Saturday, 7 December 2013

Property and the exponential function

Imagine mortgage rates like they were in 1980 at 20% and imagine them in 2010 at 4% the same as today, we have a 30 year period of declining interest rates. Interest rates simply price the cost of borrowed money, it was the movement downwards of these interest rates over the last 30 years that caused the huge property bubble in most western countries and the implosion of the financial system when it inevitably collapsed.

Western Governments were going ever more into debt throughout this whole period, they therefore needed a lower interest rate, or a lower cost of money. I contend that it was this lowering of interest rates to facilitate the western governments growing indebtedness, that spawned the runaway and out of control housing bubble.

The problem is actually very simple when interest rates were at 20% and you reduce those rates by 1% to lower the debt carry cost for the Government, you also reduce the cost of money in the real economy, so you have the beginnings of the start of the boom. If you can afford a $100,000 mortgage at 20% then at 19% you can afford a $105,263 mortgage, or just over 5% more. However this applies to everyone, so you have a mass of people now willing to go into more mortgage debt as the debt service costs actually remain the same. This increase in mortgage borrowing meets a more fixed and inelastic supply of housing = Property rises.

The Government is happy as its own interest cost is not increasing, people are happy there major asset increases in value, and business is happy as its interest costs decrease and potentially there are some new "consumers"  who are extracting equity from there higher valued properties.

By Reducing interest rates from 20% to 19% you have effectively cut the cost of money by 5%.

The Government keep borrowing so they need to drop rates again, this means mortgage rates lower once again, which means a lower cost of money and therefore bigger mortgages and house price rises again.

Keep this process going and eventually you hit 10% which is a full 50% lower than 20%. So if you could afford $100,000 debt at 20%, you can afford $200,000 at 10% the same function applies to the Governments debt which keeps growing.

So time to lower rates again from 10% to 9% however this time lowering rates by the same 1% as when they were lowered originally from 20% to 19% means a 10% drop in the cost of money and not 5% as before.

This process continues as the Government always needs to sell more debt, until we reach 5%. Now at this point if you could afford $100,000 at 20% and $200,000 at 10% you can afford $400,000 at 5%. We now have a huge property boom in full swing, and a huge rise in Government debt which can all be funded at the new low rates, Politicians love this "new normal" as they get to promise lots of money they do not have, to win votes at election time.

The Government still need more money as they have promised a lot of people a lot of "entitlements" to get votes, so we eventually end up at 0% for short term Government debt costs, and 3% for longer term debt and 4% for Mortgages. This is because, why would you lend to an American family for less than the cost of lending to the American Government whose security is the American Taxpayers?

So if you can afford $400,000 at 5% a fall to 4% means you can afford $500,000 a full 25% bigger mortgage. Now lets just stop there for a moment, when we dropped rates from 20% to 19% the same 1% fall meant that instead of a $100,000 mortgage you could afford $105,263 or a 5.26% bigger mortgage.

This exponential function is what drove property to insanity in 2008, and led to the implosion of the whole banking sector which was leveraged into this exponential madness. The situation now, is that there is no driver in the property market to drive prices any higher thank god! sanity returns. However we have millions of people now stuck in vastly overpriced houses that they cannot afford, they are very susceptible to rising rates that the dreaded fed tapering may entail. They have therefore hunkered down and are not spending in the real economy which still remains in deep trouble. They are simply surviving.

The Government as usual still needs more debt, but can no longer afford the interest rate that a free Bond market would dictate, so they have resorted via the Federal Reserve to counterfeit the currency that they need to continue to operate, it has come to this, and it is called Quantitative Easing or easing the quantity of currency. I refuse to call it money, it is simply bits of paper so it is only currency, it has no real value.

Because the real economy is very subdued, and because of the Governments counterfeiting to try and keep the party going for a big longer. We now have real inflation that is a long way ahead of income increases for the average person, this is leading to major living standard squeezes. If you are already struggling with your huge mortgage brought about by the exponential function, explained above. This is simply making matters much worse. God forbid if interest rates on the mortgage begin to actually rise.

We have had 30 years of falling interest rates, mandated by Governments refusal to live within its means that set off a massive property bubble and bust. They still refuse to live within there means and they have now resorted to counterfeiting money to survive, we also have the not insignificant problem of the baby boomers retirement directly ahead.

Alexander Fraser Tytler:

"A Democracy is always temporary in nature, it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by a dictatorship". 








     

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