Wall Street’s recent histrionics have made it clear that many investors feel the same way about a rise in interest rates as they do about food poisoning. And although many were expecting the shoe to drop last week, the Federal Reserve decided to wait.
Still, most economists, financial observers and Fed officials agree that after years of near-zero interest rates, the Fed is going to be raising them by a quarter of a percent before the end of the year.
And Eitan Weinstock, a managing director at AST Defeasance in Mid-Wilshire, is convinced his business – along with his and his employees’ pay – will benefit greatly whenever the Fed does act.
“We’ll have seven Ferraris lined up in the parking lot when rates go up,” he said.
Weinstock is certain he’ll get a boost, and others in L.A.’s finance industry are likely to benefit from higher rates, that are also plenty of firms – especially real estate investors and possibly mortgage lenders – that stand to lose out once rates inevitably rise.
Banks, which pay virtually nothing for deposits, should benefit from higher loan rates, while mortgage companies are likely to see a drop in refinancing-related business once rates cross a certain threshold. But even that might result in a boom for auxiliary businesses including defeasance companies such as Weinstock’s, which could see a surge in work as borrowers rush to lock in cheap mortgages before they go away.
Scott Anderson, chief economist at San Francisco’s Bank of the West, said some industries will thrive and some will suffer from the adjustment, but that’s part of getting to the new normal. And despite years of hype and anticipation, its effect on the larger economy should actually be pretty muted. Markets might overreact, but he sees no need for alarm for the average Angeleno.
“We’re not going to be in an environment where rates are zero forever,” he said. “I think the economy’s going to evolve and adjust to these raises. But I don’t think there are a lot of hidden land mines.”
Banking on rise
One industry that should stand to gain from higher rates is financial services, with commercial banks in particular getting a boost.
Since the 2008 crisis, banks have been squeezed by near-zero interest rates and escalating compliance costs. Low rates might even have been a factor in the decision in January by downtown L.A.’s City National Bank to sell to Toronto’s Royal Bank of Canada.
Matthew Clark, an analyst at Minneapolis investment bank Piper Jaffray who formerly covered City National for another investment bank, told the Business Journal earlier this year that City National’s decision to sell might have been prompted by near-zero interest rates lingering for longer than the bank’s decision-makers expected.
And RBC, figuring that an eventual uptick in rates would almost immediately boost City National’s profitability, might have been inspired by those longer-term prospects.
“Most of their loans are floating rate,” Clark said of City National. “So if you get the Fed to start raising rates, those will reprice very quickly. Their interest margin would expand.”
Century City’s 1st Century Bank is another institution that’s anxious for some relief in a higher-rate world and Chairman Alan Rothenberg said he’s looking forward to it.
“We’re in the same holding pattern we’ve been in for several years,” he said.
Like many banks, most of 1st Century’s deposits bear no interest – essentially free money for the bank to lend – while most of its loans carry a floating rate. That means a rate increase will have an immediate, and favorable, impact on the bank’s books.
“Our business is really directly and solely affected by what the rate is,” he said. “Once rates go up, there’s more income.”
Race to refi
Once rates start moving, some expect there to be a flurry of landlords and real estate owners moving to lock in low mortgage rates before they rise too far.
Prospective Ferrari driver Weinstock is certainly one of them.
He thinks his firm, AST, should see a surge of clients once the rush to refinance begins.
Unlike home mortgages, commercial real estate loans often come with a kind of prepayment penalty. In many cases, lenders are guaranteed a certain amount of cash flow over the life of the loan. So when borrowers want to sell a building or refinance their loan, they often are required to replace the cash flow that would have continued going to the lender had they carried the loan to term.
To do that, borrowers can turn to defeasance companies, which put together securities portfolios designed to replicate the yield of the loan being paid off.
While Weinstock said AST has grown substantially since the recession, he’s expecting business to explode when rates start climbing. He believes investors will rush to pay off their floating-rate debt in order to lock in new fixed-rate debt while bargain-basement rates still exist.
“Our fun will be when interest rates have begun to rise,” he said. “People will say, I’ve got to get off the bench now. We need a healthy fear to exist in real estate owners of interest-rate risk.”
Weinstock said with persistent rock-bottom rates over the last few years, there hasn’t been a lot of urgency on behalf of borrowers to refinance. But once the movement begins, he expects that to change in a hurry.
“It’s not so much once they rise – it’s the fear of a significant and immediate increase that will suddenly drive the market to go crazy,” Weinstock said. “People will get fearful they’re missing the boat.”
Rebecca Rothstein, a managing director at Merrill Lynch Private Banking and Investment Group in Beverly Hills, also expects defeasance companies and similar businesses to benefit from a change in the interest-rate paradigm. A lot of borrowers have carried floating-rate loans for many years, and their monthly payments are likely to jump fairly quickly when rates go up. Many might find it time to take some of their chips off the table, defease their existing loans and lock in a fixed rate.
“People have been cocky about having an interest-only loan,” she said. “There’s going to be a tremendous amount of activity around this in the next 12 months.”
But Weinstock knows the flurry of activity won’t last forever. He believes rates will eventually hit a level where fear of missing the boat turns into resignation about missing the boat, and that’s when his firehose of business will start to taper off.
“There’s a ceiling on this,” he said. “If rates get up to 6 or 6.5 percent, people aren’t going to be so happy to lock them in.”
Drying up
Daniel Walker, chief executive of Farmers & Merchants Bank in Long Beach, which does a substantial amount of mortgage lending, said he’s also anticipating a surge in business once the movement begins.
“I would expect new home originations not to change that much,” he said. “But the refinances will actually increase in activity, as it will intimidate folks that interest rates will get out of control.”
New home mortgages shouldn’t be overly sensitive to a rise in rates, as other factors such as lower unemployment and a growing economy will place more first-time buyers and erstwhile renters into homes of their own. And existing homeowners who have been putting off refinancing might be suddenly motivated.
Walker and Weinstock think that’s going to result in a nice burst of business as rates start to climb and borrowers fear missing out. But Jeff Seabold, co-founder and chief banking officer at Irvine’s Banc of California Inc. and founder of Beverly Hills mortgage firm CS Financial Inc., which is now part of Banc of California, isn’t expecting any refinance boom. He thinks that a rise in rates will immediately crimp the flow of new mortgages, especially refinancings.
“It will move hard and fast and it will suck the air out of the market rather quickly,” he said.
Seabold, who’s been in the mortgage industry for more than 20 years, said he has a two-to-one rule: For every unit the federal funds rate goes up, he believes mortgage rates will jump twice that, which he thinks will cause originations to dry up quickly.
“The difference between when I first got into the business and today is the velocity of change and how quickly the pendulum goes from one side to the other,” he said. “The market tends to overreact.”
Seabold expects mortgage companies’ margins to shrink as they undercut each other on fees and pricing to try to buy volume, which is likely to lead to a race to the bottom.
However, he thinks higher rates are actually a net positive for Banc of California and other lenders not focused so heavily on mortgages.
“Here, the residential mortgage business is the icing, not the cake,” Seabold said. “If it’s the cake, you’re going to be on Mr. Toad’s Wild Ride.”
Rough road?
Another sector that could see turmoil by rising rates is the auto industry. Car sales are set to rise for the fifth straight year – something that hasn’t happened since 1960 – thanks to generous manufacturer incentives and low interest rates.
But Anderson, the economist, sees some red flags ahead.
“Credit has loosened there a little faster, so we’ve seen a little tick-up in delinquency rates,” he said. “Banks are looking to see if buyers can handle these higher auto rates.”
And if they can’t, the effects could reverberate beyond just auto lenders. Securities backed by auto loans have been popular assets in recent years, and a wave of defaults could put pressure on those securities and the investors who own them.
But Paul Kerwin, chief financial officer of Mid-Wilshire subprime auto lending giant Westlake Financial Services, said the rating agencies have been vigilant, influencing Westlake’s decision to ask that borrowers put more equity down on their cars as the firm’s delinquencies and charge-offs have ticked up.
He said Westlake is actually poised to benefit both from more defaults and a higher-rate environment. Westlake’s core borrowers are people with weaker credit who need a car for work. For those customers, a small move in the central bank rate has little effect on what are often double-digit interest rates or on their need for a car.
Kerwin added that there’s a substantial margin of safety built into Westlake’s securities. Also, the company has a significant cash hoard and credit lines that shouldn’t be impacted by marginal interest rate moves. He said that means the firm will be able to continue to lend when competitors might be hit harder by nonperforming loans, just as Westlake did after the 2008 crisis.
“If there’s an uptick in delinquencies and losses in the entire market, we’re going to fare pretty well,” he said. “Our margins may get compressed, but we can increase market share because we have plenty of liquidity and little leverage.”
Alternative asset managers might face challenges, too. A lot of money has flowed into assets such as noninvestment grade corporate debt, venture capital and emerging market equities and debt, as investors desperate for yield have been willing to assume more risk. A return to normalcy in the yields of traditionally safe investments could change that calculus.
But Richard Jones, a managing director at Merrill Lynch Private Banking and Investment Group in Century City, said he doesn’t expect that to happen soon, as the yields on safer stuff remain far away from their historical norms.
He pointed out that the average yield on the 10-year Treasury, which is widely used as a benchmark, has hovered around 4.2 percent over the last 20 years, which is about 2 points higher than it is now. And he doesn’t believe the Fed is in any hurry to get to those historical rates soon.
Building concern
Rock-bottom mortgage rates and a white-hot rental market have likely created opportunities for marginal real estate investors to get into the game without having the resources to cushion themselves against a dip in the market or a rise in loan payments. Most real estate loans are floating rate, which means a bump by the Fed should directly, and quickly, translate into more money out of landlords’ pockets. That might be too much for some overly aggressive borrowers to withstand.
“Rates have been so low it’s been very attractive for some folks to take advantage of free money,” said Bank of the West’s Anderson. “I wouldn’t be surprised to see people playing it too close.”
Steve Sherline, L.A. market leader for the private client practice of Minneapolis’ U.S. Bank, said that as rates go up, profit margins are going to shrink. And landlords who have paid premium prices could have little room for error when their loan payments reset.
“This has been a boom time for real estate investors,” Sherline said. “Values have gone up dramatically, especially in Southern California. But we all have to be a little bit cognizant that as rates rise, net operating incomes are going to go down.”
Nelson Rising, chairman of downtown L.A. developer Rising Realty Partners, said investors would be wise to protect themselves against a rise in their floating-rate loan payments either through refinancing into fixed rate or buying a derivative called an interest-rate swap from a bank, which effectively converts floating-rate debt to fixed. If they don’t, they risk being squeezed at both ends, particularly if the robust rental market takes a hit.
“Floating-rate debt is very risky,” he said. “It’s a bad combination when you have rising rates and decreasing rents.”
That could mean trouble for investors who are borrowing heavily and might find their profit margins crimped – or even reversed.
Sherline said those without a cash cushion could find themselves gasping for air.
“This is a time when we think building capital reserves and having liquidity pools is really important,” he said. “Investing in real estate without excess liquidity is like swimming without a bathing suit.”
Given challenges in the global economy, Sherline doesn’t see anything out there that would trigger the type of accelerated rate increase that would give him real cause for concern. While the low-rate party appears to be over, at least there shouldn’t be a jarring moment where the lights come on and everyone scampers to the exits.
“The environment seems to suggest that we’re going to have slow, predictable rising rates,” Sherline said. “It could be the soft landing we’ve been waiting for.”
