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February 04, 2008 – Comments (5)

The price of credit is increasing.  From the WSJ today,

"The January survey shows that more domestic institutions have tightened lending on commercial and industrial loans, on commercial real estate loans, and on prime and subprime residential mortgages in the past three months. And while Treasury yields have dropped sharply in the wake of the Federal Reserve’s actions, corresponding interest rates — such as those for prime mortgages or jumbo mortgages — have not. The federal-funds rate has declined by 2.25 percentage points in the past year, but the average 30-year mortgage rate is at 5.58%, compared with 5.96% a year ago, a 0.38-percentage point decline. Jumbo loans are higher, at 6.71%, from 6.19% a year ago."

The banks are repricing risk back into lending.  Personally, I don't think they have priced enough risk back into lending because they are still matching short term deposits with long term debt.  It means that say 3 years from now interest rates are 7%.  They are losing money.  The only way the banking system stays solvent in that case then is if interest rates are artificially discounted, which I think the federal discount window is already doing.

The Canadian system is simply better.  It matches loans with term deposits, hence we have mortgage renewals and the rates we pay change.  It enables banks and consumers to adjust to current rates, which can be "good" or "bad" depending on which way the rates go.  It also encouages people to take the debt more seriously because rates can go up.  

The lack of matching deposits with debt essentially forces the government to keep rates artificially low because as soon as rates are raised banks find themselves in trouble again.  

You might argue that it is good that consumers can get long term low interest rates, but it creates gross financial instability. 

5 Comments – Post Your Own

#1) On February 04, 2008 at 10:44 PM, Imperial1964 (97.82) wrote:

I dunno if adjustable rates make the financial world more stable. 

If you look at the huge increases in some peoples' mortgage payments, it seems to create a lot of instability.  Payments rise by several hundreds per month, putting a drag on consumer spending and spiking foreclosures.  I'm not sure which is worse for banks: loaning money at a loss or foreclosure?  I do know which is worse for the homeowners and consumer spending.

Now the Fed is having to manipulate rates lower to 1)save the homeowners with ARMs, and 2)save the banks from the impending defaults.  I'm not sure I see a lot of difference in terms of economic stability.

I think the issue has more to do with financial education.  Many people in the US think they can afford anything they can get financing for.  Lenders have over-lent and borrowers have over-borrowed.  Both parties should've made sure the borrower could afford to repay, but too often nobody worries about tomorrow.

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#2) On February 04, 2008 at 11:30 PM, dwot (40.33) wrote:

What you are referring to is very different than what Canada has. 

You can lock into a rate for 1 to 5 years, but it is a market rate. 

The way those loan resets were priced was by giving an unsustainably low rate to start.  You don't get unsustainably low rates to start in Canada, although we've had floating rate mortgages which can be a very low rate when the bank rate is low.  Banks don't have to match deposits to that kind of loan until such times as it gets locked in.  It floats up and down with the bank rate so there is no risk of paying more for deposits that you are collecting.

If you got your mortgage when rates were low, you would run the risk of having it renew at a higher rate in Canada and that is a problem and it can be spread over a few years as people choose the term they want.  Rate were low when I took out my mortgage so I went for 5 years and for the first two years we doubled up on payments just to get the principal down.

The problem has little to do with the fact that mortgages come up for renewal, but rather that the banking lending and qualification standards are not adjusted to the nature of the lower interest rates and had nothing built in for the obvious risk that rates could go up. 

The math says that even though you can borrow more for the same payment, as the rate goes lower the risk of it going higher increases and therefore you need to lower the amount of income that can go to mortgage, or set the mortgage term lower, say 20 to 25 years rather than 30.  It is not a reset problem but an adequately pricing for risk.  And what the US did that was even more insane was as rates when down the amount of income that could be used was increased...

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#3) On February 04, 2008 at 11:39 PM, dwot (40.33) wrote:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aHBPDpMwyUMI&refer=home

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#4) On February 05, 2008 at 12:07 AM, abitare (35.12) wrote:

dwot,

Good write up. Most Americans think that the 30 year fixed is a blessing. But if it did not exist real estate prices would be significantly lower. With out Fannie and Freddie Mac to buy all these mortgages many people would be unable to get a loan based on the credit risk. 

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#5) On February 05, 2008 at 9:41 AM, dwot (40.33) wrote:

Yup, the more I think it through, the more I see Japan style deflation coming...

It could be fixed by putting regulations on the amount that can be borrowed that gives room for rates to go up.  But one thing is clear, deregulation hasn't worked, at least it hasn't worked for the masses.  It has grossly increased the discrepancy of wealth, and I have nothing against a discrepancy of wealth as long as your poor people can get by.  They can't get by anymore and deregulation has hit that group the hardest.  The article that I have linked on Canadian income is showing that the poorest 20% saw their wealth decline by 8% over the past 4-5 years whereas the top 20% cut off bracket went up about 80%.

I should count myself among the highly fortunate, and I do feel that I earned my place among the highly fortunate, in that our household wealth went up a percentile bracket between the two surveys. I feel like I earned it because we've been very responsible about spending relative to our income, putting off, shopping around, and doing without lots of things.  I've spent a lot of my life wondering how people afford what I see them spending and now I know, it was an illusion.  My lifelong, pay-myself-first philosphy has really made a difference in the past few years. 

We paid ourselves first by aggressively hitting mortgage debt.  Early in my marriage I'd have these conversations with my dear husband about putting more to the mortgage and we'd barter back and forth because he really didn't want to.  Later I'd just call the bank and ask them to increase the payment and he'd see the increase go through and come back to me with this tone in his voice, "when did we discuss increasing our mortgage payment?"  The second method worked much better than the first method, lol.  Increasing the payment also put the breaks on other spending because the money was tied up.

 

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