In the late 1970s, America was experiencing a period of stagflation. High unemployment, high inflation and high interest rates. The Fed was trying to fight the inflation by raising interest rates. Rates for durable goods, such as cars and homes were over 20%. The interest rate solution was part of the problem, where monetary policy was part of the solution. Interest rates were so high, that economic activity was stifled. The Fed eventually had to respond by flooding the market with new dollars. With money to lend, banks had to respond by lowering standards so that more people could borrow money. But with interest rates so high, it was worth the risk.
Failing to tighten standards once interest rates became low again is one of the causes of the current economic situation. The reason is that the higher the interest rates, the lower the risk of lending to someone. The lower the interest rates, the higher the risk.
Interest rates today are low, and than means the risk of lending to someone, anyone, is very high. If anyone has tried to purchase a home, recently, they know how difficult it is to qualify. The bank who loans the money for a mortgage has very little room for error.
The conventional wisdom is that lower interest rates spur borrowing. But interest rates that are too low do not spur lending. And that is what is happening today.
The Fed has been keeping interest rates low to spur spending and borrowing, but it is not the Federal Reserve Bank that assumes the risk. Foreclosure is the first big risk that a bank takes when underwriting a mortgae. If there is a 15% chance that a home is going to go into foreclosure, then there is a 15% chance that the banks will lose. Foreclosure is expensive. It involves court costs and legal fees. Homes in foreclosure will sell for a reduced value. It is often doubtful that banks will recover the difference. The only way that banks make money on a foreclosed property is if property values are increasing. Often, the bank takes a big hit on a foreclosed property, even if values are increasing.
The second problem is the rate of inflation. If the inflation rate is 3%, and mortgage rates are 3%, then the bank will still be at a loss due to the cost of processing the mortgage. If the inflation rate is 5% and the mortgage rate is 2% then the bank loses, even if the borrow pays on time.
FHA exists to help banks mitigate the risk. But the real mitigation comes from having the interest rate more closely tied to the rate of inflation. It may sound counter-intuitive, but the fed needs to let interest rates increase gradually. Not back to where they were, just enough to spur lending. It may discourage some people from borrowing, but if more people can borrow, who will notice?
It's just like a friend told me. We needed some tightening in lending, we needed lower interest rates, but the pendulum has swung too far in one direction. It now needs to swing back. Not all the way to where it was. It just needs to retreat back a little.
One of the Fed Banks backs up this opinion piece.
Step 1--Fix the corporate tax structure.
Step 2--Interest rates and lending
Step 3--Energy
Step 4--Legal Reforms
Step 5--Outsourcing
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