[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.
