Decapitalization – back to sanity

There is no established word for it, I will call it “decapitalization”. Not to decapitalize as in going from “A” to “a”. What I am talking about is decapitalization as opposed to capitalization.

When you capitalize something. You take for example a future income stream of USD 100 000 per year in rent from a property and turn it into its equalent in present capital. At 10% interest rate a 100 k annual return is worth USD 1 million in today’s money. One is as good as the other.

Now if interest rates go down to 5% the capitalization increases by 100% because USD 2 million also gives 100k at 5%.

Remember that Alan Greenspan drove the interest rate in the U.S. down to 1%. At 1% the 100k return when capitalized is “worth” a staggering 10 million dollars, ten times.

Interest rates went down and down because the Federal Reserve pursued easy money vigorously. The FED pumped new money into the economy to offset the recession that the .com bust and 9/11 would otherwise have produced. By increasing the supply of available money, while demand was going down because of a slowdown, the price (interest rate) on money went down.

Of course a rational market should not fully capitalize any short lived present interest rate, but would make sure to anticipate future changes in the interest rates. However this is not how markets seem to work. Markets tend to use current interest rates as “the true” interest rate and overcapitalize towards the present interest rate, whatever it happens to be. The markets thus do not behave rationally. Just as no investor you may know personally is fully rational (if you know one please point him out to us) the market collectively is not fully rational either.

So, ok, this was the capitalization part. The capitalized “value” on U.S. assets soared in the 2000′s as interest rates went down. All assets deemed as producing a return, a rent in valuation or capitalization went up to the stratosphere. This was particlarily true for housing.

Now comes the decapitalization part, the reversal of this trend.

Interest rates bottomed out at 1%. They could not really go any lower. Remember that at 1%, when inflation was ticking along at 2-3-4 times as much (who knows what the real consumer price inflation is) investors are loosing money.

At 1% the USD 100 000 return was “worth” USD 10 million.

Now the tide is turning. How far up will interest rates go this time? No one knows. What we do know is that the FED has used up a lot of it’s ammunition. Federal defecits and entitlements will eventuelly force the FED to monetraily inflate massively, and inflation drives interests rates up. Massive monetary inflation should at some point lead to massive inflation. It is reasonable to assume that over some time the interest rate will again work it’s way towards some king of ceeling.

If interest rates go to 10%, the value of the 100 k rent is worth USD 1 million, down from 10 million.
That is a 90% haircut on the capitalized “value”.

Decapitalization.

Hans Lysglimt, Farmann. Sept 13. 2008

Share
This entry was posted in Uncategorized. Bookmark the permalink. Both comments and trackbacks are currently closed.