The Feds raised rates … now what?

If you’re old enough, you may remember the old Pee Wee Herman movies … where Pee Wee falls off his bike and with brash bravado claims, “I meant to do that!”

Well to no one’s surprise, the Fed inched up their “target” Federal funds rates by 25 basis points.

So now, instead of just one-quarter of one percent (.25%), the rate is now a whopping one-half of one percent (.50%).

Of course, as we’ve previously discussed, the market already beat them to it.  So like Pee Wee Herman, it seems the Fed is not in as much control as they pretend to be.

Investor Summit at Sea™ faculty member Peter Schiff had some great commentary on this topic in a recent podcast.  You can listen to it yourself, so we won’t repeat it here.

But one of his best points is that the Fed’s own forecasts are WORSE going into 2017 than they were going into 2016.  Yet last year, the Fed projected FOUR increases for 2016.

In fact, in a panel on last year’s Summit, Peter and Jim Rickards debated this very point.

Jim said yes, the Fed would raise four times.  Peter said no raise in 2016.  Both were wrong, but Peter was closer to right.

So it seems even super smart guys have a hard time figuring out what the puppet masters are going to do.

But just because no one can say for certain what will or won’t happen … doesn’t mean we don’t pay attention.

We just don’t go ALL IN on any one outcome.  Why? You NEVER know what will REALLY happen.

Right now, both the stock market and real estate have been on multi-year booms… after HUGE declines in 2008.

According to data compiled into this nifty chart by the Pew Research Center, U.S. home prices “have almost recovered from the bust.”

Of course, the daily financial news is constantly blasting about the stock market … with the Dow flirting with 20,000 … in spite of the Fed’s interest rate “increase.”

Apparently people are continuing to pile into the stock market at these nose-bleed levels.

So that’s a lot of EQUITY happening in both stocks and real estate.

It’s no secret we’re equity guys.  We LOVE equity.  When we’re not talking real estate on the radio, we’re forcing equity through real estate development.  Equity’s AWESOME.

BUT … as we often point out … equity comes from cash flow.  They aren’t mutually exclusive.  In fact, they go hand in hand.

However, there’s another kind of equity out there.  The kind which comes from what David Stockman would call “bubble finance.”

That is, when central banks pump cheap money into the system, it can cause asset prices to rise WITHOUT underlying cash flows to support it.  It’s AIR.

This is a REALLY important concept, so PLEASE don’t tune out …

Think about it.

It’s easier to understand with stocks, but the principle is the same with real estate.  When buyers are paying MORE than the income justifies, it’s NOT sustainable.

But it IS tempting.  When you can buy a stock or property, hold it for a short period of time, and sell it for much more than you paid to a “greater fool,” the checks still cash.

However, when you stay in the casinos too long, the house (not yours) usually wins.

So YOU need to know how to tell the difference between real value and a bubble.  And then you need to have some strategy tools in your kit, so you can take appropriate action based on what you see.

Here’s how income creates equity:  If an asset is valued at some multiple of earnings, i.e., a rental property selling for 10 times gross rents, and the rents go UP $2,000 per year, the property’s VALUE just went up $20,000.

That’s cash-flow-driven equity growth.  (We know in the real world, properties are valued by Net Operating Income, but you get the idea.)

What if properties are going up but rents are NOT?  At some point, that’s a problem.

With home prices, in spite of still record LOW home ownership rates, values are still largely driven by affordability.  That’s REAL wages and mortgage rates.

We already know mortgage rates have been on the rise.  Those are easy to see.  There’s no massaging the numbers.  No seasonal adjustments.

Discerning real wages and inflation is a completely different matter.

The Fed says we have a “tight” labor market with a claimed unemployment rate of 4.6%.  Of course, you have to look at that in the light of a decades-low labor participation rate.

We’re not going to attempt to dive into any of that.  If you go too macro, you can’t see the ground anymore.

Here’s the point …

There’s a lot of equity happening.  Hopefully a lot of it is happening to you.

But if the Fed is really going to turn down the air to the jump house, some of your equity might leak out.

As real estate investors, our job is to proactively manage debt, equity and cash flow.  We let the property manager worry about tenants and toilets.

And when the wave machine of cheap money starts receding … potentially washing some of our newfound equity out to sea … we think about what we can do to protect it.

The GREAT NEWS is that mortgages in bubble equity markets are still cheap and readily available.  It’s a big part of why bubbles form.

But easy mortgage money means you can take equity off the table … even if you want to hold the property for the long term.

Accessing the equity isn’t the danger.  It’s what you do with the proceeds, how you manage the cash flow, and the risks.

Before he was President-elect Trump,  Donald Trump told us it’s ALWAYS smart to keep a little dry powder.  We’ll see how he does as a politician, but he’s got pretty good cred as a real estate guy.

So it’s probably smart to stash some cash … or other highly liquid assets (preferably without counter-party risk) … arbitrage the debt (loan out a chunk at a rate higher than you paid) … and/or reposition the equity into income producing properties in NON-bubble markets.

Yes.  Non-bubble markets exist.  These are markets where there’s very little if any financing and the income is real … not dependent on cheap money from central banks.

We know this idea may be getting a little repetitive.  But that’s partly because of the nature of real estate.  It moves SLOWLY.   So it’s easy for investors to nod off.

The bond market and the Fed’s rate hike are reminders for us to PAY ATTENTION.

And then … like The Real Estate Guys™ motto, use your Education for Effective Action™.

We know it’s a lot to absorb.  We have fond memories of living in our own little bubble from 2001 to 2007.  It was fun. It was easy.  Everything worked.  We were geniuses.

Then WHAM!

We didn’t see the problem until it washed away huge amounts of our portfolios.

We’ve been at this a LONG time.  But there are people in our audience who started their investing careers in the run-up since 2008.  They’ve only seen sunshine.

We’re not saying rain clouds are forming.  But they might be.

So we think it’s a good idea to be prepared no matter which way the wind blows.

That means investing in education, networking… being attentive to cash flow…and sometimes getting chunks of equity out of harm’s way.  Just in case.  And it’s better to be early than late.

More From The Real Estate Guys™…

The Real Estate Guys™ radio show and podcast provides real estate investing news, education, training and resources to help real estate investors succeed.

How The Fed Rate Increase Affects Real Estate Investors

janet yellen fed rate increase

Overview

The Fed FINALLY raises rates for the first time in nearly a decade. Now what? How does a Fed rate increase impact real estate and real estate investors?

In this episode, Robert and Russ discuss the short term and big picture impact of the Fed’s long awaited move…and what it might mean for real estate investors.

Discussing what the Fed rate increase means, coming just in time for Christmas:

  • Your happy and jolly ho-ho-host, Robert Helms
  • His brimming with Christmas spirit helper, co-host, Russell Gray

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(Show Transcript)

Welcome

Robert: Welcome to The Real Estate Guys Radio program. I’m your host Robert Helms. Let’s say hello to our co-host, financial strategist Russell Gray.

Russ: Hey Robert.

Robert: And Ho, Ho, Ho.

Russ: Yes I am. (laughter)

 

Discussing The Fed Rate Increase

Robert: Yes you are. We love this time of year, lots of great stuff going on hopefully with people you care about a lot and stay warm. Today, we are going to talk about really the thing everyone has been talking about the last few weeks, which is the interest rate increase by the Federal Reserve. They’ve not done it for years and years and years, and finally Janet Yellen stepped up and despite our friend Peter Schiff saying she’s not going to be able to raise the rate, raised the rate in a range of up to 25 basis points.

Russ: Right, so just no investor left behind, a basis point is one one hundredth of a point, 25 basis points would be one quarter of 1%.

Robert: So, previously the target range was between zero and 0.25. Now the target range is between 0.25 and 0.50.

Russ: Yeah, and actually I listened to one of Peter’s podcasts the other day that was talking a little bit about that. This is a very difficult thing to interpret. Obviously, you can see how large the Fed’s influence is. Every financial talking head on earth has been watching and waiting for this move. There are people listening to this podcast that were in junior high school the last time the Federal Reserve moved the interest rate up. And, it was a very, very minor move. It had been extremely well telegraphed.

The purpose of telegraphing which is, the Federal Reserve coming out, “Hey, we’re going to do it, hey, we’re going to do it, hey, we’re going to do it,” is giving everybody plenty of notice to reorganize their positions, restructure their portfolio to adjust for whatever they think is going to happen as a result of this raise in the rate.

Robert: Which is why, in the news you hear that this was already priced into the market.

Russ: Right. Of course because of that, sometimes the market does things you don’t expect. Theoretically this was a tightening which would be constricting of the money supply. Normally, that would mean the stocks would go down, and yet the day it was announced, the stocks went up. Part of that is because the announcement was accompanied not just with the move itself but with the tone. The tone was dovish, meaning they are less likely to move quickly and aggressively.  This isn’t maybe necessarily the first round in a rapid volley of rate increases. It was really communicated that this was going to be a very delicate, very slow, very tender, very gentle move …

Robert: Which it kind of had to be given the fact that there’s not been a move in nine years.

 

Looking At The Big Picture

Russ: One of the big concerns around the world is the strength of the dollar. We’ve talked about that in our blogs and our newsletter. It’s hard to spend a bunch of time in the space and not get disconnected from what’s going on on the street, right?

But you have to understand that corporations have been making decisions about taking their profits and borrowing at cheap rates, then reinvesting in their stock. That creates better earnings per share which creates a wealth effect, which means people are more prone to go out and spend. That means that they might buy a house, they might push up the demand for houses.

These macroeconomic things do trickle down to main street. Obviously, job creation is huge. One of the things that came out of this the day that this interest rate was raised was that oil dropped 3%. Oil has already been an 11 year lows.  Then within a day or two it dropped another 1%.  That’s a 4% loss. You’ve got oil that was priced over $100 a barrel, now all the way down in the $30s.

The reason that’s significant to real estate investors or anybody who cares about financial markets is you have these banks and these major bond buyers have been funding the borrowing of these energy companies to go out and develop oil.

A lot of them are pumping oil right now at losses, like it’s on the P&L and it’s a loss, but it’s cash flow that keeps the doors open a little bit longer hoping that the rates are going to come up.

Just saw an article on the Wall Street Journal the other day talking about banks and how banks are betting by continuing to extend credit to these leveraged operators, these oil operators, that the oil price is going to go back up, and they are going to be able to save themselves. If the banks get that bet wrong, those debts will go bad and it could be a whole lot bigger than the subprime crisis ever was.

 

The Energy Industry’s Impact On Real Estate

Robert: I seem to remember a lot of real estate investors that had that same kind of mindset that, “Hey, next month the prices are going to go up and next year the prices are going to go up. Every market goes up.” And, lo and behold, that isn’t the case. A lot of folks in oil are super concerned about this.

Your point is a good one. It’s not only that some producers of oil today are continuing to produce oil even at a loss. It’s that of course exploration stops, new drilling stops, all of that means those jobs stop and many of those jobs are tenants.

Russ: That’s the main point, because if you go back and you net out all of the job creation from 2009 until today, it doesn’t mean it’s the only place the jobs were created. But if you look at the gross number of jobs created and the gross number of jobs lost, there was a net number. If you look at that net number, you could assign 100% of that net number to the oil and energy space. That’s how important it’s been to this US recovery. Right now, it’s arguably one of the most distressed areas of the economy.

fed rate increase impact on oil industry - pic of oil fields at sunset

If you’ve invested in marketplaces that are strong in energy or are strong supporters of companies or areas that are strong in energy, that’s where we talk about the concept of primary and secondary, even tertiary jobs. The secondary and tertiary jobs, a lot of whom are your tenants are all based upon the income being derived in the selling of oil. In fact, congress and the president just lifted a 40 year ban on oil exporting. I’m sure part of that is to try to figure out a way to generate more revenue in the oil space.

Oil is something I think we all need to be paying a lot of attention to because of the impact in the debt markets and the bonds which, come right back into the availability of credit and mortgages just like the subprime prices. It’s had a lot to do with the net job creation as I mentioned earlier.

And so again, that has been a big story in the economy and the recovery since the great recession. If that job creation begins to slow down, that will have a net effect on the price of real estate, the number of tenants, demand, the strength of wages, job creation and all of those things. That’s a very important point.

If those debts go bad and it rolls into the banks, that’s where we had the big bail out last time. So, today with the Dodd-Frank rules, it’s not as easy for them to bail out. And that means if they can’t go to that path where else might they go, we don’t know. It’s very, very uncharted territory.

The good news in all of that of course is that any time there’s chaos, any time there’s uncertainty, any time there’s change, there’s going to be little gaps, little pockets of opportunity for the people that are thinking about things that are paying attention.

fed rate increase wish i had a crystal ball to see the future

I wish I could sit here with a crystal ball and say, “Hey everybody, look, here’s where all the opportunity is,”. I’m not that smart. I think I’m smart enough to know I need to be paying attention and spending a lot of time listening to what people are saying about it and trying to figure out, “what does this mean to me? What does this mean to real estate investors? What does this mean to the cost and supply of money? What does this mean to credit? What does this mean to jobs? What does it mean to income? What does it mean to taxes? Where’s the opportunity going to be?”.

 

The Process Will Take Some Time

Russ: I think it’s a process that will unfold over time. It’s not just going to show up on your door step in a little package for the holidays and go, “Hey guys, here’s where the opportunity is.” It’s going to be something that unfolds over the next few years.

Robert: That’s such a good point, any time there’s major market news, there’s whatever reaction, but a lot of times you hear this whole thing about, “Well, you know that’s already been priced into the market. People knew that was coming. This is obviously something that was anticipated.” And so we can’t expect it all to happen on day one.

If you think just in a logical point of view, all right. If the rate goes up, that’s going to have some effect. We have to first step back and say, “what rate are we talking about?”. This isn’t the rate that your credit card charges you. This isn’t the rate of home loans. Let’s talk about what exactly this rate that got hiked by the Federal Reserve really is?

 

Which Rate Got Hiked With The Fed Rate Increase?

Russ: Yeah, this is the federal funds rate. This is the rate that the banks loan to each and overnight lending. It’s designed to prevent a liquidity crisis. It means that if Bank A has more withdrawals than cash on hand or deposits coming in rather than run out of money and have to close the doors, they just borrow from another member bank.

Robert: At a nominal and in this case interest rate.

Russ: Yeah. There’s another rate that didn’t get announced, and it’s not the rate that everybody is focused on. But, it’s the rate that the Fed pays on banks on their excess reserves on deposit with the Fed. If they get a good rate, a higher rate, it encourages them to put more money there which pulls money out of the economy.

That’s why this is considered to be tightening. This is not accommodative, and yet you can make the argument that the interest rates historically are still so ridiculously low and the Fed has still kept all of these assets, four trillion dollars of assets they purchased going through the crisis still on their balance sheets.

So, this is a long way from being tight, and it is a long way from not being accommodative. The Fed is right in telegraphing everybody, this is going to be done very, very, very slowly.

 

Pay Attention To Long Term Trends

The danger is that as investors we don’t pay attention to the little changes that are setting the direction and the tone for what’s coming five and 10 years down the road.

As real estate investors, we arguably have to be even more tuned to that because when we are making investment decisions, we don’t jump in and out of position the way stock and bond traders do.

What we do is we evaluate a market. We look at its economic drivers. We look at its economic prospects, it’s migration in and out. We look at the legislative environment and how friendly they are to business and job creation.

Then we make a decision to really get married or at least get into a long term relationship with that market. Then we sign on a 20 or 30 year mortgage. And, we put a bunch of capital in there, and we’re prepared to be in there for several years if not decades.

When you are investing that way, you have to pay attention to these long term trends, because like everybody who’s trying to figure this out, we all want to be ahead of the curve.

This is a very slow moving curve. It’s easy to fall asleep at the wheel. One day you wake up and everything has changed, and by the time you figure it out if you’ve been asleep, everybody else ahead of you has figured it out. Now you are all rushing towards the exit and the exit is crowded. So, you want to be paying attention early.

Robert: When we come back, we’ll talk about the myriad ways that this interest rate hike can affect and will affect real estate investors, and we’ll make some best guesses as well. You are tuned to The Real Estate Guys radio program. I’m your host Robert Helms.

 

Come To Our Goals Retreat

Robert: Welcome back to The Real Estate Guys Radio program. Thanks for tuning in to the show. If you are trying to figure out what you want to do with the rest of your life, come on out and join us at Creating Your Future at the 2016 goals retreat. It happens the second weekend of January in beautiful San Diego, California.

You can really get your life on track and spend some time figuring out what you want to do when you grow up. You’ll find all the details on our website, RealEstateGuysRadio.com under events.

 

Will The Fed Rate Increase Impact Mortgage Rates?

We’re talking about how the Federal Reserve interest rate increase will affect you as a real estate investor. I think one of the things to talk about of course is we think interest rates, we think mortgages. If you have a mortgage in place, that’s a fixed mortgage, this does not affect that in any way, shape or form.

Part of the reason that as real estate investors we look at encumbering property with leverage is that we love the magnification of return.

However, given what the market gives us and Russ you were talking about before the break, we are in it for 20, 30 years. If the mortgage money at the time is affordable, like it has been for many, many years, then lots of real estate investors opt to get into fixed rate product and that makes a ton of sense, and it has for a long time.

We’ve been through the other side of it. We have enough gray hair to have been through the time where adjustable rate mortgages made a lot more sense for particular investors in certain situations. It’s always about you and your investment strategy. How long are you going to hold the property. Is this small increase also going to eventually translate into an increase in mortgage rates?

Russ: I think the thing to think about is, just really understanding where mortgage rates come from. It’s gotten to be a lot more complicated which again opens up a much bigger discussion because you have many of the rules, kind of the cause and effect things that we get used to when we try to figure out how things are going to work. And they don’t work the way they are supposed to.

That’s because you have people who are trying to create outcomes by moving results. They move numbers on the results column.

And so the causation doesn’t seem to match up, you are like, “Okay, I don’t understand, if this then that, but that didn’t happen, why didn’t that happen?”.

This is because somebody is manipulating the result to try to make it look like something else.

There’s a lot of that going on. You can call it conspiracy theory. You can call it professional management of markets. You can call it smoothing out the rough edges and stabilizing the economy. It doesn’t matter what you call it. I think everybody agrees it goes on. It just makes the job of figuring out where things are at quite a bit more complicated.

In the basic picture of where mortgage rates come from, it’s based on supply and demand. If you have a lot of people who want to borrow and not very much money available, the lender can charge a high rate and the weaker people get priced out, and only the strongest people can borrow.

fed rate increase on mortgage rates - supply and demand chart

You flip it over and there’s a lot of money that needs to be lent and there aren’t very many borrowers. Everybody is dropping their interest rates offering free toasters, we’ll pay you points …

Robert: Or lowering their standards.

Russ: Or lowering their standards trying to get more people to borrow. We’ve been in a very, very, very accommodative scenario where there has been a lot of money pumped into the market, specifically the goose real estate.

And largely it’s done that, you have a lot of prognosticators out there saying, “We are in a bubble and the bubble is about to burst.” In some markets I suppose you can make that argument because a bubble is when the incomes that need to debt service the mortgage don’t go up as fast as the payments do.

In other words …  and that can happen because the rates adjust but … If the load of debt just gets so high that that monthly payment gets to be too much, even if it’s a fixed rate based on how fast incomes are rising, you are going to hit a plateau where people just can’t borrow anymore, unless either the rates come down or their incomes go up. Well, nobody is running around saying that incomes are going up at any substantial level.

Now, the Fed says they think that’s going to happen. So, part of the effect of the mortgage industry is what’s going on with incomes. Supply and demand in what we call capacity to pay which comes from income.

 

We’re In New Territory

It used to be anyway that when the stock market was hot, money would come out of bonds, people would sell their bond positions and they would go into the stock market to participate in the growth. That would make less money available in the bond market which would mean less money available to lend, which means that rates go up.

Typically, when the stock market goes up, rates go up. That’s the way it used to be. Post crash that changed. Pretty soon bonds were able to go up, which meant interest rates went down and stocks were able to go up. That didn’t seen to make sense based on the old rules but it made a ton of sense when you realized the market had been flooded full of money.

Robert: How much quantitative easing and money printing and the money had to go somewhere, the squish factor. When there’s more money injected and you squeeze your hand around it, where is it going to come out? We don’t know. It’s going to come out somewhere.

Where it didn’t go is into the hands of businesses and even into real estate investors hands to go do something with it. A lot of that money got stuck.

Russ: Yeah, the money that did end up in the real estate space went in through hedge funds who bought for all cash and didn’t even use mortgages. You’ve had that … I’m not going to call it a distortion, but it was definitely a new factor that didn’t exist in real estate 15 years ago.

Robert: Add that you have the knee jerk reaction of lenders and rightfully so of all the crazy loan products that they got stuck with in the downturn, and all the defaults, and all the foreclosures and all of that meant that the lending standards increased.

It became harder and harder and harder to get a basic consumer loan. Even if you had a good job and good credit. More hoops. More Federal regulations. More state regulations. Harder to get a loan even though you can say interest rates are low and it’s an affordable time to leverage, not everybody could get a loan.

 

Challenges Force Ingenuity And Create Opportunities

Russ: Historically, the last time this happened was after the savings and loans collapse which is only the birth of creative real estate. If you really think back and you go back and you look at the history of real estate in modern history anyway, in terms of creative finance, a lot of that was birthed when we had those ridiculously high interest rates in the wake of the savings and loan crisis.

Robert: Of course, see, people figure it out. When there’s a challenge it also creates an opportunity. When interest rates went to 18, 19, 16, pick a number, when interest rates were like that you got creative. You figured out a way to make it happen and there were all kinds of crazy fun interesting ways that the folks did that. A lot of that has continued on today in various formats.

Russ: That was really the birth of the non-agency lender, the brokerage channel about 30 years ago and it grew to where it was originating three quarters of the loans, the real estate loans in the country.

Robert: And if you have a tin foil hat, this is where you would put it on and say, and the entire meltdown was orchestrated to remove that channel, but we are not going to go there.

 

The Impact On The Mortgage Industry

Russ: Yeah, we definitely had some people in the mortgages who felt that way. I was in that channel, and I got wiped out as a result of it. So, I know exactly how that felt like, but, whether it happened on purpose or whether it happened by accident, at the end of the day, it happened.

The role of the government and government lending came back. Well, if you’ve been paying attention, you are seeing more non-agency money coming available, more private money coming in. More money has been printed. More money is looking to get into the mortgage space. So, coming back to rates.

Now you’ve got the agencies who are subsidized, right? That’s why Fannie and Freddie keep losing money more often than not. Sometimes they make money but more often than not they lose money. They are a subsidized rate. They have access to money cheaper because the interest rate on a mortgage is based on risk.

When you are lending money, buying a mortgage bond, if I’m buying a mortgage bond issued by Fannie or Freddie, I had prior to the crash and implied the government guarantee but not an overt government guarantee. Today, I have an overt government guarantee.

Robert: I’m not sure that’s any better.

mortgage industry and fed rate increase

 

Russ: Which means it’s less risky. Which means that I will accept the lower interest rates. When I don’t have that overt guarantee, if I’m another provider of funds in the marketplace, I have a higher cost. But, I may be able to compensate for that with more efficient operations or whatever. So I go in and I try to compete, but I also may compete a little bit off to the fringe. We are seeing more of those non-agency players come back in and begin to compete.

Robert: By the way, on next week’s program, you are going to meet one of those folks. You are going to learn a lot about these new loans that are available to real estate investors, including the fact that you can basically forget about getting Freddie and Fannie’d out today. There’s a lot of new alternatives, excited to talk about that next week.

Russ: Yeah, a lot of people are motivated to see people be able to finance real estate. We’ve always made the argument that the powers that be, whoever they are, whether it’s government, politicians, banks, private industry, the largest trade association in the country is the realtor organization.

You look at all of that, you say, “There are so much political and financial benefit to seeing real estate get propped up, even if it has a problem,” like it did. It just had the biggest problem ever in 2009.

You see everybody rallying around and if you are willing to wade into the mess, you actually can make a lot of money. A lot of people made a lot of money coming out of 2009 and there are some of us that are sitting around looking, “We hope this is a bubble. We hope this thing pops. We hope that this quarter point interest rate increase actually pops it a little bit and some of the prices will come down,” because the rents probably will not come down as far as the prices will.

If that happens and money remains cheap and we get to go in and purchase, we’ll actually get a chance to scoop up some bargains. That’s obviously what everybody is hoping for.

Robert: Before we are done today, we’ll talk about some of the strategies that you might consider given what’s happened.

 

Mortgage Interest Rates And What to Watch

Russ: Yeah, so in terms of the interest rates themselves, obviously mortgage interest rates are going to stay very low. If you really want to get some idea about where they are headed, I would pay attention to the 10 year Treasury bond.

That’s really the epicenter of where risk pricing is in the debt market, at least as far as mortgages are concerned. If you can imagine the 10 year bond yield at the center of a bull’s eye, then each concentric ring out is a little bit more risky. And you could make the argument that real estate is just slightly more risky than the government bond. So, there’s going to be a little bit of a spread.

You can go further out all the way to another topic that’s been quite a bit in the news lately – junk bonds that are way out in the outer rings, because these are basically poor credit corporations that are borrowing to fund maybe negative cash flow operations, like we were talking earlier about the oil companies.

And they’re high risk, high rewarded investments. If you make that loan and you get it right meaning I buy that bond and loan that money company and they pull themselves out of the fire, they owe me a lot of money. I can do real well.

But, the flipside of that is they could completely default and then I get maybe pennies on the dollar if I’m lucky in a bankruptcy proceeding or whatever.

So, mortgages tend to be very near, and they are the beneficiary if you will of the flight to quality just like bonds are. As people get nervous about all the gyrations in the economy, they jump into treasury and the dollar which is why both the dollar has been strong and treasuries have been strong. That pushes yields down. When people are bidding up the treasury bonds, bidding up the price to buy them, the inverse of that is you are bidding down the yield.

I would say that if this quarter point raise creates uncertainty in the market, and clearly the stock market is not liking it. It liked it the first day, maybe that was plunge protection team trying to create a PR move, but since then, hasn’t liked it so much.

If that trend continues and people will start looking for safety, you are going to see them move more and more into bonds. If that happens then you are going to see to see those 10 year yields begin to come down. That would be reflected in mortgage rates.

Personally, and I’m hardly a genius at this, but I’ve been watching these markets for a very, very long time, I really don’t see mortgage interest rates running away.

Does that mean you should run around and use adjustable rates? I don’t think so, only because the chances of them going up substantially versus the chances of them going down substantially, I think you have a greater chance of them going up substantially just because of where they are at.

They are so far near the bottom right now, why take a chance, right? Because if all of a sudden the credit market sees up or we get a big boom of inflation and we have to raise interest rates real high to cool it off or everybody runs out of bonds because bonds are losers in an inflationary environment. Everybody will be running into stocks and other places, money would be coming out of the bond market, then the bond prices will go down, bond yields will go up more, mortgage rates will go with them.

That’s the way it works, again, these markets are managed, manipulated, whatever you want to call it. They don’t always act the way they are supposed to act, at least in the short term, but if you watch them over the long term, usually the market behaves as you would expect it to do. But you have to just look at it over the longer term.

Robert: We are talking about how the Fed rate increase hike is going to affect us as real estate investors, more when we come back.

 

How The Fed Rate Increase Impacts Real Estate Markets And Tenants

Robert: We are talking about the recent hike of the interest rate, and it’s really a range of interest rate that the Federal Reserve has come out after all these years of no change and said, “We’re going to raise it, we are going to raise it, we are going to raise it.” They finally did and there has been all kinds of market reaction to that.

Russ: Yeah. This really affects financial markets a lot more than it does at least directly real estate markets, but then again it affects the way banks and corporations behave which ultimately will affect real estate investors. Those are all things that we need to be concerned about.

Robert: One of the things is, as we look at real estate investors, I’m looking at any change in the marketplace, whether it is, like we talked about the price of oil, some of that is good, right? My tenants can now afford rent if gas cost them less.

At the same time, if my tenants have jobs in those industries, they could be at risk. Part of what you do is you look at which tenants are being affected the most by any change you hear about and are those tenants, if they are your tenants going to be able to pay. The durability of your rent is a thing to consider in any news event.

 

A Strong Dollar Making An Impact

Russ: Yes, you obviously need to stay focused on what’s going on in your regional economy, your local economy because that’s where you are living.

The only exception would be … We talked about farm land investing. If you are investing in farm land, it’s maybe less important that you get the geography right except for the quality of the crop. But, what you are really interested is getting the commodity right and then it can be shipped anywhere in the world. Commodities in general right now have been suffering, and that has been a direct result of the strong dollar.

Think about this. If you have a local economy that is commodity dependent, we’ve been talking a lot about oil and gas. But, it isn’t just oil and gas, it’s any commodity. Minors our laying off right now. If you are in a mining community, coal, copper, zinc, if you are in lumber, there are commodities right now that are being hurt because commodities are priced in dollars and the dollar is getting stronger.

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The dollar is getting stronger, not just because of the quarter point rise, but it’s also getting stronger because when the Fed does this it actually creates difficulties in the emerging markets. This is where your head is going to explode.

Robert: Follow along here, it’s not that difficult to grasp, but you are going to have to think a little bit.

Russ: I’m not going to profess to be an expert in foreign exchange and currency markets, but I’ve been paying a lot more attention to them lately because the last time that Janet Yellen did not raise the rate in September, she said it was because of what was going on in emerging markets.

The concern was that the dollar was getting too strong relative to emerging market currencies. When emerging market currency or any other country’s currency goes down, it makes their exports less expensive for their foreign customers to buy.

It’s like you lowering your prices and being more competitive on the open markets. Conversely when your currency gets strong, then it makes your product less competitive in the global market.

Robert: With a strong dollar right now, there are some good things about that, the challenge is exports of the US become expensive to other places.

Russ: Right. If your local economy is being largely driven by a company that does a lot of exporting, especially when it’s doing exporting to a country like China who has been on a little bit of a decline, and on top of that, they have been devaluing their currency, the Yuan in relationship to the dollar, it means those dollar denominated exports from the United States trying to be sold into China or other countries are now more expensive which means it’s harder for the US company to compete.

It’s one of the reasons why a lot of the US companies who are selling abroad don’t necessarily like a strong dollar policy. Now, the good news is that the dollar is able to buy the more labor, the dollar is able to buy more land or capital equipment or whatever in the markets there’re in.

Robert: Quick aside, right now is an excellent time in certain foreign real estate market to be an investor in real estate. There are sales because of the exchange rate and we look to exploit when those things happen either way. So, again, a strong dollar isn’t a bad thing necessarily it depends on which side of the equation you are on.

Russ: Coming back into an interest rate rise, creating a strong dollar, a stronger dollar and now a stronger dollar creating pressure on commodity prices downward which we are seeing. And again, we’ve talked a lot about oil but other places.

Australia and Canada are two countries that have been okay places to invest in, especially Australia over the years, but now they are suffering. They are suffering partly because the Chinese economy is down and Chinese economy has been the largest consumer of commodities in the world.

With that demand down, those sales are down. And on top of that, the dollar value of the sales is down because the commodity’s prices have gone down in dollars.

Again, it kind of makes your head want to explode, but if you just spend time thinking through it, it is logical. And if you start to pay attention to it little by little, it will start to make more and more sense. Then you just have to keep following the path all the way back to wherever you are invested.

We have listeners all over the world. We have people listening to us in Canada, in Australia, in Hong Kong, in addition to in the United States and many other countries. A lot of you are on the other end of a strong dollar. You are on the end where it takes more and more of your local currency to purchase the dollars you need. In many countries, real estate sales are denominated in dollars, not the local currency for this very reason.

Robert: Good point.

Russ: Because it’s more stable currency. Now when you go to buy, it’s going to cost you a lot more of your local currency. So, as an American, we can come in using our dollars and purchase your assets and get more for our money, whereas the reverse is true. If you are there and you are trying to purchase real estate competing with Americans coming in with dollars using your local currency, you need more of it.

And so as you are thinking about all of this, especially if you are an international investor, you need to be thinking about the role of the dollar in your local economy and the relationship of your local currency to the dollar and how that could that affect both the price of the real estate but also the jobs that might support the people who are going to be using the real estate.

If you are in a resort community it can be good, because now you get strong dollars coming into the resort community and you are doing well.

If you are in a community where maybe it’s local industry and they are trying … And their biggest customer is the United States and they are trying to sell, that could be okay, because they are going to do well.

If you are there and you are trying to sell something that’s going to be denominated in dollars, now you are going to have a problem. So, talk to the people who you know who are in these different businesses and begin to understand what it looks like through their perspective.

I think one of the best things you and I are able to do Robert is we get to travel around a ton. We get to talk to a lot of different people who look at the problems and the challenges and the opportunities through different lenses. And then we can begin to take all those little pieces of the puzzle and put them together and get a broader perspective. In fact that’s the Summit coming up at the end of February. We get a chance to do that.

We get probably 100, 120 investors from all over the world, they come in, we sit down we have these conversations like, “Okay, what’s life for you like now that the dollar has gotten so strong. What’s that doing for you in your local economy and how does the Fed …” Because everybody around the world is watching what the Fed is doing, it’s not just the United States is fixated on it. It’s everybody because it affects everybody.

The dollar is the global reserve currency. And even though it’s diminishing in its role, it’s still the big horse by far and away. Anything the Fed does affects the value of the dollar globally which affects every man, woman and child on planet earth that conducts business in any way, shape or form. It’s very, very important for you to pay attention to it even though it’s a little bit of a brain strain.

 

Join Us On The 14th Annual Summit At Sea

Robert: Well, what’s great about being on the Summit this coming year is the fact that we’ll be able to have those conversations with Mr. G. Edward Griffin who wrote, ‘The Creature From Jekyll Island’, a wonderful expose on the Federal Reserve. Great, great book, great, great man.

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Robert Kiyosaki who certainly has his mind all over economics and just to hang out with that guy is brilliant. We are going to have an owner of a bank and a gold expert.

We’ve got lots of great people coming and of course we’ll talk oil because oil is in the news. Oil is going to affect us in real estate in a lot of different ways.

Join us there’s a few cabins left for the 14th Annual Investors Summit at Sea. Get all the details on our website at RealEstateGuysRadio.com under summit.

When we come back we’ll talk more about things you can do in light of the new Federal Reserve move. You are tuned to The Real Estate Guys radio program. I’m your host Robert Helms.

 

Learn How To Raise Money For Bigger Deals At The Secrets Of Successful Syndication

Welcome back to The Real Estate Guys radio program, thanks for tuning in to the show. If you’ve ever thought about doing bigger deals by raising money from other investors, then you owe it to yourself to come out to The Secrets of Successful Syndication that happens January 29th and 30th in Phoenix, Arizona.

The amazing Ken McElroy will be there, Attorney Mauricio Rauld and a great, great cast of faculty, including a couple of new folks this time around. To get all the details at realestateguysradio.com under events.

 

More And More Renting Households

Talking today about how the Federal Reserve rate increase here is affecting real estate investors. I think the main thing to focus on is where is housing going, where is affordability going, where are tenants going?

The good news … We’ll cover this in more deep down next week. I know we keep teasing next week’s show but before we are done I’ll tell you why I’m excited about the four at least guests we’ll have next week, is that, there are more and more renter households.

More people today than in a long, long time are renting. They are choosing not to or they can’t afford to own or they can’t get loans. So there’s more renters.

That bodes well for real estate investors. Interest rates continue in spite of this, uptick from the Federal Reserve continue to be great. Again, next week we’ll learn about some loan programs that aren’t dependent on your credit, which is fabulous. So, all in all, not a bad time to be in the real estate investing business.

 

Pick The Right Markets

Russ: No it’s great. The key is just to make sure that you pick rock solid markets and diverse markets. The things we preach about here all the time.

You know you want to have those wide variety of the diverse drivers. You don’t want to be in the one trick pony town where it’s all about the one industry or the one company.

You need to make sure that you are diverse and then invest in the bread and butter properties. Invest in things that people will always need that aren’t fads, that are affordable. Think about your macroeconomic considerations within the scope of maybe a state and it being job friendly, aggressive …

Robert: Or tax friendly.

Russ: And tax friendly. Those are things you’ve got to watch the big baby boomer demographic. You need to watch what the millennials are doing because they’ll begin to give you some indication to what they are thinking and where they are moving.

 

Keep An Eye On Bond Markets And Stay Liquid

I think that it’s important to pay attention to the credit markets right now because … Especially like … I don’t know if you saw this Robert but a couple of big bond mutual funds basically blocked their investors from being able to liquidate. The idea of a mutual fund is, you are able to go in there and get your money out whenever you want. It’s highly liquid.

Robert: Right, I can sell, I can buy into it, it’s liquid.

Russ: We teach our syndicators, don’t ever do this which is exactly what these bond funds do and that is they invest long but they have this mismatch maturities where they are giving you basically demand, like a demand deposit but they are making these long term investments.

Well, if they have too many people coming who want their money out they have to begin to sell these assets at whatever price they can get. The problem is when too many people get spooked. This is always the danger in paper markets, when you can move in and out.

Too many people get spooked, then everybody comes looking for their money and it’s just like a run on the bank, the only difference is it’s run on a bond fund.

This is what blew up the financial crisis in 2008. This has the potential to do it again. You definitely want to be watching that. Everybody is paying more attention to it now. You want to be paying attention to that. Use financial structures that you feel very comfortable with being stuck within the long haul.

Don’t get penny wise and pound foolish. Don’t think, “Oh, I can save an extra $100 a month if I use this super teaser rate deal,” when the probability is rates are on their way up, not on their way down. I would be very, very careful about that. Some people will use these balloon payment loans where it’s 30 year amoritized, so you get a low payment but it’s all due in five.

Robert: Meaning that in five years you have to refinance it?

Russ: Yeah, you either have to refinance or sell and that’s all predicated on the value still being in the property, meaning that you can still qualify, or there’s lenders out there.

Back in the day when condo hotels were all the rage, a lot of these developers’ projects were all predicated on your take out buyers, the people you are going to sell the finished inventory to having access to credit markets that would finance those purchases. When those loans went completely away, then there was no liquidity and these developments failed.

Things can change. They start in the credit markets.

Most real estate investors aren’t trained and don’t really pay attention to the credit markets. I think big picture lesson from 2008 that we’ve harped on for years now is savvy real estate investors got to pay attention to these credit markets.

When the big elephant in the room, the Federal Reserve comes in and finally after nearly 10 years actually begins to move the rate, you have got to perk up. You’ve got to pay attention, because the last time they did this was 2006. They went into an aggressive rate hiking cycle and it led directly to the crash. This time they came out with a much more metered or muted languaging.

Robert: But they did also talk about gradual increase over time, this has definitely set the stage for more small increases. If you just step back and look, that means it’s probably an excellent time to make sure your financing is in place. Is it long term, if your strategy is long term? If you still have properties that you haven’t re-fied, now is the time to take a look back.

You’ll definitely want to pay attention to the next week’s show because of that. Real estate and these markets move slowly, and overnight reaction is not the ultimate reaction. Your mission is to pay attention now more than ever before, you better be paying attention.

Russ: And really know your demographic. Know where their money comes from, not just that they have income or they’ve had a job for a couple of years, but what industry they are in, who their employers are, who the major employers are in the area?

They may not be the people you are renting to directly but you may be renting to people they do business with. They may be an engineer or a scientist or whatever that is a home owner, but they do business with the guy at the laundromat. They go the restaurant. They are getting their car done. They are doing business with the local merchants, and these people are the people that you are actually renting to.

Without these primary people in the marketplace, those jobs go away. Pay attention to that, because, again, the markets are fragile … My estimation anyway, I think the markets are fragile right now.

Even though things are booming, things that boom can dry up in an instant when people get spooked. The evidence that these big mutual funds had to shut down not one, not two but three of them. The first time I read about it, it was only the one. Then it was another one. Then it was another one. If that’s a trend that continues, you could begin to see bond markets lock up.

When this happened in 2008, it all unraveled very, very quickly. If you’ve got credit lines out there that you are counting on for liquidity, I wouldn’t do that. That would make sure I have some real cash on hand, so that if things tighten up you do have some liquidity that isn’t a credit line.

 

Go Out And Make Some Equity Happen

Robert: One of the big differences between our show and a lot of real estate shows is we spend some heady time in the clouds talking about broader picture, economics.

To make up for that next week it’s all about single family houses. We’ve got a bunch of great guests next week and a lot has changed in the single family marketplace, including financing. You are going to learn next week about some great alternative financing that real estate investors should be excited about.

Until then, it’s the most wonderful time of the year, make sure you are given big hugs and high fives to the people that matter in your life, and let’s all get excited for a new year which is coming before we know. Until next week, go out and make some equity happen.


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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!

The Great Debt Ceiling Debate – Part 1

This is part 1 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.

As the debate rages on about whether and how to raise the U.S. debt ceiling, it’s hard not to have any discussion of the topic degrade into political diatribes.

But as real estate investors, we’re not too concerned about what the policymakers SHOULD do (since we don’t have any direct control anyway).  Instead, we’re much more focused on what IS happening, what is LIKELY to happen, and what we can do in response to avoid loss and/or create a profit.

In short, we refer to discussions about opinions about what should or shouldn’t be done (or who’s to blame) as “political” discussions.  After all, politics is a pretty “shouldy” business.  But you already knew that, didn’t you?

We prefer that our discussions be more practical in terms of what’s likely to happen and developing a plan A, B or C to react to it.  We may have political opinions (some of which leak out from time to time), but you know what they say about opinions: Opinions are like armpits.  Everyone has them and most of them stink.  We don’t have to like each others’ political opinions to enjoy a healthy conversation about what’s happening and how it affects real estate investors.

Since the debt ceiling debate is a complex, polarizing topic with huge global economic consequences, we thought it was worthy of a bigger discussion than our regular broadcast blog.  So strap on your reading glasses and get ready for a big discussion.  And be sure to listen to the podcast on this topic also.  It doesn’t replace this article, but it will help if you’re new to all of this.

We STRONGLY encourage you to plow through it all because the discussion of the U.S. debt and financial system has a DIRECT impact on interest rates, availability of loans, job creation (the best tenants have jobs), wages and the value of your real estate – Just a few things that are probably pretty important to you.

In a Rising Tide, All Ships Rise and Vice-Versa

We all found out a few years ago that no matter where or what kind of real estate boat you were floating, when the MBS (mortgage backed securities) money drained out of the tub, values dropped.  Really astute investors paid attention to the macro trends BEFORE this happened and drained their own equity while the tide was still high (back in 2005 we did some shows on “equity hedging strategies”, which you can find in the Backstage archives).  The rest of us learned (the hard way) that we better pay closer attention to the big picture for next time.

The big question is: will there be a next time?  That is, will real estate values rise again?  If real estate is down, never to rise again, then you can still make money, but you need to approach the problem differently.  If the tide of currency (the money supply) rises, then real estate values are likely to rise over time and you would structure your portfolio accordingly.

So what’s LIKELY to happen? And how does the debt ceiling debate impact you?

You could say that prices are so low they can only go up.  Just like at the peak, when people said that prices were so high they could only go down.  Those are nice sayings, but even a broken clock is right twice a day.  What are the economics behind the predictions?  Is it all such a complicated mystery that merely guessing or listening to the loudest voice is the only way to know?

No.

Here’s the good news.  You can understand all this.  In fact, you may be surprised at how easy it is.  So the goal of this series of articles and the accompanying podcast is to give you a basic understanding of “the mechanics of the money”, so you can begin to plot cause and effect, then decide for yourself what you think will or won’t happen.  But keep in mind, the best strategy will consider all possibilities.

At a recent conference, we heard a quote that has become one of our favorites:

“Better to prepare, than to predict” – Henry Brock

So in this series we’ll take a look at what happens if the DO raise the debt ceiling and what happens if they DON’T.

Of course, who can resist the temptation to predict?  So, at the end, we’ll go out on a limb and make a prediction.  Just keep in mind that our prediction is just our own opinion, and probably about worth what you paid for it. 😉

Ready?  Here we go.

The U.S. Money Supply

First, let’s talk about how money gets into the U.S. system.  When the government needs money, the Treasury either taxes (takes it from the productivity of the people) or borrows (pledge the future productivity of the people).  Since the government has a chronic problem of spending more that it takes in (does that happen?), it’s no surprise that they both tax AND borrow.  In fact, most of the taxes go to pay the interest on the debt.  But no matter how you slice it, the productivity of the people pays the bill.

When Uncle Sam borrows, he writes IOU’s called bonds and sells them in the open market.  Uncle Sam’s bonds are called Treasuries and, at least up until recently, Treasuries have been considered the safest debt you can buy.  After all, they’re backed up by the “full faith and credit of the U.S. Government”, which is really an euphemism to say “the full power and authority of the I.R.S. to tax the earnings of the most productive people on the planet”.

Do you feel any temptation to talk politics?  Stay calm.  Keep your arms and ammunition in the vehicle until the ride comes to a full and complete stop.

So who buys Uncle Sam’s IOU’s?  Lots of people.  Private investors, banks and foreign governments to name a few.  Over the last several years, China has purchased trillions and is now the largest single foreign holder of U.S. debt.  Recently, there’s been another big buyer whom we’ll talk about momentarily.  But for now, let’s talk…

Interest Rates

If you’re already bored reading all this, just think about how important interest rates are to you.  From your savings account, to your mortgage, to your credit cards, to your car loans and all your investment properties, interest rates affect what you earn and what you pay.  More importantly, interest rates are at the heart of the great debt ceiling debate and the motivation behind much of the Fed’s monetary policy.  So stick with us, even if you’re not sure how the Fed’s policies affect you.  You’ll know before this is over.

Interest rates are the price the lender charges for the risk of making the loan.  That’s why if you have bad credit or bad collateral, the rates are higher.  Common sense, right?

But interest rates are also a function of supply and demand.  This means that when there’s lots of money to lend, but not too many borrowers, rates are low.  The lender lowers the price to entice you to borrow.  Low rates encourages borrowing.  High rates encourages saving.  Think about that one.  But not for too long, because we need to move on.

Conversely, if a borrower wants ( really needs, is desperate, etc.) to borrow, he may have to offer a higher interest rate to attract a lender’s money.  In other words, if there’s a big demand for loans, but not many lenders willing to lend, the interest rate a borrower must offer to a lender will rise until someone wants to buy the debt (make the loan). So far so good?

The Bond Market

Remember: Bonds are debt.  So when someone buys a bond, they are effectively lending to the bond issuer.  So when Uncle Sam wants to borrow, he goes into the open market to sell bonds.  This is elementary to some of our audience, but less so to others, so in keeping with our “no investor left behind” mantra, we wanted to make that clear before moving forward.

Now, let’s talk about that other big bond (debt) buyer we mentioned earlier: The Federal Reserve or “The Fed”.  That’s the private (as in, not Federal) network of international banks (that is, not U.S.) whose leader is  appointed (that is, not elected).  How accountable is the Fed to the United States citizenry?  You don’t want to know.  Let’s just say, not very.

Contrary to popular myth, the Fed does NOT set interest rates – at least not directly for things like Treasury Bonds.  The interest rates the Fed sets are the rates at which the banks do business with each other. There’s two: the discount rate (what banks pay when they borrow from the Fed) and the federal funds rate (the rates banks pay when they borrow from each other).  We’re not going to talk about those now because they have nothing to do with the debt ceiling or Treasuries. Well, that’s not entirely true, since Treasuries are competing with banks for the savings of all the “A” students who produce more than the consume and save the excess.  So if the Fed wants Treasury rates low, the banks better be low too, or people would put their money in FDIC insured savings accounts.

Hmmm….there seems to be a relationship between the Fed, the banks and the bond market.  This would be a fun topic to explore, but we’ll leave that to you for extra credit.  For now, we just don’t want you to confuse the rates the Fed sets directly (the Discount Rate and the Federal Funds rate) with how yields (interest rates) are established in the open market where bonds are sold.

Summary of Key Points

  • Money gets into the system when the Fed purchases U.S. Treasury Bonds
  • Interest are determined in the open market by supply, demand and risk versus reward
  • Private investors, including the Fed, purchase U.S. Treasury Bonds, effectively lending to Uncle Sam
  • U.S. Treasuries are considered the safest of all all debt (so far) and are the basis for virtually all other bond offerings, with higher risk investments paying higher interest rates

In our next scintillating article in this series, we’ll discuss the mechanics of how the Fed affects interest rates on Treasury Bonds and why you should care. Don’t miss it!