Below is a chart of the interest rate on the 10 year going back to 1880. As we all know the 10 year is a reasonable benchmark for mortgage rates. In other words, or what matters to investors, the 10 year determines how much your monthly payment will be to the bank (consistent on a fixed rate, fluctuating on an adjustable rate). I'll list my key take aways below the chart and I'd love to hear the BP communities thoughts on the chart as it pertains to current day REI strategy and future RE prices. My take aways and questions I ask myself... 1. Bull and bear markets in the 10 year normally last around 30 years. 2. Interest rates have been going down since 1981. Since lower interest rates decreases monthly payments (which increases purchasing power, which increases the price of home affordable, which increases home prices), has the rise in home prices since 1981 been exclusively a result of lower interest rates? What happens to home prices if we go into a 30 year bear market (interest rates go up) in the 10 year? 3. Massive increase in volatility since going off the gold standard in 1971. How could that volatility affect the debt in a real estate portfolio? 4. The US national debt is 19 trillion. The average interest rate on that 19 trillion is approximately 2% making annual debt payments around 400 billion (interest only). If rates just went to 4% (still very low historically) the annual interest payments would rise to 800 billion. If the government has 400 billion less to spend into the economy how does that affect overall consumer spending and how does that trickle down to home affordability and prices? Taking it a step further what happens to the debt payments if the 10 year enters a 30 year bear market (interest rates going up). At 15%, where we were in 1981, 100% of tax revenue would go to pay the interest on the debt...how would that affect real estate prices? 5. How much of consumer spending/economic activity is based on credit? If interest rates go up, consumers have higher monthly payments on their credit cards, this will decrease spending. If the US economy is 70% consumer spending how does a long term reduction in that spending affect real estate prices? 6. Taking it a step further...interest is the cost of money and money is one half of every single transaction. If the interest or the cost of money increases steadily over the next 5 years, 10 years, 30 years how will that affect everything sold in the economy and/or real estate? 7. If interest rates rise corporate profits decrease because debt payments consume a higher percentage of profits. If overall profits decrease that will put massive downward pressure on stocks? What does that do to 401k's? If people have far less money to retire, due to corporate profits decreasing, does that affect spending? If so, how does that affect RE? 8. Finally, fixed rate debt seems incredibly prudent. Any deal with a ballon payment must include an extremely conservative amount of equity. There's a much higher than average risk that inflation adjusted real estate prices will be lower in the future. 9. Negative real interest rates are the only solution for the government and the economy. If the federal reserve can pull that off, what does that look like, and how should my RE portfolio be structured to prepare and hopefully take advantage of it? I could go on but I'd like to hear what other people think about the chart above. George

George, You're talking about something that has a very low chance of occurrence IMO. In general, higher interest rate is typically a result of an overheating economy. The cap rate tends to get compressed towards the end of the housing cycle. If history is any indication, higher interest rate = higher home prices. Can you show me a period in history where interest rate went up and RE prices went down? Off the top of my head, this is how CA real estate had performed in the past 1970-1980, interest rate went from 7% - 18%, RE prices tripled 1980 - 1990, interest rate went from 18% - 10%, RE prices doubled 1990 - 2000, interest rate went from 10% - 8%, RE prices upped 25% 2000 - 2010, interest rate went from 8% - 4.5%, RE prices upped 25% 2010 - 2020, interest goes from 4.5% - ???, RE prices ????? QE has ended for almost 1.5 years now? Why did mortgage interest rate remain relative flat? Did QE have that much of an impact on interest rate? Balloon or not ballon is not really relevant. First Republic Bank is offering 5/1 ARM with a 10 year ballon, which should be long enough for people to ride through a full housing cycle. Chase is offering 5/1 ARM loans with 30 year amortization and NO BALLOON. Once you understand how to hedge your bet, you will understand that fixed mortgages come at a premium price. Worth it or not? Who are the ones getting 30-year fixed? Do you want to be part of the fixed mortgage herd, or would you like to join the 1% and understand how to use ARM loans to your advantage? I don't know if you will buy this theory. If the Great Recession 2009 is similar to the Great Depression 1929, does this mean there's a chance that interest rate may keep trending down until 2021? Is it possible for the 10-year treasury to drop to 1% and 30-year fixed mortgage rate to drop to 2.75% during the next recession? Your guess is as good as mine.

George, No worry. I don't really care what others have to say about me. I'm comfortable in my own skin. Had I found your post condescending, I would have ignored it rather than responded to it. No sweat. To me, real vs. nominal are used more often by economists rather than the average Joe. How often do you hear people on BP using real vs. nominal prices? Thus, I believe the average investor looks at nominal not real prices. I would presume that 1.75% compound annual appreciation is above the real (inflation adjusted)? If that's the case, my theory panned out as I explained to you in our off-line email @David Faulkner. That's why I love Bay Area real estate. :>) You're doing things right by buying with a margin of safety, and every property can carry his own weight. My partner and I are doing the same in our inflated market so our thinking is aligned there. With respect to 500 bp absorption rate, it means if we're currently borrowing at 3% on a 5/1 ARM and interest rate shoots up to 8% in year 6 and beyond, we should be able to service our debt without any issues. Anything higher than 8%, we will have negative cash-flow and bring cash-in to refinance. With respect to getting any terms we want on a commercial loan, the longer the terms, the higher the interest rate. It's about risk/reward to you and the bank. I've learned things about commercial loans, which are so out of the norm, that only @J. Martin would understand since he's a bank regulator and have seen those files, and of course the players who play in this arena would. I've shared some of the details of how I structure my loans with @Jeff Pollack over lunch earlier in the week. I believe he was fascinated by it. The delta between a recourse and non-recourse loan is 10 bp so you have the option to limit your downside risk in case SHTF. I know some BP members on here think I leverage to the hilt based on my posts, but I'm at 45% LTV in my entire portfolio and looking to reduce it to 30%. One half of my portfolio has 30-year fixed so I'm not a gambler as I appear to be. David, I was a little off when I told you roughly 48% LTV the other day. :>) Economics is quite fascinating to me, and I'm glad that J found it fascinating as well. If we ever sit down to talk, I believe we have more commons than you think. I started study the housing data since 1999 and have watched my market on the sidelines since then. That was the reason I went all-in in 2009 when the data suggested that my market had over-corrected. It's funny I told my ex-boss back in early 2000's that I wanted to retire by 40 and not sure how I was going to accomplish it, but I got there with real estate in one of the most expensive markets in America. Along the way, I was able to help one of my partners to retire at 40 in Brazil with his then 33 years old wife. Now, if I can get my wife off her W2 by 44, that'd be quite an accomplishment. I'm hoping to net $30-$35k/month by the end of next year and $50k by the end of 2018. Then we will spend more time doing charity work rather than being on BP. Enjoy your weekend everyone.

George, You post reminds me of people on Zerohedge. I gave up debating on this inflation/deflation/stagflation topic a while ago. I've been making my bets based on my data, and I suggest others do the same. The end results will show if you have been correct with your data interpretation. As @J. Martinand a few other local BP members have seen, I've been fortunate enough to have been right on a series of predictions. To address some of the points above, commercial loans are negotiable. You can have whatever terms you want. You take the terms that fit your situation and live with the consequences. My partner and I stress-tested our model, and we could absorb 450-500 bps interest rate increase. In fact, J Martin asked me about this same topic a while ago, and that was my response. With respect to QE, people on Zerohedge were yelling and screaming interest rates would rise once QE is over. I argued otherwise and luckily have been correct.....so far. @Johnson H.reminded me of this conversation a while ago. It's nice to have people comeback and tell you year after year how your predictions came to fruition. All I can say is I have been on a lucky streak. Your interest rate chart doesn't look like a 30-year cycle to me. It's a much longer cycle if you compared peak to peak or trough to trough, but I believe I understand your 30-year cycle is peak to trough or vice versa. IMO, there's no repeated patterns in your chart to make any kind of reliable prediction. Let me ask you this question again. What do you think would make short and long-term interest rates go up now? Do you think 30-year fixed mortgage rate will go up after the Fed raised short-term interest rate to 1%? How about 1.5%? I'm banking on the Fed raising short-term interest rate to 1.5% by the end of next year, and that may be proved to be a little aggressive, but what the heck do I know? Your guess is as good as mine. It makes total sense for cap rate to get compressed now because we're approaching the top of the housing cycle. Common sense would suggest that higher interest rate = lower home value. Unfortunately, that's not what history has shown. That was why I asked you for a period where home prices went down while interest rate went up. The Fed tends to be reactive rather proactive. They have been proven over and over again that they're always behind the curve. Real and nominal are good for comparison, but an average Joe buying a house in 1972 for $17k, which is now worth $650k, doesn't care whether it's real but rather nominal dollar. I'm willing to bet that we would not see home prices drop back down to 120 on inflation adjusted basis in the next decade. In fact, I wouldn't be surprised if we don't see home prices drop to 120 on inflation adjusted basis in our lifetime, and I have my theory on that too. J, it'll cost you lunch if you want to hear it. :>) With respect to bigger homes, how about smaller lot or zero lot for newer homes? Should we use dollar per sq. ft for comparison purposes? Where do we draw the line? Let me ask you this question. How many indicators do you use to come to a decision it's time to buy or sell real estate? How many indicators do you use to say if you should leverage or not? I've openly shared my point of view at meet-ups as well as the details of my acquisitions at meet-ups. People seem amazed that investing in the Bay Area is possible and can be so lucrative. It goes back to the saying "it seems impossible until it's done." Here's a chart for CA real estate appreciation in the last 42 years.

@J. Martin Account Closed Minh, Let me start by making it very clear I'm not arguing that we'll see inflation, deflation or stagflation. I'm arguing that we as investors need to understand the economic environment we live in and maybe more importantly, the history of our economy. As we all know, "those who do not learn history are doomed to repeat it." After reading my last post I must apologize. In my concluding couple of paragraphs I used the word "you" a lot. I didn't mean you (Minh) directly, I meant "you" in broad, general terms, meaning the average investor. I think that came off as me being condescending and that wasn't the intention. Writing is in no way a strength of mine and I haven't yet figured out how to edit these posts... ;) 1. Regarding zero hedge. I've heard of it but never read any of their posts...maybe I should? And I respect your decision to make bets based on the interpretation of data. The point I'd like to make to the general reader is be smart about interpreting data. Most investors read book after book on real estate investing that focus on the micro. While this is extremely important, macro, at times, can be equally as important (i.e. 2009 crash). Minh, I think we'd both agree on this. Therefore, I'd encourage the general investor to read a macro book for every micro book you read. If you read a Gary Keller book make the next book Keynes, if you read a Robert Kiyosaki book make the next book Hayek. You, the general investor, will be no worse off as a result. 2. If you can get whatever terms you want I need to switch banks or hire you as my negotiator! ;) When you say your portfolio can handle a max of 500 basis point increase it confuses me. Maybe I'm just not understanding something, and if I am please help me understand, but I can't imagine risking my entire portfolio, if rates go back to their historic norms, to gain a couple extra points of interest per year? Why wouldn't you fix the rate and eliminate the risk of totally loss? The risk/reward just doesn't make sense to me? Again, maybe I'm not fully understanding your capital structure? 3. Charts are subjective to a degree. Here's another chart that might illustrate my point better. Please notice the time frames the chartist for CNBC pointed out. 4. To answer your questions on where I think interest rates will be at the end of the year...I have no clue. I can give you a compelling argument for both higher and lower. But what I can say with 100% confidence is there's more credit in the system than there was in 2007 relative to GDP. Therefore my personal priority is capital preservation/reducing as much risk as possible. 5. I'm not sure I follow your logic on home prices never going down as interest rates have gone up? It's obvious, based on the crash in 2009 that home prices go down as a result of interest rates rising. If you're saying interest rates rise after or during home prices going up I'd agree, but then you're left guessing at what point will the fed funds rates get high enough to prick the bubble? .5%? 1.5%? 5%? To me that's a game of musical chairs that I'm too risk averse to play. 6. That's why the average Joe makes money only based on his degree of luck...not skill. You could very well be right on the 120 prediction. The only thing I'd predict with any degree of confidence is we'll go lower than 175. I'm happy to buy if I'm invited ;) 7. Great point on the smaller lot size. I'm not sure where to draw the line? Although I firmly believe it must include real and nominal prices. How many indicators do I use to buy or sell or to determine how much leverage to use? Now this is a good question and one that I've never thought about. Let me write down the detailed process I actually used and then analyze it to try to answer your question and hopefully give the general investors some ideas. I started real estate investing in 2012 after retiring from a career as an entrepreneur, I knew nothing about RE. In 2010 I started to study economics as a hobby, as I had more free time I studied it more. The more I studied macro the more I realized I didn't want my all my money in a bank. I studied all asset classes and RE was a no brainer. Once I decided I needed to diversify with some RE I started to study current prices (remember this was 2012), I noticed that they were getting very close to the historic inflation adjusted trend line. I saw that RE prices always seemed to revert to a mean which made sense to me because if people spend a consistent percentage of their income on a mortgage payment, home prices should stay consistent with real wage growth and population. And if home prices go up based on another factor that's unsustainable, such as credit growth, the prices will at some point revert back to the mean. All of these data made me come to the conclusion that now (2012) was potentially a prudent time to buy. I then took it a step further. Because the extreme nature of the US credit crisis I wanted to juxtapose my US data with Japans data going back to their credit crisis in 1989. I was trying to get a rough idea as the max probable downside for US home prices. I found that Japans market, at it's worse, had declined 10% more than ours had currently declined (from their respective high water marks). Based on the fact that prices were at their historic mean and Japan had only declined 10% more, I made the decision that 2012 was good time to buy considering the risk/reward. Next, I started to focus on the micro that most investors are familiar with. I wanted to buy distressed properties and rehab them A. to build equity B. cushion my principle from the market declining further C. be all in for 70% of the ARV so I could extract 100% of my principle D. be all in under the replacement cost of construction. I started looking at markets in the US. I wanted a linear market because through my research I came to the conclusion that the way you invest in RE is cash flow and building equity by adding value. The way you speculate is betting on appreciation. To me speculating is gambling dressed up in a nice suit. I have no desire to gamble with my money. That led me to Kansas City where I happened to have some friends in the construction business. I went there for a few months and did all the typical micro stuff. Looking at school districts, neighborhoods, population migration, local preference of house layouts etc. High yielding C and D areas had no appeal whatsoever because through time the home prices tend to lag inflation and I wanted a good store of value. I limited my selection to A and B areas. Finally, I took all the capital that I'd allocated to RE and bought your typical foreclosure props, tax deed props and a couple short sales (paid cash). I rehabbed them, rented them out and flipped a few. In total I bought about 15 SFH's and an office building. So how many indicators did I use? probably about a thousand...;) How many indicators did I use to determine leverage? 1...inflation/deflation. I had no clue back then and I have no clue now, so if I use debt, I make sure I have an equivalent amount of cash (or highly liquid, non-correlated assets). It gives me a portfolio thats inflation/deflation net neutral. Please keep in mind this is a long term buy and hold strategy. 8. Those people shouldn't be so surprised. Seven years of zero percent interest rates can make the impossible possible in any asset class. Regarding your chart...those are nominal prices. If you adjust for inflation CA prices (based on the chart) have had a compounded annual appreciation of 1.75% per annum. Like so many Zimbabweans, I base my degree of wealth on purchasing power not the number on my bank statement, so I'm going to stick with inflation adjusted data... ;) Thanks again for the dialogue Minh, I think there's a lot of value in this thread for the average investor... George

I love this thread. Quite interesting. Let me get your opinions on this. So if we enter a period of deleveraging and deflation, the fed will most likely either employ some form of NIRP or QE? But if inflation then gets out of control, can they really raise rates substantially without blowing the national budget on interest on the debt? And in the long term is there any other way of reducing the national debt substantially other than inflating it away? Given the track record of the fed, am I wrong in concluding that the likely hood of inflation is much greater than deflation? --Steve

Adjustable Rate/Ballon Payment Crisis Ahead?

Charlie Fitzgerald

Lender · Las Vegas, NV · Member since 2015 · 2k+ posts · 1k+ votes

10y

10 year is applicable to fixed rates on conventional loans. Commercial loans, HML loans and ARMs...not so much.

1 Reply

David Roberts

Brownstown, MI · Member since 2014 · 344 posts · 98 votes

10y

I was 3 years old at the start of the bond bull market, wtf do i know about rising interest rates? Lol

2 Reply

George Gammon

OP

Flipper/Rehabber · Las Vegas, NV · Member since 2016 · 174 posts · 251 votes

10y

Originally posted by @Charlie Fitzgerald:

10 year is applicable to fixed rates on conventional loans. Commercial loans, HML loans and ARMs...not so much.

Charlie the chart looks the same for the fed funds rate. Here's a chart of the prime rate which obviously is applicable to commercial, HML and ARM's...they're all the same. I used the 10 year because most people associate that with mortgage rates. Bottom line is interest rates, in general, have been going down since 1981. Are real estate investors (including lenders) prepared, if rates do what they've done throughout history, and start going up for 30 years?

0 Reply

Chris MasonPro Member

Moderator

Lender · CA · Member since 2015 · 9k+ posts · 10k+ votes

10y

10 year tnote is fairly strongly correlated with mortgage rates. Some ARMs use it as the index basis for adjustment, too.

If I'm in a day-trading mood because I'm ignoring my own advice about day-trading (the same way most folks ignore their own advice haha), I'll look at where the 10 year tnote closed on the East Coast as a sneak peek for where rates might be tomorrow morning, and still have 3 hours left (CA time zone in a CA headquartered company, baby) to decide if I want to lock today or wait until tomorrow. This method is correct probably about 65% of the time.

To respond to the OP's concerns specifically, I'll say that the overwhelming bulk of loans we do these days for middle class families are fixed rate. Rates are still low and younger people especially (that watched their uncles/cousins/etc get foreclosed on during the recession) want their mortgages to be as BORING as humanly possible. Good for them, I get it.

Interestingly, and perhaps perplexingly, a significantly higher percentage of jumbo loans are ARMs. People buying the $2m homes are much more OK with ARMs, and are often the ones to bring them up with me. Even 1/8 to rate makes a huge difference when the debt is that large, and an ARM might be 0.5% or 0.75% or more lower at the teaser rate ("teaser rate" is what we call it internally when you pesky borrowers aren't in earshot :P ), I get it.

I'd say about 70% of the loans I do for $1m and up homes are ARMs, and probably 5% of the smaller loans I do are ARMs.

So that's where we will see it, if there's a crisis because 7 or 10 or 15 years from now all these ARMs I've been doing adjust significantly upwards: It'll be a crisis that hurts rich people way more than people of modest means. So if I'm being cynical, the fact that the pain will be concentrated among the wealthy means there will be a bail out for the wealthy that we didn't see during the recession for the middle class. (To be clear, I don't begrudge folks for their success & am in fact happy for them... but I sure as heck am cynical about our political system!)

2 Reply

George Gammon

OP

Flipper/Rehabber · Las Vegas, NV · Member since 2016 · 174 posts · 251 votes

10y

Originally posted by @David Roberts:

I was 3 years old at the start of the bond bull market, wtf do i know about rising interest rates? Lol

To your point David, probably not much if anything at all. That's what worries me and thats why I took the time to do the original post.

Just read the posts on BP. Most investors endlessly scrutinize comps, ARV's, cap rates etc. and totally ignore the most important components of our current economy...interest rates, debt super cycles and deleveraging. These are things real estate investors need to think through very carefully.

Here's a chart of total debt to GDP. Look at how much debt has had to expand to get the GDP growth we've had since 1970. What happens if debt goes back down to 150% of GDP because of deleveraging? Debt can't expand infinitely. I'm only encouraging investors to be cogazant of these things when setting up their long term portfolios or business models.

1 Reply

David Roberts

Brownstown, MI · Member since 2014 · 344 posts · 98 votes

10y

i tend to agree, although friends of mine that bought their homes with ARMs ten years ago while i bought with a fixed rate let me know how smart they are lol. You would think the rush is to the upside with ARMS these days but rates just continue to fall.

I tend to think its a good time to leverage up now while rates are low, with fixed if you can. You would think rates would have to go higher sooner than later, but who knows. If rates go higher them paying cash makes more sense than leveraging.

Ive personally gone to a flipper mentality lately given that the higher prices go, for me to cash out a higher dollar amount to get my cash back lowers cash flow and the risk is to the downside on prices, so i want to be in and out. To get the better return it seems you have to move down a class of neighborhood and i dont want to do that.

But that's just my opinion. For once in my life, can i be in cash when an asset falls? Sheeesh lol

0 Reply

George Gammon

OP

Flipper/Rehabber · Las Vegas, NV · Member since 2016 · 174 posts · 251 votes

10y

Originally posted by @Chris Mason:

10 year tnote is fairly strongly correlated with mortgage rates. Some ARMs use it as the index basis for adjustment, too.

If I'm in a day-trading mood because I'm ignoring my own advice about day-trading (the same way most folks ignore their own advice haha), I'll look at where the 10 year tnote closed on the East Coast as a sneak peek for where rates might be tomorrow morning, and still have 3 hours left (CA time zone in a CA headquartered company, baby) to decide if I want to lock today or wait until tomorrow. This method is correct probably about 65% of the time.

To respond to the OP's concerns specifically, I'll say that the overwhelming bulk of loans we do these days for middle class families are fixed rate. Rates are still low and younger people especially (that watched their uncles/cousins/etc get foreclosed on during the recession) want their mortgages to be as BORING as humanly possible. Good for them, I get it.

Interestingly, and perhaps perplexingly, a significantly higher percentage of jumbo loans are ARMs. People buying the $2m homes are much more OK with ARMs, and are often the ones to bring them up with me. Even 1/8 to rate makes a huge difference when the debt is that large, and an ARM might be 0.5% or 0.75% or more lower at the teaser rate ("teaser rate" is what we call it internally when you pesky borrowers aren't in earshot :P ), I get it.

I'd say about 70% of the loans I do for $1m and up homes are ARMs, and probably 5% of the smaller loans I do are ARMs.

So that's where we will see it, if there's a crisis because 7 or 10 or 15 years from now all these ARMs I've been doing adjust significantly upwards: It'll be a crisis that hurts rich people way more than people of modest means. So if I'm being cynical, the fact that the pain will be concentrated among the wealthy means there will be a bail out for the wealthy that we didn't see during the recession for the middle class. (To be clear, I don't begrudge folks for their success & am in fact happy for them... but I sure as heck am cynical about our political system!)

Chris thanks for the post, you bring up some interesting points. Unfortunately you might be viewing this from a narrow lens. Residential may offer fixed rate long term loans but what about commercial? Based on the conversation I had with several bankers in that space most are ARM's or short term fixed with a ballon, which effectively is the same thing. Most credit card debt is adjustable. Also remember most corporate and government debt is rolled over on a short term basis making it adjustable.

So in that regard I think this is a potential problem not only for the "rich" buying 2 million dollar homes but anyone with a credit card, commercial loan, every corporation and government.

It sounds like you're in residential lending so you know very few banks will keep long term fixed rate debt on their books. They immediately sell it to fannie/freddie. Why don't they want to keep it on their books? Because its a bad bet. Would anyone in their right mind loan out money at 3.5% over 30 years? If interest rates go up, the value of that debt on the open market goes down. The banks would never take that much risk with their exposure to rates mid to long term. So if those loans are being originated someone is taking on excessive risk...that someone is fannie/freddie or the name I prefer "tax payer".

If interest rates do what they've historically done fannie/freddie will have the greatest exposure. If they go bust (again) the tax payer will get burdened with the bill. All those young people that you're selling "boring" loans to will pay for the profligacy of a 30 year credit expansion.

I'd argue the rich will most likely get hurt the least because the burden on them is a much smaller percentage of their net worth.

Again, I'm not saying this will happen. I'm saying based on history, it's a possibility we as investors shouldn't ignore when assessing our portfolio's.

0 Reply

George Gammon

OP

Flipper/Rehabber · Las Vegas, NV · Member since 2016 · 174 posts · 251 votes

10y

Originally posted by @David Roberts:

i tend to agree, although friends of mine that bought their homes with ARMs ten years ago while i bought with a fixed rate let me know how smart they are lol. You would think the rush is to the upside with ARMS these days but rates just continue to fall.

I tend to think its a good time to leverage up now while rates are low, with fixed if you can. You would think rates would have to go higher sooner than later, but who knows. If rates go higher them paying cash makes more sense than leveraging.

Ive personally gone to a flipper mentality lately given that the higher prices go, for me to cash out a higher dollar amount to get my cash back lowers cash flow and the risk is to the downside on prices, so i want to be in and out. To get the better return it seems you have to move down a class of neighborhood and i dont want to do that.

But that's just my opinion. For once in my life, can i be in cash when an asset falls? Sheeesh lol

The beauty of a fixed rate is it caps the exposure to interest rates increasing but doesn't limit your ability to participate in interest rates falling because you can always refi at the lower rate...

Be careful with a lot of leverage because in a deflationary environment the real value of debt increases.

Totally agree with you on class of neighborhood!

Haha exactly ;)

0 Reply

J. MartinPro Member

Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes

10y

@George Gammon,

I like your posts, economic analysis, and someone finally posting some actual data to back up their opinions! Thank you!

For all the talk about the relationship between the 10yr Treasury and 30yr fixed mortgage rates, yes, and here is the evidence to prove it, for those who are not as familiar.. There tends to be about a 150-175bp spread of 30yr fixed mortgage rates over the 10yr Treasury (constant maturity shown here.) It can get squeezed as low as 100bp or as high as 200bp or so during volatile changes..

10yr Treasuries and 30yr Fixed Rate Mortgage Rate

I'd be more concerned about the long-term effect of potential negative rates than a huge increase in rates today. Futures markets aren't pricing in nearly as much increases as the Fed, world growth is slowing, China is weaker than it has been in my lifetime probably, BRIC's are weak, energy slowing down, and there is $7 Trillion or so in worldwide debt with negative rates. With international rates so low, and the 10yr depressed by lower sovereign rates internationally, can the Fed push up short term rates and, very possibly create an inverted yield curve, without punishing the US economy?

International Discount Rates

Here is a representation of the how the yield curve is flattening already..

10yr minus 2yr Treasuries - "10's and 2's"

10's and 2's flattening (line going down) is not usually great for the economy, and when it goes negative, we usually get one of those grey lines..

Leading indicators don't look great..
Yield Curve (10's and 2's), ISM Manufacturing Index, Leading Economic Index for US

And we see declining leading indeces in a surprising number of states, even larger states like Texas, New York, and Washington - similar to the lead up to and during the last recession..

1 Reply

J. MartinPro Member

Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes

10y

@George Gammon,

I like your posts, economic analysis, and someone finally posting some actual data to back up their opinions! Thank you!

For all the talk about the relationship between the 10yr Treasury and 30yr fixed mortgage rates, yes, and here is the evidence to prove it, for those who are not as familiar.. There tends to be about a 150-175bp spread of 30yr fixed mortgage rates over the 10yr Treasury (constant maturity shown here.) It can get squeezed as low as 100bp or as high as 200bp or so during volatile changes..

10yr Treasuries and 30yr Fixed Rate Mortgage Rate

I'd be more concerned about the long-term effect of potential negative rates than a huge increase in rates today. Futures markets aren't pricing in nearly as much increases as the Fed, world growth is slowing, China is weaker than it has been in my lifetime probably, BRIC's are weak, energy slowing down, and there is $7 Trillion or so in worldwide debt with negative rates. With international rates so low, and the 10yr depressed by lower sovereign rates internationally, can the Fed push up short term rates and, very possibly create an inverted yield curve, without punishing the US economy?

International Discount Rates

Here is a representation of the how the yield curve is flattening already..

10yr minus 2yr Treasuries - "10's and 2's"

10's and 2's flattening (line going down) is not usually great for the economy, and when it goes negative, we usually get one of those grey lines..

Leading indicators don't look great..
Yield Curve (10's and 2's), ISM Manufacturing Index, Leading Economic Index for US

And we see declining leading indeces in a surprising number of states, even larger states like Texas, New York, and Washington - similar to the lead up to and during the last recession..

0 Reply

Chris MasonPro Member

Moderator

Lender · CA · Member since 2015 · 9k+ posts · 10k+ votes

10y

@George Gammon- You're absolutely right I view things through a narrow lens. It's the lens I'm familiar with, being that I'm not an economist and do not pretend to be. :)

"It sounds like you're in residential lending so you know very few banks will keep long term fixed rate debt on their books. They immediately sell it to fannie/freddie. Why don't they want to keep it on their books? Because its a bad bet."

Eh, I'm going to disagree with you here a little bit.

We sell it on the secondary market because we need that money to lend to the next guy, not because it's bad debt (we're flippers like you might do with houses, but we flip debt). Not all of it goes to fannie/freddie, but a lot of it does. If rates go up to 7% on 30 year fixed loans, the selling price of a loan @ 7% on the secondary market will actually be identical to a loan of the same amount at 4% when 4% was prevailing (yup we don't care about your rate, only where it is relative to what fannie will pay for it). This is true regardless of if it's a GSE buying it, or a South Korean Teacher's Pension Fund.

Fannie/freddie build the expectation of that interest rate, some chance of foreclosure, some chance of being paid back early, etc etc, into their calculations. They are for-profit enterprises, essentially buying high stability low return annuities. They have so dang many of these mortgages that they can afford to pay themselves with that little 4%. They are 100% perfectly fine with getting the 4% they were promised, it's when everyone goes belly up (2009 etc) that the taxpayers are on the hook.

If rates go up and they need to unload those loans to buy some at future-higher rates because they want to make more money, they can sell the older lower rate 4% loans off on that same secondary market to gain access to that capital needed to buy some 7% loans. Or, if the prices offered for it aren't right, they can sit tight and still remain perfectly solvent collecting 4%.

Think about it this way. Suppose rates go up. Suppose you've got, oh I don't know, $10bn in assets at 4% and your only job is to process the checks coming in. You're not even a landlord any more that has to fix the properties, you just collect the checks! If I give you $33m each and every month, do you think you could maybe find a way to process that $33m, maybe by using part of that $33m? I think you could find a way. In fact, I think you could find a way to process that $33m in monthly payments, AND have enough left over to purchase the sexy new investments available at 7%.

Oh look at that! You just purchased some of that sexy 7% debt over the course of the last year. Now you don't just have $33m coming in each month, now you've got $38m coming in! Sweet. Let's process those checks, baby, and keep the money factory going.

The GSE model works because of scale. You as a single individual, or even a modest sized firm, would indeed be in a tough spot with all your capital tied up earning only 4%. But the GSEs are GIANT, that's why it works for them.

3 Reply

George Gammon

OP

Flipper/Rehabber · Las Vegas, NV · Member since 2016 · 174 posts · 251 votes

10y

Originally posted by @Chris Mason:

@George Gammon- You're absolutely right I view things through a narrow lens. It's the lens I'm familiar with, being that I'm not an economist and do not pretend to be. :)

"It sounds like you're in residential lending so you know very few banks will keep long term fixed rate debt on their books. They immediately sell it to fannie/freddie. Why don't they want to keep it on their books? Because its a bad bet."

Eh, I'm going to disagree with you here a little bit.

We sell it on the secondary market because we need that money to lend to the next guy, not because it's bad debt (we're flippers like you might do with houses, but we flip debt). Not all of it goes to fannie/freddie, but a lot of it does. If rates go up to 7% on 30 year fixed loans, the selling price of a loan @ 7% on the secondary market will actually be identical to a loan of the same amount at 4% when 4% was prevailing (yup we don't care about your rate, only where it is relative to what fannie will pay for it). This is true regardless of if it's a GSE buying it, or a South Korean Teacher's Pension Fund.

Fannie/freddie build the expectation of that interest rate, some chance of foreclosure, some chance of being paid back early, etc etc, into their calculations. They are for-profit enterprises, essentially buying high stability low return annuities. They have so dang many of these mortgages that they can afford to pay themselves with that little 4%. They are 100% perfectly fine with getting the 4% they were promised, it's when everyone goes belly up (2009 etc) that the taxpayers are on the hook.

If rates go up and they need to unload those loans to buy some at future-higher rates because they want to make more money, they can sell the older lower rate 4% loans off on that same secondary market to gain access to that capital needed to buy some 7% loans. Or, if the prices offered for it aren't right, they can sit tight and still remain perfectly solvent collecting 4%.

Think about it this way. Suppose rates go up. Suppose you've got, oh I don't know, $10bn in assets at 4% and your only job is to process the checks coming in. You're not even a landlord any more that has to fix the properties, you just collect the checks! If I give you $33m each and every month, do you think you could maybe find a way to process that $33m, maybe by using part of that $33m? I think you could find a way. In fact, I think you could find a way to process that $33m in monthly payments, AND have enough left over to purchase the sexy new investments available at 7%.

Oh look at that! You just purchased some of that sexy 7% debt over the course of the last year. Now you don't just have $33m coming in each month, now you've got $38m coming in! Sweet. Let's process those checks, baby, and keep the money factory going.

The GSE model works because of scale. You as a single individual, or even a modest sized firm, would indeed be in a tough spot with all your capital tied up earning only 4%. But the GSEs are GIANT, that's why it works for them.

Great insight Chris. I'm not following you on being able to sell 4% loans for the same price they're purchased for if rates go to 7%? maybe I'm misunderstanding you?

I'm basing my analysis on the market value of a loan going down if interest rates go up and the market value going up if interest rates go down...like a bond. Assuming this is true for F/F, if they have to liquidate assets due to higher than expected defaults they'd take a big loss if interest rates were higher when they're forced to sell.

They're for profit and backstopped by the tax payer. The profits are private and the losses are public naturally incentivizing them to take excessive risk.

I'm by no means an expert on the secondary debt market so thanks again for the dialogue. :)

George

0 Reply

J. MartinPro Member

Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes

10y

Originally posted by @George Gammon: