Then, the bottom fell out. The Nikkei plunged, and has never again approached its 1989 high. Real estate plunged as well. GDP growth has been nearly nonexistent; the "Lost Decade" has endured for more than 20 years, with no end in sight.
In response to this unfortunate turn of events, the Bank of Japan has cut interest rates over and over, but the economy hasn't responded to traditional monetary policy. Japan is stuck in a deflationary cycle, with no end in sight. Paul Krugman and others have suggested that Japan has experienced a liquidity trap, characterized by a lack of aggregate demand, and ultra-low interest rates that have failed to stimulate the economy.
Today, in late 2011, the United States is experiencing a similar post-bubble hangover. The Nasdaq peaked 11-1/2 years ago, the Dow 4 years ago; both are down significantly since then. US stock portfolios have (at best) stood still for more than a decade in nominal terms; in real terms, equities are underwater--even as a majority of Americans have grown to count on the stock market for their retirement savings. Real estate peaked 5 years ago, and is down 30% nationwide; parts of the "sand states" (Nevada, California, Arizona, and Florida) are down more than 50%. Unemployment has remained stubbornly high, even as Ben Bernanke and the Fed have reduced short rates nearly to the so-called "Zero Lower Bound". The Fed is giving money away, and still, there is no demand for it. Krugman (and many others) have called an American liquidity trap.
Naturally, students of history are wondering whether America is leading the West into a long-term low-growth era, similar to Japan's "Lost Decade". Recent US short rates have traced an eerily similar path to Japan's rates in the early '90s. David Rosenberg did a nice write-up on how the U.S. is "Turning Japanese", here's his chart showing the two countries' post-bubble interest rates.
If you're American, you may be saying "Crap! That's terrible! I'm not looking forward to that!" And I'm not, either. But there may be ways to take advantage of the situation...if life gives you lemons, you might as well make lemonade! So, let's talk about adjustable-rate mortgages.
If you're American, you may be saying "Crap! That's terrible! I'm not looking forward to that!" And I'm not, either. But there may be ways to take advantage of the situation...if life gives you lemons, you might as well make lemonade! So, let's talk about adjustable-rate mortgages.
Adjustable-rate mortgages (ARMs) are loans designed for low initial payments, with the borrower paying the loan off relatively quickly (by selling the property or refinancing to a fixed-rate mortgage). If you're thinking of buying a home, or an investment property, or if you're thinking of refinancing your existing mortgage, it's a great time to think about taking out an ARM.
While the vast majority of residential loans are fixed-rate (usually 30 year), the rest are adjustable-rate. Interest rates on fixed-rate mortgages are determined by capital markets; they usually follow Treasuries Bonds. ARMs, on the other hand, follow short rates, which are dominated by the Fed's actions.
On August 9, the Fed announced that it would keep interest rates “exceptionally low" through mid-2013. So Ben Bernanke just told you that (if you take out an ARM before mid-2012) you will enjoy at least two years of "exceptionally low" interest payments. (ARM payments typically adjust annually, so you will have till early 2014 before your rate adjusts up.) Furthermore, if the US follows Japan into long-term economic stagnation, you will enjoy low payments far beyond 2014. Both long and short rates are likely to remain low for several years (we'll look at contrary views a little later).
Let's take a look at some numbers. My credit union offers 1-year ARMs at 2.875%, 3/1 ARMs (fixed for 3 years, then annual adjustments indexed to LIBOR), and 5/1 ARMs at 3.125%. They also offer an interesting option, the 5/5 ARM, at 3.375%. This loan would start at 3.375%, stay there for 5 years, then reset every 5 years. By contrast, a 30-year fixed is quoted at 4.375%. (All loans are 0 points, on a 30-year amortization schedule.)
If you borrowed $200,000, the 1-year ARM payment (principal and interest) would be $830. You would pay $844 on the 3/1 ARM, $856 on the 5/1 ARM, and $884 on the 5/5 ARM. The conventional 30-year fixed mortgage would cost $998 monthly. So, if you took out a 1-yr ARM today, Ben Bernanke has guaranteed you that your payment won't go up until late 2013, and you will save $168 per month for 24 months, or $4032. This is slightly more than 2% of the original principal. Not bad! In two years you can continue to take your chances with short rates, or refinance to a fixed if the economic picture has changed significantly. If you have a lower risk tolerance, you could select one of the other options. The 5/1 ARM would save you $142 per month for 5 years, or $8520 (more than 4% of principal). The 5/5 ARM is my favorite, it would save you $114 per month for 5 years ($6840, or 3.4% of principal). And, after 5 years (when I believe rates will still be low, a la Japan), you can lock in for another 5 years of low rates.
What are the risks in this strategy? Let's think about the future level of interest rates, and what that would imply about the economy. Until 2013, we're certain of interest rates, they will be "exceptionally low". After that, rates are less certain. We could follow the "Japan Scenario": the economy continues to stumble, Fed Funds rates are virtually zero, and long rates stay low (perhaps they'll be even lower than today, if deflation kicks in). In this case, our ARM strategy will look wise, we will have saved quite a bit of money and are perfectly poised to save more.
What if a more normal economy prevails, housing and other asset prices rebound, and both long and short rates rise? This scenario is bad for our interest-rate bet, but is positive for your home value, your career, your savings, and your other investments. So in this case, we can look at our interest rate bet as a hedge--mortgage payments will go up, but we'll better be able to afford them than we are today. And we will have enjoyed many months of savings.
The third case, which I view as quite unlikely at this point, is one of inflation. In this case, both long and short rates will be higher than they are today. The Fed may raise short rates above long rates to slow inflation. In this case, your house will have appreciated and your bank savings will be doing well. It's not as favorable as the second case, but your ARM will have acted as an effective hedge.
Of course, the further out in time we go, the less visibility we have. We can say with a high degree of certainty that we will still be in a low interest-rate environment in two years, but we're less certain in 5 years, and even less sure in 10. The 5/5 ARM seems the best balance of interest rate risk with a guaranteed long run of low rates (5 years) and another 5 years of very probably low rates.
Disclaimer: This strategy is quite risky, and may not be for you. It's appropriateness depends on many factors: your age, income, marital status, tax status, local real estate market, credit rating, and some I'm not thinking of. DO NOT use an ARM's low initial rate to buy a property that you can't otherwise afford!!! That approach is responsible for many of the recent tsunami of foreclosures. Only take out an ARM if you can afford the worst-case payments.
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