@davidt1
RE:If banks don’t adjust rates up no one would lose their house, banks wouldn’t have to take losses on foreclosures, the housing market would be in better shape and the stock market would not slow down. This would be good for everyone, no?
Hopefully you have not been scared off of this page by some of the responses. Unfortunately you walked right into a community that deals with these things at a fairly complex level. Your question was kind of like: Why doesn’t the stoplight turn green when I approach? It would be so much easier for me because I would not have to stop. type of question. I am going to get very basic here to try to explain. The bubble primer does not cover financing and how the banking industry works. I hope the fellow Piggitonians don’t get too irritated here in my explanation. I am going to try to be simple. On a side note: davidt1’s question only re-enforces what I have said about the state of financial education in the United States.
First, and the most important thing to realize; Money does not come out of thin air. Only the Fed has the ability to ‘create’ money. Banks can leverage money based upon assets on hand(deposits) by loaning that money out (and pays a percentage of the money back to the depositor as interest – ie CDs Certificate of Deposits).
The most simplistic form of mortgage financing is where it comes from a bank, and the bank holds the mortgage for the life of the loan. Because that money came from people’s deposits at the bank, the bank will generally pay a interest rate into these peoples accounts for the use of the money. The bank effectively borrowed the money from your deposit to loan to someone for their mortgage. The mortgage holder then pays interest on the loan and you, as a depositor, get a cut of that interest because it was your money that was loaned out. What would happen if you had a choice between 2 CDs at different banks, one of them 3% and the other 5%. You chose the 5% because of better return. How would you feel if that 5% return suddenly became 2% on your CD because the person who was borrowing your money through the bank could not pay the interest rate?
The banks used to trade loan packages amongst themselves (peoples mortgages). This helped handle problems when people would close their CDs or transfer funds between banks. The fact that the trades were done within a small group also allowed the banks to keep the return rate on CDs artificially low (they would use your deposit in the form of a CD and pay you about 5%, while the mortgage that was funded by your money was paying 8%. The difference was profit for the bank (3%) on money they did not own). Around 1970 (I think I got the time period right), the ability to trade or pick up loan packages was allowed to the investing public. This closed the difference between what the bank would pay on a CD versis what it would earn on the mortgage (closed the spread). This process is known as securitization and produces such things as CDOs/MBS. It is also where the term tranche comes from.
Now we get to the whole interest rate deal and the Federal Reserve question. The Fed has 3 ways to influence the economy. Each of these ways has risks to the economy. The ways are: 1) increase money supply (print money). This is highly inflationary. 2) change the fractional reserve rate. This can put banks at risk of the fractional reserve rate is too low. 3) change the Federal reserve rate, ie. treasury interest rate. This is inflationary/deflationary depending upon whether it is an decrease or increase in interest rates respectively.
The Treasury Rate is also considered the Risk Free Rate of return. Risk Free because it is viewed that the US Treasury will not default on its debt. There is no risk of loss. If there is a risk of loss, you would expect to get a better rate of return to offset the risk of losing it all and getting nothing. If the Treasury Rate is 5% and a banks CD is 4%, you would be getting less than what could be had by a no risk investment in Treasuries (ignoring Treasury tax advantages). Therefore people with 4% CDs would want to cash those out and go for 5% Treasuries. This way, the Fed can push the return on CDs as well as the interest rate on Mortgages. Not mentioning the intra bank loan rates here. It adds even more complexity.
When it comes to ARMs, the bank is allowing the mortgage borrower the option of a lower rate, but with the risk of the rate going up should the Fed raise the Treasury rates. The bank has to anticipate what the Fed will do because very few CDs are 30year, but most mortgages are. They will need to make sure the return for their depositors is sufficient to keep deposits on hand to cover the mortgage. When a person cashes out their CD, the bank has to cover the withdraw from funds on hand/other deposits. Here comes the interesting part. You can see what the Banks think is going to happen to the interest rates by looking at the difference between 2/28 ARM interest rates and 30year Fixed interest rates for a high FICO score. The 30year fixed will be about 1% above what the Banks view as the average rate on Treasuries over a 30 year period (Note: This is an approximation)
