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!