Did you catch the story from last week where former Fed Chairman Ben Bernanke told an audience at a Chicago conference that he recently tried to refinance his mortgage and was denied?
After all I’ve written about Dr. B. you didn’t think I was going to let this story slip by did you? It’s too juicy to pass up, but don’t worry, I’ll keep it clean.
Bernanke attributed the rejection to mortgage lenders tightening credit conditions too much. That may be true, but I would like to offer an alternative explanation that the academic minded Bernanke (and his former Fed colleagues) may be overlooking.
While the Fed’s intention in holding interest rates at zero for six years is to stimulate lending, counterintuitively it actually makes lending riskier. Why?
Let’s say I lend a business money when the Fed has rates at 4%. I tack on 2% to compensate for the credit risk, so I’ve lent at 6%. Assume a year has gone by and the economy has taken a turn for the worse. Recession is on the horizon. What happens to my loan?
The risk that I’m not going to get paid back rises during recession. Which means that the spread on a new loan to the same borrower that I lent money to might now be 3% instead of 2%. But, and this is the key point, during an economic downturn, risk-free interest rates fall as the Fed lowers the Fed Funds Rate. Let’s say the Fed cuts interest rates to 2% as recession approaches.
Now I own a loan or a bond as the case may be, that pays a 6% interest rate, but the same loan should pay 5% today despite the higher risk of default (the lower 2% risk-free rate plus the now higher 3% credit spread). Since bond and loan prices move inversely to yield, my loan has actually increased in value even though the risk of default on it has risen.
If I am a lender when rates are at normalized levels, I know I can always be bailed out by lower interest rates so I might be more willing to lend. When interest rates are at zero and credit spreads are at historically tight levels as they are today, the calculus changes.
If I underprice a loan today, lower interest rates aren’t going to bail me out because they are already on the floor. That makes lending riskier and it could be contributing to the tight credit conditions that Dr. B and others are still reporting more than five years after the official end of the last recession.
Jeremy Jones, CFA
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