Bottom’s Up

One year after cutting the federal funds rate to the modern-day low of 1 percent, and four years after embarking on a protracted game of interest-rate limbo, Federal Reserve chairman Alan Greenspan finally raised the interest rate he controls. Widely predicted for months, the increase was perhaps the most anti-climactic scrap of news to cross the tape since Nathan Lane came out. And though it was but a mere quarter of a point, the hike is likely to be the first of many. “When rates reverse, they typically start going in a new direction,” says James Grant, the proprietor of Grant’s Interest Rate Observer. If this is, in fact, what comes to pass, the implications for New York City—at least the version of it we have known and grown comfortable with over the past three years—could be dire.

Just as the Wall Street boom defined the eighties, and the dot-com era branded the nineties, the first half of this decade can be considered the era of cheap money.

The long-term cycle started way back in the early eighties, when Paul Volcker, the cigar-chomping Federal Reserve chairman, launched a jihad on inflation by jacking up interest rates into the high double digits. (In 1980, my bar mitzvah money went into a Dreyfus money-market account that yielded about 18 percent.)

After generally falling throughout the eighties and nineties, with some upward bumps along the way, rates plunged in the past few years to record lows.

Many factors were responsible: a recession and anemic recovery, rampant productivity, and the widespread disillusionment with stocks after the dot-com crash. Above all, we’ve had a Fed chairman whose preferred response to virtually every crisis—from the Asian meltdown of 1997 to the 9/11 attacks—has been to lower the price of money. Last June, fearing deflation, Greenspan took the federal funds rate to 1 percent—down from 6.5 percent in May 2000—and left it there.

New Yorkers will start to scrutinize restaurant bills more closely—“That’s your $18 martini”—and think twice about Anguilla in February. Fort Myers is warm then, too.

Such low rates, of course, were accessible only to banks like Citigroup and Goldman Sachs. But ultracheap money for the few translated into cheaper money for the masses, a verifiable case of trickle-down economics. Thirty-year mortgage rates fell from 8.5 percent in 2000 to below 6 percent last year. The Big Three automakers rolled out unprecedented zero percent car loans in the fall of 2001.

But it was in New York that the effects of cheap money were most visible and far-reaching. The city is populated with more people, companies, and public agencies that borrow and spend than anywhere else. It houses the industries for which low interest rates are a license to mint money—bond-trading notably, as well as the securitization of mortgages and other financial instruments. And because housing costs more here than virtually anywhere else in the country, and because people borrow heavily to buy it, New York real estate was among the nation’s greatest beneficiaries of the era of cheap money. The city has been awash in cash in a way that we will come to appreciate ever more deeply as Greenspan begins to tighten the spigot.

over the past three years, super-low interest rates offered a psychological salve for New Yorkers who found their nerves frayed by 9/11 (and by that suddenly smaller matter of the dot-com collapse). For many of us, spending became a kind of therapy. We took the windfalls from mortgage refinancings and hastily blew through them: on $300 meals at Alain Ducasse, on spa treatments and trips to the Ocean Club.

Nationwide, inflation may have been muted. But the cost of daily life in Manhattan rose spectacularly: 95 cents for a Gray’s Papaya hot dog, $2.50 for a gallon of gas, $10 for a movie ticket, $100 for a Producers ticket, $16,000 for nursery school. We accepted the higher prices with alacrity because cheap money acts as the ultimate absorber of sticker shock.

Cheap money also paced the relentless march of the Upscale. Whole Foods replaced the Korean grocer as the supplier of choice for produce. Barneys revived from its long post-bankruptcy slumber. The $40 Gap button-down gave way to the $130 Thomas Pink in the closets of middle management. On the Lower East Side, dining used to mean a $3 falafel and a $1.25 Snapple. Now it’s the lamb with aged goat cheese and hibiscus date purée ($30), accompanied by a 1999 Meo-Camuzet Bourgogne ($48) at WD-50.

Most of all, New Yorkers spent their cheap money on condos, co-ops, brownstones, lofts, carriage houses, and country homes. In the seventies, cash disappeared up the noses of the upwardly mobile; more recently, yuppie cash was shoveled into brownstone Brooklyn. Since the end of 2000, the nation’s total household debt has risen from $7.01 trillion to $9.46 trillion, up 35 percent. Nearly three-quarters of that debt resides in mortgages.

Bonuses may have been flat and new jobs still hard to find, but thanks to falling interest rates, homeowners found themselves sitting on cash—much as the Beverly Hillbillies discovered black gold in their backyard. They refinanced or took home-equity loans at absurdly low rates to pay bills or tuition, or to renovate—which stimulated the businesses of architects, plumbers, and contractors. In 2001 and 2002, Home Depot opened eight stores in the city.

Cheap money created a virtuous, profitable, and satisfying circle of consumption, investment, and sales. And so early this year, according to Douglas Elliman, the average sales price for a Manhattan apartment below 96th Street on the East Side and below 116th Street on the West Side rose to $998,905, up 28 percent from the year before. And why not? Even as houses were getting more expensive, they were getting cheaper. Paying down a 5.6 percent, $800,000 mortgage over 30 years costs $4,593 a month; at 8 percent, the prevailing rate in 2000, the monthly payment on the same was $5,870—over 30 years, that’s a savings of $460,000. Just as people who came of financial age in the nineties believed that stocks moved only in one direction, those who matured financially in the early part of this decade knew that interest rates moved only in the opposite direction. You could overpay for that four-bedroom Colonial in Montclair, or for the two-and-a-closet in Gramercy, secure in the knowledge that you could quickly refinance.

In 1996, the 35 brokers at the Manhattan Mortgage Company, a firm founded in 1985 by Melissa Cohn, originated about $700 million in mortgages. Last year, Manhattan Mortgage’s 140 brokers, working out of offices from Amagansett in the east to Croton-on-Hudson in the north, clocked $5 billion. Cohn herself did $1.125 billion in 2003, closing 2,700 loans—more than seven closings per day, every day of the year. That earned her the rank of No. 2 originator of the year from >Mortgage Originator magazine. “It was insane,” says Cohn, who speaks almost exclusively in short, clipped sentences, one eye on her e-mail; no time for lengthy discourses when home buyers are queued up like 737s at La Guardia.

Cheap money acts as the ultimate absorber of sticker shock.

The neighborhood in which the effects of cheap money and falling interest rates were most pronounced was a metaphorical one: Wall Street. A few years ago, the financial industry was laid low. The stock-market crash, the attacks of 9/11, corruption scandals and indictments, Eliot Spitzer. One by one, the ringleaders of the stock-market circus left the scene.

Into their soft leather shoes stepped the bond guys. In the late nineties, M.B.A.’s who entered the bond-trading field were thought to be chumps. There were millions to be made instantly in startups. And with the sudden appearance of a federal surplus, there was talk of the government’s paying off the entire national debt, thus obviating the need for bond traders. In retrospect, however, it was a classic contrarian move. Low interest rates spurred waves of refinancing—by home buyers, companies, governments—and the massive accumulation of new debt. Most of that debt was packaged into bundles and sold as bonds. In 2000, $482.4 billion in mortgage-backed securities was issued; last year, there was $2.14 trillion. The explosion created constant work for bankers, lawyers, accountants, and printers. Happiest was the lot of traders. Daily trading volume of mortgage-backed securities rose from $69.5 billion in 2000 to $211.5 billion in the first quarter of 2004.

Companies, like consumers, have refinanced their debt by selling huge amounts of bonds. That added to the profits of the Wall Street firms that specialized in bonds, like Lehman Brothers and Bear Stearns. But it also gave screwups a new lease on life. Many companies that overborrowed to overinvest in the nineties faced a reckoning in 2002. And just at the moment that lots of debt needed to be restructured, interest rates began to fall to new lows. “In 2002, companies that we thought were bankrupt pulled themselves together,” said Steve Rattner, principal at the Quadrangle Group and member in good standing of John Kerry’s economic-team-in-waiting.

On Wall Street, minuscule interest rates gave rise to the carry trade—the phenomenon whereby professional investors borrow cash short-term and buy higher-yielding long-term securities. So long as short-term rates remain low, it’s automatic money. With IPOs slow to recover and the stock market generally flat, proprietary trading—i.e., gambling with the house’s money—helped restore Wall Street profits to their boom-era levels. Those who made the bets won the internal sweepstakes. Lloyd Blankfein, an unassuming former gold-coin broker, rose in the past several years to head Goldman Sachs’s fixed-income unit, the company’s profit engine. He earned $20 million in 2003, and was catapulted to the posts of president and COO. “Fixed income, commodities, and currencies—these guys had a huge run, because they were strapped to a rocket ship on a trading desk going to Mars, and it landed,” said David Hendler, an analyst at Creditsights.

All this activity—the forgiving interest-rate climate, the creation and packaging of bonds, the frenzy of housing sales and the rise of property values—also redounded to New York City’s benefit. New York City is America’s great civic borrower. But even as the city’s debt rose from $37.78 billion in 1999 to $47.765 billion in 2003, or 26 percent, the cost of maintaining and paying it down fell sharply. In the New York City general fund, total funds spent on debt service went from $3.74 billion in 1999 to $2.52 billion in 2003, from 10.4 percent to 5.7 percent of total expenditures. “New York City now pays 1.2 percent on its variable debt,” says Marcia Van Wagner, an economist at the Citizens Budget Commission. “If you go back to ’94 or ’95, the city was paying about 3.5 percent on its variable-rate debt.” Without low rates, Mayor Bloomberg would have been forced to enact budget cuts and tax increases far more vicious and relentless than we’ve seen.

Now the era is ending much as morning cracks over the East River—gently, until the light spreads across a broad canvas. Stock-market cycles tend to end cataclysmically, on a single day: October 29, 1929; October 19, 1987; April 3, 2000. But the interest-rate worm is turning slowly. With signs of inflation and stronger economic growth, investors since March have started to push interest rates higher, even as Greenspan sat on his hands. The interest rate on the ten-year Treasury bond has risen nearly 25 percent since March. It’s not just that interest rates are going to spike and run up hugely, but that people are beginning to realize they won’t fall anytime soon. “The next ten years won’t be like the last ten or twenty years,” says Columbia University economist Richard Clarida, a former assistant Treasury secretary in the Bush administration. “There aren’t going to be those big powerful forces pushing interest rates down, because the Fed has won that victory over inflation.”

The mortgage brokers are already feeling the pain. “The refinancing market has dried up to a great extent,” says Melissa Cohn, whose firm’s business will probably decline by 20 percent this year. “My entire industry is going to contract tremendously this year.” And real-estate brokers are having to hustle. “If you did 30 or 40 deals last year, you’ll probably have to work a lot harder to do the same thing,” says Chris Halliburton, a broker with Warburg Realty who specializes in Harlem. Prices aren’t falling by any measure yet, but the likelihood of a repeat of the past few years is increasingly distant.

As the Fed continues to raise interest rates in the coming months, the discomfort will spread. On Wall Street, it’s dangerous simply to extrapolate a whole year based on the first six months. But thus far, it’s shaping up to be a typical rate-rise year. Both the bond and stock markets are flat, and trading volume hit the summer doldrums in springtime. In mid-June, David Goldfarb, CFO of Lehman Brothers, hosted a conference call to report the latest earnings and crowed about the company’s second-best quarter ever. There were cracks in the smiley façade, though: Revenues fell 10 percent from the first quarter. Bond underwriting was flat. Goldfarb added that the firm is “looking for a fixed-income origination, probably down somewhere between 10 and 15 percent” in the second half of the year, and suggested that Lehman could make up for the declines with more stock-market and advisory businesses. Investors didn’t bite. Lehman has other lines of businesses for the same reason Peter Luger has salmon on its menu—more for show than for true diversification. Bonds are Lehman’s porterhouse and home fries. The day earnings were announced, Lehman’s stock, down about 15 percent since March, fell another 4 percent.

Bad as it may be for Lehman, New York City could eventually be hit with a double whammy, paying more to service its huge debt and raking in fewer tax receipts from Wall Street. That means the already-bitter partisan warfare between the Republican mayor and the Democratic City Council will intensify, as they battle over painful choices on taxing and spending.

And what of the rest of us? Just as cheap money made us all feel and behave a little richer than we really were, an era of more expensive money will leave us all feeling and behaving a little poorer. People will start to scrutinize restaurant bills more closely—“That’s your $18 martini”—and think twice about Anguilla in February. Fort Myers is warm then, too.

But housing is where we’ll see and feel it most. When interest rates rise by one full percentage point, it saps about 10 percent of buying power. Worse, we’ll have to pay down the mountain of debt that has piled up on our homes and credit cards. And refinancing at a lower rate may not be an option for years. “We’re addicted,” warns hedge-fund manager John Succo, “and we will go through withdrawal.”

But instead of going cold turkey, many New Yorkers are turning to harder stuff. The great blessing of the era of cheap money was that you could get a low interest rate and insulation from credit risk—a guaranteed low rate for 10, 15, or 30 years. And so when interest rates rise, borrowers’ first step is frequently to assume greater risk in exchange for a temporarily lower rate. This winter, Alan Greenspan, momentarily morphing into CNBC personal-finance therapist Suze Orman, suggested that people make greater use of adjustable-rate mortgages—inviting people to expose themselves to interest-rate risk precisely at the time when it would have been smartest to lock in a long-term rate.

And New Yorkers are taking heed. Melissa Cohn says buyers are looking at interest-only products, variable rates, 40-year mortgages, or shorter-term debt—anything to keep the payments low. Meanwhile, the smart money is moving in the other direction. “I have gone the other way and fixed a bunch of stuff,” says a partner in a high-profile private-equity firm.

In time, we may look back nostalgically on the cultural artifacts of the era—the Lincoln Navigator we bought with a zero percent loan, that apartment with an asking price we thought preposterous until it was topped by three bidders. We’ll reminisce about all this with the same fondness with which today’s fortysomethings rhapsodize about the Wall Street bonuses and the Columbus Avenue singles bars of the eighties—a great good time that slipped away, never to return.

Bottom’s Up