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Are Low Interest Rates The Problem...??



-- Posted Wednesday, 19 June 2013 | | Disqus

By Harris Kupperman

What if the Central Bankers have it all wrong? What if low rates are actually the problem, not the solution? We all know and basically accept that low rates thwart the creative, destructive process of capitalism, where inefficient companies go bankrupt and remove competition from the marketplace so that stronger companies can thrive. If you can forever refinance and reduce your interest cost, it’s pretty hard to go bankrupt. But what do low rates mean to investors?

Bernanke has repeatedly been baffled and disturbed by the fact that cash continues to build up in the banking system, but refuses to enter the broader economy. At the same time, investors continue to clamor for negligible returns on money market accounts, rather than reinvest in the economy. In Central Banking circles it’s compared to pushing on a string. You can print all the money that you want, but unless you can get it into the broader economy, the effects are somewhat muted. Central Bankers have even talked about taking interest rates into negative territory—thereby penalizing investors who keep their capital outside of the non-banking economy. Could it be that the Central Bankers are their own worst enemy?

Let’s say that you are an investor, where do you want your money? Would you prefer the surety and liquidity of a money market account at no return, or would you want to venture out into the marketplace looking for a return? If the expected returns were high, you absolutely would want to go out there and take on some risk. What if the expected returns are being suppressed by low rates? Maybe you don’t really want that risk.

zero interest 1

Look at property investment for instance. There was a time about a decade ago, when you could expect a high single digit yield plus moderate appreciation—even in super-premium properties. In total, you could probably expect a low double digit compound return and in less than a decade, you would double your money. If you used some leverage, you could even double your money in five years, and do it in the relative safety of super-premium real estate. What are the returns now? If you look at a very desirable location like South Beach, where I live, you are lucky to eke out a 3% yield. Is there appreciation potential? Probably—but at 3%, why would you bother? Just look at the risks.

The obvious risk is that you have to worry about your cash flow. Where will revenues come from? It’s not like the economy is exactly booming. Then look at expenses. We know that inflation is here and it’s persistent. All of your fixed costs are expected to go up—especially your large ones. Does anyone expect property taxes to decline? At 3%, are you paid for these risks? Would you go somewhere less desirable for a 6% yield? That’s the question facing investors. What if interest rates rise in a few years? What happens to cap rates then? You can lose your shirt. So in the end, you’re probably better off in the relative safety of 30 day government paper that yields nothing. At least it’s liquid and it will be around tomorrow.

krugman 2

Now think like a banker. You have a whole lot of capital, you’re probably willing to lend against that building in south beach if they put up enough collateral, but what about the small businesses out there? Do you want to lend money to some guy who’s only marginally profitable? If the yield is good enough, maybe—but at current rates? In the past, one reason you loaned money was because you always had the chance to see interest rates drop—so that you could lower your cost of capital and increase your lending margin. That’s off the table. Rates aren’t going lower. If anything, you may end up locking in historically low rates on your lending—who wants that? Meanwhile, you always have business risk—it’s a risky world out there. Maybe it’s better to accept a lower net interest margin and just invest in government paper? Welcome to the club—everyone else is doing the same.

In summary, the money is being printed, but except for the government deficits, it’s not showing up in the broader economy. It’s sitting in the banking system. Low interest rates are their own worst enemy. Fear of risks and fear of higher rates in the future is keeping this money immobilized. Maybe it’s time to re-think things and raise rates. Higher returns will bring the money off the sidelines. Low rates certainly are not the solution except for those that already have too much debt.

http://adventuresincapitalism.com/


-- Posted Wednesday, 19 June 2013 | Digg This Article | Source: GoldSeek.com

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