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My two cents on rate cuts My two cents on rate cuts
by Joseph Gatt
2019-08-19 08:56:50
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Perhaps the biggest economic blunder ever made was around 2002. The discussion went like this: “we're going to abolish rent control so that people can find housing more easily. To encourage people to build and buy more property, we're going to cut interest rates, and that will compensate for abolishing rent control.”

Three things happened with this blunder. First, the rent price of almost every apartment in big cities tripled or quadrupled or more. Second, people started investing in “new cities” thinking that people would buy property and move to those “new cities” when those cities became ghost towns, in some cases, were transformed into concentration and labor camps in some countries. Third, the saying goes that “property prices collapsed in 2008.” That's not correct. Property prices in ghost towns collapsed. Those in “uncomfortable towns” collapsed, as in towns that have no grocery store and where people have to do their shopping at the gas station. But property prices in established cities, anywhere from Paris to NYC to Des Moines, Iowa to Mexico City to London and Buenos Aires, stabilized.

rate01_400In 2019, again, people are like “if we cut interest rates, people are going to buy more property, build more property and that's a great thing.” Now I'm not going to discuss raw economics or burning economic theory, but I will discuss fictional example of real stories that I'll be changing a bit so you can get the idea.

Case 1

Jack and Jill got married in 2004. They met in Sacramento and before marriage shopped around for property. Jack is a teacher and “poet in residence” and Jill is a paralegal. Jack makes 30,000 a year after taxes, sometimes more with the help of a little tutoring. Jill makes 35,000 a year after taxes.

So Jack and Jill are led by a real estate agent to pick a really nice home, located at a 1 hour drive from Sacramento. The house is beautiful, a nice backyard, a garage for 4 cars, 5 bedrooms, a large kitchen, three bathrooms and many other things.

Jack and Jill decide to buy the house. The real estate agent had not told them that in their suburb, there were no gas stations, no grocery stores, no supermarkets, no hair salons, no restaurants, no pubs, and virtually no residents. The next gas station is located at a 45-minute drive, the next Wall Mart is located at a 60 minute drive.

Jack and Jill did not know. They bought the house for 200,000 dollars, put in a down payment of 60,000 dollars, where Jacked borrowed 20,000 from his father and Jill borrowed 15,000 from her aunt, and have monthly payments of 2,200 dollars. Remember Jack makes 2,500 and Jill a little less than 3,000 a month, so Jack's paycheck is going into the mortgage.

Jack and Jill move into the house. They quickly realize they will need two cars. Jack leases a car with a 600 dollar monthly payment and Jill leases a car with a monthly payment of 550 dollars. So Jack's paycheck goes to the mortgage, and Jill leaves 30% of her paycheck into car payments.

Jack and Jill spent a wonderful honeymoon in Barbados, but by 2005 their marriage is turning into a nightmare. Life in town is super boring, Jack gets arrested 3 times for DUI and gets his license suspended, Jill has a tendency to overuse her credit card, Jack finds nothing to do but drink beer and watch baseball, and Jill has to drive Jack to work, meaning they have to wake up at 5 AM every weekday.

Gas prices keep going up, and Jack and Jill start thinking about selling the house and living in a less “creepy neighborhood.” Problem is, a couple of drunks and a dozen drug addicts are roaming the streets of this ghost town.

Jack has trouble waking up in the morning, and Jill gives up on waking him up and Jack misses work a couple of times. Jack gets violent with Jill, and Jill seeks a divorce. 2008 recession hits. When Jill asks a real estate agent how much her property is worth, the real estate agent tells her “maybe 30,000 dollars.” Jill can't believe it.

Jack and Jill divorce but California law does not allow property to be split in divorces. Jill gets to keep the property, and Jack is forced to make half the payments on the property.

So Jack is paying 1,100 dollars monthly on property he does not live in, and whose value is down to 30,000 dollars. Jill now lives alone in a ghost town, and can't even find someone to go on a date with, unless it's one of those drug addicts.

Jack and Jill took all those stupid loans because the interest rates were low. Notice that I didn't discuss their student debt. 

Case 2

John is a life insurance broker based in New York City. He majored in biology and graduated in 1993, slowly went up the ranks in the financial business, and by 2002, was making a million dollars a year after taxes.

Joe and Mary bought an apartment East 49th street for 300,000 dollars in 1993. In 2004, the price shot up to 1.2 million dollars. The apartment is very clean, three bedrooms, a laundry room, two bathrooms, a nice living room and a small kitchen. Very clean, well-located. Joe and Mary's kids are now in college, and Joe and Mary decide to sell the apartment so they can move to Vermont.

John takes the deal and buys the apartment for 1.2 million dollars. He used to rent a place down East 71st street, but decides he needs to settle down a bit.

John makes a lot of money and is a brilliant life insurance salesman. He uses his biology background to his advantage, and uses charm and seduction along with scare tactics to get clients to sign up.

So in 2004, John buys the property, and takes out a mortgage with a 400.000 down payment and 8,000 a month monthly payment.

Three problems. Despite making over a million a year after taxes, John likes to head to Vegas once a month by renting a private jet, and can ''flame” as much as 100,000 dollars per trip. Second problem is John likes to head to the Playboy Mansion every month or so, and throws vast sums there. Third, John likes to impress chicks he picks up at bars by taking them on private jets to all kinds of places.

2008, John's seduction tactics are no longer working in the life insurance sales business. John has a target of getting 100 people a month to sign up, and he's only getting around 30, then 20, then 15, and in the end his boss fires him.

John doesn't freak out. He sends dozens of job applications in the finance business, but only gets offered a couple of positions as a clerk making 40,000 a year.

Now John is stuck with an 8,000 a month payment, plus other loans here and there, that he took because interest rates were low.

He decides to sell the apartment. He checks with the real estate agent, apartment is valued at a million. A 200,000 drop is no big deal, but still a big deal. He puts the apartment for sale for a million anyway. First month, no one comes asking for it, not even for a visit. Second month, same thing. Sixth month, same thing. A year, a year and a half.

John has to find 8,000 a month. He's blown all his savings paying for that mortgage and other loans, and has tried his luck with everything. He tried writing a book, book sales were morose. He tried setting up a stock broker firm, few people came to him. He tried to invest in an internet retail company, few people came shopping. House isn't selling, John is on Prozac, went around trying to get psychotherapy and is now contemplating suicide.

Something to think about when cutting interest rates “to encourage people to buy property …Higher.” interest rates and people will think twice before buying property. 

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