Got To Keep The Loonies On The Path

Recent news stories are enlightening me to a painful fact. Most people no nothing about finance. I am not talking about high finance engineered in boardrooms around the globe, but personal finance. Recently, we saw how investors (and some advisers) confused the word auction with maturity. Ignorance also exists on the financing side of personal finance. It turns out, many people do not understand how their financing vehicle of choice works. Many people have no idea how lending rates are set. While the detailed story is beyond the scope of a daily blog, we will attempt to she some light on the subject.

An article on the front page of today's Wall Street Journal discusses declining home prices. One person interviewed by the Journal was disappointed because he could not refinance his adjustable-rate mortgage into a fixed-rate mortgage and thought that the lower Fed Fund rates would cause fixed rate mortgage rates to drop.

What this and many other borrowers do not understand is that the Fed does not directly influence long-term interest rates. Long-term interest rates are mostly influenced by inflation data and expectations. This is evidenced by the steep U.S. treasury yield curve. Higher inflation is preventing long-term financing rates from falling further.

Another factor preventing the refinancing of adjustable-rate mortgages is that banks have more stringent lending standards. It is more difficult to qualify for a mortgage and those who can qualify are paying a higher spread over treasuries than in the past. This is not unexpected as banks are attempting to better quantify credit risk.

One has to ask the question: Didn't borrowers realize that adjustable-rate mortgages adjust? Most did, but believed (or were duped into believing) that if rates went up, they could refinance in to a low-rate fixed-rate mortgage. Few were concerned with home prices as they always go up, no? Why someone would gamble with their home is beyond me. Never risk the roof over your head. Buy a home you can afford with a fixed-rate mortgage and be happy.

Some politicians are voicing opinions about how to bail out homeowners and preventing home prices from trending even lower. Unfortunately, failure to let prices adjust to the forces of supply and demand (there is much more supply than demand) will only deepen and prolong the pain. This is making people loony.