The Problems are the Path: Investors are Almost Alway Wrong on the FED

Investors, home buyers, and agents are convinced the FED will lower rates later this year. However, their record is not that great!

Whether the investor is a Wall Street Titan, a Commercial Real Estate Investor or Speculator or an individual investor in stocks and bonds or real estate, they have been caught offside in both directions while making their decisions on the Path of Interest Rates over the past years.

Let's take the commercial bets on office buildings.  No one expected a major shift in employees working from home as a result of the Pandemic. The shift created massive vacancies in office buildings across the United States and major world centers.  Office building owners felt it wise to take additional loans on properties before the pandemic, planning to refinance at lower rates in the future.  It did not work out well for them.  The FED raised rates to combat inflation and vacancies created a fall in income that put properties at risk.  Offices were not the only victims of improper planning on interest rates and the FED. Apartment owners expected rates to remain low or go lower and also borrowed. Speculators saw great opportunities in remodeling and renting out new apartments or home at higher rents or resale prices with *Due On completion loans.  The loans were cheap.  Unfortunately, when the loans came due the rollover rates were not cheap.

*Due On clause in loans on real estate are what lenders put in to get their money back.  In residential properties the Due On Clauses have been mitigated by legislation.  Not so in Commercial Loans.  If a commercial borrower remodeled or developed a property with a construction loan or some variation of it.  They have a Due On Clause that states once occupancy or completion permits are issued by Planning Departments the Loan is Due and Payable.  Some loans may have a rollover clause to a new loan at market rates.  Other loans will have a repayment demand within a specific time frame. 

The FED has not complied to the plans of lower rates.  While the forecasters claimed a cut in rates in March 2024, maybe 3 rate cuts for 2024, no 7 rate cuts. The FED said NO.  The FED also indicated that rates may remain up for well after March 2024.

On a daily or weekly basis reports do not indicate a softer economy.  It is becoming evident that the savings of Americans have created a cushion that allows growth to continue at a steady pace.  Home owners have refinanced their mortgages at sub 4% rates, put more into cash savings instruments and accounts. That has created a resistance to the thought of selling and moving. The result is no resale of existing homes. Inventories of homes for sale are at historic lows.

Wall Street made bets in the future markets that rates would drop.  Mr. Powell said, not yet and maybe not so soon as you thought.  So now those waggers on lower rates have shifted to May 2024.  At some point those waggers unwind and rates move up and bonds sell off.

The economy keeps moving along as the employment numbers were above expectations and another blockbuster for the economy moving forward. Moving forward with the economy is INFLATION.  The Federal Reserve Bank of Atlanta has now forecasted inflation for the first quarter of 2024 at 3.4%  This is no where near the FED target of 2%.  Rates will remain higher for longer than expected all pointing out the inability to forecast.

Near the end of 2023 and the early days of 2024 a decline in rates from the high of 2023 unleashed a wave of borrowing by highly rated U.S. companies with issuance of debt at near records for 2024. That does not bode well for the belief of lower rates in the future.  The "in the know" U.S. Corporations are borrowing at the present higher rates.  They must foresee higher rates in future than lower rates.

While U.S. Corporations are borrowing the Banks are not.  The recent survey by the FED of loan officers show fewer banks are tempering their willingness to lend.

The U.S. budget deficit is increasing.  The increasing deficit is financed by U.S. borrowing and issuing new debt.  The debt has higher interest rates. The higher interest rates keep rate on all loan high.  The increase in debt and higher rates create a larger Federal deficit.  High interest rates feed on themself.

What is at stake?

The prospect of higher rates for a longer period than expected could upend the Bond Market.  The decline in the Bond Market will create higher yields, with the higher yields will come a decline in the stock market as investors are willing to take on secure returns and sell their stock positions and speculative investments which pay capital gains.  More and more commentators are questioning the value of stocks and whether the advance has gone beyond fundamentals into risky bets based upon concepts of technology developments yet to be proven in growth and earnings.

The prospect of higher rates will create issues on valuations in the home residential market.  Higher mortgage rates will put first time home buyers back into rentals or back to Mom and Dad.

The Biggest Risk is the Bond Market!

As time passes and rates remain high debt will have to be refinanced. If the financing rates are too high for the the party needing to pay off the debt, the only recourse is to sell the underlying asset.  Should a Bond Market sell off occur, more assets will be discounted.  New Housing Developments will sell off their inventory and fail to take on new projects in face of high rates.  There will be some buyers in real estate who will take on property in discounted markets, even if rates are high to finance their purchases.

The risk that lies ahead is for the highly leveraged private equity, commercial real estate or lenders as regional banks. This could end up being a slow burn as as delinquencies mount, notice of defaults become more common and with that Foreclosures.



The Problems are the Path: History Repeats in Interest Rates

REMEMBER!  Lenders and owners are Diametrically Opposed!  This Adversarial Relationship stems from GREED, an entrepreneurial trait which brings both parties together.

From the 1960's forward, Legislatures and Judiciary parts of our government have worked to protect lenders from the abuses that created an uneven playing field that favored lenders. (Residential)

The most important legislation came from California in the "Anti-deficiency legislation of the 1930's.

Rising inflation during the 1960's produced a severe real estate recession in 1965-67.  This occurred while the economy improved due to employment from the war effort of Viet Nam. 

1963-64 Boom Led To The Savings and Loan Crisis.  

Lenders viewed excess money on deposit as wheat to be harvested.  Money was lent quickly and deals where chased aggressively.  Brokers were in control, rates were below 7% and deals were taken on without regard to risk as inflation was low. 

The result was excess Real Estate inventory.  To save themselves Savings and Loan and Small Bank mergers created larger firms with the same insolvent inventory.  

In 1965 Interest Rates Increased!  Money Supply Tightened! Availability of funds decreased and inflation soared!

Savings and Loans who provided most of mortgages were caught in a vice.  The cost of funds, deposit interest, increased over the Fixed Rate Mortgages income of mortgages held.   A quarter of the Savings and Loans in California were in Financial Trouble.  Added to that risk the developments financed by the Savings and Loans could not sell new homes without mortgage funds and qualified investors.  Foreclosures came in by the thousands and a new term for the Balance Sheet of Banks became known as REO, Real Estate Owned.

To avoid "Due on Sale" covenants of mortgages All Inclusive Trust Deeds or wrap mortgages were formed using Land Sale Contracts so the new buyer assumed the old lower mortgage rate.  Variable rate or Adjustable Rate mortgages became popular.  Land Sale Contracts, Carry Back Financing all were used to bypass the "Due On Sale" clause of mortgages.

While Wall Street and Owners got creative, the Federal Reserve still tried to stop the inflation from the boom in real estate prices.  By the time the FED rates hit 14.5% the Real Estate Bubble had busted and with it Savings and Loans!  Resolution Trust Company liquidated Savings and Loans REO properties at wholesale prices.  Home owners were evicted as the recession was more in line with a depression with loss of jobs and income to support their homes or real estate Speculation.  The recession was not kind to other assets, the Stock and Bond Market collapsed.  Only Gold became a Store of Value.  

The Next Cycle: Millenium Boom

Legislation was passed, interest rates declined and the stock market and bond market rallied from a severely depressed level.  But still Foreclosures increased eightfold in the early 1990's.  The economy righted itself, jobs and income increased.  The dramatic increase is asset values and the return to work created another cycle of inflation.

In 1998 the Federal Reserve once again began rising interest rates to induce a recession.  By FED action and legislation real estate prices froze on their highs without having a chance of adjustment.  On September 11, 2001 the FED opened the Floodgates controlling the flow on money into mortgages.  The FED bought treasuries and loaned money for mortgages.  This added large amounts of cash to the Money Supply.  The seeds of the MILLENNIUM BOOM began to sprout.  

During the same period the U.S. Treasury and Congress deregulated mortgage lenders and Wall Street Bankers.  This removed the safe fundamental lending practices for safe mortgage lending.  Wall Street bypassed the FED and created MBB, mortgage backed bonds and no longer looked to the FED to create money supply.  Wall Street took over with no oversight!

Congress got into the game by 2005.  The legislature had succeeded in removing what few restraints remained on mortgage lending by withdrawing bankruptcy court authority to help insolvent and over mortgaged homeowners.  

This was the Final Straw following 25 years of loosening controls over Wall Street's involvement in the mortgage industry.  By 2007 mortgage borrowers began defaulting en masse!  Almost overnight the Millennial Boom became the Great Recession!  It left 40% of California's 6.5 million homeowners with Negative Equity!  Another foreclosure Crisis was created!

The Next Cycle: Today

Back From the Bottom again, the FED fed money by buying MBB to keep funds flowing into mortgages, government subsidies in the form of tax credits to home buyers were issued.  Dodd Frank Act and the creation of the Consumer Financial Protection Bureau were created to help homeowners.

Then came the pandemic and the FED and Government increased the flow of funds into the economy to the tune of a FED Balance Sheet of over $9 trillion dollars!  A double in the size of the FED's Balance Sheet which had already doubled from past historic averages.  

The Pandemic ended and Americans found themselves with savings and cash reserves from being home bound and splurged, inflation was fed and the FED just watched.

When the FED acted by raising rates rates went to a +20 year high.  The economy was resilient just as in the past.  Stock prices boomed again, but only in a select group of technology stocks, the Mighty Seven led the run.  Last half of 2023 Wall Street pumped the public with forecasts of interest rates cuts in March of 2024 and possibly 7 in total for 2024.  The stock market went to a new high on the promise of lower rates.  Lower rates that did not come.  January 31, 2024 the FED said no rate cuts coming and none for March 2024.

How long will high rates continue?  Will high rates create the repetition of the past 60 years?

As Yogi Berra was supposed to have said, "It's Deja Vu All Over Again"?

In the past 60+ years there was never a Soft Landing.  Crashes were the norm.  

The past does give some guidance as commercial property now seems to be the area of concern.  Watch for Commercial sales when owners are Private Equity Groups who purchased property in 2019-2021.  The loans given were basically construction loans created in the form of mezzanine loans.  These loan give lenders the rent and income flow when in default.  The Due On Clause is valid in Commercial Loans where they are not in Residential Home Loans.  Generally speaking the Due On Clause is exercised when the commercial units are given building permit releases of their construction permits.  At that time the loans must be renegotiated to current market rates or properties must be sold. The refi efforts are the main benefit for new buyers as the refinance rates are +10%.  Owners must sell or be faced with high interest rates that may not be able to be covered by rental income.  Junk Bond rates for CCC rated corporations are 13.5%,

This the the Opportunity Area for investors.

Signs of lowering rates or a repeat of the past

1. Credit Card Debt as historic high with defaults

2. Luxury Rental Market declines: Austin Texas down 20%, Chicago giving free month(s) rent.

3.  December 2023 inflation numbers lower than expected.

To counter the signs of a slowdown the Federal Reserve of Atlanta has forecasted a 3.4% inflation rate for the first quarter of 2024, wll above the 2% FED target.  Rate will remain high until signs indicate a FED forecast of 2% inflation rates.  What lies ahead?  Bond market crash, stock market crash?

History Repeats Itself?


As before, call or write for any question you may have and think of me of your "in the know real estate professional".



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