Should Bernanke raise or lower rates?

Who are the biggest losers in the current economic mess in the US? What should people do? What’s the FED to do? Should it raise interest rates? Or should it lower rates?

Much has been said and written about the current housing problem in the US. We now know that this was brought about by mortgage bankers who encouraged borrowers who could not otherwise afford the debt servicing to take out housing loans. These were taken out by enticing so-called sub-prime borrowers with low little to no money upfront, coupled with low introductory rates on the loan that they COULD afford. These special rates normally lapsed after two years.

At the end of two years, regular rates kick in. But this loan structure was pushed to the borrowers on the assumption that when the two year special rate period lapsed, the market value of the house would have increased (These loans were offered during the peak of the housing boom). If and when the house’s value went up, so the belief went, the added market value of the house would amount to additional equity of the borrower on the house. With the added equity on the loan assumed into the loan structure after two years, they all figured that the borrower would qualify to keeping the low rate on the loan.

But the housing boom ended. Interestingly, it ended just when rates first started to go up. And that couldn’t have happened at a more inopportune time. It happened just when investors were starting to get skittish on the loan structures, when a lot of newly-built homes were getting into the market, and many borrowers had already taken up on the “innovative” structure.

When rates went up, it ended the long line of speculators lining up to buy and flip houses. Thus, house prices started to go down. There suddenly was a glut of houses on the market.

When house prices started to go down, this unravelled the very assumptions of the loan structures. When the special rate period started coming due on the first sub-prime loans, the rates of the loans did not go down or even stay put. They went up. At the end of that period, many borrowers simply still did not have enough equity on the house yet. And because houses prices went down, for many of these homeowners, the amount owed to the bank was suddenly much higher than the price of the house itself.

So what is a homeowner/borrower to do? Just imagine yourself with a loan you can’t afford, taken out to finance a house that is now worth even less than the loan itself. You had barely put in equity in the house to begin with because of the loan structure, and all that was to lose was the little money put on the house during the special period. What are you to do? Unless you were back in the street if you defaulted on the loan and let the bank foreclose, you did not have much incentive to continue the loan. In many cases, EVEN IF the borrower would end up on the street upon default, they simply could not afford the loan anymore.

Thus the housing problem started. The more people defaulted, the more houses were put on the market (after foreclosure), the more house values went down, the more people ended up with loans they could no longer afford. This is what we learn in Economics 101 as a vicious cycle.

Now this housing problem is being punctuated by the recent run-up in inflation. Oil prices are going up. Food prices are going up. And just about everything else is getting more expensive as a result.

The Fed’s initial solution to the housing problem was to lower interest rates. This was meant to put a backstop to the vicious cycle of people simply allowing their mortgages to default and further exacerbating the housing crisis. This was meant to make the investors and lenders less skittish and start providing capital to the market again.

But Economics 101 also tells us that when there’s a run-away inflation on hand, the Fed is supposed to increase interest rates. This is meant to put a clamp on capital, and to minimize the velocity of money. With higher interest rates, less companies and individuals take out loans to finance inflationary activities.

But again, there’s still the housing problem to take care of. Higher prices would further exacerbate the vicious cycle of mortgage defaults and house foreclosures.

What’s the Fed to do ? Who suffers if its raises rates? Who suffers if it lowers rates?

For reasons already pointed out, if it lowers rates, inflation is believed to stay, putting a damper on everyone as the price of everything goes higher. If it increases rates, it will make the already long-suffering sub-prime borrowers suffer even more. And it would make the already skittish capital providers withdraw more capital from the market, thereby making the cost of funds more expensive for everyone, including companies and individuals with the best credit scores.

Looks like Bernanke is in a real bind. No matter what he does, he’s bound to make a significant group of people very unhappy and to think this mess was created long before he came to the Fed.

What do you think he should do?

My best guess is that if Bernanke raises rates, the effect of further crimping the capital markets and causing more sub-prime defaults is the much greater evil.

Why? Well, with oil prices going up, everybody’s costs are already going up significantly. A rate increase gives further cost pressure on everyone, particularly those who are of good credit, but cannot otherwise avoid some form of debt in the course of doing regular business.

And with the sub-prime mess already significantly pronounced on the American economy, a low rate will not necessarily cause another run-up in borrowing to finance both speculative and legitimate investing. Banks are still too much in the red to simply lend more. To lend more means that they need to raise more capital to maintain the approved capital adequacy ratios to do more loans.

And companies simply are already saddled with too much costs now, with the price of oil eating into their margins. To add more cost by borrowing at this point in time is tantamount to a reckless bet on both the company’s and the economy’s future. Both finance officers and bankers should be conscious of the increased dangers of providing more capital to a company that has decreasing profit margins, and in a lot of cases, losing sales due to decreased consumer spending.

So with this assumption (I admit this is another assumption, much like what the mortgage lenders assumed into their loan structures), a decrease in rates will not cause as much damage as feared.

An increase in rates however – well, you can just imagine the further damage that might come from our vicious cycle going into hyper-drive. A rate increase will also likely result in more companies closing shop, putting more people on the street, and maybe putting the vicious cycle into ultra-drive.

Which is not to say that I favour a lowering of interest rates. After all, the further the Fed lowers rates, the further depreciation there will be on the US dollar, the further will US inflation be exacerbated. (How many times have I used this word today?)

Maybe the best is for Bernanke to just stay put. To just – how did they say it last year – hover like a helicopter.

But then again, I am not Bernanke. I do not see what he sees now. Who knows? We might just see another drastic volatility coming up sometime soon.