Deceleration of inflation on Main Street lowers interest rates

Not only are we seeing housing prices dropping, but on the other side of the coin (or, more aptly, the dollar), demand for cash is rising since there is less of it readily available in the market, called a liquidity crisis, all according to a report by the American Enterprise Institute for Public Policy Research (AEI), The Rising Threat of Deflation.

For instance, homeowners, painfully aware they are not receiving sufficient assistance from the government, their lender-banks or bankruptcy courts, resort to helping themselves by strategically defaulting and living in their homes rent-free off their lenders. They also hoard the cash they are not using on housing payments to save for their future housing needs after they lose their homes to their lenders.

Even those homeowners who are not underwater and in distress are beginning to understand the need for reserve funds — the personal savings rate in the US has gone from 0% of income during the Millennium Boom to roughly 6% of income today — and the trend will be to save more if general uncertainty and a lack of understanding about the future increases.

Employers are equally cautious, choosing to keep money in store rather than hire workers.

Thus, cash is pulled off the market and kept in reserve, making it even more sought after and respected as more valuable in the real estate market — which works only to send property prices into a further downward spiral of depreciation since the relative strength of cash as king grows.

Hampering the real estate recovery

Support of the banks by the Fed, Congress and the administration ties the hands of the real estate recovery. Protection means banks will not be forced to cram down principal balances (via Congressional decree authorizing bankruptcy judges) or foreclose on delinquent loans (via the Fed’s and the Federal Deposit Insurance Corporation (FDIC)’s regulations).

Cash is pulled off the market and kept in reserve, making it even more sought after and respected as more valuable in the real estate market.

The alternative “fix” for the real estate industry involves finding users of property, such as homebuyers and buy-to-let investors. They are most able to buy since the Fed will see to it the MBB market has all the funds it needs for purchase-assist loans. Unfortunately, the age shift in demographics will not create buyers until well into 2016-2018 when Generation Y-ers begin to form households and put down roots by purchasing homes in significant numbers. [For more information, see the upcoming first tuesday article, The demographics forging California’s real estate market: a study of forthcoming trends and opportunities – Part I.]

Financial subsidy stimulus to encourage homeownership from mid-2009 to early 2010 produced the same lackluster results as the federal stimulus to create jobs at the corporate level. While home purchases were temporarily buoyed by the federal first-time homebuyer tax credit, it did not organically create buyers. Worse, it appears to have had the unintended adverse consequence of encouraging builders to ramp up new home starts.

Further, the temporary increase in buyers triggered by the tax credit subsidy was merely a result of poaching the less risk-averse homebuyers from future prospective homebuyers — who would have purchased a home in a year or two anyway. [For more information on the efficacy of the federal housing tax credits, see the May 2010 first tuesday article, Federal housing tax credits = success?]

Thus, the administration must help create buyers. Two ways exist to do this:

  • create jobs; and
  • provide financial support for buy-to-let investors.

As is every day apparent, jobs are not being created (California is currently losing jobs) and in turn are not producing ready, willing and able homebuyers. Those few individuals who do have the cash to buy come face to face with the pricing volatility of the SFR market.

On paper, cash on hand and cheap prices may look good, but the widespread depletion of equity in homes — the single largest asset most people ever own — is devastating for homeowners and in turn for consumer confidence. When paired with the current dreary jobs outlook, those few who are capable of buying a home as their principal residence are definitely thinking twice before pouring their cash into property — to them, the timing aspect for purchasing real estate simply isn’t right. [For more information on the next wave of future homeowners, see the July 2010 first tuesday article, Boomers retire, and California trembles.]

Banks, if they can ever be counted on to act in the interest of the larger economy, and the government must take a much more gracious stance towards buy-to-let real estate investors by making loans available to them on the same terms as they do for buyer-occupants. The current housing foreclosure policy practiced (if not, then permitted) by the government is manufacturing large numbers of long-term tenants who will seek shelter in renting a home, not ownership (which to them now seems rather repugnant).

Buy-to-let investors, comparable to our apartment project syndicator, have money to put into the real estate market. If allowed to get financing on equivalent terms and guarantees as homebuyers, they will put a stop to price level declines. Buy-to-let investors help real estate through their long-term ownership and operation of property, providing valuable stability as small businesses in a sea of bank owned properties (REOs) and vacancies.

Editor’s note — Buy-to-let investors are to be differentiated from pure speculators. Speculators are only in the market to make a quick buck over a three-to-six month period (ideally, that is) with absolutely no concern for the care of property or its use by tenants. Buy-to-let investors who seek to “score” short-term are the antithesis of speculators as they are in the market for the long-term, caring for their properties for much the same reasons as buyer-occupants do — buildup of wealth over time. [For more information on the role of investors and speculators in the real estate market, see the August 2010 first tuesday article, Speculations on speculator suppression.]

With an insufficient number of existing homebuyers in the market, investor-averse lending policies and ineffective efforts to create buyers by the federal government — the lender and employer of last resort — the only remaining path to recovery is the one blocked by the coquettish interplay between the Fed, the FDIC and the banks — a prompt clearing out of the delinquent and defaulted loans through foreclosure. Is the country’s housing recovery doomed to trudge on at this snail’s pace to the end? [For more information on the shape of the real estate recovery, see the November 2009 first tuesday article, Divining the future: the letters game.]

The deflationary warpath

In the very early 1990s, both Chile and Japan suffered financial crises exposing their respective banking systems to the same danger of failure currently experienced today in the US. Chile quickly seized and liquidated their insolvent banks, then promptly sold off the remnants. This flushed out the bad loans, allowing Chile (as they expected) to suffer a relatively brief but abrasive period of economic distress, followed by a quick recovery. They have experienced significant growth in their economy ever since.

In contrast, Japan held interest rates low following their 1990 financial crisis, not to encourage growth, but to prop up the large (‘too-big-to-fail,’ in American parlance) banks, seized none of them and experienced a 20-year economic depression. Japan has only very recently begun to recover from this depression, and some 20 years on, real estate prices in that country are half of what they were before their financial crisis. [For more information on the mismanagement of financial crises, see the September 2009 first tuesday article, Beware the drastic measures brought on by desperate times.]

Some economists and the AEI point out the US financial crisis has the potential of becoming a decades-long depression reminiscent of Japan’s deflationary depression; the increasing power of cash and the near-zero interest rates sustained by the Fed suggests they believe we are heading towards a deceleration of the core inflation on a year to year basis, called deflation when it passes beneath 0% inflation.


Deflation must be fought with every tool the Fed has to avoid the Japanese experience and enjoy the Chilean-type recovery. As of July 2010, the year-over-year US core inflation rate was at 0.9%, however it is likely to have fallen closer to the negative tipping point by now.

Deflation’s fearsome grip on economies usually accompanies a financial crisis, according to the AEI. The Fed, ever wary of the long and self-sustaining destruction brought about by deflation,will try some new tricks to straighten out the economy. The use of the interest rate to subsidize bank profits may not tread beyond the 0% line to get further relief from a deflationary trend (although the Fed could go negative, but never has). At some point, the Fed will need to consider stimulating bank lending by buying treasury bonds at ever greater prices (and lower interest rates) and releasing yet more money into the financial system. This increased flow of money (liquidity) will drive interest rates lower on business, consumer and real estate loans since the money in the banking system will be lent at lower rates than available today. Banks will then be compelled to lend to business and consumers (in the form of mortgages) since the Fed-set bond rates will be too low for bank management to justify leaving funds in risk-free treasury bonds.

Editor’s note — Even though nominal interest rates (i.e., the advertised interest rates) may be historically low, the real return (read: profit) banks are making on these “low” interest rates is historically very high. This is a function of the Fisher equation: rate of inflation + real rate of return = nominal interest rate. Since the cost of funds to the banks is today the rate of inflation, which is approaching zero, when banks are charging 4.00% – 4.75% (nominal) interest rates, they are collecting profit margins equal to nearly the entire rate of interest charged. Consider that historically, banks prosper lending money at a profit margin of between 2.50% – 3.00%; nearly half their current margin, the real rate of return.

Even though nominal interest rates (i.e., the advertised interest rates) may be historically low, the real return (read: profit) banks are making on these “low” interest rates is historically very high.

Besides a watchful Fed, the US has the strength of a youthful population to stir growth in the economy and help fight the onset of deflation. California, though not without its own financial difficulties, still leads the nation as the West’s great bastion of innovation (resulting in low homeownership levels for quick relocation to new job opportunities). Its entrepreneurship in technology, eco-energy, film production and other cutting-edge business endeavors guarantees California will retain its lead in the nation’s economic recovery. But first, the Fed and the FDIC must pull the plug on the banks (of which the weakest are in California-Nevada and the Georgia-Florida section of the US).

It was true before, and is still true today — when times are tough, the advice of parents and advisors is to, “Go west, young man; go west!”[For more information about California’s economic ability, see the November 2009 article, Once out of hibernation, the Bear Flag Republic will flex its fierce economic muscles.]

The new paradigm calls for brokers and agents

The flush real estate market which existed during the Millennium Boom is gone, and with it the days of lax regulation and easy money. While cash is king, property values will fall or, at best, remain stagnant. To survive, brokers and agents must keep their ears to the ground to learn which direction the economy is going, and why. They must keep abreast of the news to see where they fit into it – they must listen to the news bearers.

More than ever, the practice of real estate requires flexibility, and flexibility by definition means change. Only those brokers and agents who understand the economy whirling around them will be able to carve out niches for themselves. Those who saw the real estate bubble implosion coming became versed in the ins and outs of REO sales. Those who are keeping an eye on the market now are brushing up on strategies for short sales and REO listings and sales, with more than just an eye on property management. [For more information on other possible niches for real estate agents, see the August 2010 first tuesday articles, The private owner auction niche and licensees: Part I and Part II.]

Brokers and agents must divine these paths and continue in their role as matchmaker — pairing up properties on the market with buyers who will occupy them or rent them to others. [For more information on the new real estate paradigm, see the May 2010 first tuesday articles, Looking through the window towards recovery; a real estate paradigm shift: Part I and Part II.]

By now, the brokers and agents who were in it for the quick buck or who lacked proficiency have exited the scene, and those who remain are those who will drive the new real estate paradigm — and flourish. They remain standing, but not still, for they know no status quo. They will cling dearly to three key fundamentals to get through the long period where cash is king:

  • they must be receptive to new ideas;
  • they must be willing to embrace new ideas; and
  • they must be quick to discuss alternative steps if or when the new ideas do not fully pan out.

Those licensees only comfortable with the known and knowable facts of the past real estate game are of the old guard, willing to let the money come in without caring to think about how to keep it coming in, will not likely make it through this long housing recovery without substantial reserves. Instead, it will be the innovative, the risk-taking, the fluid brokers and agents who will find ways to remain solvent, to weather the storm and prosper in this decade’s mini-boom, circa 2017. [For more information on the exodus of sales agents and brokers from the market, see the March 2010 first tuesday article, The rise and fall of real estate brokers and agents.]