QE4, 5, 6 & 7?) in order to keep interest rates down.  Remember what that means:  Lots of new money coming into the economy.  It wouldn’t surprise us if they set up straw buyers to hide the fact that the Fed is flooding the system with new money.  But as we said earlier, the excess funds will eventually trickle through the economy and land at the doorstep of the American public in the form of higher prices.

Further, it isn’t likely U.S. productivity could increase enough to offset the volume of new money entering the system, so once again inflation is the likely outcome.  Commodities will spike and prices will rise as the cost of raw materials works their way through the supply chain.

Now you know why Peter Schiff thinks gold will hit $5,000.  It also helps explain why Robert Kiyosaki says “savers are losers”.  Holding dollars in any of the aforementioned scenarios is a sure path to lose purchasing power.  Savvy people will be dumping dollars and purchasing anything real.  Go do a quick study of the Weimar Republic in pre-World War II Germany and you’ll get the idea.  Never in America?  That’s what they said about a default by Uncle Sam.

What’s a Real Estate Investor to Do?

Are you freaked out yet?  You should be concerned and aware, but don’t hit the panic button.  Just keep getting educated, watch the developments, and think through the possibilities.  Then take action as you deem appropriate.  We think you’ll find it helpful to be a part of a “master mind” group of similarly concerned and informed people, so you can discuss issues and bounce ideas off each other.  It’s a big reason why we continue to run our Mentoring Clubs and annual Investor Summit at Sea™.  Look to join or start a group in your area.

As real estate guys, we can no longer just think about real estate outside the context of currency, commodities and Fed policy. Those days are gone – at least in the U.S.

But if we pay attention, then we can use commodities and foreign currencies to protect the value of our cash reserves, go aggressively into debt to acquire properties that will likely increase in dollar denominated value against fix dollar debt (equity happens!), and purchase properties that are most likely to appeal to Americans who are growing poorer, and foreigners who are growing richer.

Take some time and think about that last statement, because that’s there the rubber really meets the road.  We’ll talk more about all this as the weeks and months roll by.  And it will be a major topic of conversation on our 2012 Investor Summit at Sea™, where we will have Robert Kiyosaki with us for an entire week – plus an all-star faculty of experts in a wide variety of relevant subjects.

In closing, let us say that while these are certainly uncertain times, those who are best educated and well-connected will prosper, while those who aren’t are more likely to sell assets, avoid debt and hoard dollars as they’re being squeezed by inflation.  Think through where that will lead. Selling things that are real in order to collect paper dollars which have no intrinsic value and are losing purchasing power.  Does that sound like a formula for success?

Now just one final illustration to make a point, then class is dismissed. Thanks for sticking with us this far!

Imagine if you purchased a $125,000 rental property in a market that produced something the world rally needed- something like oil and gas.  Even if Americans can’t afford much, the hot economies like China will need it and be willing to pay for it.  So it’s likely there will be jobs in any U.S. region that produces energy.  Jobs mean people, and people mean housing.  So an area like that will have a demand for rental housing.  Best, those jobs can’t move away from the region because the product is locked into the land itself.

Now, imagine that you put down $25,000 of cash, which, if left in the bank would go down in value as the dollar falls through inflation.  You get a $100,000 loan at a today’s low interest rates and lock it in for the long haul.  Then you rent the property out for a positive $200 a month.

Big whoop, right?  But at least the property is feeding you and not vice versa.

Then let’s say that you use the extra money to buy a little gold and silver every month.  Of course, you run the risk that the dollar could get strong against gold, so you have to decide what you think is the most likely outcome.  You could also use foreign currencies to hedge against a falling dollar.

Now, doomsday comes.  Zimbabwe-like inflation hits and it now takes $100,000 to buy a loaf bread.  Those $200 a month investments in gold and silver will have held their purchasing power, so you take a small fraction of your gold and COMPLETELY pay off your rental property (not that you would, but you could).

Meanwhile, gas and oil are selling to China so your tenant is earning good money.  Now there’s probably lots of competition for tenants, so your rents aren’t through the roof (though they probably would be thanks to inflation), but you have cash flow.  Or, you have a house that’s paid for that you could live in if you had to.

The point is that the right real estate in the right market, when structured properly, is a great way to benefit from inflation, whether it’s slow and steady (like the Fed prefers), uncomfortable (if Uncle Sam doesn’t slow down the pace of the growth of its debt), or out of control (if Uncle Sam defaults and the magic checkbooks start working overtime).

Your mission, should you choose to accept it, is to understand the economic mechanics of the flow of money and where and how it’s likely to flow. Then position yourself to benefit from as many of the most likely scenarios as possible. As illustrated, we like real estate for this reason.  And if we had time, we could show that even if deflation occurred, you can still win with real estate.  But that’s a topic for another day.

Our Prediction

You thought we forgot, didn’t you?

We think after all the yelling and screaming, that a compromise will be reached and the debt ceiling will be raised.  And whether it comes through a higher debt ceiling or a secret Magic Checkbook in the hands of the Treasury, the U.S. will not default.  Of course, that’s just our opinion and we could be wrong.  We’ll see.

Now take a shower. That was a long workout.  We’re going to buy a bag of popcorn and watch to see how the movie ends.  See you on the radio!

Have a comment?  Use our Feedback page.

The Great Debt Ceiling Debate – Part 4

This is part 4 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”.  You can download the episode on iTunes or find it on our Listen page.

We’re excited you’re here.  In case you missed the header, this is Part 4, so if you just got on the bus, be sure to go back and read parts 1-3 before jumping into this one.  For those who’ve been on board since the beginning, welcome back!  Now go grab an espresso and let’s get into it!

How the Fed’s Purchase of Treasuries Affects the Money Supply

Most people who pay attention to the economy have heard of “quantitative easing”.  But in talking to lots of people and teaching this topic in seminars, we’ve found most people don’t really understand how it works.  Since there’s been a lot of QE’ing going on, and potentially more to come, it’s important for all investors, real estate and otherwise, to really understand how it works.  And the topic is especially relevant in light of the current debt ceiling debate.

As you should recall from previous installments in this series, the Fed has a Magic Checkbook.  We explored how and why Big Ben is inclined to use it.  Now we’re going to discuss what happens when he does.

The Sound Money Concept

Big picture economics can be intimidating and confusing.  But a global economy is simply a collection of national economies.  And a national economy is simply a collection of many citizens’ economies.  So if you understand basic economic principles on a small scale, when everything blows up (figuratively speaking, at least so far), the numbers get bigger, but the principles still apply.

So, let’s imagine that you show up at a Treasury auction and you decide to buy Treasury bonds.

When your write your check and hand it over to the Treasury, they deposit it into their bank account (with the Fed) and the Treasury’s bank balance is increased by the amount of check.  When your check clears, your bank balance is reduced by the same amount.  What you have done is exchanged the cash in your bank for Uncle Sam’s bond.  This is your basic everyday transaction.  Just like buying furniture.

Now imagine that you and Uncle Sam are the only two people in the economy.  If, between both of you, there were $100,000 divided evenly, then you would each have $50,000.  When you buy $10,000 worth of bonds from Uncle Sam, you write a check and Uncle Sam’s now has $60,000 cash, while your balance is now $40,000.  You have a $10,000 asset (Uncle Sam’s bond) and Uncle Sam has a $10,000 liability (the debt to you).  But when you add it all up, it balances.  This is a “sound money” system because after the transaction is closed, everything balances.  That is, the same amount of money ($100,000) is in the economy is before, it is just allocated differently between the parties as a result of the transaction.

The Funny Money Concept

Now let’s look at what happens when Big Ben Bernanke buys a U.S. Treasury bond using his Magic Checkbook.  Remember, Ben doesn’t have any money in his checkbook.  He doesn’t need any because his checks never bounce. They’re magic.

Big Ben buys $10,000 worth of bonds from Uncle Sam.  Uncle Sam’s bank account goes up by $10,000 and Big Ben gets the bond.  Seems normal right?

Well, let’s take a closer look.

In our two person economy (you and Uncle Sam), you each had $50,000 for a total money supply of $100,000.  But when Big Ben buys the bond, Uncle Sam gets $10,000 for a total of $60,000 and you still have your $50,000 for a total money supply of $110,000.  The money supply just grew!  The technical term for expanding the money supply in this fashion is “Quantitative Easing”.  You may have heard of it.  There’s a lot of it going on lately.

Take It Queasy

What is the effect of this “quantitative easing” on an economy?

Remember, you can’t use money itself for anything, so it’s only valuable when you can use it to purchase products.  Money (for the purists: technically, “currency”, since real money is a product, which is what make it real)  isn’t a product.  Money is simply a means of storing value until you can convert it to something useful (i.e., buy something).

Let’s say that in our little economy, we have 1000 bottles of water, 1000 sandwiches, 1000 magazines, and 1000 more of 7 other things so there’s a total of 10,000 products.  In the real world, the price of each product would reflect the effort to locate and convert the raw materials into finished goods, and then prices would fluctuate based on supply and demand.  But to keep it super simple, imagine that all the products are priced equally, so the $100,000 in our economy is divided equally among the 10,000 products.  Now each product is worth $10.  $100,000 / 10,000 = $10

But if our money supply expanded to $110,000 courtesy of Big Ben’s Magic Checkbook (when he bought the $10,000 of Treasury bonds), then each product is worth $11.00 because $110,000 /  10,000 = $11.00.  That’s inflation.  More dollars divided over the same productivity.

So simply stated, inflation occurs when the amount of purchasing power (money, credit) goes up faster than the supply of goods (production).  In a stagnant economy (one that isn’t producing more stuff), when you add new money, prices go up.

The important thing to know is that when people with regular checkbooks (like you) buy Treasuries, the transaction balances out because the buyer’s checkbook balance decreases while Uncle Sam’s increases.  But when Big Ben uses his Magic Checkbook, NEW money enters the system because Uncle Sam’s balance goes up, while all the regular checkbooks stay the same.  Again, this is Quantitative Easing and it’s inflationary.

In the real world there are lots of moving parts, but if you just stick to the basic principles, you can clearly see what’s happening.  Because it all gets blended in with real world supply and demand dynamics (and confusing econo-speak), a lot of inflation can be hidden for awhile.  But not forever.  After a while it all “trickles down” to the man on the street and first prices rise (you know, like food, gas, clothing, etc.), and then eventually in wages (that one hasn’t hit yet).

Got it?

If you want to understand this “trickle down inflation” better, listen to our 2/20/11 radio episode The Coming Wave of Inflation – Profiting When the Levee Breaks, available on iTunes.

So now that you have all of this under your belt (just think how much fun you’re going to have at your next cocktail party!), in our fifth and final installment, we will finally look at how all this affects the Great Debt Ceiling debate.  And, we’ll unveil our bold prediction of what we think Congress will actually do about the debt ceiling.

The Great Debt Ceiling Debate – Part 3

This is part 3 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”.  You can download the episode on iTunes or find it on our Listen page.

In our last installment, we explored the bond market and how interest rates are established in the open market.  Bonds are debts and the interest rates are set by risk, reward, supply and demand.  Now we will explore how the Federal Reserve Bank affects interest rates.  You should already know how interest rates affect you. 😉

How the Fed Influences Interest Rates

The Federal Reserve

The Federal Reserve Bank (the Fed) is the bank of the Treasury.  The Treasury is the government.  The Federal Reserve is NOT the government.  If you want to learn more about the Fed, we highly recommend reading The Creature from Jekyll Island, which is conveniently located in The Real Estate Guys™ Recommended Reading area.

The Magic Checkbook

For now, you only need to know that the Fed can write checks on itself that will not bounce.  In other words, it doesn’t need money.  It creates money simply by writing a check.  That may sound unbelievable, but for now, just take our word for it.  This isn’t an expose on the Fed, so you can look it up in your spare time.

Now that we know how the Fed’s magic checkbook works, let’s imagine that Uncle Sam shows up to hold a Treasury bond auction.  But there isn’t enough demand, so interest rates start to go up.  In prior installments, we discussed what happens to the value of all the existing debt out there when interest rates go up (it goes down), but to toss in some extra motivation for the Fed, the current Fed leadership believes that low interest rates stimulates borrowing, which stimulates spending, which stimulates production, which stimulates hiring.  This is a “Keynesian” view of economics.  That is, that borrowing and spending is the key to growth and job creation (how’s that working out so far?).

Side note: For an opposing viewpoint, may we recommend you look into “Austrian” economic theory, which puts forth the idea that one must actually produce before one can consume or borrow, and that production and savings are the keys to economic growth.  In other words, in its most rudimentary terms, before you can eat, you need to grow or hunt food.  And if you have more food than you need, then you have something of value to trade with.  If you don’t have anything to eat and nothing of value to trade with, you need to either beg, borrow or steal from someone who actually does produce.  And the only way to have trading partners is if they produce more than they consume, so there’s something extra for you to trade for.  The bottom line is that production, not spending, is the key to prosperity. That’s why printing money or stimulating consumption doesn’t create jobs.  And as real estate investors, we want to invest where jobs are being created.  Because unless you’re renting to people subsidized by the government, your best tenants will need jobs to pay you rent. Now, back to our main feature….

Now if you, like Big Ben Bernanke, believe that borrowing is the key to prosperity, where do you think interest rates need to be?  Hint: LOW interest rates attract borrowers.  Sorry, was that hint TOO obvious?

Let’s get back to our Treasury auction.  Uncle Sam is there holding his bonds out for sale, but not enough buyers show up. So Uncle Sam has to start lowering his price (increasing the yield) and interest rates start going up.  Big Ben thinks this is bad.  So he gets out his Magic Checkbook and buys, say $600 billion of Uncle Sam’s bonds (does the term QE2 some to mind?), to help create some extra demand.  Shazam! Interest rates stay low.

Well, if you’re a government addicted to debt, deficits and spending, this makes you very happy.  Just like when the interest rate on your growing credit card balance stays low.  With low interest rates, you can borrow more for the same payments.  No need to cut spending. Let the good times roll!  The only thing better than low interest rates is an increase in your credit line (isn’t there some discussion about that?)

To summarize, when the Fed buys Uncle Sam’s Treasury bonds in the open market, the extra demand drives the bond prices up and their yields (interest rates) down.  Then, the ripple effect of interest rate pricing kicks in, as all riskier debt pivots off the interest rate of Uncle Sam’s “safest debt in the world”.  That is, if Treasuries pay x, then a riskier debt pays x plus a little bit more (usually denominated in “basis points”, which are 1/100 of a percentage. So 25 basis points is 1/4 of 1% or .25).  The farther away you move up the risk scale, the more expensive the debt is for the borrower.  This is why everyone has their undies in a bunch over Uncle Sam’s credit rating.  It he loses his coveted super-duper AAA rating, then interest rates go up….and Big Ben may need to step in with his Magic Checkbook.

But what happens when Big Ben uses his Magic Checkbook?  Are there any side effects we should be considering?  Hmmm….?  Inquiring minds want to know!

So join us next time, as we delve into How the Fed’s Purchase of Treasuries Affects the Money Supply.  Hint: “Trickle Down” isn’t just for supply-siders any more.

The Great Debt Ceiling Debate – Part 2

This is part 2 of a multi-part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”.  You can download the episode on iTunes or find it on our Listen page.

How does the Fed affect the interest rates on Treasury Bonds and why does it matter?

Good question.  We’ll divide our answer into three parts (though we won’t get to them all in this installment):

  1. How Treasury rates affect interest rates on mortgages, corporate and muni-bonds and most all other debt.
  2. How the Fed influences interest rates in the bond markets.
  3. How the money supply is affected when the Fed purchases Treasuries.

After all that (and you should go grab a double espresso to make you stay awake for the whole trip), we’ll talk about what happens if Congress raises the debt ceiling, and what happens if they don’t.  Then as a special prize for your time and attention, we’ll throw out our crystal ball prediction.  So go grab that espresso and hurry back!

1. How Treasury Rates Affect Interest Rates on Almost Every Kind of Debt

Bond prices are determined in the open market.  That means buyers and sellers coming together and negotiating a price.  In actuality, the negotiation is done by auction.  Think e-Bay.

When Uncle Sam (the Treasury) goes into the open market to sell bonds (borrow), investors bid on the bonds.  If there are lots of buyers, the bids go up, which drives yields (interest) down.

The Inverse Relationship Between Bond Prices and Yields

Time out.  Because we teach this at live seminars, this is where some people go “puppy dog” – their heads goes sideways and they get a confused (but cute) look on their faces.  Since it’s important that you understand the inverse relationship between bond PRICES and bond YIELDS, we want to take a minute to explain it.  It isn’t that complicated once you get the math, but it’s important that you understand because once you do, it’s easier to understand which direction interest rates are likely to go and why.

To use extreme examples with simple math:

If you pay $100,000 for a bond (a promise to pay) with a face amount of $100,000 and it yields 5% per year, then you earn $5,000 per year on your $100,000 investment.  If the bond has a 30 year maturity, then at the end of 30 years, you get paid the face amount ($100,000).  You earn interest along the way, then get paid the principal back at the end.  Pretty simple.

Here’s where it gets tricky.

If you have bought a $100,000 bond when yields were 5% and the market changes, then the fair market value of your bond changes.  That is, while the face amount and interest rate stays the same, what someone would actually pay you for your second hand bond in the open market (if you wanted cash now) will depend on what else is available to them at the time.

For example, if new bonds are yielding 10%, then a new $100,000 bond would pay $10,000 of interest per year.  That’s obviously better to the bond holder (the lender) than the $5,000 your old $100,000 bond is paying.

So if you wanted to sell your bond in the open market, you would have to discount it (sell it for less than the face value) until the yield was comparable to the going rate in the open market.  If you don’t, who would want to buy your “second hand” bond?  This is an important principle even if you couldn’t care less about Treasuries because it’s the same principal used with discounted notes, which is a staple for in creative real estate.  But we digress (how unusual!).

Back to bonds.  So if someone wanted a 10% yield on their cash and your bond is paying $5,000 per year, what do you have to sell it for to attract a buyer?  Do you remember the high school algebra you never thought you’d use?  It’s time to use it.

$5,000 = 10% of what?

The answer is $50,000.  Because 10% of $50,000 is $5,000.

Ouch!  That’s a big haircut.  Your $100,000 bond dropped in value to $50,000 in order to pay the same yield.

Now in the REAL world, it’s not that simple.  Because the $100,000 bond will still pay $100,000 at maturity, that also gets factored in.  But it makes the math too difficult for this article.  And then it gets more complicated, because smart investors are going to factor in inflation (the decrease in the purchasing power of the dollar over time).

For purpose of our current discussion, the main point is that when a buyer pays more for a bond, the yield goes down and vice versa.  So when lots of buyers show up (high demand) at a Treasury auction, interest rates go down.  Conversely, when there are few buyers (low demand), interest rates go up.  If you didn’t track with that, take a sip of espresso and a deep breath (not at the same time or you’ll choke), then read it again and noodle through it.  Trust us.  This is important for you to understand, not just as a real estate investor, but as a taxpayer and a voter.

Now the bonus lesson is that when interest rates rise, the value of the bonds you already bought goes down.  Back in March, Bill Gross, the guy who manages the world’s largest bond fund (PIMCO), sold ALL his Treasuries.  Where do you think HE thinks rates are headed?

Treasuries as the Foundation of All Interest Rates

Now, let’s talk about how Treasuries affect interest rates on everything else important to you, like mortgages.

Because Treasuries are considered the world’s safest debt, imagine their yields (interest rate) at the center of a target.  Each ring away from the target is another type of debt.  The farther away you get from the center of the target (ultimate safety), the riskier the debt is.  And the riskier the debt is, the more the borrower has to pay to attract your money away from the center.  After all, as a bond investor, you’re only going to buy something less safe than a Treasury if it pays you better, right?

So you could say that the yields on Treasuries are the foundation for all debt pricing.  When Treasuries go up, it creates a ripple effect to all other debt offerings.  And all the money that people borrow, from mortgages, to cars, to credit cards, etc. all gets packaged up and sold to investors as various forms of bond (to say nothing of derivatives!).  It’s no surprise that the bond market dwarfs all other markets, including the stock market.  In other words the world is swimming in debt.

To bring it back down to earth so you can relate to it, think about it this way:  If you’re a real estate investor sitting on a portfolio of adjustable rate mortgages which you’re using to control millions of dollars of real estate, what happens to your cash flow if interest rates rise?  It drops.

And when more of your rental revenue is being used to pay interest, do you have more or less profit to invest in maintenance, repairs, improvements and new acquisitions? Less.

Take that same principle and apply it to a government.

When a government is sitting on a large portfolio of debt (bonds it has issued), big chunks come due (mature) constantly.  With each set of maturations, the bond holders expect to get paid the face value of the bond.  But where does the bond issuer (the borrower) get get the money to pay off the bond?

If you had a loan come due on a property, you would have to pay it from your savings (Uncle Sam has none), sell the collateral (US bonds are only secured by the “full faith and credit” of the government, so there’s no property to sell), or refinance.  Bingo!  Uncle Sam needs to borrow more.  Just like if you were spending more than you earn and running up your credit cards.  You need the credit card company to raise your credit limit, so you can borrow more to pay off the old credit cards.

And how does Uncle Sam borrow?  He sells bonds in the open market.

Now if current interest rates are higher than the rate of the bonds being paid off (retired), then the interest payable on the freshly issued bonds will be higher, and the debt service (interest payments) will take a bigger bite out of revenue.

But if you, or in this case, Uncle Sam, are already upside down (negative cash flow, i.e., budget deficits), then the rate at which you must borrow increases.  You’re borrowing to pay interest on borrowed money.  It’s a crushing, compounding effect.

Do you see a problem?  It’s a vicious cycle of continual, perpetual debt.  And you either have to find a way to out produce the problem (earn a lot more, as in higher taxes) or you have to make drastic cuts, or both.

That is, unless you have a Magic Checkbook (oooh, ahhh). And wouldn’t you like to know what a Magic Checkbook is?

Join us next time for the next exciting installment of The Great Debt Ceiling where we will discover How The Fed Influences Interest Rates and The Secret of the Magic Checkbook.  Don’t miss it!

Now please pick up your trash and move in an orderly fashion to the exits.  See you next time!

7/24/11: Raising the Roof – How the Great Debt Ceiling Debate Impacts You

The U.S. debt ceiling debate of 2011 is one of the biggest financial stories since the mortgage meltdown set off a chain reaction of quantitative easing, government stimulus and swelling deficits.

For the average person, a lot of this is so big and far away from Main Street, that watching, waiting and wondering seems like the best you can do.  A few real adventurous souls are lighting up social media with political rhetoric and semi-serious calls for revolution.

But we’re just real estate guys.  Politics is about what SHOULD happen and who’s to blame when things go sideways.  We prefer a more practical discussion about what IS happening, what is LIKELY to happen and what we can do in response to either avoid loss or make money (or both!).  Let the politicians and the pundits solve the mysteries of the universe.

In the studio for a practical discussion of the great debt ceiling debate:

  • Your practically perfect host, Robert Helms
  • The partially politically incorrect co-host, Russell Gray

For this episode of The Real Estate Guys™ Radio Show, we take a look at the debt ceiling debate and what it potentially means for real estate investors.  And if you happen to be listening after some or all of the dust has settled, it’s still worth tuning in because this isn’t the first time Uncle Sam has faced this dilemma.  And it’s a safe bet it won’t be the last time.

Meanwhile, for those that are glued to their TV set watching the whole sordid affair unfold, we took some time and prepared a series of blogs on this issue.  Well, okay.  It’s more like a mini-book.  But if you’re interested in understanding how the deficit, the bond market, the Fed, interest rates and inflation are all inter-related, them watch for our special series of articles on The Great Debt Ceiling Debate.

Listen Now:

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