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What Greenspan Missed

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October 09, 2010 – Comments (2)

Rosey has a post on how Greenspan's attention has turned to the debt load and the deleveraging of debt.

He was in the most influencial position in causing this problem in the first place. 

Lowering of interest rates giving a declining benefit and hides problem.

I am still not sure that people get it as to how interest rates played a roll in beliefs and how those beliefs were very short sighted.

Lowering interest rates only benefitted people with existing debt who were able to refinance at lower rates.  It probably also benefitted the banks that were able to increase profits by charging a penalty which gave a much larger return in the short term at the expense of the long term.

I have referred back to Low Interest Rates:  As Destructive as Usury many times.

The conclusions from the analysis are:

1) At higher rates people are incredibly empowered to reduce their overall debt burden with just making very managable increases on their mortgage.  A 10% increase in mortgage payment when mortgage rates are 10% saves $56k of interest per$100k of debt.  This is huge.

2) At low interest rates increasing payments does little to reduce overall debt burden.  By comparison, a 10% increase in payment when rates are 4% only saves $9.4k per $100k of debt, or about 1/6th the benefit. 

3) Lowering interest rate can result in large reductions of payments at high rates compared to lower rate.  A rate change from 10% to 9% can lower payments by about $70 per month per $100k whereas it is about $54 per month per $100k of debt going from 4% to 3%.

4) At higher rates, 10% compared to 4%, a 25 year term can be reduced to 20 years by simply increasing the payment by 6.2%.  At 4% the payment must be increased by 14.8% to knock 5 years off the term.

All of these things make getting out of debt much more difficult based on the policy of debt servicing being to a certain percent of income.  Clearly a very rudimentary analysis shows that as rates have declined, choices about how to manage and reduce debt have drastically declined.

This is further compounded by in a low interest rate environment you expect less inflation and therefore less in terms of wage increases.  My parents generation had a number of years where wage increases were huge.  If you had fixed debt your debt burden relative to income changed dramatically.

If prices actually stayed the same, low interest rates would have been an enormous benefit for everyone and for the economy.  However, it is only a poor application of math that allows borrowing percent of income to remain constant through declining interest rates.  Indeed, it seems that the percent of income for debt financing was actually increased through the declining rate environment, which was insanity on top of incompetent analysis of what lending policy through declining rates ought to have been.  Income allowed for debt financing ought to have decline by 1-2% for each 1% decline in interest rates, with 10% at 30% of income being the starting standard.  So by 4% you can only borrow to debt servicing levels of 24% of income.  

 To borrow $100k at 10% if you are allowed 30% of gross income, you income has to be $35,100.  At 4% with 24% of income you could borrow $147k.  Without the decline of income the amount would have gone up to $183k.  Clearly even with reducing the amount of income you could use for debt servicing as rates decline would still lead to some asset price inflation, but in at $147k the person's payments are actually 20% less so there is that room in the household budget to reduce debt and choices remain.  I didn't take into account some of the things that are expected to be included in the 30% of income, like taxes or utilities or strata fees.  I just looked at the loan.  In this example even though more is borrowed, the payment is $877 in the 10% example and $702 in the 4% example.

The beliefs that I found to be false in my lifetime were:

1) You payment relative to wages declines over time (try zero increases for 14 years and then a 23% decline in income).  The truth that I found was other costs of living that increase gradually squeeze your disposible income over the years when income is utterly flat and costs are increasing.

2) Low interest rates make homes more affordable - not when home costs increase to the same percent of income.  The difference here is that low interest rate home buyers tend to be debt slaves because of the lack of empowerment for lowering debt, as explained above.

3) Housing is always a good investment - we've seen how that turned out for some people...

2 Comments – Post Your Own

#1) On October 10, 2010 at 8:56 AM, blesto (31.64) wrote:

Amen sister!

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#2) On October 10, 2010 at 6:55 PM, dwot (97.03) wrote:

And something else, this policy of a percent of income for debt servicing, that policy was also set in an environment where relative debt was declining.  I would suggest in a static world, where you didn't have any inflation, that percent being allowed to go to debt servicing is too high over all.  The only reason it worked was because of rising wages relative to debt.  I heard my parents generation advise several times, "It is only hard the first few years because it gets easier as your wages go up."  Well, I spent my adult life in a relatively flat wage environment and I can't imagine what kind of financial trouble I'd have been in had I'd come anywhere near to what the banks would have loaned.  I don't think we ever went over about 60% of what banks said we qualified for.

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