In early February 2017, the Federal Reserve Bank (Fed) held $1.75 trillion of mortgage-backed securities (MBS), compared to none in December 2008 and $908 billion in December 2009. The Fed’s large scale asset holdings were driven by three rounds of quantitative easing (QE) used to spur economic growth following the Great Recession. As a result, the Fed sharply increased MBS holdings between 2008 and 2014, as shown in Figure 1, which placed downward pressure on interest rates.
Since the Great Recession, key interest rates have been artificially low due to the Fed’s QE plan, but as the Fed begins to sell MBS on the open market and decreases the size of its balance sheet, interest rates are expected to increase above and beyond changes in the federal funds rate. This could have a significant impact on the U.S. economy, the ARM industry, and enterprise business valuations in 2017 and beyond.
Conceptually, when the interest rates rise, consumers generally save and invest more, but spend less. This tends to hold true except during a strong economy that is able to support higher interest rates. Conversely, if the economy is too weak to support these higher rates, then consumers would be less willing to take on additional debts such as auto loans and mortgages. For example, the Fed’s large scale purchase of MBS supported the housing market by lowering interest rates, which increased demand for housing, and pushed prices higher, as shown in Figures 2 and 3. Therefore, we can infer that a decrease in Fed MBS holdings will lead to an increase in interest rates that may negatively impact consumer loan demand since higher rates increase the costs of borrowing, unless the U.S. economy truly strengthens enough to support them.
As for the ARM industry, consumers may over-leverage themselves as a result of the increased interest rates, which could create higher delinquency rates, thus stimulating the ARM industry. However, if consumers reduce their use of revolving credit and/or other debt burdens, the demand for debt collection services may be negatively impacted. Therefore, volatility within consumer loans and the ARM industry creates uncertainty, which increases industry risk ratings that could impact enterprise value.
As illustrated previously, a reduction in the Fed’s MBS holdings will likely lead to an interest rate increase, which indirectly hampers growth, at least in the short-term, for the ARM industry and its ability to generate value. However, interest rate changes would also have a more direct impact on enterprise value since it increases risk-free interest rates.
The income and market comparable valuation approaches are the two most widely used approaches to value labor-intensive and service-based industries like the ARM industry. Changes in performance are likely to influence the market comparable approach, but the income approach is particularly susceptible to changes in the risk-free interest rate. To examine this effect, let’s consider the capitalization of earnings and discounted cash flows methods, two of the most popular income-based valuation methods.
- Under the capitalization of earnings method, the risk-free interest rate is a component of the Ibbotson Build-up Method, which derives a capitalization rate to determine value. As a result, increases (or decreases) in the risk-free rate will increase (or decrease) the value of the capitalization rate, which leads to a decrease (or increase) in enterprise value.
- Under the discounted cash flows method, the risk-free rate influences the cost of debt and is a component of the cost of equity. Therefore, if the risk-free rate increase (or decreases), a business’s costs of debt and equity increase (or decrease), leading to an increase (or decrease) in the weighted average cost of capital, and thereby lowering (or raises) enterprise value.
While this may sound overly academic, the theory is justified in real world applications. If a buyer of a business were to take on a loan to finance an acquisition, then interest rate changes will directly impact the buyer’s ability to finance the acquisition by increasing borrowing costs, just as consumers are impacted by interest rate changes.
Ultimately, higher interest rates are usually the hallmark of a strong and healthy economy that should not diminish a consumers’, businesses’, or buyers’ willingness to accumulate debt. However, there are a number of uncertainties behind the U.S. economy due to the long-lasting low interest rate policy since the Great Recession. As such, the Fed will need to closely monitor the performance of the U.S. economy, especially as it relates to wages and consumer loans. Additionally, those looking to sell or value their business, specifically those in the ARM industry with consumer credit grantor clients, should be aware that valuation ranges may be more conservative in the near future due to growing interest rates and uncertainty over the strength of the U.S. economy.
If you’re interested in speaking confidentially with a member of our team about valuing and/or selling your business, just send us an email at firstname.lastname@example.org.
Comments are closed.