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.
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Spreads were also tighter due to an active secondary market, securitization and increased competition. The re-emergence or stagnation of this market will play a large role in managing current interest rates if the cost of funds increases. At this point, it’s anybodys guess which will play out in what order.
Whatever the Fed does, it should be in the interests of the larger population.
Adding to JWB comments, the rise of Mortgage REIT’s may substitute for, or at least supplement, the re-emergence of the CMBS market. This could already be happening as several large mortgage REIT IPO’s have come to market with potentially much more to come. However; I do not believe that mortgage REIT’s can ever match the relatively lower rates of CMBS. Part of the magic of securitization was their ability to split market to different investor groups by creating tranches of low risk/low yield debt sold in huge volume to risk adverse pension plans at rates below traditional mortgage funding costs. The relatively small proportion of the high risk/high yield tranches meant its higher yield was more than offset by the savings on the much larger low risk/low yield tranches. Mortgage REIT’s can’t perform this magic and will require higher rates on their mortgages. This is a permanent structural increase in the cost of capital that will remain with us until and unless the CMBS market is fully revitalized.
Deflation will partially negate inflationary policies
Or you can say it this way –> extreme inflationary policies are in place to negate a deflationary spiral. I guess it boils down to how you define inflation. While the money supply has surged as the fed responds to deflationary forces, the destruction of wealth in the shadow banking system is approaching $1.7 trillion or so. The main reasons deflation will offset inflationary policies are:
1) The deflationary episode we are in will negate any inflationary effects for as long as the system takes to delever, restructure, handle bankruptcies and failures, write down toxic assets, and destruction of bad debts through defaults – this is ongoing and WAVE 2 still lies ahead of us
2) The feds hundreds of billions of money printing is sitting idle in excess reserves and not being lent out – this is what is keeping the multiplier effect of our fractional reserve system muted. Recall that the fed requested and received authority to pay interest on excess reserves last September, and since that approval came in, boooooom, excess reserves started to surge. The reason the fed did this was to sterilize their stimulus and money printing policies so that the banks had an incentive to keep that money sitting idle instead of putting it to work through new loan creation that could have sent the system overboard in terms of credit creation and inflation. Plus, the fed knew the banks needed to recapitalize and still had loan losses and toxic assets improperly marked that needed to be taken care of.
Recall Jeff’s statement on excess reserves in January: “My guess is that these excess reserves will be melted away as banks absorb losses on delinquent loans and as marked down securities see their income streams actually collapse.”
3) Credit is contracting! Mish is all over this and a believer that money supply contract/expansion and credit contraction and expansion play a major role in the definition of inflation. In short, you cant have hyperinflation if credit is contracting! I tend to agree 100%!
4) Destruction of credit is greater than money creation – think of Printer Ben pouring hundreds of billions of newly created dollars onto the ground, except, there is a huge hole in this ground that represents the destruction of hundreds of billions in credit. This money is not piling up on the ground, ready for people to take, because it is falling into the big hole, not to be seen!
These are the main reasons why I dont see inflation as a threat right now, or even in 2010. Yes, we are seeing a stimulus induced reflation trade that people are building foundations of hope on. Not me. I am still cautious, will continue to ask questions about the stuff sitting on balance sheets (off and on) and the accounting tricks that allowed things to get covered over. However, the fed cant control the treasury market, especially the longer end of the curve. At some point investors will demand higher yield and rates are going to go higher. The question is when and how long the fed can pull of this banking recapitalization engineered environment. So far it is pretty impressive I must say.
Hi JWB, Thanks for your post. “Anybodys guess” is correct. It will be interesting.
Hi Hyperbad, thanks for your post. I am suggesting nothing other than that.
Hi Tommy, Good points, as always. The access to public capital is a key element to our real estate recovery.
Hi Noah, thanks for your post. I really like your stuff, and here, your points are very well made. Thanks again.
Hey Bob,
I saw your blog recently, knakalstreetwise.wordpress.com
Very well presented. It is just what I was looking for.
Great effort keep up the good work !
John
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