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Banks are stupid for issuing fixed-rate mortgages when rates will increase.


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2012 May 30, 5:07am   4,420 views  12 comments

by EconPete   ➕follow (2)   💰tip   ignore  

When interest rates go up to 5.5% from 3.5% banks will be losing a full 2% on their fixed-rate investments. Why did banks ever issue long-term fixed-rate mortgages based on the short term decline in interest rates, did they forget that they are in the business of managing risk? These banks, or the people who purchased these mortgages after the fact, are in for huge losses once interest rates increase. Interest rates may not go up next year or in five years, but in ten years interest rates will have to restore to their average.

Can the banks not remember 40 years ago when interest rates did something other than decline? Fixed-rate mortgages are amazing for bankers when interest rates are falling because the bank gets a higher return until the mortgage holder refinances. When interest rates increase, a fixed rate mortgage is a banker’s enemy. Banks will steadily lose money holding on to these low interest fixed-rate investments.

With the federal funds rate a 0.25% banks have to know rates cannot possibly go any lower. This means that rates will either stay the same or increase, not many other options. So given the circumstances, it would be irrational to issue fixed-rate loans if you were a bank, there is no benefit. Are banks so used to getting bail-outs that they don’t even understand the core of their business model, risk management?

This is a prime example of moral hazard. Banks know they will get bailed out so they stop caring about the longevity of their financial transactions. The very fact that banks are not only providing variable-rate mortgages right now says they don’t care what happens after the mortgage is sold to Fannie or Freddie. They think “As long as the investment isn’t on my books, I don’t care.” And who is buying/backing the buyers of these faulty investments? Yep, the federal reserve. Wow, it sure comes full circle now.

I hope taxpayers are ready for more bailouts. Or, we could always turn “Japanese” and hold rates down for 15 more years!

#housing

Comments 1 - 12 of 12        Search these comments

1   Patrick   2012 May 30, 6:48am  

That's a great point.

The value of the mortgages held by the bank will decline as interest rates increase. They won't be able to sell the mortgages except at a discount, once rates increase.

2   PockyClipsNow   2012 May 30, 7:19am  

Thus rates will never increase significantly. Ever. (see Japan)

3   FNWGMOBDVZXDNW   2012 May 30, 7:28am  

The banks are selling the mortgages to Fannie / Freddy. Fannie and Freddy are taking all of the risk.

The banks are simply doing some paperwork, and collecting a couple of thousand dollars from Fannie / Freddy.

It seems to me that the retail banks understand the risk perfectly, are not taking it themselves, and are making easy money pushing some paperwork.

4   fewy   2012 May 30, 8:08am  

EconPete,

Your entire assumption is wrong, mortgage backed securities are complex financial instruments which are hard to price. First of all when interest rates rise bond owners don't lose money they just don't make as much. One way to hedge against rising rates is to service the mortgages. The general rule is that servicers take .25% of the mortgage as a fee, the service rights are usually traded separately from the MBS and it takes 12+ months to make money servicing a mortgage. In a falling rate environment banks(servicers) lose money when people refinance too quickly.

FYI: The 10 year treasury rate fell to the lowest rate in 60 years today at 1.625%, the 30 year rate is something like 2.7%. So a MBS investor is getting about 1% more on the 30 year.

5   FortWayne   2012 May 30, 8:51am  

I thought they sell mortgages within 2 to 3 years to FN/FR anyway? They won't care to hold on to them.

6   CashWillCrash   2012 May 30, 8:59am  

As we all know, banks unfortunately NEVER think about tomorrow. If they can make $100 today even if it costs them $100 Million tomorrow, they still do it. But interest rates have only gone down since 30 years and the government will do all they can to keep it that way with their $15,748,045,000,000 debt. Interest rates will never ever go up again, that's for sure.

7   FunTime   2012 May 30, 9:17am  

Although, the banks obviously benefit from interest rates going up too, right? So they're striking some kind of balance. I agree that the balance seems to mean a heavy interest in low interest rates.

8   nope   2012 May 30, 9:27am  

The logic of this post is beyond words for how wrong it is.

9   CL   2012 May 30, 9:41am  

Here is what I thought: say a sovereign wealth fund needed a "safe" investment, they might choose mortgage backed securities. A tranche of a MBS made up of safe loans could be sold off to one of these investors. If there are lots of entities vying for these investment vehicles the interest rate goes down.

It's not the banks money, nor any real interest of the bank's to worry about the long term profitability of the investor.

If the Sovereign, (or Insurance Company, or other large institution) stagger their purchases they can smooth out their investments.

In fact, if I recall correctly, the new wealth of China and India helped push the bubble along due to the securities being rated AAA and thus a legal investment for them.

(If I'm wrong, please tell me!)

10   lostand confused   2012 May 30, 1:49pm  

Japan is a good case , but most of their debt is owned by Japanese. Ours is owned by the Chinese.

11   MarkInSF   2012 May 30, 4:59pm  

Japan's rate is about 2.4%. Of course it can go lower.

I know there are lots of people on this board that still think Treasuries are a "bubble" that will pop any time, and interest rates will go up any time now. I have posted on this board for years and I've always been right about interest rates. I will continue to be right.

12   tdeloco   2012 May 30, 5:32pm  

EconPete says

Or, we could always turn “Japanese” and hold rates down for 15 more years!

We are not Japan. Japan always had a trade surplus for 3 decades (1981-2010), ending up with $1.3T in foreign holdings. This allowed them to keep borrowing at ultra-cheap rates. Well, those who follow MMT will probably argue that the central bank (BoJ) has good control over the rates. Interest rates may never go up. Fiscal repression is the name of the game.

Japan has a large trade deficit in 2011, so things are different now. If their trade deficit continues, their debt will continue to increase exponentially. They may resort to just printing money out of thin air. Either way, we cannot rule out a massive devaluation of the Yen (even if the rates remain repressed).

What puzzles me is why they didn't use all that money towards debt reduction. Japan's debt-to-GDP is approx 233%, but their massive foreign holdings can bring that down to a net-debt of approx 130%. However, I don't think they can dump their foreign holdings without strengthening the yen, and therefore widen their trade deficit.

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