Thursday, June 09, 2005

Interest Rates

I've been thinking an awful lot about interest rates recently (for reasons that are mostly personal) and believe that the current environment will end badly. Hopefully not too badly, but badly just the same.

I think we were spared the depressing effects of the stock market bubble bursting due to the stimulating effects of a low interest rate environment. This environment led to the current housing bubble and a belief that adjustable rate mortgages were a great thing. When interest rates are low or falling ARM's are a great thing - you get a low rate and capture the benefit when it falls. It lulls you into a state where you feel you can afford a much larger house. The problem that most people don't realize is that their expectation that rates can both rise and fall is limited by the fact that rates are really just about as low as they can go.

When the discount rate is close to 0 and the spread between mortgage rates and Treasuries is so slim there really is very little room for a downward trend. This means that at best rates will stay near the same (the current state of affairs) but that is unlikely to last for an significant period (two years at the outside). Couple this with the possibility that the demand for investment picks up then rates will start to leap.

Once that occurs, those people that are highly leveraged into their homes and were at the limit of their finances will be forced to sell their houses. Just as with a demographic bubble those early ones will be the beneficiaries and may survive with their wealth intact. Unfortunately, the resulting depression of housing prices will force those that miss that early sell-off to lose money and potentially to go bankrupt. I find it interesting that the financial industry used the preceding bullish years to push through the new laws limiting consumer rights.

The implications for the economy are not good and my suggestion to you is, unless you are of substantial wealth, that you stay away from ARM's and their kindred.