I recently had lunch with a real estate broker, who was gloating over the sale of a $600,000 “starter” house.

The buyer was currently serving a seven-year prison sentence.

How do you buy a house from prison?  Stated income, on a 100%, interest-only mortgage.  The builder paid the closing costs.  In fact, said the broker, unless a buyer just sold another property, no one brings cash to a purchase.  She was surprised by one buyer who actually had $12,000 in cash reserves (not as a down payment, just reserves).  Most of her clients qualify for a mortgage only at the teaser rate.  They have to refinance every few years for a new teaser rate.

And housing has bottom.  Really?

Lending insanity is being played out on a vast scale, encouraging investors to drive up the price of every asset class.  Commercial real estate cap rates are not only low but compressed.  A client recently paid (with after-tax dollars) a six cap for property in rural Alabama (and if you don’t know what that means, you have no business buying investment property.)  A recent Bloomberg article discussed how private equity firms buy companies largely with junk bonds – and then issue more junk bonds to pay themselves huge management fees.  In a separate article, these same firms avoid junk bond investments with their own money as too risky.

Smart money is predicting interest rates are about to decline as the economy slows.  I am clearly not a smart person, because while rates may ultimately fall, I can only conclude the next direction is unavoidably UP:

•    The Federal Reserve is insistent that inflation, rather than a slowing economy, is their primary concern.  Apparently the market agrees.  When rumors of a rate cut loom, gold prices invariably jump.

•    Particularly as other central banks world-wide raise rates, the Fed cannot cut rates (and may not even be able to just hold rates) without collapsing the dollar.

•    The bond market is the ultimate arbiter.  Bond yields did not follow the Fed rate up, and are not obligated to follow them down.

•    Bond yields are low and extremely compressed, reflecting (among other things) virtually no default risk.

•    If the economy does slow significantly (the only basis for the falling rate theory), defaults will rise (and may rise anyway).  Bond yields will react to burgeoning lender risk by …falling?  Lending standards will… loosen?  No, they won’t.

My suspicion is that the trigger will come from real estate or credit derivatives.  A friend with a mortgage REIT anticipates class-action lawsuits from adjustable-rate mortgage borrowers claiming misrepresentation.

Avoid interest rate risk.  Borrow long, at fixed rates; invest short, at variable rates.  Likewise, avoid investments driven by the carry trade.  The math is the same.