Volume 60 | Number 10
Its late September, and the global economic crisis is once again near a boiling point – as marked by the sharp equities sell off around the world, the start of Operation Twist by the Federal Reserve, and the G20’s call for more action from the Europeans. The ongoing banking crisis in the developed world has led to a near standstill in economic activity, which is now threatening the formerly robust growth in the developing markets – as reflected in collapsing commodities prices. Businesses collectively are waiting for a signal from governments which does not appear to be shortly forthcoming. The most likely path is for financial markets to ratchet up the pressure on politicians to act proactively – but the risk is that the situation will devolve into greater weakness before they move in reaction to a crisis so great it finally gets everyone marching in one direction. The markets negative response to the Fed’s larger than expected Operation Twist, and the politicians’ lack of concern about timely solutions will only intensify the pressure for strong leadership. Unfortunately, we do not yet see that leader arising, either here or inEurope.
At home, the crisis is now illustrated by the squabble between House Republicans and Senate Democrats over the funding of the emergency aid for the flooded North East. The amount, between $3 and $7 billion, is infinitesimal in the scope of recent problems. It is the simple issue of whether or not government should spend borrowed money at all that is at the heart of the matter – and there seems little room for compromise from the current combatants. The risk is another government shutdown in mid-November, and, more pressing for those affected, the exhaustion of FEMA aid. The Senate has proposed a vote on its version for Monday, but further consideration in the House may not come until October 3rd. The reality is this new uncertainty about the direction of government policy will translate into 100,000 less hires in September than might have occurred if we were simply muddling along at 2% real GDP growth. The risk of slipping off the edge into recession – which will cost hundreds of billions in economic activity and tax collection — is significant. The financial markets have already lost trillions in wealth as a result of government inaction. Clearly, everyone is already yelling at their Congressman and the Administration – but we are all still saying different things. Unfortunately, history suggests that it may take a momentous us against them moment (the Declaration of Independence, the Secession of the Southern States,Pearl Harbor) before we can come together to put this depression behind us.
InEurope, everyone outside of the leaders of the stronger economies seems to understand that Greek default is imminent and that the risk to the poorly capitalized European banking system is profound. The European finance ministers were roundly pounded at the G20 to clean up their mess, but they simply do not have the authority to agree for their nations. All ideas raised this week must go back toEuropeto be discussed and voted on – and a unanimous vote for approval is required. The latest idea is for the European Central Bank to loan $2.4 trillion to the banks with the $600 billion European Financial Stability Fund taking the risk of losses – essentially a European TARP. Unfortunately, most contributors to the EFSF never expected their entire donation to be lost, so it seems unlikely this idea will generate a rapid unanimous decision without a significant increase in the crisis first. Indeed, no idea seems destined for rapid approval and therein lies the problem for businesses and the financial markets.
The Fed’s Final Volley
Just six weeks after promising to hold short term interest rates at near zero through mid-2013, Federal Reserve Chairman Ben Bernanke has defied the Fed President’s again by announcing a larger than expected Operation Twist to push down long term rates from already post-war lows. The Fed over the next nine months will swap $400 billion in short term debt (1 to 3 years) currently held in its portfolio for longer term securities (6 to 30 years) and reinvest any money rolling off of its portfolio of mortgage backed securities back into similar securities rather than into Treasuries. The response was for the ten year note to fall from 1.95% to 1.81% at the close Friday, and the thirty year bond plunged from 3.25% to 2.9%. Indeed, since the Fed’s committed to holding short rates unchanged for two years – and the downgrade of the US debt and everything going on in Europe – ten year notes have plunged from 3.00% to 1.81%, holding out the possibility of a profound refinancing cycle. This may be the last best hope for any positive momentum in theUSeconomy.
We are well aware that many potential refinancers are blocked by their low loan to value ratios. The catalyst for positive action from the Fed’s easing must come from the government sponsored agencies (Fannie Mae and Freddie Mac) allowing homeowners with mortgages in their portfolio to refinance regardless of LTV. This is a no-brainer to almost anyone who has looked at the economy’s problems – but still fails to be forced by Congress. Still, even without the LTV waiver, the drop in rates is so large that it may set off a strong round of refinancing among those who have successfully refinanced in recent months. Given these filers will have recent paper work, banks may waive some fees, speeding the process and releasing income to boost spending or pay down debt.
More importantly, the decline in borrowing costs is likely to boost the value of existing rental properties and accelerate the shift of more single family units into the rental stock. Simply put, a rental property is like a bond, and given that rents are unchanged by any of the Fed’s policies, the value of that stream of cash flow is worth more when competing investment opportunities yield less. Any increase in the value of rental type property would lift prices at the bottom of the market where persistent foreclosures have made the loan to value pressure greatest. A 100 basis point reduction in financing costs for a rental property could be worth a 25% increase in the value of its rental cash flow (assuming a 5% rate drops to 4%.) At such low interest rates, decreases in discount rates have huge effects – in both the residential and the commercial rental markets. Shifting residential foreclosures into the rental market would increase frictional vacancy (rentals are typically unoccupied for longer periods of time than owned homes) helping to reduce the excess capacity. Moreover, any improvement in home values at the low end would allow easier movement by trapped homeowners, allowing more to make more reasonable long term decisions about where to work and what type of housing is best suited for their needs. Indeed, higher prices for all types of rental properties — especially for nonresidential buildings where the market is currently less depressed than the residential market — would strengthen bank balance sheets and allow them to increase lending.
Finally, an often unrecognized benefit of Operation Twist and earlier Fed actions is their beneficial effect to the budget deficit. When the Fed earns interest on government securities, it returns the interest to the Treasury. During QE, the Federal government was able to collect interest on almost a trillion dollars in mortgage backed securities (earning higher interest rates than corresponding Treasuries) and during QE2 to issue another $900 billion in short term Treasuries at no interest cost while simultaneously lowering the cost on existing short term debt not held by the Fed. Now in Operation Twist, the Fed will eliminate the interest cost on $400 billion in longer term Treasuries, while holding short term rates flat for two more years. Finally, and least recognized, the refinancing that occurs at these lower rates generate a significant savings to the Treasury through reduced mortgage deductions. For many of the mortgages refinanced, the loser of the interest income is a tax free entity (like a pension fund), while the winner from lower interest rates loses a tax deduction worth 28% or 35% of their savings (those at 15% likely still take a standard deduction). Bottom line, the government deficit falls as interest rates decline – and they are down a lot recently.
The End of Schedule A?
A significant refinancing cycle might also bring the long sought after tax simplification a giant step forward. The main reason most households itemize is their housing expenses – combined mortgage and property tax deductions. A 1% reduction in mortgage rates would reduce the value of itemization by 3% to 4% of income for most itemizers, bringing many closer to where the standard deduction was a better deal. Itemized deductions have risen 12.6% over the past five years while mortgage rates have fallen over 7% to under 4% — and many have taken advantage of refinancing. Even at the million dollar limit and a 35% tax rate, the maximum mortgage deduction at a 4% interest rate is worth just $14,000 – and that is assuming the AMT does not reduce the benefit of the deduction. Just ten years ago, a million dollar deduction might have generated three times as much tax savings. It seems with the benefit of the largest individual tax deduction falling precipitously; this is the time for tax simplification through a creative use of larger standard deductions, lower tax rates and/or tax credits rather than deductions to eliminate complexity in the tax filing.