Wednesday, March 30, 2011

Some Follow Up on Credit Markets and Today's Presentation

Interest rates were indeed quite high in the late 1970s - early 1980s, but the practice is usually to distinguish between nominal interest rates and real interest rates with the latter equal to former less the rate of inflation. Real rates were quite low in this period (which is typical for an economy in recession). When I was in grad school my classmates and I would often talk at lunchtime about whether the real rates were negative and if that is even possible (it is) and what that would mean. At a macroeconomics level economic growth requires a positive real rate. You can work through the rest. I mention this because the table that was presented for 30 year mortgage rates presented nominal rates only.

One of the things we didn't talk about today is refinancing. It warrants a mention. The underlying economic question is when there is a long term loan and there is a risk that interest rates will vary during the term of loan, who bears the risk? In the case of a fixed rate loan, borrowers make out if the interest rates rise in the future but still during the term of the loan. One might think that it is the lenders who make out when interest rates fall, and if the variation in rates is small, that is true. But with larger declines in the interest rates borrowers might refinance. That means paying off the old loan in full and taking out a new loan (incurring the various origination charges with that) and securing a lower rate in the process. With refinancing a possibility the lender for original loan can't expect to make out when interest rates fall substantially, the same way that borrowers make out when interest rates rise. But now some caveats on that.

Every mortgage I've ever had has allowed prepayment in full at any time during the term of the mortgage without penalty. I take that to be the norm for mortgages with borrowers considered a safe bet to repay the loan. But some mortgages have stiff pre-payment penalties. The ones which have early teaser rates but rates rising in the future may be in that category. This is a way for those lenders to assure they get back the interest they gave away with the teaser rate (and then some). There is nothing fundamentally wrong with pre-payment penalties providing the borrowers understand them and their function.

There is also a second issue about whether the individual can qualify for refinancing (has the requisite income and other desiderata). For many of the troubled mortgages that resulted after the burst of the housing bubble, quite a few of the homeowners couldn't refinance under the existing rules, even as market interest rates declined substantially as the Fed tried to pump money into the economy.

Because of the crisis, one might argue that the typical rules should have been suspended to allow these homeowners to refinance as an alternative to having the bank foreclose on them. There is a very provocative Op-Ed piece in today's New York Times by the former special inspector general for the TARP program, Neil M. Barofsky. Since he just stepped down from that position one can imagine there's quite a lot of inside baseball behind the decision to write that Op-Ed piece. It needs to be interpreted as such. Nonetheless, the message is interesting to read. TARP was supposed to encourage these bad mortgages to be renegotiated, but in may cases it didn't do that.

Let met close with a point about education for using credit wisely. There is a significant question about what is possible in this regard from the point of view of timing the education versus when the need to know arises. If you have classes on this too early, before you are using a credit card with consistency, the education may go for naught. My guess is that the right time for most of you would be between the Freshman and Sophomore years or when people move out of the dorms and get off meal plans. I wonder if a purely voluntary training specifically aimed at using a credit card while staying on a tight budget might have lots of takers. I don't know. It seems to me an interesting possibility. It also occurred to me after listening to you discuss not monitoring your credit card spending, and what I suggest here may be difficult to implement because of the security that's needed, but a smartphone app that popped up once a day with your recent credit card spending might do the trick. If having that were a way to attract customers, the credit card companies themselves might offer it.

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