The Myth That Lending Rates Rise in Response to Policies

There's a credit crisis going on right now. Credit is what you get when a lender lends money to a borrower. Therefore, any attempt to address any credit crisis is, by definition, going to affect lenders. For pundits of a certain political disposition, that's all they need to know. In one of the most annoying rhetorical tropes around, they take any kind of policy which might impinge borrowers or lenders, and immediately decree that it's going to have adverse deleterious effects. For a prime example of this, look no further than Peter Schiff:

Although there are mountains of uncertainty as to how the plan will be structured and implemented, there is no question that as lenders factor in the added risk of having their contracts re-written or of being held liable for defaulting borrowers, lending standards for new loans will become increasingly severe (higher down payments, mortgage rates, and required Fico scores, lower loan to income ratios, and perhaps the death of adjustable rate loans altogether).

According to Schiff, there is no question! None at all! But this is utter bullshit, and it's worth unpacking the reasons why, since the same argument is trotted out in all manner of other contexts as well. (Regulate payday lenders? Stupid idea! It will just make vital credit that much harder to find! Reform bankruptcy laws to include mortgage debt? Idiotic! Mortgage interest rates would certainly rise as a result!)

For one thing, it's worth looking at what the mortgage-lending industry did at the end of 2006, when subprime default rates started skyrocketing. Everybody expected underwriting standards to tighten significantly, but they didn't. It turns out that an industry as enormous as the mortgage industry takes a very long time to turn around, which is why so many bad loans continued to be written in 2007. If something as obvious as soaring default rates didn't result in much tighter underwriting standards, it beggars belief that something as marginal as this voluntary mortgage-freeze plan would do so.

Now it's entirely possible that lending standards are still unreasonably lax, and that they will be tightened in further. But that would happen anyway: it's got nothing to do with the mortgage-freeze plan. How do I know this? Because the lenders, who Schiff seems to think are going to be worse off as a result of this plan, are the people who came up with it in the first place! The plan is first and foremost in the lenders' best interest: it was designed by lenders for lenders, and the borrowers come second, not first. Are the lenders really going to punish themselves for their own initiative? Indeed, can Schiff point to a single lender who has said that he will be damaged by this policy or will raise lending rates as a result of it?

As for the "death of adjustable rate loans", that's not going to happen. What might happen is the death of teaser-rate loans with high prepayment penalties and rates which adjust to ridiculously high levels when the teaser period is over. And good riddance, if those things no longer get offered. But a simple UK-style adjustable-rate mortgage where the borrower pays a small fixed premium over Libor or Treasuries is a very good idea for both lenders and borrowers. As a general rule, no one should ever offer or take out a mortgage where the one-year adjustable rate, if applied using today's prevailing interest rates, is higher than the rate on a 30-year fixed mortgage.

And as an even more general rule, be extremely suspicious of anybody who tells you that a given proposal is certain to result in a rise in lending rates. That's a tired rhetorical device, and it has had precious little predictive success in practice.

(Via Carney, who's also guilty of false certainty when he says that the mortgage-freeze plan is a bailout, on the grounds that someone, somewhere, may end up losing money as a result of it.)

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