…Low interest rates are a prescription for asset inflation. There are some uses for low interest rates in exceptional circumstances of limited time duration. There are dangers when they are used too long, or under non-exceptional conditions. We are witnessing the results of that right now….
Interest rates effects are similar to the truistic Laffer Curve (great insight, [snark]). At low interest rate everyone borrows, at high rates no one can or will borrow. The shape of that curve formerly was defined by the 4 Cs of Credit.
1. Character: The quality of desiring to pay debts when due (ALWAYS ranked first).
2. Capacity: The ability to repay debts as scheduled. (Essentially the free cash flow of the borrower net of primary obligations)
3. Capital: or the net worth of the borrower. (Does the borrower have other assets it can monetize to continue to service the debt)
4. Conditions: Aside from the above factors, what systemic risk (recessions, job loss, etc may impact the ability of the borrower to service the debt.)
When the party making the loan, is the party holding the loan, the 4Cs determine the shape of that lending curve. Low interest rates are NOT a risk, because lenders ARE at risk.
What happened here was not a problem caused by low rates. While there were bad actors taking out loans, their motivations are effectively irrelevant. What happened is that default risk was decoupled from the people who originated the loans. Once you decouple the risk, the 4Cs above become irrelevant at the point of loan origination.
Immediately, the banks and mortgage brokers sold off the loans, collecting fees in the process, and Wall Street mix-mastered them into structured investment vehicles, collecting fees in the process. Lots of incentive to ignore risk.
So from 50,000 feet, Tim is correct that low credit standards had an effect. But the reason why we had low credit standards is because we deregulated the basic stuff and never regulated the new, Wall Street Masters of the Universe stuff.
Without regulation you increase systemic risk (the risk that cannot be diversified away).
Without regulation, business plays a game of hot potato with non-systemic risk (the risk of the loans individually and in the aggregate).
Without regulation, the game will always end badly, and if you don’t want a complete frigging meltdown of the banking and financial system – which drives you into, yes, depression, from the rapid vaporization of asset value and the popped balloon like deflation of the money supply - the government has to catch the potato and and hold it, no matter how badly it burns. |
