Rising Interest Rates Bring Challenges and Opportunities

The Federal Reserve announced on November 1st that interest rates will remain unchanged, for now. However, analysts are all but certain that the Federal Reserve will raise rates in December, and four more times in 2018. Economic growth remained at a robust 3% in the third quarter, even with the losses from Hurricanes Harvey and Irma. Despite the growth, inflation is still languishing at 1.3%, well below the 2% target rate set by the Federal Reserve, prompting the desire for an interest rate hike.

For those of us in the real estate industry, this means we can expect mortgage rates to rise. Corelogic is predicting a mortgage rate of 4.7% by the end of 2018.

This will make buying a home less affordable, for two reasons. The first reason is that higher mortgage rates mean more expensive mortgages. A common rule of thumb in the mortgage industry is that for every 1% rate increase, consumers lose 11% of their purchasing power.

The second reason is that current homeowners will be less motivated to sell, enjoying the low interest rates they currently pay from mortgages written since the Great Recession in 2008. This will mean fewer homes on the market, further reducing affordability. CoreLogic Chief Economist Frank Nothaft predicted a 5% rise in home prices in 2018. Clearly, the mortgage industry will see some impact. The economic fallout will not be contained to one industry, though. Home buying generates billions in economic activity from appliances, furnishing, repairs, and remodels.

If you’re already a homeowner, rising home prices doesn’t sound too bad on its face. The average American homeowner saw their equity increase $13,000 over the past year. In Texas, that was $11,000 in equity increase, and in Austin, as much as $20,000 for the median priced home.

Even if you’re enjoying the increased home equity, there are still negative effects to consider. For one, if you’re unwilling to sell your home due to the increased cost of buying somewhere else, you’re less likely to move to pursue a higher paying job or better opportunity elsewhere.

Decreased affordability also reduces household formation. We saw a huge drop in the number of households formed following the Great Recession, further dragging down the economy. When young people can’t move away from their parents and form new households, downstream industries suffer.

Finally, the ability for existing homeowners to “move-up” to a bigger home, better location, or even adding a second vacation home will be greatly reduced. Again, these effects aren’t just contained to the housing industry. Real estate decisions touch most every part of the US economy.

While rising home prices and interest rates present challenges, it is no reason to lose optimism in our current market. Nationally, the unemployment rate is at its lowest level since December 2000. As the economy nears full employment, wage growth should follow. Locally, job growth and immigration continue, bolstering our housing market. Austin is still a very attractive market for skilled workers, offering good quality of life and relative affordability compared to other job-growing metros.

Texas continues to outpace the national economy

Officially, the Great Recession reached its lowest point in June of 2009, and the national economy began its path to recovery. Almost six years later, some states like North Dakota and Texas with strong energy industries are home to the most fully recovered economies in the aftermath of the Great Recession.

However, if we look at the majority of the country, unemployment has not recovered in 95% of the near 3,100 county economies to pre-recession levels according to a new study by the National Association of Counties.

A county-by-county breakdown of local economic performance was issued in the association’s 2014 County Economic Tracker. The study spans all 3,069 U.S. counties and suggests the majority of local economies have not fully returned to pre-recession stability. The association’s report, based on data obtained from Moody’s Investors Service, breaks down local economic performance into four major categories: gross domestic product, employment totals, unemployment rates, and home pricing. The findings for 2014 were compared to pre-recession figures to get a feel for which local economies have recovered best since the Great Recession.

This analysis of county economic conditions identifies patterns of growth and recovery in 2014 across the 3,069 county economies by examining annual changes in jobs, unemployment rates, economic output (GDP), and median home prices. In addition, it explores 2013 wage dynamics by adjusting average annual pay in county economies for the local cost-of-living and inflation. The overall analysis reveals that:

• 2014 was a year of recovery, but unemployment has yet to return to pre-recession lows in most county economies.

• Job growth accelerated in 2014, economic output expansion and county housing markets stabilized across the country, yet most have not fully recovered.

• Economic recovery is starting to spread, although only 65 county economies have fully recovered.

• 2014 recorded higher net job creation than the previous year, with 40 percent of the new jobs in industries earning more than the average county pay.

• On the positive side, we find out that 72 percent of county economies recovered on at least one of the indicators we analyzed.


newsletter 3-26


In Texas, the recession is in the rearview mirror. Economic growth across the major Texas metros has been impressive since the recession and they have fueled the state’s job growth. However with crude oil values down 52% in February from year ago levels, Texas employment growth will moderate in 2015, affecting the Texas’s metros in varying degrees.

The Houston economy has grown over 310% since the recession, Dallas / Ft. Worth 228%, and Austin 114%. Houston has experienced the greatest benefit from the energy sector and its rise after the recession. D/FW lagged behind the other Texas metros after the downturn, however of all the Texas metros it will probably have the strongest growth and continue to propel the state’s growth after the oil decline going into 2015.

The recession’s impact was not as severe in Texas. Also realize that this last recession was the worst since the Great Depression as shown by this great chart from Calculated Risk.

newsletter 3-261

To say that this last recession significantly affected job growth is an understatement as the chart shows. From peak to trough, the Texas region fell 4%, compared to the national decline of 6%.
So what is causing the national economy to lag? First we need to understand what made previous booms and recessions. Realize that the economic contraction in 2008 was nothing like past recessions. Inflation and monetary tightening had nothing to do with the recession: core CPI peaked at just 2.5%. It was, instead, a financial crisis, comparable in recent US history only to the Great Depression.

During the course of 2007 and 2008 recession, US household wealth fell by 25%, equal to about $15 trillion dollars. To put that number in perspective, annual GDP in the US in 2008 was $14.8 trillion. Nothing close to this had happened in the prior 75 years. In fact, the annual change in household wealth had never been negative.

When wealth falls, consumption falls. Remember we are a consumer driven economy, where the majority of our GDP is driven by the consumer’s ability to acquire debt and spend it. Consumer sales in the US were negative year over year for six consecutive quarters during 2008-09. In comparison, consumer sales actually grew 1% during the trough of the 2000-02 recession.

The Texas region suffered, but not near like other states, particularly California, Nevada, Arizona, and Florida, where speculative appreciation was strong and the base of the consumer economy was home equity. This collapse of wealth in so many other states had little to no effect in Texas due to the lack of speculation and various regional banking laws.

In the wake of the dot-com bubble, the housing market inflated like never before. This was completely unlike prior economic cycles. Some states experienced not only double digit appreciation, but high double digit appreciation (40-50% annually). Additional speculative housing supply created a demand vacuum when this bubble burst. A major engine for the economy was damaged, the tail effects of which are still being felt. New and resale home sales are just beginning to recover from the lowest level experienced in many years.

During this real estate and financial boom, a byproduct was an increase in household debt. This leverage was in large part underwritten by inflating asset prices and ease of loan qualifications. When those prices collapsed, so did the ability to fund debt. The economic expansions in the prior 30 years were fueled by leverage. The current recovery has not had anything like that to propel faster growth. Leverage is lower now than it was 30 years ago. Without the leverage from previous recessions, the economic recovery is based on truer means; supply and demand.

Because of the increase in “equity wealth”, consumption exploded. Therefore with the collapse in housing and consumption came a collapse in employment two to three times more severe than prior recessions in the post-war era. This becomes a vicious cycle: lower demand leads to lower employment, leading to even lower demand. The dynamic is not unique to the current recovery but the damage inflicted in 2008 was orders of magnitude more severe.

Texas did not have the speculative housing economy as seen in other states. Therefore we did no have very far to drop when the national bubble burst. The Texas economy slowed in 2008-09, but showed relatively little real estate depreciation. Because of the nationalization of so much lending, development slowed or stopped. Yet in Texas we continued to see good employment growth across all sectors, not just energy. This employment growth drove ‘true demand’ as housing supplies dwindled across our state. In 2015, most metros continue to see a sellers market as demand outstrips supply in almost all Texas metros, cities, and towns.

Texas should continue to see growth. In the short term, continued growth is dependant on how severe the oil downturn is on our lending institutions. Presently, the Dallas Federal Reserve shows little impact on regional growth. The sweet spot for the economy is between $55 and $90/barrel. Below $55/barrel hurts energy employment in this state. Above $90/barrel starts to put a strain on household budgets.

Texas continues to be the ‘land of opportunity’ that California used to be. With lending rates low, supply low, and demand great, there is not a better opportunity to buy and see long term appreciation than in Texas real estate. Remember, I am coming from over 35+ years of watching, engaging and analyzing this regional market. No one I am aware of has called me optimistic. Compared to over 3000 counties nationwide, Texas counties seem to be faring better than most.

Should you buy or rent?

We’ve been asked numerous times if this is a good time to buy a home. The short answer is ‘Yes!’. Prices continue to steadily increase in most areas of Texas’s four metros; mortgage rates are bouncing off of historic lows and beginning to rise; inventory is diminishing; and home values are rising; and rental prices and occupancy rates are moving up. Currently, in most cases, it is more affordable to buy than to rent. And while all of these are compelling reasons, one of the biggest incentives to buy is the tax benefits to homeownership.

Buying a home is a major life investment and should be taken very seriously. Consideration of your current financial status and your future plans should play a part in when and where to buy and how much to pay. Understanding the tax benefits to buying a home is critical to your decision making process so that you understand the full value of your purchase.

But, let’s back up. Presently if you compare home prices vs. rents in your Texas metros, rents have increased rapidly in some markets such as central and west Austin or Houston’s Woodlands. Most regional rentals have had steady annual increases, sometimes out stripping home value appreciation in the same sub market. That said, homeownership is cheaper than renting by quite a bit in all Texas metros.

If you have not sat down with a mortgage professional to see what you qualify for, now is the time. You may not be able to afford or find where you want exactly, but the forced tax savings and value appreciation over the next 3 to 5 years in Austin, San Antonio, Houston and DFW will help purchase that next property. The other markets should have healthy appreciation over the next 3+ years. Why the difference? The entitlement process in Austin slows down how quickly we can address the need for shelter (housing), so they will play catch up for a while. Also, financing is still a challenge, both from a mortgage side as well as from banks. That said, banks have more capital than they have had in the history of US banking. Mortgage companies are looking to help as many people get into homes as possible. You won’t know unless you start the process.

To determine for yourself whether renting or buying a home costs less, do the following:

• Calculate the average rent and for sale price for an identical set of properties. If you currently lease 1500 sq ft., find something comparable. You want to estimate prices and rents for similar properties in the same neighborhood, to get an ‘apple to apple’ comparison. Even if there is nothing available in the area, you want to know what costs will be. You should not compare the average rent and average price of homes in your submarket, which would be misleading because rental and for sale properties are very different. More importantly, for sale homes are 45+% larger than most rentals in the same submarket.

• Calculate initial total monthly costs of renting and owning, including maintenance, insurance and taxes.

• Calculate what future total costs will be for owning and renting by looking at the history of the submarket. Take into account inflation, price, and rent appreciation.

• Factor onetime costs and proceeds like closing costs, down payments, sales proceeds and security deposits. Factor in the opportunity cost of spending money now (that is, examine where else you could put the money for a better risk/return ratio).

• Presently affordability is the best it has been in the last 60 years. I would not wait for rates to come down, they will continue to increase based on most factors. In addition home values in all Texas metros continue to increase. So waiting to make a decision will cost you.

Now compare the payments; rental and to own. How close are they?

When confirming buying costs know that in most cases, homeowners can take the following tax deductions: (disclaimer; I am not a CPA, Tax lawyer, etc.)

Mortgage interest

The interest you pay on the mortgage you obtain for your primary residence is deductible from the income you report in your Federal Income Tax filing. In many cases, this is a substantial amount and, in the early years of your loan, account for most of the payment you make each month. There are limitations to the amount of interest that can be deducted as well as other important considerations for those who wish to utilize this deduction. Even better, unless changes are made by the IRS, this deduction remains in effect for the life of your loan.

Generally speaking, your mortgage payment will remain relatively steady throughout the time you own your home. As you make payments, the amount of interest you pay goes down while the amount you pay towards the principal goes up. In other words, early in your loan you will pay more in interest (which is deductable) while later in the loan you will pay less interest. Regardless of where you are in the life of your loan, the interest is deductable, meaning your purchase today could benefit you tax-wise for years and years to come. This is one of the key advantages to owning over renting. When you rent, you may not deduct any amount of your payments from the income you report to the IRS. Therefore, every dollar less you pay in taxes due to the mortgage interest deduction is an advantage you would gain from owning instead of renting. The difference is not just between paying rent and buying.

Points and/or origination fees when obtaining a mortgage

When purchasing a home using a mortgage loan, certain fees will be charged for the purchase to be finalized. One is the origination fee, which is the amount charged to the borrower (buyer) to cover the costs of providing the loan including processing the loan application, credit checks, evaluating the loan, and other expenses related to the purchase. Buyers also have an option when applying for their mortgage loan to pay discount points in order to lower the interest rate charged to the balance of the loan. In other words, a buyer can pay extra up front to decrease their monthly payments for the life of the loan by locking in a more advantageous interest rate. In some cases, the seller will pay the discount points as an incentive to the buyer to purchase their property. According to the IRS, origination fees and loan discount points are tax deductible to the buyer, in most cases. Even better, it doesn’t matter who paid the points or fees, the buyer is allowed the deduction. So even if the seller paid the discount points, the buyer gains the tax advantage. What moving costs do you deduct when you rent? Not much!

Mortgage Insurance Premiums (MIP)

Certain mortgage loans require buyers to pay mortgage insurance and is stipulated at the time of purchase. In many cases, borrowers who obtain a mortgage by paying less than 20% of the purchase price as a down payment will be required to pay mortgage insurance premiums. Different loan products have different requirements, so be sure you understand the structure of your mortgage loan by having your lending professional explain the loan terms to you in detail.

Basically, to help buyers purchase homes without having to save 20% of the purchase price for a down payment, they may have the option to pay a smaller down payment along with a Mortgage Insurance premium every month. This helps borrowers purchase their homes sooner. While this deduction may or may not remain in the future, as of today the premiums paid for mortgage insurance are generally tax deductible. In fact, the IRS recently announced that mortgage insurance premiums paid in 2011 will continue to be tax deductible. Some rules and limitations apply, so be sure to check the IRS website or with your tax professional for the details on this deduction or speak with your tax professional for advice.

These three deductions can amount to a significant sum of money that you can deduct from the income you claim in your Federal Tax filing, potentially lowering the amount of tax you are required to pay each year and ultimately the cost of your payment. More importantly, those who choose to rent are not able to enjoy these tax benefits. That’s one of the primary reasons why owning a home is actually more affordable than renting in most cases today. With rental occupancy rates going up, rents are rising. As rents increase, those who are able to buy should be do so.

The tax benefits to owning a home don’t stop there. Barring any changes to the tax code by the IRS, besides the points and origination fees from the issuing of the loan and the mortgage interest and mortgage insurance premiums that can be deducted for the life of the loan, homeowners also have two additional tax benefits they can take advantage later in the life of the loan. Tax benefits that can be enjoyed later in the life of the loan include:

Interest on home equity loans

Over time, as you’ve continued to make your mortgage payments, the principle of your loan will decrease. At the beginning it will drop slowly (since more of the payment goes towards interest), while later in the loan it will begin to drop more rapidly. At the same time, the value of your home will change, hopefully for the better. Generally speaking, over time, a home becomes more valuable. In other words, the amount you could sell it for in the future is usually more than the amount you bought it for, especially when you look at it over a time period of five years or more.

As you owe less principle on your mortgage loan and the home experiences appreciation, the difference between those two amounts is known as ‘equity.’ Many people use the equity in their homes to secure a loan to pay for projects, major upkeep or upgrades, or even paying off balances owed to credit cards, auto loans, or other creditors. Homeowners who consider a home equity loan must understand that they are putting up the equity in the home to act as collateral for the new loan. That means, if/when the home is sold, the home equity loan will need to be paid off in full. Just like the main mortgage loan, interest paid on the home equity loan is also tax deductible. In other words, even while you are decreasing your reported income in your Federal Tax Filing to the IRS for your original mortgage, you can further reduce your taxable income by deducting the interest on your home equity loan. There is nothing like this available to those who rent their homes.

Profits from the sale of your home

If you decide to sell your home, another tax advantage comes into play. Whether you are moving up, downsizing, relocating, or selling for other reasons, the profit on the sale can be exempt from Federal Income Tax. Again, barring any changes to the IRS Tax Code, sellers may be able to avoid paying income tax on up to $500,000 worth of gains made from the sale of their home. Couples can claim up to $500,000 in profits without paying income taxes on the gains while singles can claim up to $250,000 in profits. Currently, it is an IRS requirement that sellers must have lived in the home as their primary residence for at least two of the past five years to qualify for this tax benefit. In other words, if your home goes up in value while you are living in it as your primary residence and you sell it for more than you paid, the IRS will not tax you on the gains up to $500,000 (for couples). If you made gains from nearly any other investment, you would be required to report it as income and pay capital gains taxes. That is one of the main reasons why purchasing a home is a better overall investment than nearly every other option. While there are other tax exempt investments available, few will have the same potential as the purchase of a home.

The tax benefits to owning a home start from the date of the purchase and continue to the date of the sale. Especially right now in Texas the advantages of owning versus renting are becoming more and more important. If you are currently renting and would like more information about preparing for your first home purchase, please contact a financial professional. The first step is gaining the knowledge you need to make the right decision and we highly recommend that you speak with professionals in the industry before moving forward.

Here are some quick summary thoughts on benefits of renting vs. buying.

• Easier to Relocate
• Limited cost & responsibility for repairs
• You can split rent with roommates
• Renters insurance is cheaper than homeowners insurance.
• No property tax payments
• No equity lost to foreclosure

• Homes builds equity
• Buy low, sell high. There has never been a better time to buy
• No rent hikes
• Low interest rates for a while
• No land lord
• Christmas time every April, when you get money back.
• Numerous tax benefits.
• The pride of ownership

Another look at Basel III

Last year, we raised concern about a new round of banking regulations, known as Basel III, that was put in place for banks at the start of this year. The overall affect on banks is to require more capital and harsher terms for real estate loans. The new regulations began to be implemented January 1st of 2013, so we thought now would be a good time to touch on this subject again.

For those unconcerned and uninitiated about Basel III, from my eyes it has the potential to slow real estate and small business lending from banks, local and national. Basel III’s purpose was to set precautionary measures on banks and were made to protect the economy from financial crises similar to that of our last recession. There was a real danger of the international banking system collapsing in 2008. The Federal Reserve and other countries’ central banks stepped in to bail out the affected institutions, in some cases even taking over investment banks to ensure their continued operation. The prevailing thought was to keep the banks and those industries open to prevent a total international financial meltdown. Basel III was intended to ensure banks accept a level of responsibility for the financial economy they operate within and to act as a safeguard against further collapse.

The Basel III reforms arose from the concern of the world’s leading countries, politicians, central bankers, business leaders, and economists that entire national economies and to a great extent the material well-being of all their citizens had been put at risk by the high-risk behavior of a handful of major banking institutions mainly located in USA, Switzerland, England, and other industrial powers. They had grown so big, particularly when you looked at the size of their assets and risks compared to their national economies, that they had become “too big to fail”. If they were not rescued, their collapse would cause even more severe national and international economic damage through job losses, housing repossessions, reduced GDP and lending of credit. In addition, the burden and need of saving these giant institutions would and will continue to cost ordinary taxpayers heavily.

Although Basel III was initiated and championed by the finance industry, the industry has lobbied since aggressively against certain aspects of the Basel III reforms. Lately though there seems to be mounting evidence that the industry sees and agrees with the requirements as beneficial in the long term. That’s good, since the industry needs help in improving and rehabilitating the industry’s reputation among the investment community, depositors, law-makers, and consumers.

Basel III put in higher capital and liquidity requirements that require three times the equity buffers previously required under the old Basel II accords. In addition, Basel III puts harsher requirements and restrictions on banking activities such as trading for their own profit and forced structural changes for most international and large banks. The whole purpose was to force the financial industry to have a much stronger foundation of solid assets that are designed to withstand sudden market disruption as experienced in late 2008. And to do this, they must have greater stores of spare capital on hand to tide them over temporary difficulties.
Basel III was designed to eliminate – or at least greatly reduce – the danger of another financial crisis. These guidelines were produced by the Bank for International Settlements that is referred to as the “central bankers’ bank” – based in Basel, Switzerland (from where the Basel Accords draw their name). These financial and accounting guidelines are intended to make the world’s banks – and especially the systemically important international institutions stronger and safer. These global standards were initiated January 1st of 2013 and must be fully implemented by 2019.

It was the financial industries interconnectedness, massive trading, and lack of oversight and vulnerability of the financial sector that caused the crisis. For those outside the financial industry, what does this mean? Many banks, investment banks and hedge funds of many countries had built up excessive on and off-balance sheet leverage. In the eagerness to achieve profits there was an aggressive erosion of the level and quality of the capital base being held to protect and potentially prevent risk (derivatives come to mind). During this time, regional and international banks were holding insufficient capital liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses, which in turn resulted in the financial meltdown of 2009. All this was created by aggressive liberal lending standards that many financial institutions were using. Politicians were calling for more aggressive liberal standards for lending to increase home ownership rates for decades. Home ownership shot up to 69% nationally from its previous average of 65%. It doesn’t sound like a lot, but a devastating effect on the financial world.

The overall purpose of the Basel III regulation package as well as the previous two agreements was to ensure that the financial sector remains in a position to fulfill their primary function of providing credit to individuals and businesses and maintaining their liquidity by maintaining a safety net of capital. The hope of the reforms is to improve the banking sector’s ability to absorb shocks arising from future financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.

The underlying principle or purpose of Basel III is clear and simple. First and foremost the financial community is there to serve the broader economy. The self serving attitude of bankers engaging in high risk, high profit investment strategies, secure in the knowledge of a government bailout, has to stop. The federal government established the Federal Reserve to have “A strong and resilient banking system to be the foundation for sustainable economic growth, as banks are at the centre of the credit intermediation process between savers and investors.” The banks are to provide and offer critical services to consumers, small and medium-sized enterprises, large corporate firms and governments who rely on them to conduct their daily business, both at a domestic and international level.

Some of the unintended favorable consequences of the new rules are already emerging. Banks are seeing their capital boosted much more quickly than either they or the regulators expected. That’s good news, correct? Yes and no – many banks have been forced to shed assets and cut back on lending rather than go to their shareholders to ask for more capital to help boost ratios the regulators require. It may be making the banking system more sound, but have these capital requirements had the necessary effect on lending? Locally and regionally in Texas the answer is yes, however on a national basis the capital requirements have slowed the lending process. As well as Texas is doing, we are dependent on the rest of the nation. Small business loans as well as more aggressive real estate lending are part of the rebuilding process.

So yes, Basel III and other financial regulatory related measures (Dodd-Frank, etc.) adopted by the national and international regulators have forced the banks to maintain a much bigger capital base. The long term result is that the banks will be forced to adopt a more responsible outlook that reflects on their contribution to society at large in their actions as well as to their own internal goals. A great example is that bonuses will only be paid out for longer-term, sustainable performance rather than for short-lived profits. Most importantly, Basel III outlines that banks small and large have been warned to devise a system for closing their doors without help from taxpayers if they get themselves into trouble.

How does it work?

This is probably more than most want to know; as stated previously, the main elements of Basel III are designed to render the financial sector as immune and protected as possible from future upheavals both from within and outside national borders, as well as protect the banks from themselves and aggressive practices. They start with the integrity of their capital base. Individual banks must in future hold more, high-quality capital to protect them against unexpected losses to help them ride through any traumas in the financial markets. There are four main elements in the package.

First, more capital is required. Banks and financial institutions must hold core tier one capital – the highest-quality assets – equal to seven percent of their assets after they’ve been adjusted for risk. The biggest institutions – the so-called systemically important financial banks (a bank, insurance company, or other financial institution whose failure might trigger a financial crisis) must carry an extra 1-2.5+% in capital, giving them a total of up to 9.5% of risk-weighted assets. If they don’t, they face restrictions on the payment of bonuses and dividends that might otherwise affect the firm’s overall integrity. If the bank is thought to be failing or “non-viable”, the capital can be written off or converted to common shares at the discretion of the local regulator. The purpose of this is to force losses on the risk takers and shareholders rather than on taxpayers or the central banks. Other regulatory guidelines are put in place to further shock-proof a firm if needed. If authorities judge that a bank has put itself in danger by lending too much, they can order it to boost common equity by up to 2.5%. Again, this is a large amount of capital when you begin to look at the weighted risk of certain loans such as real estate, which went from a 100% risk to 150% risk.

Second, management of risk. Among other measures all banks must conduct much more rigorous analysis of the risk inherent in certain securities such as complex debt packages and the capital needed. Derivatives and their capital requirements should garner much more analysis and capital potentially.

Third, leverage. Leverage of capital at banks has always been regulated. However Basel III focuses on reducing the ratio of assets that banks, especially the biggest national and international institutions, have built up in relation to deposits. Basel III raises much tougher standards than before. In the future banks must include off-balance sheet exposures when they measure leverage.

Fourth, market discipline and disclosure. To improve the understanding of the risks banks may be running, they must make far more complete disclosures than before the crisis. This particularly applies to their exposure to off-balance sheet vehicles and corporations, how they are reported in the accounts, and how banks calculate their capital ratios and include those risks under the new guidelines.

What does this mean for the banks in layman’s terms?

As stated above, all banks and financial institutions must have enough cash and easy-to-sell assets on hand to survive a 30-day crisis in the financial markets, even though the turmoil was caused by outside forces.
You have read about the bank stress tests. Basel III demands stronger stress tests. Under new standards, banks and financial institutions must retain sufficient high-quality liquid assets to survive a 30-day scenario when its funding comes under pressure whether through its own or another’s actions. For you and me, it means that small business and real estate loans will require stronger capital or equity in loan to value needs. No more interest only or less than 20% equity on loans.

To avoid an excessive reliance on short-term financing that is vulnerable to abrupt changes in the markets; Basel III established a new net stable funding ratio designed to meet any mismatches in a firm’s liquidity profile. Thus, a bank’s obligations are carefully compared with its sources of financing.

To help bank supervisors analyze the status of a bank’s liquidity, Basel III has drawn up what most consider harsher and stronger industry-wide measurements known as “monitoring metrics”. Once again, the systemically significant banks whose failure is deemed to be particularly dangerous will be required to “gold-plate” their liquidity ratios. Again, the idea is that banks manage their leverage and risk appropriately and have capital to serve as a buffer. Overall, purpose of the metrics is to increase their capacity to absorb losses without endangering the rest of the banking community.

So, what does this mean for you and me? First realize that banks in the US have more capital today than ever before in banking history. That foundation of capital strength is needed as the economy continues to struggle towards growth.

We are blessed in Texas with quality job creation and a strong economy, which in turn has helped the large and regional banks to be able to maintain and raise their capital standards, which in turn allows them to have more aggressive lending practices.

The ability to fund new businesses without a track record will be challenged. Banks and regulators want to see a strong track record and capital to sustain any hiccups along the way in a business’s growth. Again in Texas, because of the strength of the markets, it should allow lending that other regions of the nation are not seeing presently.

Nationally the banking and ‘shadow banking’ industry are recovering. But lending in Florida, Nevada and other states that were hit so hard by the financial bust will continue to be challenged. This challenge opens up the opportunity for businesses to look to Texas and its growing economy.

So, Basel III seems to have stabilized the market both regionally and nationally. But we are only a few months into the new guidelines. Time will tell.

Interest rate behavior

We all know that now is the time to buy real estate with interest rates so low. The Federal Reserve has maintained that they will keep rates low until they feel the economy is fully recovered. Even with home prices in our Texas metros near an all time high, there will not a more affordable time to buy.

Will rates go up?
As we have stated before, eventually, yes! In the short term, no. According to most experts and the Federal Reserve, they should stay low through 2013 and possibly longer. There are many factors involved. Also know that over a year ago, in this same forum, I and others felt that mortgage rates would be over 5% by the end of 2012.

Historically this is the longest we have seen rates stay this low. Please understand that the Federal Reserve has kept rates low for a reason. By law, the Federal Reserve’s monetary policy is to achieve maximum employment, stable prices, and moderate long-term interest rates.

voice graph

The Great Recession and the worldwide financial crisis that started in early 2007 and ended late in 2009 has been one of the most intense periods of national and global financial strain since the Great Depression, and it led to a deep and prolonged global economic downturn affecting almost every developed country. Europe and many countries are still struggling with the after effects of the recession.
Thankfully, the Federal Reserve, our central bank, took some extraordinary steps in response to the financial crisis to help stabilize the U.S. economy and financial system. For those of you that don’t remember, these actions included reducing short-term interest rates from the central banks (the money the Fed lends to all member banks) to near zero, in the hopes of reducing longer-term interest rates and to reduce the cost of borrowing to provide support for the U.S. economy. These lower interest rates help consumers and businesses finance new spending and investing that in turn help support the prices of many other assets, such as stocks and houses.

Quantitative easing
To further encourage the economy, the Federal Reserve has purchased large quantities of long-term Treasury securities in a strategy dubbed “quantitative easing”. The overall planned financial effect is to force lenders and equity to put their money into higher risk, higher return investments, rather than bank CDs. Slowly, the economy has begun recovering, but progress towards the stated goal of maximum employment has been slow and the unemployment rate remains high compared to historic norms. The good news is that despite rock-bottom interest rates, inflation has remained low, apart from some temporary variations associated with fluctuations in prices of energy and other commodities. Also the low lending rates have created an opportunity for buyers (consumers and business) to invest in real estate and other goods, improving the national economy.

Understand that historically, mortgage interest rates have been anything but stable: one day they would fall – the next they would rise. The only thing that was certain was that they rarely remain the same for long periods of time. Someone in the market to buy a home would keep a close eye on rates. But just what is it that causes mortgage interest rates to fluctuate so often? There are many factors involved. But I assure you, they have stayed low for an abnormal length of time. It is time for the economy to heal and with that rates will have to rise.

When interest rates change, it is the result of many complex factors. Those who study interest rates find that it is as difficult to forecast future interest rates as it is to forecast the weather. Since interest rates reflect human activity, a long-term forecast is virtually impossible. After a rise or fall in interest rates, analysts may sound confident about what caused the variation – but any truthful economist, banker, or analyst will tell you they can’t predict rates 5-10 years from now.

Some of the factors that help to dictate interest rates are explained below.

Interest rate behavior

By this time we all know that a slowing economy is good news for borrowers, as it means lower interest rates. If the demand for borrowing capital recedes, then so do interest rates. This is because there are more people who are ready to lend (sellers) than people who want to borrow (buyers). This means that buyers can command a lower price, i.e. lower interest rates. When the economy is slowing the demand for credit decreases, and interest rates go down. Now the unusual thing is that demand has picked up over the last 12 months and rates have not increased. This is because of the artificial low interest rate the Federal Reserve has imposed.

A growing economy is bad news for borrowers because it force up interest rates. When there is a greater demand for credit / money, it forces rates up. Interest rates move because of the laws of supply and demand. If the demand for credit (loans) increases, so do interest rates. This is because there are more people who want money (buyers) than there are people willing to lend it, so those lenders can command a better price; ie, higher interest rates. When the economy is expanding there is a higher demand for credit, so interest rates go up.

Interest rates are the price for borrowing money. Interest rates move up and down, reflecting many factors. The most important among these is the supply of funds, availability and parameters for loans from lenders, and the demand from borrowers. In addition, to keep our banks liquid regulators force certain parameters on the lenders which effect how much a consumer has to put down or have in reserve to qualify.

Take the mortgage and lending market for example. In a period when consumers are borrowing money to buy homes, banks and equity need to have the funds available to lend. They get these from their own depositors. The banks will pay 6% interest on certain financial instruments, and then charge 8% interest on a five year mortgage. That is how they make money. If the demand for borrowing is higher than the funds they have available, they then borrow money from other groups by issuing bonds to institutions in the “wholesale market”. This source of funds is always more expensive. When banks and equity have lots of money to lend and the housing market and demand for capital is slow, any borrower financing a house or purchase gets a lower rate, and in a free market, most lenders will be very competitive, keeping rates low.

Realize that money is perfectly liquid and because of that it is converted easily. In particular, when the demand for money rises, so do interest rates – the “price” of borrowing money. There are many economic drivers that can increase demand – rising consumer spending, the belief that costs for buying and selling will increase, the expectation of a stronger dollar in the near future, increased demand for reserves from central banks (both foreign and domestic), and a rise in foreign demand for US goods and investments. With this demand, there is less desire for the lower return on current bonds. With this greater demand for money, the central banks can charge more. So, each of these aspects pushes up the demand for US dollars, while the reverse decreases the demand for dollars. A rising demand for money, with all else constant, will raise interest rates while the opposite is also true. The opposite can also happen during times when the market becomes averse to riskier assets because investors will move into the dollar and U.S. debt in a search for safety. The demand for money, combined with the supply of money determine interest rates. Since currency is the most liquid store of value, its demand demonstrates the demand, or preference, for liquidity.

Low rates will not be permanent. The only group buying treasury bonds is the Federal Reserve. The demand for lending is picking up at most of the major banks according to a national survey of CFOs and loan officers by the Federal Reserve, and most are planning to hire as well as lend in 2013, leading to expansion. More demand on money forces rates to go up. Mortgage and housing is just one component.

For the non-finance majors out there, this happens in the fixed income markets as a whole. In a booming economy, many firms borrow funds to expand their companies, finance inventories, and even acquire other firms. With rates so low, many have held their own capital earnings, rather than invest. The return for earning for many is better than the cost of borrowing. Meanwhile, consumers look to buying cars, houses and other needs and begin to entertain more. This keeps the “demand for capital” at a high level, and interest rates higher than they otherwise might be.

The interest rates charged by banks are influenced heavily by the decisions and actions of the Federal Reserve. The Federal Reserve, known as the “Fed”, can manipulate interest rates by buying and selling bonds in the bond markets. During economic times when the Fed wants to stimulate the market, the Fed buys bonds on the open market and pays for the bonds with cash. If the Fed continues to buy bonds, the market becomes flooded with cash. This excess cash in turn makes money more available for people who want to borrow. The result is interest rates will naturally come down as different lenders compete for a limited pool of borrowers.

The effect of interest rates on consumers is well known. For every 1% rise in rates, consumers can buy 12% less. Values across the country have improved. Here in Texas they are near highs in all of our major metros. So if you don’t buy today, whether it is from increased home values or eventually higher borrowing costs, you will pay more.

As consumer confidence grows people start spending money. What do they buy? Everything under the sun, but consumer goods is the term you will hear most often. People buy cars, computers, and appliances. As demand for products increase, companies can begin to charge more for their products. As companies begin to make more profits it is not long before workers begin asking for more benefits and more money in their paychecks. As companies meet worker demands, the company experiences increased costs and expenses then inflation begins.

In the last sixty years there has not a better time to purchase a home. You will never be able to afford to buy as much house as you can today! Plain and simple. Draw all the charts and graphs you want. The fact still is: Now is the time to buy! If not now, when?