The Ripple Effect

By: Juan Carlos Garnica

From housing sales to Apple Bank, how rising interest rates are reshaping real estate and banking.

In a year highlighted by rising waves of inflation and interest rates, the world economy has been on an exciting path, reshaping the landscape of real estate and banking. It may seem like years, but it has, in fact, been only 12 months since the Federal Reserve (FED) started raising interest rates to control escalating inflation, from 0.25% to 5% today. Although it was clear that these measures would slow down the real estate market, few could predict their effects on the banking system.

The question arises again: Is the worst over?; However, this time, I want to consider another index, the recently released quarterly Employment Cost Index (ECI). This shows workers were paid 1.2% more in wages in Q1 than in the prior 3-month period, a 5.1% YoY increase, surpassing analysts’ expectations. This is a harbinger of enduring upward pressure on consumer prices.

Repercussions on Real Estate: A Three-part Breakdown

What occurred in 2008, when house prices increased to absurd levels, is not the same as the current situation. This time, prices have been on the rise since the pandemic. Now, from the US to the EU and Australia, housing sales have plummeted over the past year as the central bank raised the interest rate as a way to control the exacerbated inflation.

As has always been the case, markets did not react immediately to the FED’s economic measures; it took time to observe the real estate market slow down in sales after an almost 2-year rally. Similarly, this time, the tipping point has come after interest rates rose to 4.25% in February, constituting a 1% increase YoY, which decreased long-term target expectations. Although fixed interest rates will protect mortgage holders, particularly outside the US, most of the 2-year fixed-rate agreements will be renegotiated, and new terms will be established this year. Some will struggle with the updated conditions, while others will exhaust their financial buffers, particularly the ones with lower-income households in the Eurozone.

The consequences of the interest rate hike can be placed into three categories within the affluent world. The first category, “the early adopters,” includes countries such as Australia, Canada, New Zealand, and Sweden, where interest rates were not raised until late May 2022; buyers in these countries had significant incentives to buy houses at a low-interest rate, however, most of them on variable-rate terms. This makes them more exposed to higher interest costs, suggesting that more pain is still to come in these countries.

The second category, often referred to as the “resilient survivors” buyers category, prominently represented by the United States, where fixed-rate mortgages provide some protection for buyers, with agreements typically spanning 20 to 30 years. The country benefits from low household debt, which averaged just 124% of net disposable income in 2021, compared to 200% in the European Union. This provides homeowners with some insulation against interest rate hikes, coupled with a lower household debt ratio relative to disposable income compared to many European nations, creating a high degree of resilience.

The third category consists of “market laggards”. In this group, Britain’s housing market has experienced a 5% decline in prices, and specialists forecast a 12% peak-to-trough drop, suggesting that the worst is yet to come; Persimmon, Britain’s second-biggest builder, has even offered to pay mortgages for up to ten months after the purchase. In Germany, the property federation predicted a shortfall of the target of 400,000 units. These conditions hint at potential difficulties in the face of rising interest rates.

The Uneven Impact: Banking Industry Winners and Losers

From the banking system perspective, the landscape indicates that damage has not hit each part of the banking industry evenly. The largest such as JP Morgan and Bank of America, with trillions in assets, have seen a 15% rise in profits along with growth in bank deposits, the big winners, no doubt. The next tier lies in the regional banks, with hundreds of billions in deposits, such as PNC, which maintained their bank’s deposits although paying more interest for them, being less profitable. The third tier encompasses banks with ten of billions in deposits, such as Western Alliance which saw an increase in its bank’s interest expenses by almost 50%; although worrying, its situation is better than in 2021 when the interest rate was at zero.

The Apple and Goldman Sachs Partnership: Disrupting the Banking Landscape

To add more stress on the banking system or perhaps throw it a lifeline, Apple and Goldman Sachs launched a savings program last Monday. They offer a US savings account with 4.15% annual interest, no fees, and no minimum deposit requirements. This is more than 10x the US national average rate of 0.37%, aligning with the announcement made in October 2022. It also pressures competitors such as American Express, which offers 3.75%, or Goldman’s standalone program named Marcus, which offers 3.9%.

One primary advantage is that Apple’s global reach is much more extensive than banks and also with a better reputation and less friction with customers. While incumbent banks conduct their daily business with more than 90% borrowed money, Apple will fund the loans from its balance sheet, around $165 billion in cash. This makes Apple much less exposed to the pressures currently facing the financial industry. A cautionary tale is the case of First Republic Bank, where among other issues, a significant outflow of deposits exceeding $100 billion in Q1 alone put a huge stress on operations, precipitating a decline in customer confidence; this year, shares plunged by 97%. As Stanford professor Anat Admati mentioned in a conversation on the Greg Lablanc Podcast, “Banks sometimes forget that depositors are creditors.”

Customers have withdrawn about 800 billion in deposits from US commercial banks since the FED started raising interest rates, opening a broad range of options for customers seeking higher yields, which plays into the hands of this new financial duo.