Most value investors tend to avoid the use of leverage in their portfolios due to the old saying: “The market can stay irrational longer than you can stay solvent.” An investor can be entirely correct about his or her investment choices but the market may fail to recognize this before ruinous margin calls result in forced asset sales at depressed values. While there are many successful hedge fund managers who skillfully employ leverage and engage in short selling, most individual investors should stay far away from such strategies.
In light of this general conservatism on the part of value investors, an article suggesting the use of mortgage debt to improve investment results may seem a bit odd. In most circumstances, my view is that investors should not only avoid leverage through margin accounts but should also attempt to be free of all forms of personal debt. Excessive debt obviously played a large part in the real estate meltdown and has ruined the finances of many families. Nevertheless, opportunities now exist for intelligent use of mortgage debt for certain individuals.
When Uncle Sam Offers Subsidies … Take It
Mortgage debt has long been heavily subsidized by the Federal Government through income tax deductions for mortgage interest. However, that is only the beginning of the story when it comes to government interventions in the mortgage market today. The government now controls Fannie Mae and Freddie Mac and over the past year has implemented numerous programs to directly and indirectly subsidize mortgages. Most notably, the Federal Reserve has accumulated over $800 billion of mortgage related securities, an action that many believe prevented the mortgage market from grinding to a halt entirely.
The combined result of government actions in the mortgage market has resulted in very low interest rates on fixed rate mortgages for those who have sufficient equity in their homes. In many cases, borrowers have been able to secure fifteen year fixed rate mortgages in the low 4% range and thirty year fixed rate mortgages below 5%. The effective cost of these mortgage loans are further reduced by the interest deduction/subsidy.
Safe Leverage and Inflation Protection
Obviously, mortgage debt should only be used to the extent that it can be safely serviced without any risk of financial distress. Also, mortgage debt should not be used on properties that may have to be sold over the next five to ten years. Once these conditions are satisfied, two major advantages emerge. First, the investor has access to cheap financing for funds that can be deployed to long term value investments. At an after-tax cost of funds below 4% in many cases, it does not require heroic returns to adequately cover the expense. Furthermore, there are no margin calls associated with this form of leverage. As long as debt service payments are made, no default will occur. The investor will not be forced to liquidate holdings that are temporarily depressed to meet any margin calls. Additionally, the long term nature of the debt (fifteen to thirty years) matches the long term investment horizon that most value investors have.
The additional advantage in today’s environment is that mortgage debt provides an excellent hedge against inflation. While there is debate today regarding whether inflation will emerge, the market for commodities and foreign currencies is painting a negative picture for prospects of the US Dollar going forward. Foreigners are growing increasingly uncomfortable with holding dollar denominated assets. The Federal Government is piling up debt at unprecedented rates and the risk that politicians will attempt to monetize this debt in the future cannot be ignored.
To hedge against these concerns, many investors choose risky approaches such as speculating in commodities, shorting treasuries or participating in exchange traded funds employing an array of strategies. However, the presence of low fixed rate mortgage debt on an investor’s personal balance sheet is a natural inflation hedge. The pre-payment features of most mortgage loans also provides protection if inflation does not emerge. The borrower can always pay off the loan at any time, usually without penalty.
Value investors tend to focus on individual companies when making investment decisions and do not spend significant time on macroeconomic forecasts. While this is generally a wise approach, when a simple and low risk hedge against a growing macroeconomic risk is available, it seems intelligent to take advantage of it. While leveraging mortgage debt as an inflation hedge will not provide complete protection for most investors, it can be part of an overall strategy to mitigate the impact of potential inflation in the future.