Continued . . .
Opportunity: One can make much money by (a) choosing the right investments or by (b) shunning the poor ones. In many cases poor investment decisions could have been entirely prevented by heeding John Farnam’s Three Rules: (1) Don’t go to stupid places; (2) With stupid people, (3) And do stupid things. These are probably the same rules your mother taught you when you first started dating.
That doesn’t leave many remaining options; thus, people crowd into the investments everyone else is clamoring for. As one example of many, if you “own” a piece of the infrastructure, you get paid every time someone gets on the internet. If you “own” a share of AOL, on the other hand, you only get paid when AOL is being used and nothing if the surfer’s choice is Yahoo. Hypothetically, if in the Old Economy an investor had a few (infrastructural) shares of “U.S. Telephone Wire, Inc.” and received even a minimal fee from every telephone conversation carried in the U.S., eventually he would become rich beyond the dreams of avarice. Now consider the reward from being an initial investor in the world-wide equivalent, Global Crossing.
Global Crossing (GLBC) was born in 1997. It never had a profitable year, but by 1999 (two years later . . . internet time!) the market value of the company was $47 billion. In 2002 it filed for bankruptcy. GLBC was a speculation (it was never profitable, so it was never an “investment”) that proposed the interconnecting fiber optic cables (many being undersea) would soon enough give them a footprint in the internet infrastructure. This was conceptually similar to the early days of cross-country utility poles and telephonery. It was horrendously expensive, but the dreams matched the costs. Global Crossing finally died for sure in 2011 when the remains were sold to another company.
The DotCom Recession was not limited to a single stock, nor a single sector. It consumed the entire NASDAQ market. NASDAQ was quoted at under 500 in early 1990, grew to over 5,000 by March, 2000 before collapsing more than 70% by 2002.
The implosion of the NASDAQ bubble of 2001 was a consequence of the DotCom Recession. It foreshadowed the subsequent 2007-2009 Great Recession.
The Housing Collapse (i.e., the “Great Recession”) of December 2007 – June 2009) Duration: 18 months. GDP Decline: 4.3%. Peak
Unemployment: 10.0%. 10 yr T-Note Beg 4.03% / End 3.52%.
As noted last month, the NASDAQ bubble of 2001 foreshowed the subsequent 2007-2009 Great Recession. The Great Recession was initiated by the implosion of the housing bubble largely because participants, acting in their own short-term interest in a revised interest rate environment, gamed the system. Examples:
- Interest rates declined following the DotCom Recession of 2001 and never fully recovered. In May, 2000, the 10-yr T-Note was at 6.44%. In June, 2003 (three years after the Recession), it was at 3.33%. The Fed reduced rates to ratchet us out of the economic hole we were in – and they were successful in that the Recession did end – but somehow rates did not return to pre-Recession levels. As this is written it is early 2021, twenty years from the end of the DotCom and rates still haven’t recovered: the yield on the 10-yr T-Note is currently under 1%.
This means that in the event of another recession, the Fed has precious little room to maneuver rates lower before they drop into negative yield territory. Negative yield seems counterintuitive, but currently there are $18 trillion of bonds with negative yields (27% of the world’s total investment-grade debt). If we drop into negative yield we don’t know how it will turn out. It is just too early yet.
- Ever-lowering interest rates meant that homeowners could (i) refinance and pull money out of the property while leaving the monthly payments unchanged or (ii) refi to reduce the monthly payments while leaving the principal approximately the same. Note that in neither case was the principal reduced.
- Lenders sold the loans they’d made to institutions (pension funds, insurance companies, quasi-government agencies, etc.). Lenders are in business to make money, and to do so they must originate loans the secondary market* is willing / eager to buy. As the Example below will illustrate, lots of money can be made by selling loans. (*The Primary Market is where loans are created; the Secondary Market is where existing loans are bought and sold.) EXAMPLE: A $100,000 loan is made at 4% interest and subsequently packaged with other similar loans and sold to a pension fund at a 3.50% yield. The new sales price is $106,318. This demonstrates a 6% gain on what? A 30-day hold? That annualizes at 72%. And, of course, the originating lender has his money back so he can immediately make another loan to someone else. Being a bank can be a good life.
People – both lenders and borrowers – quickly became accustomed to expansionary money policies all while the quality of new consumer debt was deteriorating.
Lending at ever-lower interest rates continued, and eventually clouds began to appear. The worst economic environment in eighty years was forming on the horizon.
- Several very large financial businesses failed, notwithstanding some pretty remarkable tap dancing by the Fed. A couple of quick examples: Lehman Brothers, with assets $691 billion, collapsed in September, 2008. Lehman Brothers was at that point was the largest corporate bankruptcy in U.S. history and precipitated a broad Wall Street bailout. Washington Mutual, a not-insignificant presence with assets of $307 billion, was sold to JPMorganChase for $1.9 billion. That’s like retailing a cute little sundress that cost $307 (wholesale!) for $1.90. And even at that, there were people who thought Chase paid too much.
The largest bank failure prior to Washington Mutual was Continental Illinois in 1984, when it had $40 billion in assets. WAMU, with its $307 billion, was the largest bank failure in U.S. history. Overall, a total of 489 banks went under or were absorbed by other banks during this period.
The recessions we have referenced in these last few months have had many differences and a few similarities. The differences are unimportant because they are not predictive. The predictive elements are the things to keep your eye on. A major predictive is this: booms are caused by cheap money. As noted above, the 10-yr T-Note was at 6.44% in May, 2000, and at 3.33% in June, 2003. It is currently is under 1%. Even when spread over 20 years, this is a huge drop. As one would expect, this extended period of low interest rates / easy money (“monetary expansion”) combined with the leverage that real estate makes possible made the housing market soar. Hypothetically, a $250,000 30-yr mortgage at 6.44% would cost $1,570 in monthly principal and interest payments. Three years later that same $1,570 would service (principal and interest) a mortgage of $357,000. The borrower would be able to refinance and cash out double his down payment. The down payment would have compounded at 25% annually, and the borrower would still have the house and the same approximate payment. Is there any wonder the housing market exploded?
The economists call this an example of inflation. Inflation is worse than a 100% income tax, because the tax would be on income while inflation is on total assets. On an investment of $100,000 a yield of $6,000 (6%) might expect to be taxed at 33% ($2,000), leaving $4,000 for the investor. That’s if the tax was on income only.
If the same 33% tax were on wealth, the tax would be $35,000 ($100,000 plus that year’s earnings of $6,000 multiplied by 33%).
That is why inflation is worse than a 100% income tax: an income tax is applied on the milk: a wealth tax is applied on the cow.
To come full circle on the impact of interest rates on the economy, (1) lowering interest rates caused the housing bubble; (2) the bubble meant that lenders could require a higher interest rate, (3) higher interest rates, in turn, reduced the rise in housing prices and caused the bubble to implode.
This article is for informational purposes only and is not intended as professional advice. Nothing in this article is presented as investment guidance. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in vanilla as well as difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email info@KlariseYahya.com.