He says at about the one minute mark in this video that if the interest rate was anywhere near what it should be and it’s going to be, then “we would bankrupt most of our financial entities.”
Why is that? I don’t see the connection.
A large number of homeowners today have adjustable rate - pay interest only - type mortgages. Many are negative amortization type for the first 3 or 4 years before reset (payments don’t even cover the interest accrued monthly, causing mortgage principle to grow) and other mortgages have a locked in 3 or 4 year introductory teaser interest rate (interest rates below real market rates, granted to make it possible for people to buy that can’t afford the mortgage ). After the 3 or 4 years these mortgages will reset and have to be refinanced. I don’t even think lenders are even selling interest only mortgages anymore. For every 1% rise in interest rates, for the mortgage principle + interest payment to be the same, the house price has to decline 10%. Therefore, if interest rates rise then house prices will inevitably fall because people otherwise won’t be able to afford the higher payments. After the 3 or 4 year period is up (sometime between 2009 to 2010) and people’s mortgage rates expire, to refinance their mortgage and lock in an interest rate they need to have 20% equity in it. Meaning: if they had barely any down payment and the house has not appreciated in value greater than their mortgage (to give 20% equity), they have to come up with savings to pay the 20% down - in order to refinance. As interest rates rise and house prices fall the equity people have in their homes declines also. As prices fall, the amount of savings people have to come up with to make 20% down payment becomes larger. This makes it more difficult for people to refinance. If they can’t refinance and lock in a new interest rate then they will have to pay an interest rate based on the going market rate, which can be volatile and higher than what they’re paying now. If people can’t afford the new payments (which most people with teaser interest rates won’t) then they will just stop paying their mortgage and eventually lose their house. Then the loss due to mortgage default will fall on the bank’s balance sheet, which can lead to bankruptcy.
It will cause massive defaults, which would make the assets on the books of these financial institutions disappear right back into where they came from - thin air. The real asset value of these banks would be discovered, which would be just a fraction of its total liabilities.
Two great explanations. Thanks guys
Interest rates should be much higher, which would cub borrowing and hurt those that use debt to finance their businesses.
Just had a scary thought.
We are in deep trouble, according to the above explanations.
There are several possible scenarios:
- Govt, knowing the above full well, keeps interest rate down and hopes for the best. Looks like this is the current most realistic one.
What could go wrong? I heard that it’s bad, but I’m fuzzy as to why.
My first thought was because if it’s low everyone will borrow, and they can’t be turned away [though I don’t see why not]. Besides, I hear the banks have a lot of money right now in their vaults from the bailouts that they are afraid to lend anyone [cause no one can afford to repay the loan anymore].
So maybe the right answer is this: The govt cannot just declare “the interest rate must be such and such.” As this wiki explains, they deal with big banks that need money overnight, and if no other bank will lend Bank A at a low interest rate, the govt lends it at that low rate they decided on. Of course they have to print money to do this, because they have no money to lend otherwise.
Bottom line, a low interest rate means more money in the system, which means high inflation at some point.
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They can let slip the dogs of war to avoid runaway inflation, and not interfere with the interest rates. Then we have the scenario described in the elegant posts above, the big financial institutions going bankrupt. I for one strongly suspect this will not happen. The govt and the big banks are there to watch each others backs.
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The govt lets rates rise, as in 2, but throws in a huge bailout to the banks. Hey why not? We the people are used to it by now, right? Of course, to avoid total uproar in an economy where millions have no jobs, no taxes will be imposed to do this. Money will have to be printed. High inflation once again.
Of course, once there is high inflation, you can’t lend someone money with out charging hefty interest to cover the loss by inflation. So interest rates will have to go up. Which is why Peter said “As they willl go up.”
Fascinating stuff, analyzing how we are marching to zimbabwe.