[quote=CA renter][quote:davelj][quote:CA renter]Thanks for your response, Dave.
It just seems like it would be easier to manage in a stagnant/falling interest rate environment, not so easy in a rising rate environment.[/quote]
Why does it “seem” that way? (Because it’s your preference?) Please explain.[/quote]
It seems that it would be easier to manage a portfolio of loans in a falling rate environment because the borrowers who were likely to default would be more able to refinance to lower-rate loans, eliminating **some** of the default risk (to the new lender) as their monthly payments would go down. The original lender would be made whole by the refinance, so potentially lower/no losses there. Additionally, asset prices would likely be higher so that they would have the equity to refinance (yes, there are other variables).
It would also be easier to manage because the higher-rate loans could be sold off for a better price if the lender thought the default risk was greater than the benefit of holding those higher-rate loans.
Also, assuming the mortgages had rates that were fixed at those higher rates, the lenders could borrow at ever-lower costs in a falling rate environment, increasing their spread.
Essentially, I would personally prefer to hold and manage bonds in a falling rate environment, rather than a rising rate environment.
Yes, the counterparty risk on those swaps is also a great concern, IMHO. One thing I do NOT like about credit swaps (interest rate or default swaps), is that it distorts the price of money in the open market. If the swaps are not traded on the open market, and/or if the price of swaps (and swaps on swaps) is not somehow made transparent, it masks the price of risk in the open market, which increases that “systemic risk” that everyone supposedly worries about.[/quote]
Ah, I thought you were specifically talking about the asset-liability/swap portion of the portfolio management process… which is no easier or harder if rates are rising are falling. But, yes, I’d say the CREDIT COST portion of the process is more difficult if rates are rising, but recall that rents, inflation and interest rates have a very high correlation. If rates are rising there’s a very good chance that rents are rising (as they are beginning to do in the multi-family sector)… which makes home ownership look more attractive because you can lock in your cost of housing. Go back at look at housing prices and rents during the 70s. What you’ll find is that prices continued to rise as rates (and rents) rose dramatically. Now, if rates increased by 200 bps in one year there might be an issue, but if it takes 2 or 3 years I don’t think it’ll be a big deal because most of the excess inventory will have been cleared out.
It is far easier to manipulate the value of credit default swaps than interest rate swaps. The latter are far more straightforward from an accounting standpoint and have been around for a couple of decades now. There’s always risk but I’m not overly concerned about them.
