Investors With Cash, the Federal Reserve & the Misallocation of Capital

What do these items have in common? Well, a lot. I recently met with a general parter of a prospective Real Estate syndication. This general partner said he has investors willing to throw money at him, but having integrity, he didn’t want to accept the money because he wasn’t sure if he could obtain the type of returns that these investors were looking for. These would be investors have faith in this general partner, because he as previously produced solid returns. The investors know this general partner has integrity and does due diligence with a fine tooth comb, ahhh, or in this instance a calculator.

But let us back up a second and examine what might be the real problem. Ready….. There is a lot of cash ready to be invested, due to the Federal Reserves monetary manipulation, which causes mal investments and the misallocation of capital. That is a big statement, and needs some illumination and background to be fully understood. If you already understand this statement, then you can probably just move on.

What is Misallocation of Capital

First let us try to give our readers a feel for misallocation and what this means. Using a household example to illuminate a simple misallocation of capital: Let us say that a household has a choice between making a mortgage payment, or buying a new wide screen TV. This choice should be simple. The correct allocation of capital would be to pass on the TV and make the mortgage payment. But now let us add an outside influence, the offer of financing. The homeowner could now make his mortgage payment, and buy the TV. However, any financial planner would say that to finance a consumer product that isn’t necessary would be a misallocation of capital. Now certainly their are some exceptions, but if a homeowner were struggling to pay a mortgage, then this TV loan would only increase their inability to make the mortgage payment in the future.

Other Examples of Misallocation of Capital From Our Recent Past

Buying a home where the payments, even taking into consideration the tax breaks, are significantly higher that the fair market rent, because you think the home will rise in value.

Spending more money than your current income would allow because you can borrow the money from your principal residence, which you believe will go up in value.

Locking up your money in a government bond at 2%, when you believe the rate of inflation is 8%.

Investing in a internet start up that makes no money because the stock price will go up.

Building more homes, because underwriting guidelines have loosened up allowing anyone that can fog a glass to buy a home. In this last example we can see that the builder may be appropriately responding to market demand, but it is the outside influence that causes the misallocation of capital.

The Fed’s Artificially Low Rates Force Investors to Prop Up Asset Prices, Including House Prices

How do all of these examples tie together with the original title of the article? Simply put, I believe that the Federal Reserve has severely manipulated interest rates. This has created excess capital in the market, which then seeks a home. Unfortunately, the return from many investments is minimal. But because the Federal Reserve has artificially depressed interest rates, investors must accept a much lower rate of return on an investment than usual. It is this investment that occurs only as a result of artificially lower interest rates that is the misallocation of capital. When rates rise, then this misallocation of capital unwinds. The classic boom and bust.

If you could earn 5% at a bank, and if mortgage rates were 6% things would be different? Housing prices would certainly be lower, and more people would be willing to park their money in a bank account.

They say that an investors motivation is a combination of fear and greed. Fear to not loose you capital and greed to make your capital grow. Our current situation has owners of capital fearful that the Federal Reserve will destroy their purchasing power through money printing. It is this fear of loss through inflation, and the lack of other “Safe” alternatives, that prompts an investor to accept a smaller return on their money than reasonable.

Investment Returns are a Function of Inflation

So let us now define what we consider a reasonable rate of return. The first part of this equation will be a simple definition. A reasonable rate of return would be the amount returned, ABOVE the rate of inflation, that is appropriate to the level of risk assumed. The great debate amongst learned men will be what IS the actual inflation rate. Is is 2.9% like the Fed would like us to believe? or is it something more like 5 – 8%, which is more in line with my beliefs.

Without getting into the exact nitty gritty of how the CPI is calculated, let me simply state that I do not believe inflation is 2.9%. There have been many modifications over the years to how the CPI is calculated. There is even an organization that publishes what the CPI WOULD have been if it was calculated the “Old School” way, without the added Hedonics and Substitution. But this topic would require a massive Phd thesis, and is absolutely open to debate.

So I pose the question to you, my readers. When you look at your food bill, your gas bill, your health insurance, and all of the bills that comprise your living expenses. What do you think the increase in costs might be. For some framework. If over 10 years we had 2% inflation, then prices would be 22% higher today. If we had 5% inflation, then prices 10 years later would be 63% higher and 8% inflation, would produce  a 115% increase.

Without arguing the finer points, what do you think is the real inflation number? It is your answer that should guide you in all your investment decisions. Your inflation outlook will drive all investment decisions. A reasonable rate of return, “Above the Rate of Inflation” is what investors want. Investment rates of return below the rate of inflation create a loss of capital, which is defined as a Negative Rate of Return.

Negative Rates of Returns Make Gold a Popular Choice

This is why gold has performed so well over the last decade. Gold does not produce returns, it does not generate earnings. It only protects ones capital when there is a threat of confiscation. U.S. citizens, and citizens worldwide, face confiscation in the form of inflation. If inflation is really 2-3 percent, and we can earn a little over 3% in a 30 year bond yield, then our capital is being preserved, albeit, just barely. However if inflation is 5%, and a 30 year bond only yields 3%, then the government is stealing our money at the rate of 2% per year. Factoring in taxes only increases the rate of theft.

With gold climbing precipitously over the last decade it is fair to say that investors are concerned that governments, through the use of paper money are robbing them blind. It is this concern, coupled with the Fed’s money printing that is creating exactly the scenario that the fed wants. The Fed wants money in the hands of investors, without other good alternatives. The Fed wants these flush investors to use this money to prop up asset prices. It is this manipulation by the Fed that is keeping asset prices high. This is all well and good if asset prices climb because of increased earnings, but in this case asset prices are likely rising because of inflation. In other words, asset prices aren’t really going up, the dollar is just going down.

Housing Also Benefits from the Fed’s Market Manipulations

In the case of housing, the Fed has stepped in to print money and lowered interest rates. While the Government with Fannie and Freddie is willing to back stop all mortgages and banks. This keeps the housing market from being worse that it might otherwise be. On the surface, this seems like a good thing, right? Well, yes it does avoid the temporary pain of a worse housing crash by helping right the ship of many consumers balance sheets. But at what costs?

Robbing Peter to Pay Paul & the Moral Hazard

Lower interest rates steal from savers. If you have a high mortgage balance, you are a winner. If you were prudent and your savings are in a fixed income asset class, you are a looser. The government is literally stealing money from you to prop up the reckless over spenders. I have heard it said that if you want more of something, they you subsidize it. The Government is subsidizing reckless borrowing. This create the moral hazard.

How does this misallocation of capital then look in the real world. If as an investor, you were offered 5% or 6% on your passbook CD, you might decide to lend your money to a bank. They in turn would lend it out to a business owner that knew he could make a return. This business owner would be fully researched by the financial institution. They would make a profit and would hire employees.

But instead of lending your money to a financial institution, you decide to in some other venture in an effort to produce some type of return while still maintaining your capital. This alternative investment can be good or it can be bad, but if everybody is searching for some other form


invest in Real Estate because a property will serve two functions. First it will produce a yield, which can’t be obtained at a bank. Secondly, it will prevent theft from the government in the form of inflation, as Real Estate can not be debased and is not taxed until sold. And this does make sense, right now.

Property is Below Market Value relative to Rents

I have calculated that home prices locally in Long Beach are about 13% undervalued. The formula for this does take into account the interest rate at which the home is financed. If the Fed can keep rates at what I believe to be artificially low number, then all is well and good. But if the Fed looses the ability to sell it’s bonds at the current rates, then rates will climb. At this point funds that were allocated towards gold and Real Estate will flow in the other direction.

If you are buying a home and plan on staying there for 5-10 years, this will likely not be a problem. In fact since you likely will obtain a fixed rate mortgage you are going to be in great shape. As rates rise, your property might go down in value in response, but rates will only be rising on inflation concerns which will in the long run push up home prices.

Watch out when and if this misallocation unwinds

So if you do believe that rates are artificially low, what will be the impact when will rates rise or snap back. If the Fed looses it’s ability to finance its debt, then there may be a temporary mini crash in all asset classes. Homes, stocks, gold and especially bonds will take a sudden hit if a bond auction fails. From that point forward after a mini crash, an investors decision will be heavily dependent upon the Fed’s response. Do they raise rates to head off an inflation scare or do they print money to assist liquidity.

The Fed is Trying to Fix the Problem with the Same Tools that Caused the Mess.

There is such severe manipulation on the part of the Fed, that it leaves investors with few choices and often times the wrong choices. And while I understand that the Fed is trying to prevent a complete melt down of the financial markets as a results of a complete housing collapse, they are putting a band aid over a problem they created in the first place, the housing bubble.

We would be much better off if the Fed were stripped of its power. U.S. citizens wouldn’t put up with type of manipulation in the supply of any other good or service. Why should we put up with extreme market manipulation in our money supply. And if the Fed is going to manipluate the money supply should they really be favoring money borrowers at the expense of money savors. Money savors are the back on which capital formation is built and businesses expand.

When our government believes that borrowing and spending more money will solve our financial mess, we have to really consider that America, once a place where strong values of hard work, patience and thrift, has seriously lost its way. The only question will be will who will be blamed caught without a seat when the music stops.

P.S. – Just as I finished penning this blog post, the headline at MSN Money is “Is Inflation Really Running at 8%?”