Monday, February 7, 2011
FEBRUARY 7, 2011 BY GEORGE LOVATO JR
What Does a Rising Rate Really Mean?
I listened to a friend recently predicting gloom and doom about rising bond rates. The fact is a little increase in the U.S. bond rate is good. Too much and could adversely affect the economy which we all know is fragile in its current condition. What does a rising rate really mean? First better yield on parked funds. Second, lending institutions will have a better basis to forecast a base rate to lend by in simple terms. And increased yields on invested money can mean more money to lend. In short it is not the end of the world.
I can recall a time when Wall Street Prime was a reasonable reference point for the cost of money. That has gone out the window. Rates are pretty much all over the board now. There does not seem to be a clearly defined interest rate pinpoint. LIBOR was also a reference. But that too is unreliable these days. What is a good bellwether? U.S. treasuries used to be and should become again the standard. But they first must stabilize and next they must be priced attractively. So at a time when we are all searching for anchors on a sandy beach, maybe a little increase in the U.S. bond market is not a bad thing. What Bernanke is doing now and how he is managing the course is in my opinion sound. Create demand.
Time and the Cost of Money Marches On
I recently had a discussion with a client on the cost of money. His reference point was his previous loan rate which was established seven years ago. It just happened to be five and one quarter percent. He wanted to renew his loan at the same rate. When I informed him that it was going to be in the mid to upper sevens he was shocked. He could not fathom the increased cost. His position was he had been performing on the loan and all should have been left unchanged. He did not see the reason why he should pay more. After some time I explained all that has happened in the last four years outside his bubble and he was astounded. What happened he wondered? How could what happened out there affect me? Well the reality set in and he then was more accepting that what he had seen in the news did in fact have an impact on him. What a surprise. Well time and the cost of money marches on.
I hear that same argument from a lot of my clients. Why does money cost so much these days? There are a host of reasons, much too long for this blog but suffice it to say a lot has changed. Losses from lending institutions must be absorbed. Risk must be accounted for in the cost of money. The cost of management of lending must be adjusted just to mention a few reasons. Do not be so shocked when you see the proposed interest rate. It is going to cost more. Pure and simple.
The Cost of Capital
There is a story in my upcoming second book (Due out in May) about this very subject. You can find my first book here. It speaks of the cost of capital in its varying forms. Commercial bank debt costs less than semi-regulated debt. Equity is far more expensive than both of those forms and the list and prices goes on. Cost of capital is volatile in today’s market. We must plan for it along with all the associated costs that accompany debt or equity. It has now become a cost to contend with. Long ago it was by most standards inconsequential. Today it is measurable and significant. In the story I mentioned in my upcoming book it relays an incident where the interest on a loan went from six percent to fourteen percent in a matter of a few months. This increased cost was never projected nor anticipated (variable loan rate combined with default covenants added to the loan) and as a result the client went out of business in the process. Lesson…allow for the varying and increased volatility of the cost of capital.
Everything Has Changed
Some of us feel we are unaffected by what goes on in the world around us. Others feel that as long as we are unchanged so is the manner in which we do business. The fact of the matter is that many things have changed in the world of finance in the past few years. So much so that even some of the rules that guided some of our decisions are non-existent or so radical is the paradigm shift it is hard to even comprehend. Suffice to say if we are in business, we must be more observant and mindful of the changes in our world, economy and in finance. Don’t listen to opinion but search for the facts and patterns. Open your mind as well as your ears. Most of all, we know now that everything has changed and that includes the cost of money.