Lending Advice
by Mark Levine
Earlier this summer, I found myself caught up in one of those guilty-pleasure television shows. I knew that I was wasting my time watching it, yet I couldn’t stop until it reached its thrilling finale. No, it wasn’t The Sopranos, although Tony and Carmela did become fixtures in our living room each Sunday night. Instead it was the dramatic show that was broadcast at prime time yet included no actors, appeared on ESPN yet was not a sport, and operated at a very high intellectual level yet featured nobody old enough to drive a car. Yes, I was addicted to coverage of the 2007 Scripps National Spelling Bee.
If you missed all of the excitement, the 2007 Spelling Bee had special meaning for those of us in the Bay Area. A young gentleman named Evan O’Dorney, from the local town of Danville, took home the grand prize. O’Dorney beat out 285 competitors in the national finals, along with thousands of others who participated in local qualifiers. Because I know that you are curious, the final word that Evan spelled correctly was “serrefine,” meaning “small forceps for clamping a blood vessel.” As is usually the case, O’Dorney doesn’t even really like spelling. He prefers math because he considers it to be much more logical.
Me too. While I understand that our local spelling champ probably has different interests than I do, we do share a similar affinity for seeking logical answers. That’s why I tend to follow the financial markets and the treasury rates so closely. To me, they are logical, and there is always a good reason why they behave like they do and move in the directions they move. For those of you who seek explanations for market fluctuations, hopefully you also find that they usually make logical sense based on various influences occurring around the world.
Unfortunately, however, following the movements of the markets lately might also be causing you some motion sickness. Most of us didn’t realize how good we had it until the treasury markets suddenly became volatile during the second quarter of this year. For nearly three full years, treasuries fluctuated between approximately 4% and 5% and they rarely moved by even five basis points on any given day. Actually, at certain periods they often didn’t move five basis points over the span of a week or even a month. We grew very accustomed to the 10-year treasury rate being below 5% and, therefore, enjoyed steady multifamily and commercial mortgage rates near or below 6%.
Things change, and boy did they ever earlier this year. Within one week in early June, the 10-year treasury rate jumped nearly 30 basis points and remained above 5% on a sustained level for the first time in years. It didn’t stop there. Rates continued to move around for most of the early summer and the 10-year treasury rate hit a peak of 5.32% for a brief period. Within 25 business days, the rate had jumped 70 basis points at its peak. Remember, this comes after a long period during which five basis-point movements were considered significant.
Because we aim to discuss where rates are going in the future and how they will affect everyone’s business, we will not spend too much time reviewing why the sudden volatility occurred. In brief, we know that it had a lot to do with the subprime mortgage collapse earlier in the year. The perceived risk of fixed income increased and, therefore, so did the required rate of return on investments. We also know that the rate increase was significantly triggered by international events, which is evidence once again that we live within an increasingly global economy. Essentially, several nations around the world actively raised government treasury rates to curb inflation risk, so our rates increased as well.
As I mentioned, though, the goal is not to review where we’ve been, but rather predict where we are going. Obviously I can’t tell you exact numbers for where the treasury rates will be at any given period of time. If I could, I’d have a much bigger lead in our “Economist of the Month” office pool. What I can tell you, however, is how we can read indications that the rates might be moving in one direction or another in the near future.
The most important item for predicting the future is learning from the past. That’s why I can’t help myself from discussing the aforementioned market influences that led to rate movements earlier in the year. So my first question is whether or not we think that the subprime mortgage issues will continue to linger, or if they will be long forgotten by the end of the year.
Personally, I think that we need to get accustomed to more and more bad news coming from that side of the business. Because the hiccups occurred very recently and the resulting correction to aggressive lending terms is still young, there are many risky loans still out there. The nontechnical term for these loans is “ticking time bombs” because it is just a matter of time before they default. Most people assume these bombs will go off when the rate on a subprime mortgage resets from the “teaser rate” to something that’s hundreds of basis points higher for the remainder of the loan.
Often the reset occurs two years after the loan begins; therefore we still have many more months of very aggressively originated loans going through critical rate reset events. Although I hope that I am wrong, I fear that we have only seen the tip of the iceberg and that there will be a steady flow of residential mortgage defaults to come. This does not bode well for those who want to see lower interest rates.
One other treasury rate barometer we don’t often discuss in this column is the domestic stock market. Although it is not always so clear cut, generally the stock markets and treasury markets move inversely to each other. They are seen as alternative investments and, therefore, if someone takes money out of the stock market, they theoretically invest it in treasuries, and vice versa. Of course, this is a gross oversimplification, particularly with so many other global investment options available now, but you’d still be surprised by how often this simple theory holds true.
If we can predict the behavior of treasury rates from the movements of stock markets, we still have a big hole in the analysis. Namely, where are stock markets going in the near future? I don’t pretend to follow the equities markets too closely and I certainly don’t speculate on their future movements, but I did hear something interesting recently. Apparently, nearly all of the gains in the stock markets over the past 50 years have occurred during the winter, spring and fall months. Summer has generally either been too inactive to cause significant movements in any direction, or it has often been the time that markets correct after rallies earlier in the year.
That is not a good sign for investors who have money in the stock market this summer. Of course there are many other factors that can cause the markets to go in one direction or the other; however, historical trends don’t lie and this one seems to be fairly reliable. If you couple this with the fact that we have experienced a relatively strong bull market in domestic stocks throughout the beginning of the year, I would bet on a slow summer. So, if a downward trend in the stock markets does hold true throughout this summer, the basic economic principles assume that money should flow from equities into fixed income. After dusting off our Economics 101 textbook, we remember that the increased demand for treasuries should cause an increase in actual treasury prices, which always causes a decrease in treasury rates.
Of course, these two factors–ongoing subprime issues and equity market trends–are only a small part of spelling the formula for treasury rate movements. But taking these two factors into account, along with many of the other factors that shape the markets, I see a volatile yet relatively flat overall trend for interest rates. I would expect to see some continued increases due to ongoing credit issues surrounding residential mortgages. However, I would see the increases at least partially offset by continued demand for U.S. government treasuries.
Do not expect the same type of volatility that we experienced earlier in the summer; however, there should be some ups and downs depending on the news and economic statistics released during any given week. The market is a bit skittish these days, so movements might seem exaggerated at times. But overall there should be some logic to the general direction of the movements.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2007 by SF Apartment Magazine. All rights reserved.