From CNBC: The latest round of extraordinary Federal Reserve stimulus is risky and leaves little room to maneuver should another crisis hit, economist Lawrence Lindsey told CNBC’s “Squawk Box” on Wednesday. Lindsey said that with the Fed purchasing at least $40 billion a month in mortgage debt through QE3, “they are buying the entire deficit.”

Recap:  Mr. Dent’s thesis (November, 2012) was that the Baby Boom generation will march through life in lockstep and this will affect the economy.  As children the Boomers had money spent on them by their parents. Then they grew up and married and it was their turn to spend money on their own children. Basically, kids are expensive and drive the economy. But by middle age the Boomer’s home is largely paid for and their kids are out of the house. At that point Boomers focus on the need to pre-fund their retirement. It’s time to minimize their expenses. One of the things they do is to downsize their home. They sell that 4,000 sq.ft. McMansion and buy a 1,500 sq.ft. condominium. In polite company this is called “deleveraging”, and deleveraging brakes the economy.

But … but, they have to sell that McMansion to somebody don’t they?  Doesn’t that count? Well, no, at least not for very much. Our economy operates on a first-sale basis. Only the initial sale generates a profit for the timber grower, the lumbermen, the heavy equipment manufacturers, the long-haul trucker, the construction workers, etc. After that, subsequent sales benefit only intermediaries (e.g., real estate brokers, etc.), and the effect on the GDP is not the same as a first-purchase. If you buy pre-owned (anything) then that transaction is not a material influence on the economy. It’s not a matter of how much you spend, it’s a matter of whether or not you’re the first purchaser.

So when the Boomers begin to pay things off, begin to downsize to an existing but smaller home or a car just off a two year lease they withdraw from the primary market, where things are produced. They become part of the secondary market where things that were previously purchased are resold, and the Boomers no longer contribute as much to economic productivity. Less activity means a lower economy, perhaps even a deflationary economy. That appears to be Mr. Dent’s thoughtful position. It is, however, probably wrong.

The 800 Pound Gorilla

Whatever the adverse economic impact of Mr. Dent’s deleveraging Boomers, U.S. Government spending way, way offsets it. The extent the U.S. Government can impact the economy is limited not by its tax receipts but by its borrowing power, and the U.S. Government can borrow more than all the Baby Boomers combined.  As long as the government continues to borrow and spend so much, it’s difficult to believe we might face deflation (an inflation rate less than zero) as Mr. Dent expects.

It’s probably more likely that what the Federal Reserve is doing will generate inflation. That is what we may be looking at.

Buying Your Own Debt

The limit of borrowing is normally reached when nobody will lend to you anymore. But the Fed has found a way to borrow beyond even that reasonable limit.

Hypothetically, imagine the Treasury has a ton of bonds (bond: a debt instrument with a term of more than 10 years) maturing tomorrow. The bonds may have been issued in past years but they come due and must be paid off tomorrow. Where’s the money to come from? Well, the Treasury will auction new bonds today to redeem the bonds maturing tomorrow plus a bit more to finance that part of the government that still can’t quite seem to live within its means. One reason this can be done is that the interest rates on Treasury debt are very low. Currently, the government can borrow for 10 years at rates less than 2%. 

At such low rates, fewer foreign governments and fewer domestic institutions are buying Treasury bonds. Recall the definition of “debt limit”:  when other folks will no longer fund your borrowing. Right now, Treasury auctions often place only 25% (+/-) of the available debt with free-market purchasers. On that basis we seem to have reached our market limit already.

What does the Treasury do with the debt nobody wants to buy? They have cleverly arranged for us to buy our own debt. Briefly, what happens is that the Fed incentivizes money center banks to buy above their capacity. The additional capacity is created by bookkeeping entries. A fantasy conversation follows . . .

The Fed rings up the bank and says, “Chester, we want you to buy more bonds”.

The bank replies, “Can’t. We’re all tapped out from the last time you called. George even told me not to take your call”

Fed: “What if we can arrange it so it doesn’t cost you anything?”

Bank (sarcastically): “And just how might that happen?”

Fed“Well, if you owned the bonds we could lend you money on them. So what we’ll do is a “table-funding” sort of thing, where we lend you the money subject to you buying the bonds.

We’ll do it electronically. We’ll just make a bookkeeping entry on your ledger that says you have (blank) more money in the reserves we hold for you. And you can in the next instant do a bookkeeping entry to pay for the bonds we’ve lent you the money to buy”.

Bank (thoughtfully):  “That’ll work. I’ll tell George.”

What we just witnessed was the creation of money out of nothing but a book keeping entry.

Its money because those bonds can be sold or borrowed against immediately, and when the bonds mature the bank (or whoever then holds them) will receive cash. Today’s degree of Quantitative Easing ($40 billion a month, with no end date) generates obscenely excessive future money supply.  Excessive money supply facilitates inflation.

Excess Money Supply

Much public discussion has revolved around our national debt (debt: this year’s shortfall) and deficit (deficit: the cumulative shortfall). Imagine what might happen if somehow the debt was reduced, and there were fewer bills (term of 1 year or less), notes (two to 10 year terms), or bonds for the banks to buy. If that were the case, some of these horrid Quantitative Easing holdings might mature and be redeemed. The projected debt would be reduced by that amount. The bank would have sudden infusions of cash to lend out. The more federal spending  gets under control, the more Treasury debt gets redeemed, the more cash the banks have to lend out. Historically, the only way to insure there will be sufficient borrowers for all that money is if the loans are accompanied with loose qualification standards. Oh, oh. Haven’t we seen this movie before?

Ok. So now we have a situation where the country is flooded with cheap money and banks are eager to make loans to almost anybody. What is the bank’s incentive? Those bonds they were getting 2% interest on have been cashed out and now they can make loans with nominal 3 or 4 or 5% interest. When you’re talking about millions and millions of dollars, going from 2% interest to 4% earns bankers large bonuses. Collectively, as CNBC reported, the banks will one day have $40 billion (that’s with a “B”) extra to lend out every month. That excess money supply means that at some point prices have to rise.

Conclusion

We’re probably facing serious inflation. As we’ve discussed on previous months, serious inflation is handled only by serious interest rate increases. So all this quantitative easing probably won’t end well.

Management

If Lawrence Lindsey is correct and the Fed is purchasing $40 billion a month of the deficit, we don’t see any realistic way serious inflation can be prevented. But perhaps it won’t be all bad. Perhaps we can arrange our affairs to benefit from it.

Historically, you don’t want cash in an inflationary environment. Cash just erodes in value, and each day you’re a little poorer.

Hard assets tend to do well where cash does not. The best of the hard assets are probably those that (a) provide cash flow during the holding period and (b) automatically adjust to inflation. Apartment buildings fit beautifully into this niche. In apartments not subject to rent control, rents could probably be adjusted as often as necessary to offset inflation. In that manner your (real) cash flows should remain relatively level.

Where an Independent Loan Officer Might Help

Possibly one of the most important benefits of holding apartments in a highly inflationary environment, however, is that the mortgage is for a fixed dollar amount. The mortgage says, “So-and-so will pay us back $1,000,000”. Generally, the principal amount of loans are not (yet) adjusted for inflation.

As inflation reduces the value of the dollar, you are paying off your note with cheaper and cheaper money. Just for a moment, imagine what might happen if inflation averaged 12% annually for twelve years. The present value of that $1,000,000 mortgage would be about $250,000.  That’s nice for us, huh? If you’re in or nearing retirement, you’ll be able to pay off your building a lot faster than you ever thought. When this building is paid off, no matter what happens, you’ll have those 12 units free and clear.

It’ll be harder to have mortgage-free units, however, if the payments rise as fast as inflation. If this happens, at one level you’ll just be treading water. To maximally benefit you should have the longest fixed rate period you can. The longer your fixed rate period, the more you postpone being hit with inflation adjusted monthly payments. An independent Loan Officer may be able to get you a new mortgage with a better fixed rate period.

But what if you’re in the Accumulation Phase of your portfolio? You’ll have a regular need to cash out some equity and buy another building. 

  • Refinancing an existing building to get the down payment for another building is an honorable approach to portfolio growth. To withdraw cash from the first building we must have equity in that building. That equity is created in three ways: (1) the tenants pay off the existing loan; (2) interest rates decline, or (3) inflation raises the building’s price.  
  • If interest rates decline our building automatically creates equity. Remember Capitalization Rates? If our building generated $100,000 annually that was available for mortgage payments and interest rates were 9%, we could borrow $1,111,111 ($100,000 divided by 0.09). If interest rates dropped to 6% that same $100,000 would support a loan of $1,666,667. Bingo! Half a million in equity! 
  • If inflation averages (I’m making this up) 12% a year for four years, the building we just paid $1,000,000 for would probably be worth around $1,573,500. Bingo!

So we refinance and invest whenever our existing portfolio generates the necessary down payment . . . and we don’t care a fig whether that equity comes from declining interest rates or increasing inflation.

Our preferred scenario is to buy a building, allow it to appreciate in whatever manner it wishes, harvest the appreciation, buy a second building, collect the rents and repeat until you get too old to carry all that money to the bank

In an inflationary environment, the building you want to buy will certainly have gone up in price, but so will the one you own. Why couldn’t you refinance your present building as the value inflates and buy another? Then another and another and yet another?

Or you could do a little of each. Refinance your current building at present low rates and buy another. You now have two buildings. In your mind, separate them into two portfolios. One building (Portfolio A) you’ll never refinance again, you’ll just benefit from the long fixed rate term and ever-reducing present value of the new loan you put on it (example: $1,000,000 loan turns into a present value of $250,000). Your object is to pay this puppy off. You want the security of at least one good free and clear building.

The other building you just bought? That’s the start of your second portfolio (Portfolio B). As inflation pushes up its value you’ll have rapidly increasing equity to cash out and buy another building. Then you’ll have two buildings in your Portfolio B, both benefitting from inflation. When the time is right you refinance both of them and buy another, possibly bigger building. Repeat as desired.

There is no hard stop to your second portfolio. You’ll keep refinancing it (and subsequent purchases) as long as inflation expands your equity.  When inflation finally drops, probably due to the government raising interest rates like in the early 1980’s, you’ll be in that portion of your Accumulation Phase where you refinance as the rates go down, pull out money, and buy more units.  An independent Loan Officer might help in getting you mortgages with acceptable pre-pays. This is important: The bank’s Loan Officer works for the bank. The independent loan officer works for you.

It’s not necessary to fear inflation. Neither is it necessary to fear high interest rates. But it is necessary to manage them. Whether you’re beginning your investment career or nearing the end of it – or you’re a grandparent passing your skills on to one or two of your grandchildren – these next few years could be splendid. But you can’t sit on your hands, you have to actively manage your portfolio. It’s up to you.

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

 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.

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