The Finance Gourmet

Personal Financial Advice from a former Certified Financial Planner

Return of High Risk Mortgages

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There was a recent article over at CNBC about high-risk mortgages and their resurgence, sometimes at the hands of the very same players who offered them before the big banking crisis and subsequent recession of 07-08. Of course, it’s easy to wring your hands and worry, “Here we go again,” but before you do that, take a closer look.

High-Risk Mortgages Are Not “Bad”

There is nothing wrong with a high-risk mortgage. Just like a no credit credit card, a high-risk mortgage has a greater chance of defaulting than one given to lower risk borrowers. However, that isn’t inherently a bad thing.

sub-prime mortgages again

On a macro level, the credit markets work a lot like the insurance markets. Take life insurance, for example. Some people are going to die, and you are going to pay out on those policies. However, as long as the premiums you take in from everyone exceed the amounts you pay out, the company profits. Everybody wins.

Similarly, with high-risk home mortgages, you know some people are going to default. Again, as long as your portfolio of mortgages collects more payments than you lose through defaults, you win.

This is how the entire bond market works. Risk is fine, so long as you properly price your risk.

The problem last time around was everyone looking the other way when things started getting dicey. For example, when AIG stopped insuring mortgages, that should have plugged up the market for resales, and thus severely reduced the availability of that type of mortgage. However, people at the major brokerages figured out a way around that by selling the mortgage securities to their own companies to different divisions. The incentive to do so was to share the seller’s bonuses with the buyers. This is essentially a bribe, and it’s a pretty big failure that management did not see, or do anything about this.

Theoretically, there are some things in place to stop this from happening again, not the least of which is senior management who won’t look the other way this time. While this isn’t legally required, the old plan was for the CEO and his circle to let the business make money. Most of those guys are gone, their brokerages swallowed up by “gasp” banks.

The new captains aren’t looking to go down with the ship this time around.

The other big issue last time were the ratings agencies slapping AAA ratings on everything. This time around, only one rating agency is even rating mortgage bonds right now.

It’s The Economy Stupid

The real problem of the great recession was, as is always the case, the economy.

While there were some seriously dodgy mortgages last time around (negative amortization, for example), the vast majority of people who took out a mortgage, sub-prime, or no, took out one where they could make the payments on the day they got the mortgage. The problem wasn’t the mortgages, but that those people started losing their jobs, and couldn’t find new ones.

The issues with the mortgage markets exacerbated the otherwise natural downturn in the economy.

Until people are attending fix and flip seminars looking to buy “investment properties” they can’t hope to afford without tenants who never miss a single month’s rent, having a sub-prime mortgage market isn’t necessarily a bad thing.

No Criminals

If there was one complete failure in the problems of the banking system from the Great Recession, it was the Obama administrations total failure to prosecute even the most egregious cases. Ironically, it wasn’t the guys offering subprime mortgages that was the problems, it was collusion within brokerages, the abdication of duties by the ratings agencies. Just a dozen guys serving 18 months in federal prison could have saved us a lot of trouble the next time around.

The next time, incidentally, will come same as it always does, on the heels of a too-aggressive Fed puncturing an economy that is already letting the air out.

Sound familiar?

 

Rate Hike Dead for 2017

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Ding, dong, the rate hike is dead. (Or at least is should be.)

What should have been obvious since the beginning of this year to anyone who wasn’t trying to burnish their “hawk” credentials became undeniable this morning. Inflation is non-existent, jobs are faltering, and the economy is most definitely not overheating, even if you think the stock market is.

Durable Goods Orders Crater

Earlier this year, the Fed was looking at three, or maybe even four interest rate hikes. They pulled the trigger twice in 2017, with a rate increase in March, and another in June. Ever since then, however, the economic numbers just don’t support another hike. They never really did, but Fed officials glossed over that problem by saying the numbers were temporary.

durable goods report bulldozer

With every new economic number to come out, however, it looks like those numbers were not only not temporary, they were part of a growing trend of an economy that is already slowing down, and maybe getting ready to reverse. Instead, it’s the “good” numbers that look like they were temporary.

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After a big increase in June, orders for durable U.S. goods fell 6.8% for July, suggesting June’s big number was the temporary number. Combine that with the fact that inflation nowhere near the Fed’s 2% target, and you have to keep asking yourself, what is the point of more rate hikes to stop non-existent inflation, and an economy that is most definitely not overheating?

Why Raise Rates in 2017 Still?

The answer is two-fold.

The unfortunate part of the answer is that there is something of an unwritten competition between certain kinds of economist as to who can be the bold on interest rates. They love being called inflation hawks, because that seems like the more responsible position. It’s kind of like the stern parent telling you to take your medicine because it is good for you. But, just like taking antibiotics when you aren’t sick is neither strong, nor prudent, raising interest rates in an economy that doesn’t support such increases is foolish.

The second reason for raising interest rates is to reload, so to speak.

The Fed’s primary tool for boosting a sagging economy is to cut interest rates, but you can’t get blood from a turnip.

With interest rate so low already, there simply isn’t room for much cutting. Sure, the Fed can snip back another 0.25% a few times, but that won’t do much in the face of an economy that slumps in what is still already a historically low inflation environment. And, with the Fed’s balance sheet already astronomically large, there aren’t a lot of non-interest rate tools left either. This is at least a sensical argument.

Damned If You Do…

So, here’s the dilemma. Raising rates may trigger the very recession that would necessitate cutting rates in the first place. In this case, not raising rates is the much smarter move. However, the expansion we are currently in has been a long, if tepid, one. The cyclic nature of the economy suggests that a contraction is coming sooner or later regardless of what happens in interest rates. In this case, reloading the Fed’s weapons makes sense.

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For my part, I follow the maxim, “Don’t borrow trouble.”

There is no economic overheating, and no inflation, so don’t go worrying about what you will or won’t do when and if trouble comes. Instead, manage the economy for as much solid growth as possible and let the universe sort out when the contraction comes. A few more years of reasonable accommodation might just give this expansion another three or four years. In that time table, plenty of well-timed rate increases will reload the Fed’s arsenal, without prematurely puncturing the wheels of expansion.

 

Economy Slowing Down?

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Only have time for a quick and dirty update, so here goes.

It may not be the most accurate of headlines, but there were a couple of interesting numbers out today, especially when it comes to the hawks and doves inflation battle, so I thought it would be fun to take a break from all of the doomsday articles about the stock market.

Still No Inflationary Pressure

It seems that inflation is falling (not rising), countering the theory that such a drop in inflation earlier this year was only temporary.

Oh, and jobless claims are up.

In other words, the inflationary pressures are still not there.

All of this adds up to a Federal Reserve that might just be figuring out that there is no need to raise interest rates any more this year. (And the previous increase was probably unnecessary as well.)

This goes double if geopolitical trouble (Trump v North Korea) spooks business and investors.

It may turn out that this global instability is just the pinprick the stock market needs to head back down for a correction. If so, remember that it wasn’t any stock chart, or Shiller PE ratio, or super-duper analyst investigation that said it was time for markets to go down. It was, as is so often the case, completely unpredictable news events that shook investor confidence enough to trigger a selloff.

Mortgage Rates Climbing

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Mortgage rates have ticked up in the this month. Despite stories saying that rates have “jumped” the rise has been rather tepid, and still hasn’t taken rates back to their post election highs in the 4.25% range.

Rates had peaked back in January when some analysts still suspected that Crazy Trump was all an act and that the newly elected President would settle into the office as a regular business-friendly, regulation-busting, Republican. However, the Russia scandal has plagued the administration and health care has twice stalled out, pushing any pro-business legislation off. As a result, rates have basically trended eastbound and down, if you will.

Do Mortgage Rates Really Matter?

It’s always dangerous to say, “This time it is different,” in the world of finance. Such sentiments are typically used to justify things that should not be justified. However, is the world really different this time around with regards to mortgage interest rates?

rising mortgage interest rates

Consider that rates are still historically low, and that they will continue to be so long as they stay below the 5.0% to 5.5% range. A full percentage point is several Fed interest rate hikes away (a year… two?), or an economy that shakes off its slow motion ascent and plunges into overheating mode. Consider also that the limiting factor for most new home owners has become the purchase price.

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With too many homes, costing way too much, the interest rate on the mortgage isn’t the factor it once was. A young couple starting out that might be able to swing a mortgage payment on a new $300,000 house at 3.75%, but not at 4.0%, for example, would indeed have to watch mortgage rates carefully. But, with so few $300,000 houses on the market, they may be priced out by the fact that the only houses that currently meet their needs start in the $500K range. That being the case, mortgage interest rates are entirely moot.

In addition, mortgage rates have been so low, for so long, is it really plausible that anyone who wished to refinance at the least lower rates (and has the means and credit to do so) hasn’t already done it?

Equity and Refinancing

What that leaves in the world of finance is those people who take equity out of their homes as part of an overall mortgage refinance. (There are also those who use different products such as a home equity loan or line of credit, but those products use different interest rates.)

These are the people who may truly be impacted by rising rates. However, even in this case, the limiting factor is often the amount of equity, and not the ability to make the payment. Consider a couple looking to remodel (the most common reason to refinance) that has $50,000 in borrowable equity, on a 30-year fixed mortgage. Assuming they aren’t trying to do some sort of 100% finance (which would be different rates, as well), chances are that they have been paying on a mortgage that had the same balance that they will have after borrowing already, likely at a very similar interest rate.

In this case, the ability to borrow the $50,000 has little to do with whether the payment is $1,850 or $1,900, and everything to do with if they qualify and the amount of equity they have.

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In other words, mortgage interest rates may not have the same pull on the economy this time as they have in the past — and may again in the future.

The Fed and Mortgage Rates

The real story in all of this is the slow rise in interest rates from the Federal Reserve, as well as the potential unwinding of some of its “extraordinary stimulus” measures. The banks will feel the main impact as the ease of generating a profit from lending funds against an almost zero interest rate cost will require raising rates that may not be able to be raised.

Many credit cards rates are already in the low to mid 20%. Raising them by saying, “Hey, it’s just Prime + A Number,” will only work for so long. Interest rates in the 30% tend to be unacceptable to regulators, and customers alike. The profit spread will therefore tighten, which might make things more difficult for banks in the short run.

What nobody will say, but everyone knows, is that the banks haven’t had to compete in a “real” fiscal environment since 2008, and they may have forgotten how. The result could be either sliding bank profits, or customer gouging, neither of which is a great foundation for a growing economy.

As always, a diversified portfolio is best for long-term investors, but if you use a very fine diversification process, or you have some medium trades going on, it’s time for a second look at your financial holdings. In the short-term (next six months), we aren’t there yet, but be sure to watch like a hawk after the next two rate increases.

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