When the Fed Tightens, Will Mortgage Rates Increase?

During the past three years, the Federal Reserve Bank, led by Chairman Ben Bernanke, has reduced the Federal Funds Rate (FFR) from 5.25% to its present level which is a range from 0%-0.25%. While this 500 basis point reduction in FFR was occurring, our commercial real estate mortgage rates have remained fairly stable within the 5.75% to 6.25% range. This dynamic has implications for our future as many economists believe the FFR will be increasing, some say significantly, within the next few years. So the question is: Will the Fed increase the FFR and,  if so, what will be the impact on mortgage lending rates. The answer to this question has tremendous implications for our investment sales market.

Before we get into more detail, let’s take a look at exactly what the Fed is and how it operates.

The Federal Reserve System was created by an act of congress on December 23, 1913. Also known as “The Federal Reserve” or “The Fed”, it is the central bank of the United States consisting of a Board of Governors and 12 regional reserve banks. These regional banks are located in New York, Boston, Philadelphia, Richmond, Cleveland, Atlanta, St. Louis, Chicago, Minneapolis, Kansas City, Dallas and San Francisco. The Board of Governors is a federal agency located in Washington DC. This board is made up of 7 members with no more than one member from each regional reserve bank.

The Federal Open Markets Committee (FOMC) consists of the Board of Governors plus five regional reserve bank presidents such that each bank has representation on the committee. The FOMC is the group that makes key decisions affecting the cost and availability of money and credit in our economy which is known as monetary policy.

The Federal Reserve uses three main tools to implement monetary policy: open market operations, the discount window and reserve requirements. The most important of these is open market operations.

Through open market operations, the Fed buys and sells U.S. Treasury securities, trading with accredited primary dealers. When the Fed buys these securities it adds extra reserves to the banking system which puts downward pressure on the highly sensitive federal funds rate. When the Fed sells Treasury securities, it drains reserves and puts upward pressure on the FFR.

The level of the FFR is a target rate set by the Fed which has a significant impact on the marketplace as it affects yields on treasuries and, therefore, the cost of borrowing for other banks. The FFR is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. In June of 2006 when the FFR was 5.25%, if mortgage rates were around 6%, the spread for the bank was very narrow. The spread can be thought of as the profitability on each dollar banks lend. Today, with the FFR near zero and commercial mortgage rates still around 6%, the spreads banks are making is significant.

During his chairmanship, Alan Greenspan was applauded for the interest rate policies of the Fed. Today, it is largely agreed that, during this period, he kept rates too low for too long. In May of 2000, the FFR was 6.5% and by December of 2001, the rate had dropped to 1.75%. It fluctuated between 1% and 1.75% through 2004 and remained below 3% through mid 2005. Economists agree that this monetary policy exacerbated the asset bubbles which drove residential and commercial real estate values through the roof.

Today, our near zero FFR is providing the banking system with an opportunity to recapitalize itself. Solvent banks are making significant profits each quarter as they are borrowing at very low rates and lending at spreads ten times greater than they were two years ago. This is one of the many reasons for the slow drip of distressed asset out of what, we all know, is  a very jam packed pipeline.

Banks are getting very comfortable with these generous spreads and the question this piece is looking at is, what will happen to this spread when the FFR rises. During the past 11 months, the government has committed to a doubling of the U.S. money supply. This increase is larger than the aggregate increases in our money supply over the past 50 years. This massive increase has economists concerned that inflation will inevitably result, and in a very big way.

The Fed has historically had a comfort level of an inflation rate in the 1% – 2% range. Should inflation rise above this level, the Fed would use monetary policy to raise rates in an attempt to subdue it. This is referred to as tightening. Should the Fed raise the FFR, how will banks respond? Will they correspondingly raise mortgage rates to preserve the wide spread they are getting accustom to or will they keep their rates fairly stable and allow spreads to moderate? The answer could have a profound affect on the value of investment properties.

In New York City, a 25 year historical study, completed by Massey Knakal, of multifamily capitalization rates compared to mortgage rates is very illustrative of leverage cycles. In the mid and late 1980s, we see an extended period of negative leverage. “Negative leverage” is a condition in which cap rates are lower than mortgage rates. “Positive leverage” is the reverse. This negative leverage period was caused by the co-operative conversion craze the market was experiencing (up to and throughout the 1980s, to New Yorkers, condos were something retired Floridians lived in).

After the Savings and Loan Crisis in the early 1990s, lender underwriting standards became more conservative and investors became more cautious. This led to an extended period during which the market saw positive leverage; cap rates were higher than mortgage rates. This condition lasted through 2003. Then the low FFR rate environment began to tangibly take hold of the market , the condo conversion market went wild and a period of negative leverage followed repeating conditions experienced in the 1980s.  Where are we now?

Capialization rates on all property types are increasing and, while the multifamily market is still in a negative leverage condition, it is teetering on a switch to positive. All of our other property type sectors are already in a state of positive leverage (if you can get leverage).

If history repeats itself, and we are going to be heading into a prolonged period of positive leverage again, the answer to the question of how banks will respond to the Fed tightening monetary policy is significant. If the FFR goes back up to 5% -6%, mortgage rates could hit the high single digits. With a positive leverage condition, cap rates would then hit double digits. Can you imaging the additional distress that condition would cause?

Fortunately, inflationary pressures have been moderate and are not expected to be above trend in the short term. When it does emerge, the Fed will react, and lenders will have to decide what their lending rate policies will be. After last week’s meeting of the FOMC, one of the members hinted that the tightening may begin sooner than anyone expects. What the Fed does and how lenders react is something to watch very closely.