Taking Stock / What Low Interest Rates Can Do

1 Here we go again, learning something we already knew perfectly well, but we seem to have difficulty digesting it: You can't time the market. You can't know that at a given point in time it has bottomed out or peaked. The market gives returns of five years inside five months, and the market takes away returns of seven years in four months. The point is that nobody can say in advance when it will do either. In January not one analyst was predicting that by summer, stocks would have gained 45%.

With the gains comes optimism. Brokers and traders who'd lowered their profile during the months of horror have been popping up proffering learned explanations for the gains.

The main reason they suggest for the powerful rally in stocks and corporate bonds is that the economy is recovering.

Not only here but everywhere, the talk - cautiously, gingerly, warily - is about having reached rock-bottom. Even The Economist, known for its caution and skepticism, wrote last week, "With luck, the global slump has reached its trough." When companies restock, it suggested, global growth may surprise with its intensity.

But the main reason for the surge in Tel Aviv shares isn't some sharp turnaround in the broad economy. The cause lies in financial elements.

* Many of the shares that surged, rising as much as a few times over, were ones that had lost almost all their value in the last year. Share prices plunged 90% because of panic, not logic, and with the anxiety abating, the stocks corrected.

* Toward the end of the first quarter, the scenario of the financial system collapsing into rubble began to dissipate. That scenario had lurked in the wings, issuing bloodcurdling screeches from time to time, since Lehman Brothers collapsed. As it vanished, investors experienced a dramatic resurgence of their appetite for risk.

*Interest rates, interest rates and interest rates. After the crisis erupted, central banks around the world adopted expansionary, spendthrift ways, the likes of which the world had never seen. They've been spraying money into every spot that looks a tad on the dry side, and then some more into spots that they'd already flooded. In an environment of bottom-crawling interest rates, the people holding all this money couldn't take it anymore and stampeded for high-risk assets again: stocks and corporate bonds.

The gains in Israel's equity markets aren't unique. Most markets beyond the developed world shot up this year. Chinese stocks gained 90% in dollar terms, Russian equities gained 50% and Brazilian shares rose 70%. The Morgan Stanley index tracking emerging markets gained 42% from the year's start to the end of last week, as the TA-100 index did.

2 How are low interest rates driving financial markets? Look for example at the money pouring into mutual funds that specialize in bonds. Since bank deposits are hardly paying any interest, investors are willing to contemplate riskier stuff such as mutual funds.

The mutual funds have to generate returns for investors, so they rush to the market and buy securities. Since interest on short-term government bonds is also practically zero, they buy corporate bonds. Until three months ago, corporate bonds had been considered high-risk stuff; suddenly they're red-hot.

Here are two examples. About two months ago energy company Paz Oil had to offer 2.2% above Bank of Israel interest rates to raise money from the public. Last week investors were only demanding a premium of 1%.

Six weeks ago Delek Israel had to offer annual interest of 3.6% above the rate on comparable government bonds. Last week investors were settling for 1.1%.

Six months ago, the institutional investors managing our money vowed they wouldn't lend a sou to corporate Israel without solid collateral, or a hefty increase in interest rates. That was then. This is now, when they're vying to generate the highest returns again and competing over public money. And with Bank of Israel interest rates as low as they are, the only way is to take risks.

3 Since the real estate bubble blew up in America, Israelis have been wondering if the local real estate market bubbled too. Generally speaking, that's a no. Israel's housing market was and is less leveraged. Housing prices didn't double and triple as they did in parts of the West during the last 10 years. Nobody built bloated financial constructs on subprime mortgages, which means, loans extended to people who probably couldn't afford them.

Yet now that the air is escaping from the American real estate market, something new is happening over here. You can't call it a bubble, not yet, and it's not some sort of Israeli subprime. At this stage, most of the risk is by the borrowers.

I refer to the practice of taking out a mortgage bearing variable interest.

Until a few years ago, almost all mortgages were linked to the consumer price index and bore fixed interest. As inflation and interest rates fell, more and more mortgages are popping up with linkage to the CPI and bearing variable interest. You can even find unlinked mortgages bearing variable interest.

As interest rates neared zero, the trend picked up terrific momentum. In 2007, 40% of new mortgages were unlinked and bore variable interest. In the first half of 2009, the proportion of mortgages bearing variable interest rose to 70%.

Here's another statistic: Inside a year and a half, aggregate unlinked mortgages mounted from NIS 20 billion to NIS 45 billion.

During the second quarter of 2009, there was also a spike in mortgage lending, to NIS 9.3 billion.

Given the low interest rates, it makes sense to take out unlinked mortgages with variable interest rates. Doesn't it?

Yet two things niggle. Do the people taking out variable-interest mortgages think that the low interest rates they're paying now will stay that way? Do they realize that when interest rates climb, their monthly payments will too? Can they afford it when that happens?

The interest rate on the shekel to which most mortgages taken today are linked has never been this low. It could double or triple in the future, or worse.

Do these borrowers realize that? Or are they behaving like the Americans during the go-go days of the real estate bubble, mesmerized by gauzy visions of rising real estate prices and their (currently) low monthly payments? Those payments are low because interest rates are currently low. That will change.

The Bank of Israel can prevent Israeli mortgage banks from going wild with risks. But the mortgage borrowers will have to take care of themselves.