6/22/14: Stop, Go or Proceed with Caution – A Conversation with Peter Schiff

Love him or hate him, Peter Schiff always speaks his mind.

Peter Schiff was rightWe happen to love him.  Not only do we admire his courage in trusting his own judgment… even when all the “experts” say he’s wrong, but we appreciate his willingness to explain his reasoning to anyone interested enough to listen.

For those that don’t know, Peter is the founder, CEO and Chief Global Strategist of Euro-Pacific Capital.  He ran for U.S. Senate in 2010, has a daily radio show, and is a best-selling author.  Slacker.

In 2005, he was sounding the alarm about the housing market, but few would listen.  We didn’t know him back then, but we wish we would have!

After everything blew up, we looked him up and have since become good friends.  Peter has been a faculty member on our last two Summits and we just found out he’s coming back for 2015!

We ran into Peter at The Money Show in Las Vegas, so we sat down to chat.  We thought you might like to listen in…

Behind the microphones in our mobile studio for this edition of The Real Estate Guys™ Radio Show:

  • Your Go-Go-Go host, Robert Helms
  • His stopped-up co-host, Russell Gray
  • Our never yellow guest, the indomitable Peter Schiff

One of the big lessons from the Great Recession is that financial markets both affect and reflect each other.  So even though we’re primarily real estate guys, we’ve learned to pay attention to stocks, bonds, currency, commodities and precious metals.

Peter Schiff isn’t really a real estate guy.  He’s big picture economy guy…that’s probably why he’s called a Global Strategist.  He has his eyes on the horizon…watching for waves of opportunity and signs of stormy skies.

When you hear Peter talk, he explains the cause and effect behind the movement of money, and filters everything through an Austrian economics school of thought.George Bush told America after 9/11...support your country.  Go out and spend!

If you’re not familiar with the two major economic schools of thought, think of it this way:  The dominant philosophy in modern economic is the Keynesian view which says that borrowing and spending fuels prosperity and economic growth.

When you understand this, it’s easier to make sense of what the government and the Fed are doing.  Everything is designed to entice people to borrow and spend.

The Austrian school believes that savings and production create prosperity and economic growth.  That is, when a society makes a lot of stuff (production) and doesn’t consume it all (savings), there’s abundance…more to go around.  Prices drop, stuff is more affordable to poorer people, and everyone is better off.

Peter Schiff says the Real Crash is yet to comeIf you keep this in mind when you listen to Peter, it helps you understand why he describes rising prices, low interest rates, increased debt and borrowing, and excess consumption all as warning signs.

It’s like using your credit card to buy a new car, new  furniture, a new wardrobe and then going out to eat every night at nice restaurants…even though you don’t earn enough money to pay for all those things without a big credit line.  Borrowing is the only thing fueling your “prosperity”.

But if you believe that borrowing is good, deficits don’t matter, then you’ll think that all the items purchased on credit are valid signs of prosperity.  After all, you got all kinds of stuff!  And more stuff is a sign of prosperity, right?Keynesian economist believe that borrowing and spending is the key to economic growth

Of course, anyone who’s ever run a household or a business knows that eventually the credit card has to be paid.  And the longer you wait, the bigger the balance will get, and the more painful the day of reckoning will be.

Peter thinks that higher interest rates would discourage borrowing and encourage savings.  He likens the cheap money to a spiked bowl of punch at a raging party.  It’s all good as long as the punch bowl is full.  But when the credit line gets cut, the punch bowl goes away, then the party is over…and all that is left is the hangover.

Evenutally the bill for all that spending comes dueSound gloomy?

Maybe a little.  But people go to parties all the time and enjoy themselves in moderation. Of course, if the guy next to you has had a little too much, it might be a good idea to keep a safe distance.  You don’t want his over-indulgence to get on you.  That’s the problem with investing alongside “hot money”.

In other words, asset prices are moving up because of cheap money.  Peter calls these “bubbles” because there isn’t legitimate productivity (fundamentals) underneath the increases.

Getting back to real estate (we haven’t forgotten that we’re The Real Estate Guys™)…

In housing, values are driven by the demand of home buyers (which is the desire to buy a home combined with the capacity to pay for one…which means an income that can be pledged to a mortgage), versus the supply of homes available to buy.

For investment housing, it’s similar…except the income comes from the tenants.  So even people with weaker credit and no savings help drive housing.

But in a weak economy (remember, “weak” means low productivity, low wages and low job growth…not a raging stock market), the incomes needed to drive housing aren’t strong.

Is that a red light?

Not necessarily.  After all, housing isn’t optional.  It’s essential.  So there will ALWAYS be a demand, even though it might be focused on the less expensive markets and product types.  And people will cut back on almost everything in order to keep a roof over their head, so even when incomes are soft, rental income is less affected than more discretionary spending.

Does that mean real estate is a step-on-the-gas green light?   If you view “green light” as throw-a-dart-at-a-map-and-buy-wherever-it-hits (like you could do in 2004), then no.  Some markets and property types are probably a long way from recovery.

Keep investing towards your financial goals...but proceed with cautionWe think it’s a “proceed with caution” yellow light.  Even though Peter disagrees with low interest rates, we have them.  And Peter says that current monetary policy favors the borrower.

Based on that, it seems like a good idea to borrow some cheap money, lock it in long term, and buy real incomes producing assets like rental real estate.  Especially because right now, in some markets, you can still buy properties at or below replacement costs.  For example, we just came back from Atlanta, and there are still very attractive deals there.

The key is picking the right market, price point and property type.  When markets get heated up, it’s SO tempting to speculate on rising prices.  If you get it right, it’s some of the easiest money you’ll ever make.  Who doesn’t want to buy a house for $500,000 and sell it a year later for $650,000?

But if you can’t sell it, are you structured in a way that you can afford to hold on for the long term?  If you could rent that home for enough to cover the rent and all the expenses for the next 3 to 5 years…or longer…then great!  If not, then you might lose everything you put into it…and your credit score.

And if you’ve been riding the tide of the rising stock market for the last year, you might think about moving some chips off the table and placing them into real assets No one likes it when the party’s over, but better to get out before the crowd…otherwise you risk getting stampeded or locked in.

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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.