Adjustable Rate/Ballon Payment Crisis Ahead?

[George Gammon]

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

[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.