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An Exchange of Opinions # 30 Low Interest: What’s Next? – By Klarise Yahya, Commercial Loan Broker, DRE: 0095710 MLO: 249261

Posted on 15. Sep, 2012 by in all, Magazine Articles

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If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book Stairway to Wealth available at LuLu.com.

What we might face: The Wall Street Journal recently published an article by Allan H. Meltzer. Meltzer is a professor of political economy at Carnegie Mellon University’s Tepper School, a visiting fellow at the Hoover Institution, and author of A History of the Federal Reserve, so he may know something. His thesis is that low interest rates cause subsequently high inflation rates.  Here’s what he says about current low interest rates: Market interest rates on all maturities of government bonds are the lowest since the founding of the republic.
Notice that he doesn’t say they’re the lowest since, oh, the first of the year. He doesn’t say they’re the lowest since the Depression. He states boldly that they are the lowest since the founding of the republic. That sounds like it could be important. If we’re that low, is it possible that subsequent inflation may grow to be the highest since the founding of the republic? And what level of interest rates would it take to cure historically high inflation?

Here’s a Meltzer quote that illustrates the larger point of his article:  (The Fed) will wait until after . . . inflation is upon us before it does anything to stop it. The Fed’s view is that by raising interest rates enough, it can stop any inflation. True, but not entirely relevant. Will the politicians, the public, business and labor accept the necessary level of interest rates? Much history says: ˜Don’t count on it.’

The Professor argues that low interest rates will be inflationary, and uber-low rates will be uber-inflationary. Actually, if we read his last two sentences carefully it’s obvious that he foresees inflation of historic proportions. The highest inflation rate the United States has experienced since 1914 was 13.58% in 1980 (InflationData.com), whereas the highest interest rate (based on the 10 year U.S. Treasury note) was about 15% in 1982. We immediately observe a couple of points: (a) to cure high inflation the interest rate must be greater than the inflation rate, and (b) the highest interest rate seems to happen (at least on this occasion) about two years after inflation peaks.
Professor Meltzer asks, Will the politicians, the public, business and labor accept the necessary level of interest rates (to stop inflation)? Last time interest rates had to go to 15% (10 yr T-note), and this time Meltzer suggests that inflation will be so high that the interest rate cure will be unacceptable to the market (˜Don’t count on it.’).
It doesn’t get much clearer than that. Professor Meltzer expects inflation rates to climb north of 13%, to climb high enough that the necessary curative of interest-rates-higher-than-inflation will not be acceptable to politicians, public, business, and labor. Scary, huh?

What To Do About It
We’ve talked about this before, at least from a purchase perspective. When interest rates are really high (and “ teeter totter “ prices are really low), wait to buy until the Fed announces that they’re going to bring down rates. You know that as rates go down, values go up. So when the Fed announces that rates will begin to go down . . . start buying with both hands. Ride the train up the mountain. Have a piece of chocolate.
What we haven’t discussed in any depth is what we should do between now and whenever interest rates peak. You know, preparation. Well, the best suggestion I can make right now is to triage our investments by the stream of income method. Our goal is to identify which of our investments may be salvageable.
Types of Investments
Investments come in at least three forms:

¢    No stream of income. There are no rents, dividends, or interest payments. Our gain comes only from appreciation (if any). Think gold or non-dividend stocks.
¢    A fixed stream of income. Think bonds.
¢    A variable stream of income. Think investment real estate or dividend stocks.

No Income
Especially in an inflationary environment, the price of an investment that doesn’t provide a solid stream of income is subject to, ahh, fluctuation. If the public is convinced that somehow the value of a non-dividend stock (for example) will go up faster than inflation then the price may appreciate nicely. But that could be a hard sell. In most cases the investing public may see that the non-dividend investment may not keep up with inflation. I mean, if inflation is 8% then the non-dividend stock has to appreciate a similar 8% just to keep up with inflation. Is the price of a non-dividend stock likely to match (or exceed) inflation? What makes you think so? If it doesn’t, the value of a non-income investment may plummet. For example, in 1980 gold reached $615, a level it did not return to until 2007 (no adjustment for inflation) (http://www.nma.org/pdf/gold/his_gold_prices.pdf). In that same period the S&P 500 Index, with dividends reinvested, rose 2617% (again, no adjustment for inflation).

Let’s put this into perspective: if you put $10,000 in gold in 1980 you would have been underwater for twenty-seven years. However, if you put the $10,000 into the S&P 500 (dividends reinvested) it would have turned into $262,000. (http://dqydj.net/sp-500-return-calculator/)
Memo to self:  don’t buy something that lacks a stream of income and call it an investment. ‘s not. ‘s probably a disaster-in-training.

Fixed Income
Bonds, like mortgages, have both a lending side and a borrowing side. If you’re a lender when rates go up you’re going to take a sizeable haircut to your principal if you have to sell before the bond or mortgage is paid off (rates go up, value goes down). But it doesn’t work that way if you’re on the borrowing side. If you’re the borrower on a fixed rate low interest mortgage, you’d absolutely yearn for high inflation because then you’d be the one who benefits.  Your payments are fixed, but you make your loan payments with inflated dollars.

Imagine that you bought a building just a block away from yours, but much nicer. ‘s a low interest rate environment, so we know we’ll pay heavily for the building, but we don’t care. ‘s pretty. We understand that as interest rates drift up over time we’ll probably see erosion in the building’s value. We know all that, but it still could “ possibly “ be a satisfactory purchase. That’s because the rule as rates go up, values goes down applies to your mortgage, too. As mortgage rates go up, both the (a) market value of your mortgage and (b) monthly payment in constant dollars goes down.
Disregarding the occasional outlier experience, rising rates will likely be associated with increasing inflation. Right now I can’t think of a likely scenario where rates go up but inflation doesn’t. Once again, it’s not in lockstep. But over time there should be some relationship. Rising rates may permit us to profit on our low-interest mortgage as long as we have transferred the risk of inflation to the lender. This happens when we fix the interest rate. We can fix a loan for varying periods, but to maximally benefit from rising rates we must have as long a fixed rate period as possible. The reason we need to be fixed, in a non-veterinary sense, is that we want to be able to pay off the loan with fewer current dollars (dollars adjusted for inflation) than are shown on our mortgage statement. We’ll see how this might happen in a moment.

Exaggerated example: Imagine we have a $1,000,000 mortgage at 4% fixed for the next seven years, and then it turns adjustable. One month after your new loan closes interest rates shoot to 8% but you don’t care, you’ve locked the bank at 4%.
Sadly, the bank can’t raise your payments. Once your loan has funded, the bank has to honor the terms. If that means 7 years at 4% when inflation is twice that, that’s what has to happen.  So, basically, under this scenario you’re paying off your mortgage with 50 cent coins. And that will continue as long as your fixed rate period lasts. This happens because you managed to transfer the risk of inflation to the bank. If you were in the adjustable period, the bank would have transferred the risk of inflation back to you by increasing your interest rate to offset inflation. There goes your 50 cent dollars.

A low rate refi cannot happen if you wait and wait and permit your mortgage to slip into its adjustable period because interest rates will have gone up with the market. But if you game the system (in a good way!) you could prosper mightily. Since we don’t know when rates might pop up again, we probably should do an immediate refinance just to lock in present low rates.

Variable Income
Apartments, right? You buy a stream of net rental income and expect that it’ll at least be able to keep up with inflation. That’s one of the best reasons to buy units: the probability of at least maintaining your cash flow on an after-inflation basis, so you strive to keep your rents adjusted with inflation.
But how about the value of the apartment building itself? You already know the answer. If inflation cuts the value of the dollar by half, it’s pretty likely that the price of your building will double. Inflation raises the value of most hard assets, including real estate, almost automatically. That’s a good thing. Take away:

1.    Look closely at your assets.  If there are payments involved, you are either the lender or the borrower.
2.    Put the ones where you are the lender in one pile. These might include loans you’ve made to family members, all insurance policies and bonds held in your portfolio.With some of these there is nothing you can do: you made a fixed rate loan and you’re stuck, just like the bank would be if you borrowed on a fixed rate from them. With others you may be able to transfer the risk of inflation to the other guy. Offer to reduce the interest rate on the loan you made to your brother-in-law if he’ll agree to make it variable. See if it would be cost effective for your insurance policies to acquire inflation riders. Think about selling medium and long term bonds and moving the proceeds into short term equivalents. In every case you’ll probably wind up with increased (future) inflation protection in exchange for less (current) income.
3.    Put the assets where you’re the borrower in another pile. Examples would be all the loans you are responsible for, including every loan on your apartment buildings.
4.    Now divide the I’m the borrower pile into two stacks: (a) fixed rate loans and (b) loans that either (01) have a balloon at the end or (02) flip to an adjustable rate.

Loans that are fully amortized at a fixed rate are what you want. Don’t do anything with that pile. Take a sip of tea and gloat. When you’ve gloated enough, go back to stack two.
Loans that have a balloon at the end are not the end of the world. If rates are as low in the future as they are now “ and values don’t drop any further “ you should be fine. When the time comes, you’ll just refi at whatever modest rate is current then.
Loans that change, in the near future, to an adjustable rate are what you do not want. You’ll cruise along making favorable payments for the next couple of years “ if Professor Meltzer is right “ while interest rates climb. Then the loan changes to adjustable and you’re gobsmacked. Even if you refi then, the window won’t be as favorable. You’ll have squandered the low rate opportunity. Those adjustable rate loans are the ones that you should consider refinancing now, while rates are still remarkably favorable. Refi with as long a fixed-rate period as possible, even if you have to pay a surcharge for the longer fixed period. If you had a seven year fixed period (example) it would be close to 2020 before you had to refi again, and “ hopefully “ we’ll be over the hump then and rates may be starting back down. ‘s not a perfect solution, but it’s probably the best we can do.  Don’t blow it.

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email KlariseYahya@SBCGlobal.net.